A real life financial planning case study

It always surprises me a little to see the reactions of people in Facebook groups when a group member asks a simple query. Some members assume that the questioner needs to get knowledge by reading blog posts of some other members first, others advise him to go to a fee only financial planner and even give him a list, yet others tell him that one should just keep working and not think of retiring.

To come back to the recent query, here are the salient facts shared by the person who wanted advice on whether he will be able to gain Financial independence in 6 years:-

  • He has 1.2 crores in FD and another 30 lacs in equity etc
  • Can invest 20000 per month for next 6 years
  • Has a child in class 7, who should be going to college in 6 years
  • Has his own house and loans will be paid for by the time he is 50.
  • Current costs are 1 lac per month, 15000 for child and includes loan repayments.

Let me come to the question as to whether he will be able to be financially independent by the time he is 50. For this we will calculate his Financial Independence Number (FIN) in the following manner.

  • His base cost at 50 will be lower than 1 lac as child cost will be gone and so will the loan repayment. However, let us take it at 1 lac to take care of inflation etc.
  • For retirement of 30 years his cost will be 3.6 crores at zero real rate of return
  • For child higher education we can take 20 lacs
  • For asset replacement etc we can take 20 lacs
  • Total FIN therefore comes to 4 crores.

Fortunately, in real life we do not need to go with financial planner and/or calculators blindly and can use some experience and common sense. It is difficult to tell others what to do as they will have their own goals and ways. However, if I were in his place, I would be doing the following:-

  • As his child’s college education is 6 years away, I will put 10 lacs in an Aggressive Balanced fund like HDFC Prudence. This amount will take care of the 20 lacs that will be required for the child’s graduation.
  • I will redeploy the 1.1 crore left in FD to different types of Debt funds. Assuming a CAGR of 8 % this will grow to an amount of 1.75 crores.
  • His current equity investment will grow to 60 lacs if we take 12 % CAGR over 6 years.
  • 20000 SIP @ 12 % returns will grow to about 21 lacs in 6 years.
  • So at 50 years he will have 1.75 crores in Debt and 81 lacs in equity

Let us now look at deployment of corpus. In the first 10 years of retirement, his strategy can be the following:-

  • Interest from Debt portion will be to the tune of 14 lacs @ 8 % returns. This is definitely possible if he is into good quality Debt instruments.
  • As his child is in college and he is still relatively young, I will not reinvest this 2 lacs but spend it in discretionary expenditure such as travel or asset replacement.
  • At the end of 10 years, he will be 60 so the activities will reduce and on the balance his medical expenses may grow. I think an annual expense of 18 lacs will be enough. There is no need to calculate this by inflation formula – makes no sense at all to do so.
  • Assuming a 12 % return on equity his equity corpus will be 2.51 crores.

In the next decade his deployment can be as follows:-

  • Keep using the interest from Debt instruments and take out the remaining required amount from redeeming the principal.
  • Even after you finish the decade you will have some amount left in Debt instruments. I suggest you donate it to a charity of your choice.
  • Your equity investments would have grown to more than 7 crores by now and will be more than enough to last your life as well as live a legacy.

So to come back to the basic query – will you have enough to retire at 50? You bet you will. Now just shut out all the negative people with negative comments from your mind and go ahead with the plan. Honestly, if you are able to get the selection of instruments done on your own, you do not even need a Financial planner.

Will be happy to receive comments, feedback and criticism on the post.

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How I use Mutual funds for my financial planning

Mutual funds are great instruments, not only because they let you invest in equity with reduced risk, but also due to the flexibility that they offer you in terms of all the aspects of your financial life. You can use them for goal based investments, as backup for goals, as emergency fund and also for regular income.

Over the years, I have probably used in all types of MF for taking care of the different needs in my financial life. I thought it will be a good idea to outline in a post as to what types of MF I have invested in and why. To keep the post short and sweet I will only outline the main issues and not go into the features of the MF types.

