The Need for Financial Planning
There is an old saying in Tamil which challenges one to “Build a House and Marry off a Child” – a financial implication that starts when the parents are in their 40s. Today, the challenge starts as early as when the child is in preschool; when the parents are still in their twenties or early thirties. Never in India’s history has ‘quality’ education been so expensive and daunting.
The Traditional Challenges
The traditional avenues that any parent is concerned about, while planning for expenses relating to children, are for their higher education (college and PG programs) and their marriage. With inflation hovering in double digits, the expected cost of higher studies for their children, leads to a mental paralysis for any parent. A quick calculation in a spreadsheet shows, that based on today’s cost of `4 lakh for an engineering education, one requires close to `22.25 lakh in 18 years at 10% inflation. Will a young couple have the wherewithal to save for this?
Indian parents are deeply stressed over the rise in gold prices. With a sovereign of gold costing around `23,000, gifting one’s daughter 100 sovereigns of gold for her marriage is more of a pipe dream for many parents. Also consider that some of the ‘best’ caterers are charging upwards of `125 per plate for marriage functions. Is it the end of 3 day marriage celebrations with a gathering of 1000 people (for the middle class, at least)?
The Modern Challenges
The modern challenges facing today’s parents start even earlier. Just the LKG admissions cost anywhere from `25,000 to `50,000 in an ‘average’ school in a Class B city. Metro schools cost more and so do ‘premium’ schools.
Added to the above ‘basic’ needs, there are the other needs related to social and peer pressure facing children that parents feel they need to satisfy. It could be a laptop requirement from the school for students of Class 5 and above. Or it could be that foreign vacation that the parent cannot afford, which is routinely indulged in by his son’s classmates.
It could be that your daughter wants an Apple iPhone4s, because all the ‘cool’ girls in her Class XI carry smart phones. While they update their Facebook page every minute, she has to wait to get home to her PC to update her Facebook page.
Financial Planning for our children has two parts. The easier to solve is the financial part, the more intense and difficult one is the behavioural part. The financial part of the financial planning is as follows:
- To set goals on what is to be done in the future.
- Assign values / estimates at today’s cost.
- Forecast (there will be large margins of error here) the expected cost in the future.
- Start saving/ investing to reach the targets
- Fine tune on a yearly basis (more or less, or as often as the situation demands).
Just some knowledge of basic mathematics and use of a spreadsheet should be able to take anyone comfortably through this process. The data related to returns forecasting and inflation related data can be taken from Google and mutual fund sites.
Behavioural Aspects of Finance
Though the above process is (relatively) easy, each of the steps has behavioural aspects that could make or break the planning and execution. The key is to set ‘realistic’ targets /goals, with the least amount of stress. The problem is that there is no absolute standard here – everything is relative. Things such as ratios (spend 10% of your income for children, 30% on your housing loan, 10% on food, etc) also do not work, as they are all dependent on the income levels and commitments that one faces (do you live with your parents/in-laws, do you work away from your home town [travel costs], what are your existing loans, what are your hobbies, etc).
The realistic goals again depend on one’s aspirations, society (peer group) and self-image. Today, one faces questions such as - Is it ok to spend `20,000 for a birthday party? Is the school that charges `1 lakh per year in the 1st standard the right school for my child? Do I need to spend `3 lakhs for my daughter’s ‘Arangetram’ (first stage appearance in singing or dancing)? Should my child study abroad? The answer to all the above questions is “It Depends!” It depends on the family’s situation now and what we need to sacrifice now, and later.
The last thing that anybody would want to do on any given day is to fill a boring application form for an investment or insurance. Even if we cross the problems of setting goals, to actually implement them is something that faces a lot of static inertia, even if it is for our children.
Sticking to a Plan
Have you had emergencies where you had to pull out an investment? Everyone has. The difference is that the severity of the emergency will vary. The emergencies may be - My father is in the ICU; my son’s school fees needs to be paid; its Christmas/ New Year shopping season; I absolutely need to have this new car/bike/mobile phone/laptop/TV/home theatre; my mother-in-law is visiting.
The other two major reasons why many do not stick to plans are:
- Slick financial products sales people who make you change a plan because it has completed its 3 or 5 years minimum term, and he now advises you to buy a plan in the new company that he is in. This way, you lose and he wins.
- Market fluctuations – When we plant a tree, do we pull it out every month to check if the roots have grown? And if the growth of the tree (above the ground that is!) is slow, do we give it more fertilizers and protection or just pull it out and plant a new one?
Then why do we need to check if the child’s fund (which is planned for a 15 year term) has grown or not every month? If the market is down, do we need to invest more or do we close a fund and get out with a loss?
The Way Ahead
The challenges for financial planning today are very different from the ones faced by our parents. Parents need to invest time and effort in thinking ideas through; financial planning also needs a basic knowledge of economics trends and financial products in the market. It will not do to let things be and face things as they come.
