Just like a building where you start with the foundation and then move upwards towards the first floor, second floor and so on, the financial planning building has five blocks to scale. The first two blocks are the foundations and then the next three levels where you actually experience the benefits of a strong foundation. Let us have a look at these blocks, what they are and how to go about their planning:
- 4. Retirement planning
- 3. Investment planning
- 2. Insurance planning
- 1. Contingency planning
One might be wondering why the reverse order? Just as mentioned we have to build the foundation and then move upwards. The foundation starts with contingency planning and then you gradually move up.
The first two blocks: contingency planning and insurance planning is known as risk management. Also in a layman’s term, it is the foundation of a good financial planning. Once this is in place, you are not worried as it takes care of all your emergency situations (contingency planning) as well as your insurance requirements (that is your health insurance, life insurance and other insurance).
Once your risk is managed, you can then safely move on to the higher levels to plan for your goals. The next two levels are investment planning and retirement planning collectively known as goal planning.
Let us start with the foundation and the first of the two levels in risk management.
Also known as emergency planning. It has been emphasised time and again that a contingency plan or an emergency plan has to be in place before starting to plan for other goals. Why? Emergencies can come anytime or anyplace especially when we least expect it. We cannot predict it or even prevent it but what we can do is buffer ourselves against it so that our life does not go for a toss due to the emergency. It is basically saving for a rainy day. So once that you have planned for any untoward or unpredicted eventualities, you can safely move ahead to the next level of the financial plan.
How to calculate?
All your mandatory monthly expenses which you have to meet by hook or by crook have to be taken into account. A list of all mandatory expenses have been given below:
Fixed mandatory expenses (which are fixed every month) include:
- Mortgage installment
- Car loan installment
- Other loan installments
- Life insurance premium
- Health insurance premium
And variable mandatory expenses (which are mandatory but vary every month) include:
- Miscellaneous (unavoidable) expenses
The above expenses have to be calculated on a yearly basis and then divided by 12 months so as to arrive at an average monthly figure.
How much to set aside?
At least three months of your average monthly expenses have to be kept aside in the form of emergency funds since it is generally observed that three months worth of funds are enough to meet most emergencies and come back on track. People nearing retirement should try and keep aside at least five to six months of mandatory monthly expenses as contingency fund.
Let us take an example: Say your yearly mandatory expense is Rs 350,000.00. Hence your monthly average expenses will come to Rs 29,167 (3,50,000/12) (rounded off). You need to keep aside Rs 87,500 (29,167*3) that is your three months’ average monthly expenses as contingency funds to meet any eventualities.
It is not necessary to keep the entire amount in cash. You can keep aside Rs 20,000 in cash and the balance you can split between savings account, fixed deposit, or liquid funds. Why? Because all of the above mentioned products have liquidity, their biggest advantage, which is a very important feature in case of any emergencies. Also, remember that in case of usage of these funds always remember to replenish it.
Insurance planning It is the planning for an adequate amount of insurance. And it definitely does not end with life insurance alone. One needs to also plan for health insurance, disability insurance, and property insurance. These insurances are very important and everyone should try to incorporate them in their insurance planning. First and foremost, it is very important to know one very important fact. Insurance is not investment and vice versa. Never try to mix the two. Insurance is for risk management and investments are for goal achievements. This golden rule should form the crux of your decision-making when buying insurance polices. Never buy insurance just because someone advises you to buy. Try and understand the product, correlate it with your needs and requirements and only then go for it. So how much is adequate? A number of components go into the calculations in finding the adequate amount of insurance.
- Your current age
- Inflation adjusted returns
- Number of dependent in the house
- One time cost (which includes any existing loans that you may have taken, (exclude the home loan which is already insured against declining term insurance) and any other expenses such as last rites expenditure)
- Your current cost of living (only include the fixed and variable mandatory expenses. Exclude any mandatory expenses related to you since these expenses will cease to exist after your demise)
- The amount needed to pay off responsibilities like your child’s education and marriage
- Exiting investments
- Any existing life insurance
All these factors help in finding the adequate amount of life insurance. Hence if you have any existing insurance then you only need to buy the additional amount. NOTE: If you are no more an earning member of the family, that is, if you have retired, then you should not take any life insurance.