  • Equity MF Growth option: I have mainly used these for growing my portfolio. I do not really invest for specific goals, it is more like accumulating a pool of money that can be dipped into, as and when needed for a goal or some other emergency.
  • Equity MF Dividend option: I have invested in these mainly to get some regular tax free income. This forms part of my passive income base, helping my financial independence, without an active income. Most of these are close ended MF I have invested in the last 3-4 years. 
  • Balanced Funds: These provide some hedge against volatility of the markets and can be redeemed if I need money during a poor market situation.
  • Arbitrage Funds: I use this as an Emergency fund as the tax treatment is similar to that of an equity fund. Returns are low but better than FD and tax free.
  • Equity Income Funds: Similar logic as Balanced funds, helps me diversify risks. Can be redeemed if needed in a down cycle of the markets.
  • Monthly Income Plans : I have invested in the Growth option here as I am not depending on regular income from here. At the same time, I can redeem these if needed for some purpose. All of these investments are more than 3 years, so the tax incidence will be minimal.
  • Debt Funds: I have small investment in other Debt funds, mainly to lower the risks.
  • Fixed Maturity Plans: These provide stable returns and I get regular redemption from different schemes every 2-3 months. I use the capital gains as my passive income and reinvest the principal in some debt oriented instrument. With the declining rates Dual Advantage funds have been my choice of late.

As you can see from here, it is possible to invest entirely in different MF types and achieve both passive income as well as growth in your FI state. In my case, I do get some interest from tax free bonds and POMIS but that is strictly not needed. 

Are you using the versatility of different types of MF? If not, it is time you did it. I will do the next few posts on how retirement corpus can be deployed using MF.

How I plan to use my PPF account

With the rate reduction in PPF scheme and the knowledge that it is going to be aligned to market rates every quarter from now on, is it still a good idea to have it in my portfolio? In my audit of investments for last FY that was the main question I was faced with regarding my PPF investments.

Now in terms of personal finance every issue and decision is contextual and the situation of the individual makes all the difference. In my case I have a PPF account since 1994 and my wife has started a second account in 2013 after the first one was matured in 2004. Some details of these accounts are as follows:-

  • My present maturity is in 2019 April and current balance is about 20 % of our total debt portfolio.
  • My wife’s account will mature in 2028 and currently is about 3.5 % of our debt portfolio.
  • Contribution of 1.5 lacs is made every year in the first week of April to both accounts.

Given the tax treatment of PPF at EEE, I see no reason to stop my investments in it even though the interest rates have reduced to 7.8% currently. I think the returns on PPF will go down further to about 7.5% or so, but even that is not a bad rate for an EEE instrument. In the coming years the interest rate cycle is very likely to turn around and at that point in time, PPF will immediately get benefited as the rates are market linked now.

With the investment decision taken, the next issue is how to use the money in the account. So far I have not withdrawn any money out of my account since 1994 and do not plan to do so till the current maturity in April 2019. The same goes for my wife’s account. Her first PPF maturity amount had helped us greatly to boost the down payment that we were able to make for our apartment in Chennai.

So after a lot of thought these are the conclusions I have come to:-

  • Continue my account after 2019 for another 5 years while being open to withdrawals for any emergency post 2019.
  • Assuming that my daughter gets married in the period beyond 2019, such withdrawals can fund her marriage expenses to the extent needed. Even though I have investments in equity for it, a hedge against market crashes is prudent.
  • Withdrawals can also be used for discretionary purposes such as replacement of white goods, vacations outside India etc.
  • As I will normally not need the PPF account withdrawals for my regular expenditure at least till 2024 or so, in the absence of any of the above the money will simply grow.
  • As far as my wife’s PPF account goes it will grow to 40 lacs plus by 2028. At this point if the returns are decent we will continue it. Note that we can withdraw 24 lacs in the subsequent 5 years from her account.
  • Assuming that I can withdraw about twice that amount from my account in 5 years, the total withdrawn amount in 5 years will be 72 lacs. This can be used for a variety of purposes as explained earlier.

