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What's your plan?

Even if you have a sizable income and prudent habits, it's necessary, for a secure financial future

BY DEVANGSHU DATTA  

 

At 35, Kiran Kampani* thought the best investment would be to sink money into his small garment-retail business. His reasoning was logical: the business could expand, his four-year-old son would have something to fall back on and grow himself when he came of age, and in the unfortunate event of his untimely death, his wife, a home-maker, could take care of the business. He felt that buying insurance and investing in mutual funds was a waste of his money; it just allowed insurance companies and agents to prosper. So apart from a small recurring deposit with his bank, he had no other real savings. He rapidly expanded his business through online retailing.

But disaster struck in mid-2014, when there was a fire in his godown. Most of his stock was destroyed, and Kampani himself was severely injured. He spent the next six months on complete bed rest. The bank deposits helped, but the amount was meagre, as it didn't beat inflation. The huge uninsured stock losses meant that the family could barely make ends meet. Thanks to the benevolence of friends, Kampani, supported by his wife, slowly restarted his business. This time, wiser and better-advised by a financial planner, Kampani invested in health and life insurance. He built up an emergency fund and through diversified investment allocation and systematic investment, made a fresh start.

But financial planning is not a one-size-fits-all affair. Every individual and family has specific needs and a plan must cater to those.
Kampani's financial planner asked him to start here…

  • First work out the desired lifestyle and life goals and see what it will cost to maintain that over a lifetime. (Assume a regular life and retirement between 55 and 60.)  
  • Second, calculate how much of the current income must be saved and where those savings must be invested to earn the money needed to maintain that lifestyle over a lifetime.

Why is a plan needed?

The cost of living, or inflation, to call it by its proper name, is like a thief that steals savings. Over time, inflation can turn large incomes into pittances. Inflation is a killer because of its compounding effect. The best way to beat it is to find ways to make savings compound even faster than the cost of living. The minimum return on your investments should be able to combat the decreasing purchasing power of your savings. This leads us to the rules of personal finance:

RULE NO.1 : ALWAYS FACTOR INFLATION INTO FINANCIAL PLANS.

India has a history of high inflation. There have been long periods where inflation has compounded at double-digit rates. Between 2006 and 2015, inflation for consumers averaged out at 8.47 per cent per year. This implies that if you want to buy goods worth Rs 1,000 in 2016, and assume that inflation will remain at about 8.5 per cent, you'll be paying Rs 11,463 in 2046 for the same things. Ignore inflation, and you may end up a pauper in your old age, even if you have earned well and been prudent.

RULE NO.2 : LIST YOUR DESIRES, RESPONSIBILITIES AND LIFESTLYE ASPIRATIONS.

What do you want out of life? Look at both long- and short-term expenditure: a house, a car you change every five years, holidays abroad, designer clothes, a foreign education for your children, care for elderly parents, indulging your hobbies.

If you have reasonable goals, financial planning will help you achieve those. For inordinate riches, however, financial planning will not help, because extraordinary measures will be necessary. Once you know what you want, you can price it at current costs. Adjust these to an assumed rate of inflation to figure out the likely future costs. If you have expensive tastes you will need to earn more and take more risks.

RULE NO. 3 : PLAN WELL FOR A HEALTH OR JOB EMERGENCY.

This is the mistake Kampani made. There will be medical emergencies. There may be other unforeseen but unavoidable expenses. Allow for those with life and health insurance (see Rule #4 for life insurance).

For health, this will depend on whether you have free, easy access to the central government health scheme (CGHS) cover or work for a company with a health insurance plan. If it's the latter, you will still need a basic cover, as you may shift jobs, or decide to take a sabbatical. It's also helpful as you age. Sunanda Mehta*, 40, had a medical emergency when her father met with an accident. Since she had put his name down on her company group medical plan, she was able to get Rs.3 lakh to pay the bills. She combined this with a family plan that she had, to cover Rs 2 lakh more.

Maintain some easily tapped funds for emergencies, such as fixed deposits that can be broken if required and would cover between three and six months worth of basic expenses, if you are unemployed for a period. Add that to the expenses above.

