Live Life King Size By Planning Your Personal Finances

The other day, I had an animated discussion with a youngster who is in her final stages of completing her masters and is to commence her work life shortly. The discussion primarily focused on sharing my personal financial knowledge and experience with her, which she very grudgingly tried to accept. I could feel that she was not convinced with my various arguments for the simple reason that her zest to live and enjoy her life through parties, vacations and shopping had obfuscated her financial rationale. Her bewilderment at having to lock-in a sizeable amount of her salary to save taxes, naivety about the fact that wealth creation through compounding needs time and incomprehension that she must plan and start saving for her retirement from now on pushed me into penning down this article for the financial betterment of more youngsters like her.

To make the youngsters understand the financial nuances, I have assumed that they start work at age 24 years in the financial year 2018-19. They get a take-home salary of ₹ 5 Lakh (approximately ₹ 40,000 per month) along with a performance-based variable component of ₹ 1.5 Lakh per annum. Their monthly expense is roughly ₹ 25 to 30,000 that includes their daily necessities, boarding and lodging, and weekend parties. In accordance with these details, I assume that they save and invest the balance money either into high-risk diversified equity mutual fund or tax-saving ELSS mutual fund that generates a modest 10% annualized return over a long-term horizon. To exemplify my subsequent arguments and logic, I have used the undermentioned saving options:

Option 1 – the youngster saves ₹ 10,000 per month (₹ 1.2 Lakh annually) for 37 years till his retirement at the age of 60 years.

Option 2 – the youngster saves ₹ 12,500 per month (₹ 1.5 Lakh annually) for 37 years till his retirement at the age of 60 years.

Option 3 – the youngster saves ₹ 15,000 per month (₹ 1.8 Lakh annually) for 37 years till his retirement at the age of 60 years.

In all three options, the Corpus has grown sizeably after investing regularly for 37 years. As per the table and chart below, in options 1, 2 and 3, the total investment was ₹ 44.4, 55.5 and 66.6 Lakh, whereas, the corpus has grown to 4.18, 5.23 and 6.27 Crore respectively.

Details Option 1 Option 2 Option 3
Investment 44,40,000 55,50,000 66,60,000
Corpus 4,18,16,931 5,22,71,163 6,27,25,396
Growth 3,73,76,931 4,67,21,163 5,60,65,396
No of Years 37 37 37
Starting Age 24 24 24
Maturity Age 60 60 60
Start FY 2019 2019 2019
Maturity FY 2055 2055 2055

 

Mutual fund in jaipur

Planning and Spending: 

Whenever youngsters set out on their life’s journey, it is important for them to formulate their life’s goals in terms of their career, marriage, and children. Once they have clearly defined this, then they must break down their life’s journey through various stages to formulate their financial goals. These goals will pertain to their own marriage (if the parents are not financially well off), settling down into their post-marriage home to include buying a house and white goods, furniture and other furnishings that go along with it, children education especially higher education, children marriage, and finally their own retirement. These financial goals occur at different stages of life and saving for them is important. Thomas Jefferson had famously remarked, “Never spend your money before you have it.” Saving up to meet these major financial goals will help minimize debt while keeping a budget in line. People simply buy consumer goods on EMI and spend paying it off along with interest. However, if they can delay the purchase and save for it, they will both avoid debt and paying interest.

 

Save Pennies to Earn Pounds:

Warren Buffet had famously remarked, “Do not save what is left after spending, but spend what is left after saving.” A concerted and conscientious effort by an investor to make small sacrifices will lead to small savings, which over the period will accumulate large wealth and make a huge difference to his lifestyle. The table below exemplifies some common places where youngsters can make small savings

Cigarette Beer Movies & Restaurants
Skip 1 cigarette a day 1 beer over a weekend One movie & dinner in a month
Cost ₹ 15 per cigarette ₹ 200 per pint ₹ 1,500 per movie & dinner
Annual Saving Invested ₹ 5,475 ₹ 10,400 ₹ 18,000
Rate of Return 10% 10% 10%
Corpus after 37 Years ₹ 19.9 Lakh ₹ 37.8 Lakh ₹ 65.3 Lakh
Total Wealth Accumulated                                            ₹ 1.23 Crore

