Creating a Financial Plan – A real life case study

Of late I have been approached by a few readers with the request of creating a financial plan for them. I believe that the resources available in this blog should be adequate for making a plan for most people. However, the current plan that was made for a person just this week will probably be of interest to many readers. Note that, only the name of the person has been changed, everything else is his real life situation.


Ajay Narang is a software professional working in Bangalore. He is 31 years old and has recently got married. Ajay has only invested in some FD and Insurance schemes as of now. He does not have any investments in equity and his debt investments are limited to PF and a couple of bonds. Ajay now realizes that with growing family size and responsibility, he needs to focus on his investments for funding the goals he will have in the next 2-3 decades. He wants to get a financial plan done, in order to get a handle on the investments needed for achieving his goals.

Life Events for Ajay:

In a discussion with Ajay, the following life events were charted out:-

  • Birth of first child in 2018.
  • Purchase of his first car in 2020.
  • Birth of second child in 2021.
  • Current home loan to be over by 2034.
  • College admission for first child in 2036.
  • College admission for second child in 2039.
  • Retirement from regular work in 2040.
  • Purchase of second house in 2040.
  • Marriage of first child in 2043.
  • Marriage of second child in 2046.
  • Ajay expects to live till 2065.

Financial Goals for Ajay:

Based on his life events the following financial goals have been worked out for Ajay:-

  • College education for the first child is assumed to be 10 lacs at current prices. Assuming an educational inflation rate of 10 %, goal amount needed in 2036 will be 74 lacs.
  • College education for the second child is assumed to be 10 lacs at current prices. Assuming an educational inflation rate of 10 %, goal amount needed in 2039 will be 98.5 lacs.
  • Current annual expenses are assumed to be 4.2 lacs for Ajay. With an inflation rate of 7 %, his expenses in the first year of retirement (2041) will be 22.8 lacs. For a 25 year corpus with zero real rate of return, the value comes to 5.7 crores.
  • The second home Ajay is looking at will cost about 50 lacs today. Assuming an inflation rate of 7 %, the cost in 2040 will be 2.71 crores.
  • Marriage expenses of first child are expected to be 10 lacs at current prices. Taking inflation at 7 %, this will amount to 66.5 lacs in 2043.
  • Marriage expenses of second child are expected to be 10 lacs at current prices. Taking inflation at 7 %, this will amount to 81.5 lacs in 2046.

We now have a clear picture of the financial commitments that Ajay has over the years. With these inputs it will now be possible to look at a possible investment plan for him.

Before getting into that Ajay should take term insurance of at least 1 crore as his current insurance cover of 7 lacs is clearly not adequate. His Jeevan Anand policy can be made paid up as that money can be used for a term plan with some surplus for investment.

The investment plan is being done from scratch as the current investments are not much.

Meeting the Goals:

Based on the substantial goal amounts that we are talking about for Ajay, it will be important to note that Equity based investment needs to be the main route to meeting the goals. At this point of time, and for the next 19 years the home loan EMI will form a substantial part of his expenses. Also, as his family grows and he has children, his expenses will also grow in a commensurate manner.

Based on the above, a better approach will be to see how much he can invest logically and then look into which of his goals can be met and how. We will be making the following assumptions:-

  1. Ajay’s salary will increase by 8 % annually, so in essence his take home salary will double every 9 years. When he retires he will be getting about 7.5 lacs a month. This is not unrealistic but he may have to change his job a couple of times and re-skill himself along the way.
  2. From an investment perspective, we will enhance the investment amount per month by 50 %, every 5 years. This is possible as with increasing income, the proportion of investible surplus normally keeps increasing.
  3. In the initial period we will be investing only in equity and only through Mutual funds. After 5 years there will also be investment in debt through PPF. The PF will continue as usual and will be one of the key components of the retirement corpus.
  4. Right now Ajay has about 35000 to invest every month. Plotting the investible surplus by the logic outlined above we will get the following investment amounts for each 5 year block:-
    1. 2016 to 2020 – 35000 per month only in equity
    2. 2021 to 2025 – 52500 per month , 12500 in PPF and rest in equity
    3. 2026 to 2030 – 70000 per month, 25000 in PPF and rest in equity
    4. 2031 to 2035 – 105000 per month, 25000 in PPF and rest in equity
    5. 2036 to 2040 – 140000 per month, 25000 in PPF and rest in equity

How will the equity investments in SIP grow over a period of time. For the sake of being conservative we will take the long term XIRR for equity MF to be 10 %. With this assumption the following growth is likely to happen over the time period from now till Ajay retires in 2040.

