ELSS - Utilizing the power of compounding

As the name suggests ELSS invests the whole corpus in equities. Proportions as high as 80-90% of equities are found in an ELSS Fund. It is a special kind of mutual fund that qualifies for tax benefits. Basically Equity Linked Savings Scheme is a mutual fund with a lock in period of three years and has a tax saving element. ELSS gives compounding returns as well as saves tax. It’s like, “Killing two birds with one stone”.

Time/Age is an important factor to be considered here. The following example illustrates just this :

Rajiv starts investing in an equity linked saving scheme at a young age of 23 years. He goes about his investment using a systematic investment plan until his retirement age of 60 years .He invests INR 8000 per month. Similarly Naresh and Sumith also start investing the same amount in an SIP of an ELSS at the age of 28 years and 33 years respectively up to their retirement age of 60 years. The rate of return is 9% per annum on an average.

What would be the amount obtained by Rajiv, Naresh and Sumith on retirement?

FV = A x (((1+R) ^ n) – 1)/R
A = Investment per month
Each of them invests INR 8,000 per month
R = Rate of return per month
The rate of return is 9% per annum or 9/12 which is 0.75% per month as 1 year has 12 months.
n = total number of payments.

The investment tenure is on a yearly basis and has to be converted into a monthly basis
Rajiv investment tenure = 37 years or (37*12) = 444 months
Naresh investment tenure = 32 years or (32*12) = 384 months
Sumith investment tenure = 27 years or (27*12) = 324 months

Rajiv corpus at retirement is calculated as follows:
FV = 8000 * (((1+0.0075) ^ 444)-1) / 0.0075
FV = INR 28366233.
Similarly one can calculate the corpus at retirement for Naresh and Sumith.
Please Note : Inflation is not factored in this calculation.
 

What conclusion does one draw from the above example?

Effects of inflation on one’s retirement plans

Inflation is the general rise in price levels in society and eats into ones retirement savings. Inflation kills the purchasing power of money. Let us assume inflation levels of 5% on an average over the time period.

Real rate of return = (1+ nominal rate) / (1+ rate of inflation) – 1
Real rate of return = (1+0.09) / (1+0.05)-1

The rate of return is 3.80% per annum or 3.80/12 which is 0.316 % per month as 1 year has 12 months.
FV = A x (1+ R) (((1+R) ^ n) – 1) / R
A = Investment per month .Each of them invests INR 8,000 per month
R = Rate of return per month. The rate of return is 3.8% per annum or 3.8/12 which is 0.316% per month as 1 year has 12 months.

Rajiv investment tenure = 37 years or (37*12) = 444 months
FV = 8000 x (1+ 0.00316) * ((1+ 0.00316) ^ (444) – 1 ) / 0.00316
FV = INR 77 Lakhs

One notices that inflation ate up most of Mr Rajiv’s returns giving only INR 77 Lakhs instead of INR 2.83 Crores. Similarly Mr Naresh and Sumith get returns of INR 60 Lakhs and 45 Lakhs.

One can conclude that the returns of Mr Rajiv, Mr Naresh and Mr Sumith were drastically different after inflation was factored in. Clearly inflation is a game changer of returns and is an important factor in retirement planning.