Higher share of FDS can affect wealth creation

Though FD insurance cover has risen 5-fold, younger investors should use those to park short-term funds

The long-awaited hike in insurance cover for bank fixed deposits (FDS) was finally announced by the finance minister in the Union Budget. From ~1 lakh earlier, it has now gone up to ~5 lakh per depositor.

This hike alone should not, however, motivate investors to put more money in FDS, as poor post-tax returns, especially for those in the higher tax brackets, could affect their ability to build wealth over the long term.

The move comes in the aftermath of the Punjab and Maharashtra Cooperative Bank fraud that left over a million depositors in the lurch.

Banks pay an insurance premium to the Deposit Insurance and Credit Guarantee Corporation (DICGC) to provide this cover. In return, in case of a bank failure, the DICGC will, henceforth, pay each depositor up to ~5 lakh. However, bear in mind that the DICGC makes a payout only in case of bank failure and not in case of a moratorium or other restrictions imposed by the Reserve Bank of India.

Though the insurance hike reduces the risk on bank FDS even further, should it prompt you to bet more money on them? The idea behind investing in a bank FD is to pocket stable returns without taking too much risk. “The risk in bank deposits has always been on the lower side, and the current measure will further enhance the confidence of small and mid-level investors,” says Anil Rego, founder and chief executive officer (CEO), Right Horizons. For senior citizens, interest income up to ~50,000 is tax-free in a year, which makes this product more attractive for this segment.

FDS key disadvantage, however, is that interest rates, especially those offered by quality banks, are quite low. Abundant liquidity and low credit offtake could lead to banks reducing their

FD rates further.

For those in the higher tax brackets, post-tax income from FDS becomes quite low. Interest income is added to the investor’s income and taxed at the marginal tax rate. “For anyone in the 30 per cent tax slab, for instance, a 7 per cent FD actually offers just 4.9 per cent post tax. Hence, more money you lock in FDS, slower your overall portfolio will grow. You will struggle to beat inflation and meet your financial goals over the long term. It could mean not being able to save for retirement and having to continue working even in the 60s,” says Adhil Shetty, co-founder and CEO, Bankbazaar.

What then is the most optimal way to invest in FDS? “Pensioners should use FDS to generate assured income. Everyone else should use FDS primarily to keep their emergency funds and other money that may be required at short notice. Older investors may have a higher allocation to fixed-income instruments, including FDS, for the stability they provide. Younger ones should have a larger exposure to market-linked investments so that their money grows at a faster clip,” says Shetty. According to Rego, those in the higher tax brackets, who pay a surcharge on their income tax, should explore more tax efficient options like debt mutual funds, including the likes of banking and PSU funds (which have a lower chance of default).

Finally, the instruments you choose should fit into your asset allocation: 100 minus your age should be your equity allocation, and the balance should go into debt products. FDS should form a part of your debt allocation. Your choice of investments should also be aligned to your goals and time horizon. For instance, if you have to pay your daughter’s college fee one year from now, you should keep that money in low-risk bond funds and bank FDS.