RULE NO. 4 : DON'T MIX UP INSIRANCE WITH INVESTMENT.

Insurance would have tided Kampani over, helping with hospital bills (health insurance) and a sum assured due to loss of employment (a rider in a life policy). Insulate your financial plan with insurance. It is tax beneficial at the very least and it provides an umbrella for your family. Term insurance gives you the cheapest cover against death. You don't get your money back but your family will get the sum assured in case of death or in any other unfortunate situation covered under the plan. Or buy old-style "money back" insurance. This is relatively cheap: the insurer pays you a low rate of interest.

You should be able to reduce insurance cover as you age and your other assets grow. A thumb rule is to calculate your likely earnings until retirement and maintain that level of cover. For example, you can roughly calculate what you expect to earn in total during your entire working life, or what you might earn in the next five or 10 years. If you need to support your children for the next 10 years, seek that level of cover. As you come close to retirement, earnings expectation drops. So does the cover.  

Asset Allocation

This is critical and where a professional can help the most. Let's say, the individual knows how much she needs today and what she is currently saving. She must decide how to split up her savings and what assets to invest in. This is called the asset allocation mix. A young person (anyone who has at least 20 years of working life left) should have the majority of assets parked in equity (high-risk, high-return) with a relatively lower proportion of assets parked in debt instruments and very little held in gold. He or she, should have fairly high insurance cover. An older person should hold more debt assets, and less in the way of volatile equity assets and also less in the way of insurance cover. Exact proportions depend on specific individual needs and risk-appetites.

Different types of assets offer different levels of risk and different returns. Ideally, a portfolio should mix several assets to balance off the risks and ensure desired returns. Here is a quick guide to typical assets and the associated risks and returns.

Equity is high-risk and high-return and for the long term it is a must. In the long run, the shares of listed companies (equity) give better returns than any other asset class. But in the short run, shares are among the most volatile and risky of investments.

Consider the Nifty, which is the benchmark index of the 50 largest companies listed on the National Stock Exchange. In the last year (since January 2015), the Nifty is down minus 8.44 per cent. But in the last three years (since January 2013), it has given a compounded return of 8.5 per cent; in the last five years, of 4.5 per cent; in the last 10 years, of 10.36 per cent. In the last 20 years, it has given a compounded return of 11.4 per cent.

The tax treatment for profits from equity investments is also very liberal. Dividends are tax-free income. If a stock is held for over 12 months, the profits made from selling (long-term capital gains) are also tax-free. The safest way to buy equity is to hold the shares of many different businesses at the same time. That way, some of the businesses should always give returns. This is called a diversified stock portfolio.

The easy way to build a diversified portfolio is to buy mutual funds, which do this diversification for you. The returns from equity can be very large. But there is serious risk of loss of capital if the investor picks the wrong stocks.

Debt instruments are of different types, have differing interest rates and types of risk. The simplest is the bank account. A savings account carries a low rate of interest; fixed deposits carry higher rates, varying with time. Bonds issued by companies also offer different rates of interest.

There are other types of debt, which are difficult for individuals to own. For example, governments issue treasury bills and banks borrow from each other. There are mutual funds, which deal in these types of debt and an individual can buy units in those debt mutual funds.

The risk varies. Government debt is absolutely guaranteed. Bank fixed deposits are guaranteed until the Rs 1 lakh level and very safe in practice. Corporate debt can pay higher interest but it may be more risky. Debentures (or bonds as they are also called) are legally 'secured instruments' (you can sue a company that doesn't cough up). Other types of corporate deposits are not guaranteed and there can be defaults or delays in payment. The big advantage of debt investment is that the principal is usually safe except in cases of outright default. The danger is that the rate of interest may often be lower than the rate of inflation.

Mutual funds buy all sorts of assets. Some funds specialize in equity; some funds in debt; some (called 'balanced') mix debt and equity; some funds specialize in commodities; some in real estate. Each fund has a so-called 'mandate' which explains its strategy. Individual investors can use mutual funds to get exposure to the assets they want.

