Big change in Small Savings Schemes

Small savings schemes were the simple investment options, with a government guarantee and almost assured returns on maturity. The returns were almost the same for the last decade. But recently, the finance ministry has decided to link small savings rate to Government security (G -Sec) market rates. Going forward, the returns on these schemes will be decided based on the market rate of interest. The old returns and the proposed returns for 2011-12 are given below:

Why government is interested in increasing the rates now?

Government has been spurred into hiking rates due to an alarming fall in the collections of small savings schemes. Though such schemes have been a hit among small investors the high deposit rates offered by banks have led to dip in small savings collections in the past 2-3 years. These funds are used to partially finance the deficit. Also, the present high rate of return is an ideal time for this switch over to market return.

Advantages to you

As per the changes, you can expect higher returns when the market rates are high as it is today. The pricing will be transparent and it will compensate for inflation during the high inflation period.

Disadvantages

Since, the returns are linked to the government security market rates, the return will come down, in case of a fall in G-Sec rates. Such a situation will be difficult for investors like senior citizens. Please note that market linked return is double edged sword and rate could fall to below 8%. In the past decade, 10 – year yield has fluctuated between 6-10%. So your returns from small savings scheme will also fluctuate!

You will get 8.6% on your PPF account now! But it can come down also!!

Most investors look at PPF as investment for retirement and thus want some assurance on returns. This evergreen option has become much more attractive after revamp. It has been bench marked to 10 year government bond yield. Your will earn 25 basis points higher returns than the benchmark. Raising investment limit for PPF from current 70,000 to 1 lakh is another significant change. This makes PPF even more attractive tool for retirement planning. The PPF scores over other small savings schemes as corpus is totally tax free.

National Savings Scheme – NSC

NSC was losing its sheen after the arrival of many tax savings instruments. Now the government hopes to revive interest in this one time best-seller by hiking interest rate to 8.4% and improving the liquidity by reducing the tenure from 6 years to 5 years.

5 year tax saving bank fixed deposits still score over NSCs. They offer high rate of interest, and the yield is also higher since the bank deposits compound on quarterly basis but NSCs are compounded half yearly. Bank fixed deposits are also more liquid than an NSC. If rates go up and you are locked at a lower rate, you can foreclose the FD by paying a small penalty. This option is not possible in case of NSCs. The only advantage for tax payer is that interest earned every year from NSC is also eligible for tax deduction under section 80C.

The newly introduced, 10 year NSC will have an attractive spread of 50 basis points above the 10 year bond yield. The rate fixed for this year is 8.7%. However since the NSC interest is taxable, this option is not as lucrative as PPF.

Senior Citizen’s Savings Scheme (SCSS)

The generous spread of 100 basis points above the 5- year bond yield given to SCSS is a boon for retirees.  This year they will get 9% but the returns can be higher if bond yields don’t decline till March of next year. However, bank deposits can be a better alternative because of higher retuns they offer to those above 60 years. If tax saving is not a concern, short term debt funds can be a better alternative. These funds invest in debt instruments and are far more liquid than other fixed income options. If interest rates peak out, then open ended short term debt funds can be an option.

So the revamping of the small savings schemes and the introduction of market linked returns is a big change in the way government schemes works. Interest rates would no longer be fixed for the duration of the instrument but instead will be market linked. This means that rates will change (as per the prevailing economic scenario) over the term of the instrument. But there is cap for the change in interest rates in a year. The rates will not change more than 100 basis points either way. This makes small savings a safer bet among other debt products.

Make sure you don’t invest blindly and analyse all the debt options before committing money.

PPF with the flexibility to invest any amount between 500- 1lakh in a year will continue to be an attractive option for long term investors.