How will I fund the 3 lacs per year? As of now, I am doing it from my Consultancy income and hope to do so for the next 5-6 years. Beyond that or in case the income is insufficient in a year, I have plans to fund it through the redemption of debt funds such as FMP etc that keep happening every year.

In the end what does the PPF investment mean to me? Well, it is something from which I can withdraw any time I have an exceptional expense whether due to an emergency or due to an indulgence that we need to do. It also gives me the cushion of not having to redeem my equity investments for fulfilling a goal, when the markets are in a bad situation.

In short it contributes a great deal to my peace of mind.

Do you still invest in Fixed deposits? Need to change

As the readership of my blog and also the Facebook group has increased, I get a lot of queries from readers on how should they go about making a financial plan and their investments. There are also many requests from my friends and relatives in terms of reviewing their current investments and make suggestions on the same.

One of the things which surprises me every time I see it is the continued fascination that many investors still retain for Fixed deposits. Yes, I understand that they are perceived to be safe and highly liquid but from an overall financial perspective they really do not make any sense at all. Let me give you a few examples to illustrate my point.

  • A senior IT executive working in an MNC from Bangalore, had more than 30 lacs in FD. He said he was keeping it handy for his daughter’s higher education or marriage as the case may be.
  • Another IT professional from Kolkata working in TCS was having more than 20 lacs in FD. He said it was a combination of Emergency and contingency fund.
  • A cousin of mine, who is a Doctor with a private practice, recently approached me for suggestions on how he should invest 35 lacs that he got from FD maturity.

Note that these are people who are well educated, see TV a fair amount, read financial and other newspapers and are exposed to various financial blogs. If despite these they are investing in FD as a main channel then one can well imagine what most other investors from small towns or villages are doing. So while the Mutual fund SIP figures have greatly grown, the number of investors in FD and the amount of money they have in these deposits are still a mind boggling number.

But why am I saying that you should avoid FD in the main? Note that I have no issues if you have some 2-3 lacs in FD for Emergency purposes, though even that is not strictly necessary. Let me take the case of my cousin who had 35 lacs in FD till June of this year. 

  • The older FDs were at a higher interest rate so he was getting 9 % interest on them. 
  • His annual earning out of the 35 lacs was 3.15 lacs. All of this was taxable at 30 % as his other income is significantly more than 10 lacs.
  • The effective return was therefore only 6.3 %.

When the older FDs matured his banker told him that the best possible rates were 6.9 % in his bank. That would mean an effective rate of less than 5 %. It finally dawned on my cousin that it was really against common sense to renew the FDs. Even though he was told by his banker that other options are risky, he stuck to his guns about the renewal.

Are you like any of these examples listed above? Do you have a lot of money in FD and are paying taxes on the interest earned? If you are not paying taxes it is worse as the IT authorities are keeping a very close watch on all the FDs, even where a Form 15H or 15G has been submitted.

I think all readers are convinced by now that FD is really not a good idea. But the natural question then is, what do we invest in then? Will it be safe? What about liquidity? There are fortunately good answers to all these questions. I will write about it in the next post.

 

File your Tax returns – it is right and also wise

For all tax paying people July 31st now looms as the deadline, by which you need to submit your tax returns for last FY. New tax payers find it quite overwhelming, many people just avoid it through ignorance or laziness and others depend on their CA or Tax consultants to get it done. It is important to understand the need for filing tax returns and also how one can do it in a fairly easy manner.

First things first – why do we need to file a tax return in addition to paying our taxes? The answer is simple too – our tax deductions are automatic in some cases, partial in others and not there at all in some. It is therefore important for the IT authorities to determine whether you have taken all of your income into account and paid relevant taxes for the same. A few examples will make it clear :-

  • For your salary income TDS is deducted as per your tax calculations fully.
  • For your rental income of any property there is no TDS unless rent is more than 50000 per month. Here too the TDS is at 10 %.
  • For your FD interest TDS is charged at 10 %.
  • For your PO MIS interest, no TDS is deducted.
  • For your Savings bank interest, no TDS is deducted.