The best part though, is that every parent can do a proper financial plan for their children and come out successfully. The first step in this process is to realize and accept that there is a need to systematically plan and execute.
Only we are responsible for our children’s financial future.
Avenues for Investment for Children
None of the investment avenues in the market today are specifically designed for children. However, we can make use of them for our children based on our intentions. The exception to this rule is some of the protection plans from insurance companies which have special features to protect our children (and spouse) in our absence.
Savings Vs Investment
First, we need to understand the difference between savings and investments. Yes, they are different!
Savings is what you do for the short term (maximum of 3 years). Typically you do not want the value of the savings to go down, come what may; you can’t buy half a bicycle, can you? The other reason for saving may be to get a regular stream of income (interest). The objective of savings is not to increase the value of the investment (a bank deposit of `1 lakh remains the same) but to ensure that it exists after the intended period.
Investment is primarily done to increase its value. This is done for the long term - typically a minimum of 5 years (will you start a business to sell it in one year?). Since the duration of the investment is long, one does not bother with short-term fluctuations in returns or loss of invested value as long as the path taken by the investment is as per plan. Investment is not done for regular steady return but for capital appreciation. For example, money invested in the shares of a bank (in contrast to the deposit made in the same bank) may not give a steady dividend but the value of the share itself will grow.
Factors to Consider while Investing/Saving
Savings and investing are not just about returns. So it is not necessary that one plan/product that gives 25% returns is better than the one that gives only 10%. All of us have seen dozens of ‘finance’ companies promising very high returns and then running away with our money.
Even in returns we have to look at two things; the regular income that the avenue will give and the capital appreciation that it can give. We also need to see if there are fluctuations in the returns. An avenue with high fluctuations is considered to have more risk. For example, two investments may give 10% average returns over a 5 year period. The first one gives 10% on a yearly basis. The second one gives returns varying between 40% gain and 10% loss, but its compounded average is still 10%. This means that the final amount in our hands at the end of the 5 years is the same. However the second investment carries higher risk.
Liquidity or marketability is a key factor to consider while investing for children. I cannot ask the college management to hold the seat for my daughter for the next 3 months, because I have to sell a piece of land at the right market price. An avenue having high liquidity can be sold at the market price quickly. Tax implications also have to be considered before a particular avenue is chosen.
Asset Vs Liability Vs Expense
Another set of distinctions have to be studied before we can look at investment strategies for children as it will determine how we release cash for our children’s needs. This is to understand the difference between assets, liabilities and expenses. From the personal finance angle, the definition of an asset is something that generates a positive cash flow. Liabilities create a negative cash flow and expenses take away our money just once.
The car is a liability as it continues to guzzle cash (in the form of fuel, maintenance and insurance). Your daughter’s school books are an expense. Your daughter’s Apple iPhone 4S is a liability (higher rentals - in spite of the 50% discount offered by the service providers. The question is will you choose the same rental program for a normal phone?). A house given out on rent is an asset and so is the house that you live in if you intend to sell it with capital appreciation. However the house that you live in and don’t intend to sell, is a liability. Please think whether the jewellery that you buy for yourself is an expense or an asset.
Apart from the above strategies, there are a few MUST DOs related to children. The first and foremost is to take a life insurance term plan with high cover. The term plan is the only TRUE insurance. There is no money returned, if there is no loss of the life insured. A car worth `7.5 lakh will need an insurance premium of about `17,000, and you only make a claim when there is damage. For the same premium, a 35-year-old person can be insured for `1 crore. Consider the term plan premium as an expense that you make for your loved ones. By taking up a term plan I ensure that my children’s dreams and my dreams for them happen whether I am around or not.
The need for a term plan can be calculated as 12 times your annual income plus the outstanding loan principals. Reviewing the term plan cover has to be done once in 2-3 years. (The 12 comes from taking the long term average bank interest at 8%). The insurance cover should give our family members at least the income that we make today if we are no more. This can be done by depositing the insurance claim in a bank deposit and the yearly interest has to be equal to our income
So cover has to be = (Income/8%) or approximately (Income x 12). This thumb rule is the minimum cover that one needs and it does not cover for inflation.
Take up a health insurance plan for the family with at least `5 lakh as a floater cover. The floater plan is one, where the cover is shared among the members of the family. When you cross 45, shift from the floater to individual cover of `5 lakh. If your forefathers had any critical illness (cancer, heart/kidney failures, stroke, etc) then it is advisable to take a top-up health insurance going up to `10 lakh. These values are for today, as inflation increases the health care costs, the covers will also need to be increased.