A must again with the increasing amount of stress that the younger generation is facing, we would not be surprised if you have already started running huge amounts of medical bills at a young age. A minimum amount of Rs 2 lakh is a must. If affordable increase the amount. Also, if possible try to take individual policies as against family floater plans.
This is because if you have a floater health policy worth Rs 3 lakh, and you fall sick and use up an amount of say, Rs one lakh worth of health insurance, only Rs 2 lakhs will be available for the rest of the year for you and your entire family.
In fact now individuals have an option to go for a top-up, that is, if you have an existing policy with your employer or you have bought it one yourself then you can top it up to Rs 10 lakh. The premium amount works much cheaper. For example, say you have Rs 5 lakh of health insurance (this is the maximum offered by most health insurers today) and you would like to be insured for more than that then you could buy a top-up plan for another Rs 5 lakh.
So if you have a medical bill of Rs 7 lakh then the first Rs 5 lakh are covered by your existing policy and the balance Rs 2 lakh by the top-up policy. NOTE: It is very important to pay your insurance premium on time and see that it does not lapse especially for individuals who are nearing 60 as after this age very few insurance companies offer health insurance and to get a new one is very difficult. Also, for people who are working and have not taken any other mediclaim policy besides the one their company offers them, remember that once you leave the job and find a new one, you might no longer be covered by that policy.
Again an important insurance policy, especially, for individuals who travel frequently. Accidents can happen anytime and if it leads to any disability then well let’s not even think about it. This policy is not an expensive one though. There is also an option for individuals to take this insurance as a rider along with their life insurance.
Compare the premium amounts of a standalone policy and the premium if it is taken as a rider and then decide which one is better.
Your hard earned money has gone in setting up your house. If something were to happen to it, or maybe something is stolen then it is difficult to replace. So it is always advisable to have your property insured. The premium amount is low and hence this amount will not pinch your pockets.
The only hitch is that in India, property insurance is for the market value and not for the replacement value of the property. But this should not be an excuse for not taking property insurance.
Professional indemnity insurance
This insurance policy is a must for all professionals to protect them from any claim arising during the course of their business.
I know it sounds like too many insurances at one time will leave you with no money for other investment planning but the ones mentioned here are amongst the most commonly needed ones. The most important are the life insurance and health insurance and for individuals who are nearing their retirement age or are retired for them health insurance a must. Once these two are in place you can buy the others eventually. Once we are assured that your risk is managed, we do not have to worry about it anymore. Now we can safely move towards investing and planning to achieve your goals.
Why do we invest? Of course to save money and earn returns! For what?
Your obvious answer would be: for my and my family’s future. If asked to elaborate, I am sure you will find it difficult to list down five things for which you are saving money. But if the investments or the money you are saving is not invested in right investment avenues then in the hour of crisis you either have invested in a locked-in financial product or their value has become half or in a product which rates very low in liquidity (like real estate). So the right type of investment product is very important to help your money grow and in achieving your goals.
So this is where investment planning comes in place. Investments of your hard earned money should always be done considering your goals and the time frame in which you want to achieve your goals. The next question is how to go about it. First you need to start with charting, that is, writing down your goals and the time frame in which you would like to achieve them. This forms the base of your investments. To make the task simpler, you can break down your goals into three different sections:
- Responsibilities: Providing for your dependent parents; funding for your children’s education and marriage; funding for marriage of your siblings, etc
- Needs: Buying a house, saving for retirement, buying office space and any other needs you may have
- Dreams: Finally, your dreams or your aspirations which can range anywhere from buying a solitaire for your wife to going on a world tour to buying a sports car
We live only once and so no dream is too big or far-fetched. The next step is the time frame in which you would like to achieve it. Let me explain the importance of this via an example.
Let us say you want to save for a down payment for the dream car, which you are planning to buy after a year and a half. You start saving by investing regularly in equity mutual funds. After a year, just nearing the time frame you have set for yourself, you decide to redeem the investment and the market crashes. Forget the profit, your initial investments too has halved in value.
Equities are good investments but only when you have the time frame of more than eight years. Then you can be rest assured that your investments will earn on an average 13 per cent to 15 per cent return.