  • The first lot of SIP of 35000 for 25 years will grow to 4.68 crores
  • The next lot of SIP of 5000 for 20 years will grow to 38 lacs
  • The next lot of SIP of 5000 for 15 years will grow to 21 lacs
  • The next lot of SIP of 35000 for 10 years will grow to 72 lacs
  • The final lot of SIP of 35000 for 5 years will grow to 27 lacs

So the total corpus at the end of 2040, in the retirement year for Ajay will be 6.26 crores from this route. Each of the PPF accounts will generate 46 lacs in 15 years. As we plan to continue the first for 20 years the total amount from these will be more than 1 crore.

Finally the PF amount will get to 2.66 crores with it being continued for the next 25 years.

With these figures in place, let us now look at how Ajay is placed, based on his overall goals, the funding required for them and how these can be met. While a method of deployment is suggested here, it is important to understand that the market levels will fluctuate in a long period such as these. Obvioisly, it does not make sense to redeem equity in a poor market. So if in the year of a goal, the market level corrects significantly, look to meet the goal from Debt instruments – in this particular case a withdrawal from PPF will be the appropriate choice.

Note that the total future cost of all the goals put together is 11.61 crores. As against this the total investment after growth in 2040 is equal to about 10 crores. However, this will not be a problem as we have been conservative in our assumptions and part of the corpus will continue to grow beyond 2040.

Deployment for meeting goals:

In general all goals will be met by redemption of equity MF unless there is a particularly poor year in the market, where an withdrawal from PPF or even PF may be considered.

MF Portfolio:

Dilip will need to create a portfolio of 4 mutual funds. The types and suggested funds are given below:-

  1. Large cap MF such as ICICI Focused Blue Chip / Franklin Blue Chip / SBI Blue Chip
  2. Multi cap MF such as ICICI Value Discovery / Franklin Prima Plus
  3. Mid cap MF such as HDFC Mid cap opportunities / ICICI Mid cap
  4. Small cap MF such as DSP BR Micro cap fund / Franklin Smaller companies

For the initial 35000 Rs, start with 10000 Rs in the first two and 7500 Rs in the others.

Stock Portfolio:

Ajay will have enough funds after about 5-10 years to start building a stock portfolio. Though this is not strictly required as part of his financial plan, it will serve as a hedge for any unforeseen events in his retirement. I have deliberately not put a figure for it as Ajay can experiment with this, based on his interest, and put as much of his surplus available to this as he wants to do.

I hope most readers would have found this useful and will now be able to assess how their financial planner is helping them create an appropriate plan. Will he happy to hear from you through comments and Facebook Messenger.


Indexation & LTCG in debt funds – some examples

I was very pleased with some of the feedback that I received on my post on A layman’s guide to capital gains and indexation. Many people said that they had not understood it earlier and were now much wiser after reading the post – that was, of course, the whole purpose of the post. Some readers, however, said that they would have been happier with some examples of debt funds. In this post I will attempt to do just that.

Let me first take an example of a fund that was redeemed in 2013-2014 FY. Note the below carefully:-

  • Fund is ICICI Prudential FMP Series 60 – 18 months Plan B – Cumulative.
  • FMP purchase of 20000 units @ 10 Rs done on 9/11/2011. Total investment 2,00,000 Rs
  • Fund maturity on 17/5/2013 with NAV of 11.44. Total amount received was 2,28,864 Rs
  • Absolute Capital gain was therefore 28,864 Rs
  • In the relevant FY, LTCG of Debt funds were after 1 year so indexation was allowed for this.
  • Indexed purchase value was 2,39,245 Rs and therefore there was a capital loss of 10,371 Rs
  • Now, if you were having the same transaction today, the absolute capital gain of 28,864 Rs will be treated as STCG as the holding period is less than 3 years and the tax on it will be 9500 Rs if you are in the highest bracket.

