Financial Independence

 

                                   

A profession is important because it gives you salary which sustains your expenses like Loan EMIs, household regular expenses, hobbies and vacations. But does the job gives your other things which makes life more meaningful and enriching. If not, can you afford to leave the job or restructure it, may be less hours or less working days. Do you dread the consequences of broken earning stream? If yes then most probably you have not started on the journey towards financial independence.

Financial Independence is the stage when you are no longer dependent on your profession to support your current and future expenses. This is only possible if you have second source of income. This source can be build in the form of financial & physical assets which gives out regular earning stream. 

Financial independence enables you to choose to work or not work for a living. If you are excited about the possibility then talk to a reliable financial planner. He can draw a road map to take you to that stage. 

Why periodic review of financial plans?

Financial planners will recommend periodic review of financial plans. Clients wonder why I need a review. If I have taken actions as per initial plan, why do I need to review the plan progress periodically?

I will attempt to answer these questions using an analogy. Suppose you want to travel from Pune to Mumbai in car and you can spare 3 hours and 20 minutes for travel. Knowing that the distance is about 150 km you will plan to travel at an average speed of 45 km/hr.

Distance to be covered			Available Time	Speed Required
150	km		3 hrs 20 min	45	km/hr

After you travel 50 km you wish to check whether you are on time or not. You find that you have taken 1 hr 20 min. Due to high traffic in the city area you could not travel at 45 km/hr speed. Knowing that you have only 2 hr to cover another 100 km you decide that now you need to travel at speed of 50 km / hr to reach Mumbai. After travelling another 50 km you stop again to recheck. You find that you have taken 2 hrs and 10 minutes to cover the 100 km. On highway you could travel faster. Now to cover balance 50 km you need to travel at speed of 43 km /hr.

Actual		New Target
Distance Traveled	Time Taken	Distance to be covered		Balance Time		Speed
50 km	1 hr 20 min	100	Km	2 hrs		50 km/hr
50 km	50 min	50	Km	1 hr 10 min		43 km/hr

You periodically check and adjust your speed while travelling. Similarly you need to review and adjust your financial plan.

A finance plan is prepared based on various assumptions about future e.g.

1. Rate of return on different asset classes like equity and debt.
2. How much client can save annually?
3. Expected inflation till goal maturity?

Various environmental conditions can influence above parameters. Periodic review helps in realigning the course of actions based on environmental conditions in order to achieve your financial goals. 

When to sell mutual funds

Many investors appear to sell mutual funds for wrong motives.

From financial planning perspective selling funds is advisable under three situations:

1.    Investor has reached his or her financial goal for which investment was made.

2.    Financial goal is drawing nearer so a different asset allocation is more suitable. Asset allocation is distribution of investments amongst various asset classes like equity, debt and cash equivalent. e.g. If an investor is saving for his children's marriage expenses and his goal is less than 3 years ahead then  asset allocation to equity mutual funds may be reduced to reduce risk of loss when goal matures.

3.    Fund performance is not up to expectations and a better investment in same class is available.

How a Financial Planner can add value through savings optimization?

Many financial institution websites have calculators to calculate how much you need to save for any goal. For example the website can give answer if you wish to know how much you need to save every month for your child’s education.  Similarly you can calculate monthly savings needed for your retirement or other goals.

You may ask if these calculators are freely accessible, why a person should take services of a fee based financial planner. The reason is that a financial planner can add value through savings optimization and other techniques. To understand how savings can be optimized let us take a small case study. Please note that the case is simplified for current learning objective.

Case:

Mr.  Sameer, CA, aged 35, is happily married and working as finance executive in a private company. His wife is home maker. Sameer has an eight year old daughter. He thinks that he will need Rs. 6 lakhs after 10 years for his daughter’s education and Rs. 5 lakhs after 18 years for her marriage. The amounts are in current terms and are not inflation adjusted.  Sameer earned post tax income of Rs. 5.5 lakhs last year and his family spend Rs. 4 lakhs in same period.  His income is expected to grow by 8% per annum till his retirement at age 60. Household expense inflation is also assumed to be 8% per annum throughout.

Sameer and his wife’s retirement expenses in current terms are expected to be 70% of current household expenses. Sameer expects to live till age 80. All investments put together, the family has Rs. 10 lakhs worth of investments.  He wishes to tag the current investments for family’s retirement needs. Let us assume that he can expect to earn 10% per annum investment returns throughout the investment period and all monthly investments are made at the beginning of the month.