Starting Early:

The aptness of 17th Century adage that ‘the early bird catches the worm’ in financial management is unrivalled. Nevertheless, our youngsters are careless with their savings and investments during the first 8 to 10 years of their careers. It is only after about 30 or 35 years of age that they feel the need to save and invest for their financial goals. By then, it is too late and they have missed the investment bus that would have taken them to their identified financial goals. To explain the loss that one incurs by starting investments late in life, I have considered that an individual start investing ₹ 10,000 per month from the age of 24, 30, 35 and 40 years. The table and chart below clarify that the percentage growth loss is maximum when one starts investment at the age of 40 and reduces as one starts investing early.

Start at 24 Start at 30 Start at 35 Start at 40
Investment 44,40,000 37,20,000 31,20,000 25,20,000
Corpus at 60 years 4,18,16,931 2,54,84,721 1,53,43,703 90,46,929
Investment Loss 7,20,000 13,20,000 19,20,000
Growth Loss 1,63,32,210 2,64,73,228 3,27,70,002

mutual fund advisor

mutual fund advisor

POWER OF COMPOUNDING:

For wealth creation, you need to give time to the money to grow through compounding. Einstein, while describing compound interest as the eighth wonder of the world had said, “He who understands it, earns it. He who doesn’t pay it.” Financially, compounding is the process in which one reinvests an asset’s earnings, from either capital gains or interest, to generate additional earnings over time and this makes long-term investing rewarding. If one invested ₹ 10,000 per month in SIP then you will notice in the chart below that the power of compounding grows the wealth exponentially only after about 15 years of regular investment. Therefore, it is imperative to give enough time for wealth creation through compounding.

Maloo
Maloo

Save Regularly and Incrementally: A common mistake that people make is to stop the systematic investment in between for a few months or years due to psychological reasons attributable to falling markets or other frivolous reasons attributable to domestic compulsions. The losses incurred by stopping SIP midway and restarting later are dependent on the market situation. One must remember that by continuing the SIP in falling markets, the investor tends to gain due to the purchase of additional units as the NAV is also low. In fact, prudent investment philosophy suggests that the investor should increase his SIP annually to harvest better returns eventually (refer to the table below):

Normal SIP Incremental SIP
Monthly Investment ₹ 10,000 ₹ 10,000 plus an annual increment of 5%
Assumed Rate of Return 10% 10%
Investment Duration 37 years 37 years
Amount Invested ₹ 44,40,000 ₹ 84,36,000
Corpus after 37 Years ₹ 4,67,86,616 ₹ 6,71,84,005
Growth ₹ 4,25,46,616 ₹ 5,87,48,004

Inflation Reduces Purchasing Power: The youngster must understand that inflation eats into your returns and reduces the purchasing power. Therefore, today’s ₹ 100 will become ₹ 11.34 in 30 years at the inflation rate of 7 percent per annum and will not buy the same things tomorrow. The table below enumerates some examples to highlight inflationary pressure on necessities:

Price in 1947 in ₹ Price in 1997 in ₹ Current Price in ₹
Sugar (Kg) 0.4 16 40
Atta (Kg) 0.1 12 38
Rice (Kg) 0.12 20 52
Milk Full Cream (Ltr) 0.12 18 50

Real Rate of Returns: Connected with inflation is the real rate of return. It is important for an investor to understand this aspect of personal finance. Suppose a bank fixed deposit gives an interest of 7.5 percent on your investment. If the prevalent inflation is 4.5 percent and you are in a taxable bracket where you are liable to pay 2.55 percent tax on the interest earned, then the real rate of return on the investment is a meagre 0.45 percent. Therefore, for longer time horizon it is prudent to invest into equity either directly or through the mutual funds since they have the potential to beat inflation and deliver higher returns over long-term.