Let me now take an example from the 2014-2015 FY. Note the below carefully:-

  • Fund is DSP BR Dual Advantage Fund – Series 1 – 36 Months Growth
  • FMP purchase of 20000 units @ 10 Rs done on 6/3/2012. Total investment 2,00,000 Rs
  • Fund maturity on 12/3/2015 with NAV of 15.28. Total amount received was 3,05,664 Rs
  • Absolute Capital gain was therefore 1,05,664 Rs
  • In the relevant FY, LTCG of Debt funds were after 3 years so indexation was allowed for this.
  • Indexed purchase value was 2,60,891 Rs and therefore there was a LTCG of around 45000 with indexation.
  • The tax to be paid on this will be @ 20 % or 9000 Rs.

Finally let me take an example from the current FY 2015-2016. Note the below carefully:-

  • Fund is ICICI Prudential FMP Series 63 – 3 Years Plan L – Cumulative.
  • FMP purchase of 20000 units @ 10 Rs done on 3/7/2012. Total investment 2,00,000 Rs
  • Fund maturity on 6/7/2015 with NAV of 12.93. Total amount received was 2,58,676 Rs
  • Absolute Capital gain was therefore 58,676 Rs
  • In the relevant FY, LTCG of Debt funds were after 1 year so indexation was allowed for this.
  • Indexed purchase value was 2,40,375 Rs and therefore there was a LTCG of 18,301 with indexation.
  • The tax to be paid on this will be @ 20% or 3660 Rs.

In the earlier post we had already shown how to calculate the indexed purchase value of the asset by using the Cost Inflation Index of the sale and purchase year. What is the extra learning that we can get from these examples? Note the final two examples. You will see that the absolute capital gain in one case is 1,05,000 Rs and in the other case it is 58,000 Rs. Why is this so? There can be many reasons for this but think of a few such as :-

  1. The FY was different and therefore the rates of Government papers where most FMP invest in were different.
  2. DSP BR Dual advantage scheme has somewhat different kinds of holding as compared to the ICICI FMP.
  3. Plain luck on the investments of the DSP BR fund manager.

Note also, that the indexed purchase price is almost the same in both cases. This means that the growth in CII between 2011 and 2014 matches the growth in CII between 2012 and 2015. However, going forward this will be declining. In the next post, I will try to outline how these may change in the future and how it will affect LTCG, indexation and therefore the effective taxation and yield.

Tax free bonds merit serious consideration

I had written this post on Should you invest in NTPC Tax free bonds at the time the issue came out. As all of you know the NTPC issue as well as the earlier PFC one had been oversubscribed greatly. There are, of course, several other Tax free bonds in the offing, the largest of these will probably be the NHPC one. In the lower interest rate regime unfolding before us, will it be a good idea to revisit investing in these bonds?

Before getting into the 2015 series, let us look at a little history on what happened the last time these bonds were issued. In 2013 there was a slew of such issues and the interest rates then were around 8.8 % for retail investors buying the 15 year tenure bonds. As I have written in other posts, I subscribed a reasonable amount in these bonds, mainly because I wanted a source of passive income as the plan was to give up my regular job by 2014 end. Now, the three main objections that people had against these bonds were as follows – interest rates can increase and you’ll be stuck at 8.8 %, these bonds have no real liquidity and after 15 years the principal will hardly have any value.

Now that the bonds are about 2 years old, let us see whether these objections were relevant or not. The interest rates are going down and even the best rates available for FD today in in the range of 7.5 %, which is of course taxable. What about liquidity? Contrary to what most people thought, these bonds are actually selling in the secondary market at a price appreciation of 10-20 % in 2 years. What is more, you only have to pay 10 % tax on your capital gains if you sell these after one year. As far as the value of principal after maturity goes, that will be true of any debt instrument. So, as far as I am concerned, I feel quite justified in having made the investments in 2013.

Let us now come back to the point whether you should be investing in these as part of your debt portfolio. I have reproduced below a chart from the Economic Times that compares the various options in this space.

Why forthcoming tax-free bonds may be a good bet

You will see from here that these bonds score highly against most other options. Yes, if you are able to invest in actively managed debt funds and track your investments here closely, you may get higher returns as compared to tax free bonds of today. However, keep in mind that with inflation coming down, the cost inflation index will also slow down and this will mean a higher LTCG to be paid when you redeem these debt funds.