There are many advantages to using mutual funds. The managers are experts. The fund investor can keep investing systematically by buying some units every month (these are called systematic investment plans or SIPs). Mutual funds are also very liquid: they can be bought and sold (or redeemed) on a daily basis, unlike many debt instruments. (Some funds have an initial lock-in period of up to a year).

Both the equity and debt investor can use SIPs. The former need not track the market on a daily basis. Debt mutuals can give much wider exposure to debt than any individual could take. Many debt funds are specialists in specific instruments such as government debt or corporate debt of specific maturity.

If you hold an equity mutual fund, the tax treatment is like holding equity. A debt fund is like regular income if dividend is regularly paid out. But debt funds can carry other risks and also can result in capital gains or capital loss. Debt funds can be more risky and also give better returns than simple bank deposits.

An investor should pick equity mutual funds over picking stocks. There are many diversified equity mutuals with excellent track records and there are also index funds and ETFs (exchange traded funds) which track indices like the Sensex and Nifty. For a good ranking system, check valuereasearchonline.com and amfiindia.com.

Gold, silver & precious stones hold value during high-inflationary periods, but don't earn interest. Also, jewellery carries the cost of making charges. Gold ETFs allow investors to hold gold in dematerialized form. This has advantages of liquidity and long-term capital gains tax is charged at a moderate rate after indexation (adjusting returns for inflation). The new gold monetization schemes may allow individuals to deposit their gold and earn some interest.

Life throws lemons at us, but with a plan, you can juice them. Just as Kampani has, back in the game with his business.     

EXPERT INPUTS: PRERANA SALASKAR APTE, CHIEF FINANCIAL PLANNER, THE TIPPING POINT, MUMBAI

Build Your Portfolio

Government debtBank depositsSecured corporate bondsDebt mutual fundUnsecured corporate debtEquity index mutual fundDiversified mutual fundStocks
Risk levelzero riskvery low risklow risklow risk somewhat risky somewhat riskyquite riskyrisky
Ideal holding periodvariablevariable3-5 yearsmore than 5 yearsless than 3 yearsmore than 5 yearsmore than 5 yearsmore than 5 years
Expected returns fixed, lowfixed, lowfixed, low fixed, highnot fixed, very highnot fixed, very highnot fixed, very highnot fixed, very very high


Insurance

  • Insurance is one type of bet you want to lose. The insurer is betting you will not die and so the insurance company can swallow your premium. You really want the insurer to win!
  • Insurance is not an asset. Many insurance companies sell "combination instruments" (called ULIPs-unit-linked insurance plans), which are supposed to earn returns from being investment instruments as well as offering insurance. The idea is, the investor owns a mutual fund and also gets insurance cover. ULIPs are a very bad idea. They come with high upfront commissions and many financial service providers will try to hard-sell these products to customers for that very reason.
  • Remember Rule No.1?-Investments are all about compounding. The less you invest at the beginning of a compounding cycle, the less there is at the end. The high commission in a ULIP means that there is less to invest. This is only one of several reasons to avoid ULIPs.
    Another reason is that the initial payment also includes a mortality premium, which is normal for an insurance policy. But the average ULIP mortality premium tends to be high. A third reason is that ULIPs have long lock-ins, often of five years.


LIFE-CYCLE PLANNING
How will you have the money to combat inflation, your growing aspirations and contingencies? By taking some risks. How much of a risk can you take? Apart from personal inclination, risk is dictated by family circumstances and also by age. A young person should be more aggressive in creating a portfolio; an older person, cautious. As a young person ages, her portfolio will also gradually become less aggressive. There are plenty of self-tests online for risk profiling.


How inflation erodes buying power

  • Assume your daily expenses are Rs 100  
  • The cost of living rises by 5 per cent a year; you will need Rs105 to buy the same things.   
  • Inflation compounds:
  • 5 per cent of Rs105 equals Rs 5.25.
  • Fifteen years later, you will need Rs 207, more than double your current need.

 


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