Taxation: An important aspect of financial planning is the taxation policy of the government. Simply put, an individual pays taxes on multiple counts. First is the GST on purchase of goods; second is the income tax on his total income; third is the tax (short-term and long-term based on the duration of financial instruments) on the capital gains from investments or real estate sale. Capital gains tax is chargeable only on the capital gains made during the financial year as per various capital gains tax rate including indexation benefit for long-term investments. Whereas, income from interest earned on fixed income financial instruments is taxable as per existing IT slab of the individual for the entire interest earned in the financial year. Moreover, there is no tax deduction at source (TDS) applicable to capital gains but the same is applicable to interest income from financial instruments. These tax rates are subject to change as per government decision from time to time. The reckoners below will help you understand the applicable rates for FY 2019-20.

       INCOME TAXABILITY AND COMMON DEDUCTIONS/EXEMPTIONS
Details Max Tax Relief Amount
Gross Salary ₹ 8.05 Lakh
Various instruments under Sec 80(C) ₹ 1.5 Lakh
Health insurance under Sec 80(D) if self, spouse, and children are less than 60 years and parents are above 60 years ₹ 55,000
NPS (Additional Relief) ₹ 50,000
Standard Deduction for salaried employees ₹ 50,000
Net Taxable Income ₹ 5 Lakh
(a-(b+c+d+e))

Note: An individual with taxable income up to ₹ 5 lakh will not pay any taxes. However, if the taxable income is above ₹ 5 Lakh then he will pay taxes as per slab rates are given below. He can avail additional tax benefit from home loans and charitable donations.

                                 INCOME TAX SLABS (including 4 percent cess)
Income Slab Individual < 60 years Senior Citizen > 60 years but < 80 years Very Senior Citizen > 80 years
Up to ₹ 2.5 Lakh NIL NIL NIL
₹ 2.5 to 3 Lakh 5.20% NIL NIL
₹ 3 to 5 Lakh 5.20% 5.20% NIL
₹ 5 to 10 Lakh 20.80% 20.80% 20.80%
Above ₹ 10 Lakh 31.20% 31.20% 31.20%
    CAPITAL GAINS TAX (excluding surcharge but including 4 percent cess)
Tax Other than Stocks and Equity Schemes Stocks and Equity MF Schemes
Long-Term Capital Gains (LTCG) 20.80% with indexation benefit if investment held for more than 36 months 10.40% on gains above ₹ 1 Lakh if investment held for more than 12 months
Short-Term Capital Gains (STCG) As per individual’s IT slab if investment held for less than 36 months 15.60% if investment held for less than 12 months

Retirement Goal: Most people do not realize the importance to save for their retirement from the word go and tend to delay this decision for the future. All the financial aspects that we have discussed so far come into play while planning for retirement. An individual must start early, invest regularly and adequately, and allow the power of compounding to grow his wealth to avoid impoverishment during his sunset years. The table below will help you to understand the dynamics of retirement planning:

                                               RETIREMENT PLANNER 
Current Age 24
Retirement Age 60
Life Expectancy 85
Current Monthly Expense ₹ 30,000
Monthly expense after 37 years at 60 years of age at 7% inflation ₹ 3,66,709
Corpus required at 60 years of age to last 25 years of retired life with assumed annual returns of 10 percent and inflation of 7% ₹ 7.32 Crore
Monthly SIP required to build a corpus of ₹ 7.32 Crore over 37 years at 10% annualized rate of return ₹ 15,580
financial advisor in jaipur
financial advisor in Jaipur

Mutual Fund VS Unit Linked Insurance plan

A few days ago, two of my friends, one in corporate aged 50 and the other in Defence Services aged 35, came to me and said that of late an insurance agent has been pressing them to buy Unit Linked Insurance Plans (ULIP). He is giving the logic that Budget 2018 proposal to re-levy the long term capital gains (LTCG) tax on MF has made them less attractive vis-à-vis ULIP. I told them to let me carry out an objective assessment and then put across both these products. The assessment transpired as follows:

MF – A mutual fund is an investment vehicle made up of a pool of money collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments, and other assets. Mutual funds are operated by professional money managers(mutual fund company in Jaipur), who allocate the fund’s investments and attempt to produce capital gains and/or income for the fund’s investors. A mutual fund’s portfolio is structured and maintained to match the investment objectives stated in its prospectus.

