It is typical of investors, particularly those who are salaried employees, to presume that they will earn a salary until they are around 60; and thereafter, the interest on their savings would be adequate to cover living expenses during their golden years.
Such dreams can easily turn into nightmares due to the following factors if you haven't drawn up a well thought-out financial plan for yourself.
Rule 1: Equity investing for tackling inflation
Hitting a century in cricket is great; but living a hundred years can be a disaster, unless a person has planned her finances well, or receives unstinted care from the next generation -- preferably both.
Long-dated government securities are widely accepted as a critical component of investments for the long term. What is not that widely appreciated is that Rs 10,000 redeemed 15 years down the line is worth much less than Rs 10,000 invested today. Inflation can savage debt investments.
On the other hand, inflation boosts turnover and profits of companies. Higher earnings coupled with the same price-earnings ratio imply higher equity prices (EPS × P/E ratio = market price). Therefore, equities are considered a good hedge against inflation - and hence an important component of any long-term portfolio.
And, typically, mutual funds offer the best route to most individual investors for investing in equity.
Apart from inflation-risk, re-investment risk is significant in debt instruments. Until a few years ago, most senior citizens planned their life on the assumption that the interest and principal re-payments on their debt investments would be reinvested "safely" at 15 per cent per annum. Today, there is a sea change in the interest rate structure. Suddenly, these senior citizens have to eat into capital even for basic subsistence.
Rule 2: Life insurance to guard against premature death
When an earning member suddenly passes away, the family has to fend for itself. Insurance offers a solution here. An adequately insured person would have enough insurance coverage to ensure that the family is able to maintain its standard of living without financial worries.
Suppose a family has one earning member. They enjoy a comfortable living with Rs 400,000 per annum, excluding mortgage and other loan repayments. Loans outstanding as on date are Rs 15 lakh (Rs 1.5 million).
An adequately insured person would have insurance equivalent to the entire loan amount, plus a corpus, the interest on which would take care of regular expenses. If a return of 8 per cent per annum can be expected on investments, then Rs 400,000 recurring expenditure would necessitate a corpus of Rs 400,000¸ 0.08, i.e. Rs 50 lakh (Rs 5 million). Add the loan amount of Rs 15 lakh (Rs 1.5 million). The insured amount would need to be Rs 65 lakh (Rs 6.5 million).
While protection of standard of living would be a good plank on which to sell insurance, agents find it attractive to sell insurance to sportsmen and film stars on the plank of protection of income levels. Since such professions operate on the basis of high income during a limited phase in life, agents are able to sell insurance policies much in excess of what is required for protection of standard of living.
Insurance policies can broadly be endowment or term. Premium is lower on term policies. But if the policy-holder survives the term, she does not receive any amount from the insurance company. Endowment policies entail a higher premium. However, the insurance company pays the policy-holder even if she survives.
I have often come across investors who do not go for term policy because they do not receive anything if they survive. But based on cash flow comfort, they can afford endowment policies only worth a limited amount. In the process, they end up under-insured. This can be dangerous.
Depending on nature of the insurance requirements and the premium-paying ability, a mix of endowment and term policies would be advisable for all investors. If the investor survives the term policies, she should be happy to have lived, rather than brood over the insurance premium paid for risk protection.
According to a US expert, "Most financial planners agree that investing in insurance products is not the best way to save for retirement. The costs in these products are generally high compared with other alternatives. As a result, the added expense wipes out any tax advantage. Nevertheless, through aggressive marketing, the insurance industry has done a good job of educating people about their responsibility to save for retirement and, as a result, the insurance industry has gathered over a trillion dollars in retirement assets."
Rule 3: Emergency fund to guard against professional setback
This could be in the form of sudden loss of employment or loss of physical ability. Emergency funds in liquid form will help the investor tide over temporary difficult spells, until an alternative commercial activity becomes possible.
How much should be set aside as emergency funds? Depends on the standby support available in the family, estimate of the time frame in which an alternative vocation with similar remuneration can be expected, and the expenditure required to survive that time frame. Lower the skill diversity of the client, and greater the rigidity in mindset, more would be the time frame for which emergency funds need to be provided.
In the earlier case of Rs 400,000 annual expenditure, if the time frame to be provided for were 6 months, then the emergency fund requirement would be Rs 200,000.
Economic hiccup
Indian retirees went through a severe bout of economic hiccups during 2000-02. The lower re-alignment of interest rates in the economy forced them to eat into their capital. Which is why the advice by financial planners to invest in a mix of debt and equity makes sense. Even senior investors require equity in their investment basket. It may not be a question of whether they can afford to invest in equity, but whether they can afford not to.
What is in store - long life, sudden death, professional hiccup or economic hiccup - is anybody's guess. Therefore, every one needs to draw up a well-thought financial plan. An independent financial planner can make the plan more objective.
(Excerpt from Indian Mutual Funds Handbook by Sundar Sankaran, published by Vision Books.)
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