I am a strong believer that we have entered into an era of lower interest rates and instead of the earlier mean of around 9 % we will probably settle down at the present 7.5 % or so. In fact, over the next year or so, I will not be surprised if the interest rates actually reduce to 6.5 % or so. In such a scenario it does make sense to lock in the rates at these levels.

Obviously, not everyone should invest in these bonds. Young people who are into building their equity portfolio, should ideally have only PF and PPF as their debt component in their portfolios. However, people looking to set up a passive income, people in retirement, people whose portfolios are laden with tax-inefficient FD must look at these bonds as a good option for investment.

I am perfectly happy with the earlier edition of these bonds and I am sure a lot of you will be thinking the same after 2 years if you invest in this edition. Obviously, a lot of people already think so and this is demonstrated in the investor response to both the PFC and NTPC bonds.

PPF – what should be the strategy now?

Readers who have been with the blog since it’s inception will know that PPF is one of my favorite debt instruments. New readers may want to read the post on Why you must invest in PPF. As this post attracted a lot of feedback and comments, I had to do A follow-up post on PPF. Finally as readers wanted to know how I had used PPF for my own financial planning, I did the final post on PPF – A personal perspective. Now several people have asked me what is likely to happen to the PPF rates in the current interest rate regime and whether investing in it is still a good idea or not.

Before we get to the strategies of how to deal with PPF, let us first look at the historical rates of PPF over the last 30 years. It will be interesting to see that, in general, PPF rates have tended to be sticky and except for a brief period when the NDA government tried to link it to prevailing interest rates in the market, changes have been fairly rare. Look at the data:-

  • Between 1986 and 2000 the rate was fixed at 12 %
  • Between 2000 and 2003 it went down every year and dropped from 11 % to 8 %
  • Between 2003 and 2011 the rate remained at 8 %
  • Since 2011 the rates have not changed much and the current rate is 8.7 %

It is important to note that with the RBI reducing rates sharply of late and recommending that the small savings rate be bought in line with the bank FD rates, a change in the PPF rates is imminent. Politically the NDA formation believes in aligning rates of such instruments to the market rates, as they demonstrated the previous time. I fully expect the rates to come down to 8 % shortly and maybe even 7.5 % in the next budget.

So what should a new investor do now? I believe that despite the rate cuts that will definitely happen, PPF remains the best debt instrument that you can invest in due to the EEE tax treatment that it gives you. Remember that you are getting only about 7.5 % from Bank FD and and after taxes it will only be a little more than 5 %, if you are in the highest tax bracket. You can invest in debt funds where the returns will improve with falling rates, but remember that with lowered inflation the cost inflation index will also increase less and the effective taxation of LTCG in debt funds may increase. Also, PPF is a long term instrument that builds investment discipline. But most importantly, over a period of time it builds you a suitable corpus that you can tap into at the time of your goals. should the time not be a right one for redemption of equities due to the markets doing badly. This is really the biggest risk in equity investment and PPF gives you a cover for it. My suggestion to all new investors will therefore still be to open a PPF account as early as they can and maximize their contribution there.

As far as existing investors are concerned, the choice is really simple. You should simply continue investing in it without worrying too much about the rates. You are doing this as part of a financial plan and need to stick with it. In the long term these changes in interest rates will keep happening and, despite the inevitable lower returns, PPF remains the most attractive instrument for the reasons mentioned earlier in the post.

In summary, do not get flustered by the coming rate changes of PPF to 8 % or even 7.5 %. Continue with it if you are an existing investor and open a PPF account now if you do not have one yet. You will never regret it, I have not in 21 years.

A layman’s guide to capital gains and indexation

It has recently come to my notice that capital gains and indexation are two aspects of personal finance that many investors do not have a clear idea about. I was speaking to one of my friends the other day and he told me that he leaves such things for his CA to worry about. While, you can obviously take help of a CA to decide on how to deal with your taxes, it is important for every investor to understand these, especially in the context of debt instruments.