ULIP – It is a combination of insurance and investment. As a single integrated plan, the investment part and the protection part can be managed according to specific needs and choices. As a structured life insurance product, this provides risk cover for the policyholder along with investment options to invest in any number of qualified investments such as stocks, bonds or mutual funds. Here policyholder can pay a monthly or annual premium. A small amount of the premium goes to secure life insurance and rest of the money is invested just like a mutual fund does. Policyholder goes on investing through the term of the policy – 5, 10 or 15 years and accumulates the units. ULIP offers investors options that invest in equity and debt. An aggressive investor can pick equity oriented fund option whereas a conservative one can go with debt option.

Comparison

Ø  Costs – Until 2010 the cost structure unequivocally favored the MF that only levied Total Expense Ratio and entry/exit loads whereas ULIP levied multiple charges like premium allocation, policy administration, fund management, surrender, and mortality. While the MF charges aggregated to about 1.5 to 2.25%, the ULIP went as high as 25 to 30% in the first year and reduced thereafter. Consequent to directions of the insurance regulator (IRDA), the maximum reduction in yield, excluding mortality charges, due to ULIP costs are now capped in the first 5 years at 4%, from 5 to 10 years at 3% and from 10 year onwards at 2.5%. Moreover, the costs of ULIP are front-loaded (mostly levied in the first five years of the investment) whereas those of MF are even-loaded (levied regularly and evenly through the entire duration).

Ø  Returns – MF has consistently delivered better returns than ULIP in all time horizons. It is only after 12 to 15 years that ULIP comes at par with MF for returns. A comparative chart by Advisorkhoj proves this point:

Category Top Performing MF Top Performing ULIP
Large Cap equity 13 – 14 % 11 – 14%
Flexi cap Equity 14 – 16% 8 – 9%
Small/Mid Cap Equity 14 – 18% 13 – 15%
Balanced 13 – 14% 10 – 13%
Debt-oriented Hybrid 10 – 12% 10 – 11%
Income 8.5 – 9.5% 8.5 – 9.5%

Ø  Cost-Return Relationship – The ULIP have equitable cost for investment in debt and equity oriented schemes. However, the TER charged by MF is more in case of equity oriented funds and less in case of debt funds. This implies that in accordance with the lower returns of a debt MF, an investor pays lesser investment cost and pays more for investing in equity MF that give higher returns. However, in ULIP he pays the uniform cost for investing in debt and equity schemes, which is not beneficial for the investor.

Ø  Taxation – This is where the ULIP scores heavily against the MF after the recent budget proposal. Earlier, the taxation policy was slightly biased in favor of ULIP since they provided the Sec 80C relief to the investor, which MF, except ELSS, did not provide. Moreover, ULIP offered tax-free returns after staying invested for 5 years whereas only equity MF gave tax-free returns after one-year lock-in. The tax-free advantage of ULIP extends beyond the equity funds to the fixed income space, which is not the case in MF.

Ø  Liquidity – The ULIP are less liquid than MF since they have a five year lock-in period and permit only partial withdrawal after that period. In the case of MF, only the ELSS have a three-year lock-in period. In other MF the investor can redeem fully or partially after paying an exit load of about 1 to 1.5% if redeemed within one year from the date of investment.

Ø  Flexibility – This has two aspects. The first is flexibility to redeem when required that is more in case of MF as discussed under liquidity. The second aspect is switching funds or stopping investment, which is afforded more by MF than ULIP. In MF, one can switch investment at will between different schemes of the same Asset Management Company (AMC) or even switch to other schemes of different AMC. However, this is not possible in the case of ULIP where one is allowed to switch only between offered schemes of the same AMC.

Ø  Transparency – MF are relatively more transparent since they are more widely tracked by numerous agencies vis-à-vis ULIP. Moreover, charge structure of ULIP is fairly complicated and some of the charges levied by ULIP are not built into the NAV, unlike the MF, but are deducted directly from the units held.