As you can see from here if you just depend on TDS and think you have paid all your taxes, you are quite mistaken. Ideally you should be calculating your tax liability based on your overall income, during the year, and pay advance taxes to cover up the additional tax payment required. These advance taxes can be paid any time during the year and for a quarter the cut off date is normally 15th of the last month. So for the second quarter of this FY, the advance tax payment deadline should be 15th September. If you have extra taxes to be paid, based on your first quarter income then make sure that you pay it off by that date. For the last quarter of the FY, the date is 15th March.

However, if you have not done it this way in the last FY then what is your choice now? You need to file your tax returns with accurate information so that your total tax liability for last FY can be determined. If the tax deposited so far is less than this, you will need to pay the balance tax. This is easily done in the income tax website. In case you do not have an account there, create it using your PAN for registration.

What happens if you do not file the tax return? For one there is no real option and you will be fined heavily if you delay filing beyond July 31st. Also anything associated with your PAN can always come under scrutiny and the first thing IT authorities will check is your Tax return form. If you have not filed it, or filed it with inaccurate information then you are going to face a much sterner examination.

So all said and done, you will need to file your tax returns. In case you are not up to doing it yourself use a Tax Return Professional ( TRP ) to help you. You can, of course, go to a CA but they are more expensive and unless you have multiple sources of incomes that need complex book keeping I will not advise it.

In the next few posts I will show you how you can take care of your income tax and learn enough to calculate your taxes and file returns on your own. It is actually quite simple to do once you lose your initial reluctance.

 

 

Cash flow planning is key to a good financial plan

Many of my readers keep asking me as to why I do not have different portfolios allocated to different goals of mine. I have explained this in other posts so will not repeat the basic arguments here. Suffice it to say, multiple portfolios will most likely lead to sub-optimal returns and I do not look upon it as smart financial planning at all. In fact if you really look at how you go about your life and the finances you need ta take care of your plans, the most important aspect is really cash flows.

While cash flows are kind of implicit in goal based planning – we are asked to redeem our financial investments to cater for the expenses linked to a goal – it is important to understand the true nature of it. In a recent discussion with a friend it struck me that most people do not have a clear idea about it at all and do not understand how to go about it. When I was thinking of how to explain this to my readers, I thought of how we use water in our daily lives. This is an analogy I have used in one of my earlier posts and can be used well here.

Let us assume a normal middle class household in India where we have different types of expenses such as listed below:-

  • Regular monthly expenses such as food, groceries, utility bills, transportation etc.
  • Quarterly or biannual expenses such as school or college fees.
  • Annual expenses such as Insurance premiums, TV subscription etc.
  • Irregular expenses such as clothing, purchases of personal discretion.
  • Large expenses such as White goods, Vacations abroad etc
  • Goals such as College admission, marriages etc.

To personalise this example let me relate it to you as a reader. For the next 12 months, list out all possible cash needs you have out of these categories. For example you may have something looking like this:-

  • Monthly household expenses @ 40000, Annual costs = 4.8 lacs
  • School fees @ 10000, Annual costs = 1.2 lacs
  • Insurance premiums, TV service etc, Annual costs = 1 lac
  • Vacations, White goods, Annual costs = 1 lac
  • No large goals in next 12 months.

What does this really mean? In cash flow terms, your outflow will be to the tune of 8 lacs. So if you have got 8 lacs and more from your salary or business you are fine, right? This is unfortunately not true at all – understand that your outflows on large goals are not there now but they will occur at some point in time. When it does you have to spend and that amount may not be possible from your normal cash inflow. Let us say your son will go to a college that costs 5 lacs a year for 4 years. If this amount can be catered for through your active income, you are home and dry. If not then you must invest in the years before he gets to college so that when the time comes you have access to the money. Similarly you need to plan for your retirement – at that time you have no active income but your household expenses remain there. So, you must have some alternate source of cash inflow so that you are able to sustain your expenses.