Let me start with capital gains first. We buy assets, physical or financial at a given price. For example the apartment that I bought in Chennai, cost me about 35 lacs in 2003. You may be doing a monthly SIP of 10,000 Rs in one MF scheme regularly. When we sell the asset at a later date at a higher price, the gain made out of such a transaction is termed as the Capital gain. In other words, Capital gain is the difference between the sale price and the acquisition price. Of course, if you are selling your asset at a lower price then there would be a capital loss. This is normally relevant for depreciating assets such as a car, which will fetch a lower value normally when you sell it after a few years.

Capital gains are part of our income and hence they need to be taxed. For the purpose of taxation these are classified as Short term or Long term. Depending on the asset, if you sell it within a defined time period the Capital gain is categorized as short term. Anything beyond this period will be treated as Long term capital gains. This distinction is very important from a taxation perspective. For example in the asset class equity, if the sale of the asset is within one year of acquiring it then it will fall under STCG. This will then be taxed at a rate of 15 %. So if I buy 500 shares of TCS at 2000 Rs and sell them within 6 months at 3000 Rs, my STCG will be 5 lacs and I will need to pay a tax of 75000 Rs in the year of sale. 

Now for equities the Long term capital gain is applicable after one year and LTCG is currently not taxed. So in the same example as above if my holding period of the 500 TCS shares was more than one year, my LTCG will be 5 lacs but I will not be paying any taxes on it. This is true for any equity based asset such as Equity MF or a Balanced MF where the equity holding is more than 65 %.

It would be nice if LTCG for other assets were like equity but it is unfortunately not so. For Real estate and Debt instruments the LTCG applies only after 3 years. So if you invest in a debt MF today and redeem it in less than 3 years, the gain you make will be STCG and get added to your income. Also, unlike Equity the LTCG is not exempt from tax. However, recognizing the fact that inflation will have an impact on dampening the gain, a concept of indexation is used to calculate LTCG. The way this works is explained below:-

  • Cost Inflation Index of the year 1981-1982 is taken as 100. Based on inflation from that point the index is revised every year. The current index for 2015-16 is announced at 1081.
  • What this really means is an asset bought in 1981 needs to be indexed at around 10.81 times, in order to counter the effect of inflation, the asset cost in 1981 needs to be multiplied by 10.81 to get a fair value of cost in 2015.
  • The LTCG can now be calculated with this indexed acquisition cost figure.
  • For example I purchased my flat in Chennai for 35 lacs in 2003-2004 when the Cost Inflation Index was 463. If I want to sell it in 2015, when the Cost Inflation Index is 1081, the indexed purchase cost will need to be calculated by using the formula 1081/463 x 35 lacs. So the indexed cost will come out to be 81.7 lacs.
  • So if I sell my flat for 1 crore today, the LTCG will be 18.3 lacs.
  • This then will be taxed at 20 % in the relevant year of sale.

How does indexation help in debt investments and how are things changing on that front? I will try to address this in the next post.

The changing landscape of debt investments

While all the noise and excitement is normally about the stock markets, I think it will be fair to say that most investors in India historically have always depended on debt for their short and long term investments. Whether you look at the number of investors or at the financial assets invested, this conclusion is an inescapable one. Even for investors focused on equity, the almost automatic investments in FD, RD, PPF / NSC and of course PF is a reality. This is also a good thing as I am a staunch believer in having a solid bedrock of debt investments for giving stability to any portfolio.

In the present investment climate of India, the significant changes that are happening to the debt instruments and their potential returns have almost gone unnoticed. It is important to understand the changes to the landscape and more importantly, what will be the impact on the investors who are investing primarily in debt instruments. Before we look at the various classes of instruments, we need to understand the main reasons for the changing scenario.

As most of us know, returns from debt instruments have always been closely linked to the prevailing inflation rates in the country. Obviously, if the inflation is high the returns from such instruments also needed to be high, in order to remain attractive for people to invest in them. While inflation figures and interest rates have fluctuated over the last few decades, in general they have remained high. I remember the PPF rates used to be 12 % when I started investing in it more than 20 years back and went down to 8 % at it’s lowest point. Interestingly our financial institutions are quicker in lowering rates when needed and quite sluggish in raising it when the inflation gets higher.

Now all high inflation economies will get control over inflation as time goes by. Developed nations have lower inflation and going forward it is quite possible that we will be looking at inflation rates lower than 5 % before long. As the RBI Governor has signaled, it is going to work in closer coordination with the government on the policy rates. This essentially means the returns from debt instruments are going to change. What is more, with inflation being tamed, the changes in the returns may well be more permanent in nature than what we have seen earlier.