Ø  Choice – The choices available in MF are far more than those available in ULIP. There are 42 AMCs with over 2400 schemes available in MF, whereas ULIP count runs only into a hundred plus. Besides choice, it is easier to invest online in MF than ULIP, once KYC is done, as ULIP requires more documentation and insurance being an insurance product.

ULIP COMPARISON POINT MF
Higher COST Lower
Less RETURNS More
Lower TAXATION Higher
Less LIQUIDITY More
Lesser FLEXIBILITY Greater
Less TRANSPARENCY More
Less CHOICE More

Luring Investors

Ø  Insurance Cover –The investor must understand that the insurance cover provided by ULIP is inadequate. Ideally, an earning member must ensure himself for ten times his annual income. However, ULIP provides life cover that is only 10 times the annual premium, which is far lesser than annual income. Moreover, ULIP certainly does not cover deaths due to war and most of them also exclude death due to terror or terror-related activities. Therefore, read the fine print (especially defense and paramilitary personnel) for exclusions before signing on the dotted line.

Ø  Wealth Creation – ULIP is normally sold as a wealth creation instrument. One must remember that investment prudence suggests mixing up investment and insurance in one product is less productive from a wealth creation point of view than separate investment (MF) and insurance product (term plan). The wealth creation normally takes place after 12 to 15 years of investment when the ULIP starts generating higher returns with lower costs.

Ø  Age of Investor – Lot of agents incorrectly sell ULIP to retired or retiring people by saying that they must take an insurance product since their corporate or group insurance policies will cease after their retirement. Normally agents selling ULIP as an insurance product entice investors of all age groups by quoting tax-free returns, 10 fold insurance cover of the premium and its wealth creation ability. ULIP is a reasonably good product for young and high tax bracket investor. Entering ULIP after 50 or 55 years of age has some distinct disadvantages. First, you require regular cash flow to pay regular premiums or lump sum investment for a one-time premium. Second, the lock-in period of 5 years restricts your flexibility and usability of the funds. Third, wealth creation takes a long time (12 to 15 years) and thus may not be feasible for aged investors.

Exiting ULIP

Ø  Free Look Period – By and large if you are not satisfied with the terms and conditions of the policy, you can return the policy document to the Company for cancellation within 15 days from the date of receipt of the policy document or 30 days from the date of receipt of the policy document, if the policy is purchased through distance marketing.

Ø  Policy Surrender – Normally during the first five policy years, if you surrender the policy, the Fund Value including top-up fund value, if any, after deduction of applicable discontinuance charge, shall be transferred to the Discontinued Policy Fund (DP Fund). You or your nominee will be entitled to receive the DPF Value, on the earlier of death or the expiry of the lock-in period. Currently, the lock-in period is five years from policy inception. However, on surrender after completion of the fifth policy year, you will be entitled to the fund value including top-up fund value, if any.

Ø  Partial Withdrawal – In general, partial withdrawals are allowed after the completion of five policy years and on payment of all premiums for the first five policy years. You can make an unlimited number of partial withdrawals as long as the total amount of partial withdrawals in a year does not exceed 20% of the Fund Value in a policy year. The partial withdrawals are free of cost. Partial withdrawals and switches are not allowed during the settlement period.

Exiting MF

Ø  Exit Load – In case you decide to exit fully or partially, before one year then you are liable to pay exit load that is charged at the time of redeeming (or transferring an investment between schemes). The exit load percentage is deducted from the NAV at the time of redemption (or transfer between schemes) and this amount goes to the scheme.

Ask these Questions Before Investing?

Ø  What is your risk appetite?

Ø  What are your financial goals?

Ø  Do you need insurance cover?

Ø  What is your investment horizon?

Ø  Do you clearly understand the complicated structure of ULIP?

Ø  Can you organize regular and sustained cash flow to pay your premiums?

Ø  Are you an active investor to switch within the structured ULIP products?

Ø  Are you willing and equipped to continue the ULIP until its maturity or you will be forced to exit early?