Public Provident Fund (PPF), endowment type insurance plans and money-back insurance plans are a strict NO NO! They are what are technically called as ‘Asset Class Mismatches’. They are savings plans but designed for the long term. Hence, their returns are lower than inflation and they hardly have any liquidity. Their typical form of liquidity is to take a loan from the fund. It does not make sense to me to take money from my savings and then pay an interest to somebody. The money back plan of course has liquidity planned into it. But one has to pay a much higher premium for the plan.
The other ‘must not do’ is to borrow to invest in a tax savings plan or for trading in the stock market (day trading). Borrowing for a liability is also a NO NO! A car bought on loan is the typical example. On one side you pay more than the car’s worth due to the interest, on the other side the car depreciates. Instead, think of buying a second hand car with the cash that you have.
Changing trends need different thoughts too. Along with the changes in social and economic scenarios, we also need to think differently for our children. Here are a few of the things that we can do for our children. Can you think of:
- Giving your daughter a house instead of 100 sovereigns of gold on her marriage? It has more utility.
- Create a business fund instead of a higher education fund? An education loan is easier than a new business loan.
- When a child is born, instead of buying gold, plant a set of teak trees. The trees are good for the environment and also will yield timber which is appreciating in price, faster than gold.
- Build a set of row houses (2 or more smaller apartments) rather than one big one – the rental income will be higher again. Also based on the need, you can sell them one by one to meet the different needs of your children. On the same note, build a commercial building rather than a house. The rental income is higher for commercial properties.
Explaining ULIPs and Children plans
The total annual premium for any ULIP or Unit Linked Insurance plan has two components. The first is the life cover or actual insurance, known as ‘Sum Assured’. The amount deducted for this is called Premium allocation charge. Additionally administration charges are deducted, and the remaining goes into the other crucial component – your investment. Units accrue into your account from these investments made on your behalf by the insurance company, either into the equity markets, or debt markets, or a mix of both (you choose this).
In normal ULIP plans, the insurer pays out either the sum assured, (the actual insurance amount or risk cover) or the investment amount (from the Units), whichever is higher, upon the death of the insured. The total plan terminates at this point. If the person survives the entire term, only the investment amount is paid out. Units can be redeemed when needed, (the value of your investment can be tracked at the company’s website) but it pays to stay on for the full term and be regular with premium payments.
In a Child plan, the parent(s) are insured, and the beneficiary is the child. On the loss of the insured parent, the plan does not terminate, but continues till the end of term. Future premiums need not be paid, and the plan’s benefits will continue for the child. Some policies or plans also provide a monthly/yearly allowance for the child till the end of the term. Some policies give a double benefit. They pay the Sum Assured immediately upon the loss of the parent and take the onus of paying future premiums into the investment account, for the remaining term. This ensures that the investments continue to grow for the child. Since the benefits are more in a Child plan, the charges are also higher than the normal ULIP plans.
Children Plans cannot take care of all the life insurance needs. They can be taken after sufficient cover is achieved using term plan(s).
Note about the Comparisons:
- Charges mentioned are a percentage of one annual premium for the first 10 years. Fixed charges have been converted to a percentage, based on the lowest allowed annual premium.
- Only Unit Linked Plans have been compared, since only these plans make sense for long term investment. Endowment plans being savings plans are not suitable for long term investments.
- The Unique Plan Number is provided by IRDA. Quote this number when asking for a plan and cross check the same when you receive the policy document. Sometimes similar sounding names of plans have caused confusion leading to purchase of wrong plans.
- The comparisons are based on charges. The lesser the charges, the better will be the returns.
- The lumping of charges towards the beginning of the plan will lead to slower fund growth.
- When using Unit Linked Funds, invest preferably on a monthly basis. Continue investing in the equity oriented funds till 3 to 4 years to maturity. At this point, shift the accumulated corpus gradually into the debt/liquid funds. This will maximise the returns and safeguard the funds. Unless market savvy, it is not advisable to use the switching option.
Strategies for Children
No single investment avenue in the market can take care of all the needs related to our children. The best way to plan for their future is to segregate needs into the short term and long term.
The short term needs like school admissions, computer, the bicycle, holidays, hobby expenses (my daughter wants to go to Srilanka and Malaysia for Yoga camps and competitions), etc need to be met from savings type avenues.
Long term needs like college admissions, PG courses and marriages need to be met from investment type avenues. However, many of the long term investments like land and buildings have very low liquidity. Also mutual funds and direct investment in stocks fluctuate based on the market conditions. I cannot stop a market from falling because it is the year of my daughter’s college admission.
The strategy here will be to stay invested in the long term investment till a year or two before the actual need. Then the investment needs to be shifted into a savings avenue with quick liquidity. (Sell the piece of land when she is in her 10th or 11th standard and keep it in a bank deposit or debt mutual fund).This way we can make the gains and also manage the market fluctuations. One should not worry about the ‘virtual’ loss if the markets do grow in the last year also.
Karthikeyan Jawahar is a founder director of Finerva Financial Services, advising on personal finance.