Bank FD s are always the first product to have the rates revised and this has already happened. Most banks are offering rates lower than 7.5 % now and even for senior citizens the highest rates available is 8.4 %. My parents have some FD s started a year back and they were getting 9.5 % in those. It is quite possible that over the next year, as policy rates go even lower with inflation declining, the FD rates will drop to below 7 %. This will be quite significant as I cannot remember the last time when these rates were below 7 %.

The other important impact will of course, be on the rates of the small savings schemes such as PPF , POMIS etc. The RBI has recommended that returns from such schemes be aligned to the bank interest rates. While this will be politically a tough thing to carry out immediately, over a period of time this conclusion is an inevitable one. The PF rates again will quite possibly be revised downwards, though even here it will be a difficult decision to implement.

What about debt mutual funds? Well here, the returns impact will depend on the type of funds we are talking about. Liquid funds and MIP etc will have lower returns. Investing in FMP seems to have very little point now. Gilt funds and other debt funds will have higher returns in a declining interest rate cycle and they can be invested in. However, with lower inflation we will also have a dampening effect on the Cost Inflation Index. This will essentially mean that the effective taxation on the capital gains will be more when you redeem your debt funds. This is too complex to explain in the context of this post, I hope to write a post on this later in the week.

The above would have shown you that there aren’t a whole lot of options as far as decent returns from debt instruments are  concerned. What should be the debt strategy then? Let me write about this in my next post.

My mentor in the area of Personal finance

I have been fortunate to study in a great school and two great colleges during my student days and had a few excellent teachers who were able to transfer a lot of their knowledge to me. This learning continued through some very good bosses that I had in the first few years in my career. In the area of personal finance, I am mostly a self-taught person but the one person who I consider to be my mentor is the US lady Suze Orman. I have learnt a lot from her shows, not only in terms of personal finance but about life in general too.

For those who have never seen her on TV a few words will be in order. She had a fairly unremarkable beginning and worked in all kinds of jobs such as a waitress etc, before she veered into the area of personal finance. For someone without a good formal education and a late starter, her success here is amazing. She wrote her first book when she was 45 and her books along with her TV show made her one of the most sought after speakers in the US. Of course, there are many success stories like this in the US – what makes her unique is the way she blended financial issues into the lives of her callers and provided solutions that were financially sound but with a human touch.

The most important lesson I learnt from her was encapsulated in her tag line – people first, then money, then things. What this means is we should first take care of our near and dear ones even if it means we are not very sensible financially. But she was also clear that this should not be done if the people are wasteful themselves. Beyond this she wanted the viewers to focus on building a secure financial base and acquire things only when they could afford it. Some of the commandments that she wanted everyone to follow were :-

  • Always have an Emergency fund equivalent to 8 months of your expenses.
  • Go for a home mortgage only when you can pay 20 % of the total payment on your own.
  • If you are not able to settle your credit card bill in full then you cannot afford any new things.
  • Loving your adult children does not mean that you support them financially.
  • Any financial planner receiving commissions from the products that he is recommending, cannot be objective.
  • Term life cover is the only kind of life insurance you should go for.
  • Never withdraw money from any retirement scheme that you have.
  • If your child insists on studying at an expensive college with a loan, do not co-sign it and become liable.
  • Do not think you own a home that is mortgaged to a bank, reality is that the bank owns it.
  • In the above case, you are buying it from the bank bit by bit.

The other most important thing I learnt from her was that when you feel powerful because of the knowledge and skills you have to add value to others you will attract money in some way or the other. She always advised people to get into a situation where they were doing something that they loved without having the constraint of needing to earn money through it. A lot of my own thoughts on financial independence were motivated through these real life case studies.

If any of you are interested you can get some of her books or , better still, watch a few of her old shows. It used to run in CNBC for more than 10 years and I must have seen the majority of those. I still miss them, it is only after you have watched them that you realize how much better our shows can be.

The hallmark of a mentor is when she can change the lives of her followers significantly and she has definitely done it for me in more ways than one. So much so, that when I try to help someone through my knowledge in this area, I still feel that I am passing on to others what I have learnt from her.