Moral of the story:
Your investment products should be selected on the basis of the time frame within which you would like to achieve the goal. It may be difficult to list down a time frame but even an approximate figure will do.
Once your goals and time frame is in place you need to put a figure or an amount that you would like to spend for that particular goal at today’s value. Say for example, one of your goals is to save for your child’s higher education, which is 15 years from now. You are willing to spend Rs 3 lakh in today’s value. To this will be added inflation which in layperson’s terms means what you will get in today’s date for Rs 100, you will have to spend Rs 275 after 15 years taking into consideration an inflation rate of 7 per cent.
We cannot forget inflation as the amount, which we will derive after taking into consideration inflation, is the amount you will have to spend. Also, keeping in mind this amount you need to plan for it. So for the same goal, which will cost you Rs 3 lakh in today’s date, you will have to spend Rs 8,27,709 after 15 years taking into consideration 7 per cent inflation rate.
Beware of inflation!
Future value = Present Value * (1 + inflation rate) ^ Number of years left to achieve your goals.
Hence, future value = 3,00,000 * (1 + 7 per cent) ^ 15
Therefore, future value = Rs 8,27,709 (approximately).
And that is the amount for which you need to plan.
An easy way to do this is to prepare a table, which will help you in listing your goals along with a fixed time frame, priority, value and the future inflation adjusted cost. Have a look at the table above (the table is hypothetical. The values mentioned here may differ from individual to individual).
Note: If you are married, it is important that you involve your spouse when you list down the goals as even your spouse may have her/his own goals, which they would like to achieve. Also it has to be a joint effort so nothing is missed out.
The above process will help you to realise how much you need to save. The different investment avenues available are:
Important investment avenues
Equity: You can safely invest in them (that is, direct equities or equity mutual fund) if your time horizon is for more than 8 years. You can also invest in them if your time horizon is more than 5 years but the exposure should be limited. Remember one thing, though: even in the long term, that is, more than 8 years as you near the realisation of your goal, you must systematically transfer your money from equity to debt. So this way you not only protect your capital but also your profits.
Debt: If your time frame is five years, debt is for you. The return is less but you can be sure that in products like fixed deposits, your capital will be safe.
Gold: At least 5 per cent of your portfolio has to be in gold. Gold is safe haven especially when there is crisis in the world. But be very clear about one thing: jewellery does not account for investments. Investments in gold have to be in the form of gold coins or bars. Gold exchange traded funds (ETF) is also a good form of investments.
Real estate: Property has always been good a form of investment. The only problem is the amount of investment required and the liquidity. Take for example in today’s market where real estate prices have gone down, it is a good buyers’ market but for sellers in dire need of cash, they will have to break the rates and sell at a discounted price.
A professional advice for selecting the right investment avenue is always advisable.
Retirement Planning :
The longest of journeys start with a single step. We are not sure who said that, but being in the financial planning space, we think it most aptly describes what retirement planning is all about. Planning for retirement is one long journey but a resolute and systematic step-by-step approach makes it a lot less laborious.
1. Start early
A well-prepared approach towards any goal is usually the result of an early start. Retirement planning is no different. We hear financial planners say that it’s never too early to start saving for retirement, they are right. Make no mistake that an early start helps and you will be surprised at just how much it helps. Your friend or colleague who started saving for retirement even five years earlier than you with the same quantum of investments is likely to save twice as much as you at retirement. Even if you don’t have the requisite amount of money required to start, the key lies in starting with what you have and making up for the deficit at a later stage. However the opportunity to make an early start should not be compromised with.
2. Seek the assistance of a financial planner
Planning for retirement can be fairly uncomplicated. You need to have a good idea of where you want to be 30 years from now in financial terms and what kind of a lifestyle you would like to maintain. However, putting the financial plan in place (which has a lot to do with math, an unpopular subject with a lot of us at school) can be quite complicated. This is where an investment advisor steps in. He can give a concrete shape to your retirement plan by coming up with ‘the all-important figure’, based on your inputs and chart out a plausible investment strategy for the long term.