OWNERSHIP Vs FIXED INCOME INVESTMENT

Initial Investment: Back in 2000, four friends made a New Year resolution to invest their savings of about Rs. 50,000/- each with the intention to ‘invest and forget’. Accordingly, on 01 Apr 2000, in the new financial year, friend A bought 7093 shares of AXIS Bank @ purchase value of Rs. 50,006/-, B bought 1015 shares of HDFC Bank @ purchase value of Rs. 50,029/- and C bought 2571 shares of SBI @ purchase value of Rs. 50,006/-. However, their fourth friend, being conservative, invested his savings in the cumulative FD of SBI @ 9.5% initial interest rate. Now in 2018, they decided to see their investment values and compare their returns. Thus, what they saw of their returns astonished them and we have summarized it below for your better understanding:

Investment Type Amount Invested on  01 Apr 2000 The value on 01 Feb 2018 Growth of Corpus XIRR Dividend
AXIS Bank (Friend A) Shares (Ownership) 50,006 38,14,261 7528% 27% 1880%
HDFC Bank (Friend B) Shares (Ownership) 50,029 19,07,946 3714% 23% 3008%
SBI (Friend C) Shares (Ownership) 50,006 6,98,669 1297% 16% 3750%
SBI (Friend D) FD (Investment) 50,000 1,96,315 293% 8% 0%
Notes:

ØThe holding period of the securities is 6515 days or 17 years and 10 months.

ØThe FD is a quarterly compounding and a cumulative deposit.

ØDividend earned is on the face value of the shares.

The concept of Ownership: This concept entails that you buy shares of the bank or company that you want to take ownership. Buying some shares of the bank/company makes you a shareholder and provides your part ownership. However, prudence demands that before buying these shares you must check the fundamentals of the company to be sure that you put your money on a winner. The other point to be borne in mind is that you should undertake ownership for a long duration to cater for adverse market cycles and give time for the bank/company to grow adequately. Nevertheless, a word of caution that ownership is subject to market risks and subject

The concept of Fixed Investment: In this concept, you give your money to a bank/company for investment in a fixed deposit. By this, you ensure capital protection of your money but the returns are far lower than ownership. In fact, at times these returns cannot even beat the inflationary costs and gradually erodes the time value of your money. In the given example, the bank gives you an XIRR of 8% on your cumulative FD investment. In case, you require a business loan of the larger amount then the same bank will provide a loan at 12%. Now, if you have to repay this loan, then your investments must fetch you a minimum of 18% return to repay and beat the inflation.

Taxation: As per the taxation policy in vogue, the capital gains (difference of sale value from cost value) from shares is taxable only in the short term (less than one-year holding) @15%. No tax is applicable in the long term (more than one-year holding). However, the income (interest) from FD is taxable at the applicable tax slab rate of the investor, irrespective of its holding period. The 2018 budgetary proposal has introduced long-term capital gains tax @10% (without indexation) on gains more than Rs 1 Lakh with effect from 01 Apr 18 but left short-term gains and interest income taxation unchanged.

Asset Allocation: An investor must remember that he must not risk everything in one type of investment. He must follow the cardinal principle of diversification of asset allocation and invest in equity as per his risk-return profile, which is a function of his age, risk appetite and liabilities. Normally you must invest 100 minuses your age percentage in equity. Therefore, if your age is 60 then you may allocate up to 40% of your investments towards equity or if your age is 30 then the equity exposure can go up to 70%.

Lessons: Owning shares is ownership of the bank/company and is beneficial in the long-term than merely investing in FDs. Firstly, shares give much higher returns than fixed income instruments. Secondly, shares additionally earn dividend income that does not come with fixed income instruments. Thirdly, shares have lesser tax liability than fixed income instruments. However, while investment in fixed income instruments ensures capital protection, investment in shares is subject to market risk. Therefore, have faith in ownership of shares with a long-term investment horizon of more than 7 years.

Disclaimer: We have obtained the data for the above chart and graphs from Moneycontrol.com and RBI site. This example is to highlight that ownership is better than investment but equity investments are subject to market risks.