Where does cash inflow come from? Well, there can be several sources, but some of the more common ones are as follows:-

  • Salary from your job
  • Income from business or profession
  • Income from hobbies or other interests ( blogging etc)
  • Interest income, dividends
  • Rental income
  • Capital gains from selling an asset
  • Redeeming financial instruments

Where does the water analogy come in? Well, you can think of regular cash flows as the water that is supplied to your house every day by the City corporation. Most of your needs are met by that. However, you also store some water for an emergency that may occur. In case you are planning to clean your house thoroughly, you will plan to arrange for availability of water etc. What happens if you are having a big function at your house and you need to have a lot of water? Well, in case you have stored it in a tank etc you can use that. Alternately you can get some water tankers to get water for you. This is similar to redeeming financial instruments for a large goal. You can also stretch the thought process to look at these tankers as a loan – in that case you have to pay back the water just as you pay back through EMI for the loans.

The bottom line is this – your cash inflows either in term of current income or income from past investments or loans must match your cash outflow needs at all points in time. With the water analogy we have to look at running water, water stored earlier or water obtained from external sources such as tankers to take care of our needed consumption.

Pretty simple really, if you think of it a little and then the entire financial planning just becomes an exercise in cash flow management. How do we factor in investments into this? Well, I will cover that in another post as this one has already got quite long.

A life plan must precede a financial plan

With the increasing readership of my blog, I get a lot of requests to either make financial plans for people or to review an existing financial plan that was made by someone for them. What strikes me as amazing is that people by and large focus greatly on their financial goals and almost take their life goals for granted. This flies in the face of the obvious reality – your finances are there to support your life goals and therefore must come after you have thought through your life goals.

The first thing which surprises me is that people project their lives for the next 30 years or so without having the ambition to do more with it. Let us say you have passed out of college and got a job. While it may be a job which you like, you may still look at ways and means of improving it. An IT person who started his career just 5 years back may already be finding himself in the cross roads. There is no guarantee that your current job will last for 10 years, let alone 30. It is therefore imperative that you fix your life goals based on your current skills, future skills you may need to acquire and the kind of work you want to do. It may be necessary for you to take up your first job for many reasons, but there will be equally good reasons as to why you may want to do other things.

The same goes for people who are in their mid career with a family. Yes, changing your life direction may be more difficult now but it is not impossible by any means. I had a friend who was a hotel manager for 10 years, worked in Rediff for another 10 years, went on to do an MBA abroad and is now a professor in an US Business school. Note that the latter career moves were all done when he had a family. Another friend of mine who is from an IIT and an IIM, went to the US recently to pursue a second MBA as he was not happy with how his career was shaping up. In his case too he took his wife and a young daughter to the US. There is no doubt that these people had to go through a lot of tough times but they were clear as to what they wanted to achieve.

Changing careers are getting much more common nowadays than ever before. I just came to know of a Doctor, who practised for 7 years after his MBBS and has now got into IIM Ahmedabad for their one year Executive program. He wants to be associated with Health care but not as a practising Doctor and felt that an Executive MBA will give him the opportunities that he is seeking out.

The problem with financial plans is that they are done assuming people will proceed in their lives linearly. They will start with a job, increase their salaries every year, get married, invest and increase their investments, plan their finances, home buying and have other goals such as children’s education, marriage and retirement. This does not at all cater to real life and real people. For example, I started working at 24 and always wanted to retire at 45, or at least be financially independent by then. If I had been to a financial planner, he would probably have told me that I needed to work for 35 years and early retirement was just not possible in India.

The logic can get extended to any particular passion you have in life. Earlier it was difficult to take up your passion due to lack of resources and opportunity. However, many people nowadays want to take up their passion after they have fulfilled most of their responsibilities. I know of people who have taken up travel, reading, teaching and several other interest areas at a relatively late stage in life and have done very well in them.

So the point is your life plan must be dynamic in nature to fulfil the aspirations you have. We will not meet all our aspirations but there should be a clear and concerted attempt to do so. The financial plan must adapt to your life journey not the other way round. You need a financial planner who understands this.

How does one go about doing this? Let that be the subject of another post.