3. Implementing the plan
Having an investment plan in place sets the ball rolling for you and your investment advisor. He will now implement the plan by making investments in stocks, mutual funds, bonds, small savings schemes and fixed deposits among other investment avenues. Your risk profile is the most important reference point for the investment plan. The objective is to invest in avenues that lower risk and maximise returns and do so in line with your risk profile. Asset allocation i.e. investing across assets in varying degrees will play a vital role over the long run. This is where the investment advisor’s expert advice will play a crucial role. Typically a retirement portfolio should be well-diversified across pension plans, mutual funds, equities, EPF/PPF and fixed deposits.
4. Tracking/reviewing the plan
Your investment plan must be monitored regularly to make sure that you are on course to meeting your objectives over different market cycles without compromising on the risk. Again, your investment advisor has an important role to guide you in this regard. For instance, with the robust performance of equity markets over the last couple of years, you are probably over-invested in equities and have therefore taken on more risk than usual. You will have to liquidate some of your equity investments to bring it in line with your risk profile. With passage of time as your risk profile changes, the same will be reflected in your investments as well. The portion of investments in market-linked products like equities and mutual funds is likely to reduce; instead greater allocations could be made in assured return avenues like fixed deposits.
5. Don’t dip into your retirement savings
Since retirement money is sacred it is important that you treat it as such. Your carefully drafted investment plan need not go for a toss every time you witness a cash crunch. Avoid dipping into your retirement monies, unless it’s urgent. A one-time sum of Rs 5,000 invested over 30 years (at 10% compounded growth) will swell to Rs 100,000. That is what long-term investing can do for you, so money needs to go into your retirement savings kitty and not come out of it.
Retirement Planning-Case Study
Before we get on with discussing the case study, it is important to highlight that retirement planning is
- a very personalised process that is unique to every individual.
- an ongoing process because what we are aiming at is not fixed (our standard of living, which we are aiming to secure will change over time)
Our aim therefore in discussing this case study is to understand how you can get started in planning for your retirement. For you to be able to draw up a personalised retirement plan, you will require the services of a financial planner. In this note, we will discuss the retirement planning process of an individual, say Kunal. Kunal is 30 years of age; he is married and has a two year old child. He is a professional, employed in a IT company. He draws a compensation of Rs 30,000 per month. His wife too is employed, as a teacher. She draws a salary of Rs 15,000 pm. The present household expenditure is Rs 30,000 pm. Kunal is looking to retire at age 58 years.
Since we are focusing on retirement planning for Kunal and his wife, we need to look at the cost they incur in maintaining their present standard of living. Let’s assume, Kunal wants to, as of today, maintain the same standard of living post retirement i.e. he will need Rs 30,000 per month (pm), adjusted for inflation, on retirement. Therefore, we have to plan Kunal’s investments in a manner that they will yield an income of Rs 30,000 pm, 28 years from now. Post retirement, other than regular monthly expenditure Kunal will incur expenditure on travel and healthcare.
Given that health costs are rising fast and we are traveling more for leisure, it is prudent to set aside some money for these purposes. We have assumed Kunal will require Rs 500,000 per annum (pa) post retirement (Rs 125,000 pa in today’s Rupee terms after adjusting for inflation). Another head of information that will be required is Kunal’s present savings and the rate at which they are expected to grow over the years. These savings could include balances with the Employee Provident Fund (EPF), mutual funds, savings-based life insurance policies and fixed deposits among others.
The house that Kunal owns and lives in will not be added to his existing assets for the purpose of retirement planning. This is because he lives in the house and will not be able to generate income by way of rent or sale of property at the time of retirement. Finally, before we get down to the numbers, we will need to make two assumptions :
- the average rate of inflation for the next 28 years
- the low risk rate of return you can earn 28 years from now; at 58 years of age your risk appetite will be low and therefore a bulk of your investments will be in very low risk securities that yield regular income
While it is difficult to say with certainty what the actual inflation and rate of interest will be, we nevertheless need to have a starting point. In our view, an average inflation rate of 5% pa is a reasonable estimate. As far as the rate of return is concerned 28 years down the line, we think it will be about 5% pa. It is important to restate at this point that retirement planning is not a one time exercise. As your standard of living changes and the investment environment evolves, you will need to regularly make adjustments to your plan so that you can achieve your objective. Therefore, these assumptions too will change over time and Kunal will need to accordingly make adjustments to his saving and investment pattern. It should be understood that Kunal’s financial advisor will have an important role to play in the reassessment.