How much Sameer should save every month to meet his goals of retirement, daughter’s education and marriage?

Plan A:

                Using the calculators available on any financial institutions website he can get following plan:   
  

Generally the calculators do not have provision for savings growth on periodic basis. For his daughter’s education Sameer needs to save Rs. 6,430 monthly for 10 years. For retirement he needs to save Rs. 17,345 till his retirement, considering he has Rs. 10 lakhs already earmarked for it. Overall he needs to start saving Rs. 27,241 every month or Rs. 3,26,892 annually.  Considering his last year’s savings of Rs. 1.5 lakhs, Sameer may painfully conclude that he can not meet his identified goals. He may feel tense and stressful. He may opt for reducing his cherished goals.

Here financial planner can add value by his/her knowledge and skills.  Plan A does not provide for the fact that his income and expenses are increasing so he will be able to increase his savings by 8% per annum. Let us look how the plan will look after incorporating this information:

Plan B:

 In plan B  Sameer needs to start with total saving Rs. 14,769 every month or Rs. 1,77,228 annually. First level of savings optimization has reduced his first year savings need by about Rs. 1.5 lakhs. He needs to increase his savings every year by 8%. His income minus the expense is also increasing so it won’t be difficult to increase his savings as well. Plan A has serious anomaly because it does not incorporate increase in annual savings.

 In initial years Sameer has shortfall of savings as shown in above table.  In 11^th year when child education goal is met, he has savings surplus of Rs. 74,107 which is not utilized for any goal. Therefore the required savings fall short of expected annual savings in initial years but surplus is created in later years.

Financial planner can provide second level of optimization. Note the important fact that Sameer is saving for only 10 years for child education and only for 18 years for child marriage.  After achievement of child education goal he can very well channelize the possible savings for other goals. How to do that? Answer is, rather than looking at each goal individually, Sameer needs to look at them collectively and prepare a comprehensive plan.  Looking with this perspective the requirement is to meet all the three goals by saving certain amount and then increasing the savings by 8% per annum till retirement. Plan C with this perspective will be:

Plan C:

In plan C  Sameer needs to start with total saving Rs. 11,831 every month or Rs. 1,41,972 annually. Second level of savings optimization has brought his needed savings below his expected savings. Hopefully Sameer will be able to sleep peaceful knowing that he has plan in place which has higher probability of achieving his cherished goals.

Are commercial bank deposits risk free?

It is a common perception that bank deposits are risk free investments and therefore are very safe investment avenue. But are bank deposits really risk free? Answer to this question will depend on your perception of risk.

If your risk perception restricts to only preservation of principal invested then bank deposits can be considered as risk free. Although here also it is not 100% safe because if one or more banks collapses you may end up getting only up to Rs.1 lakh back (due to deposit insurance) from each collapsed bank.
But preservation of principal is not sufficient to define risk. This is one fundamental risk. There are other risks which need to be understood with reference to any investment. For bank deposits following risks are also relevant:

• Inflation Risk
• Reinvestment Risk
• Liquidity Risk

Inflation Risk
Inflation risk is risk of loosing purchasing power on maturity of deposit. Can your bank deposit protect purchasing power of your saving? Let us assume that you invest Rs. 1,00,000 in a ‘safe’ bank for 5 year deposit at 9.25% per annum interest compounded quarterly. After 5 years the maturity amount will be Rs. 1,57,970. If your income tax bracket is 30% then you will get net amount of Rs. 1,40,057 after paying income tax & cesses. It translates to after tax return of Rs. 6.97%. If price inflation during these 5 years averages to 9% per annum then your maturity amount would have lost purchasing power at the end of 5 years. In purchasing power term Rs. 1,53,862 now is equivalent to Rs. 1 lac five years back. You lost Rs. 13,805 worth or 13.81% purchase power by investing in the bank deposit. This may seriously affect your financial goal achievement unless you have considered it while investing. 

Reinvestment Risk
Reinvestment risk means possibility of getting lower rate on renewal of deposits if your investment horizon is larger than deposit term.  Let us assume that you are saving for some long term goal like retirement where investment horizon is 20 years or more. Most banks will only accept deposits for a period of 7 or maximum 10 years. You need to invest the matured amount again to match your investment horizon. There is a possibility that after 5 or 7 years the rate of interest may be lower than your current rate. So you are also facing reinvestment risk for your long term savings. 

Liquidity Risk
Liquidity risk is the risk of getting lower than appreciated amount if you need the money before the maturity date. Bank deposits carry this risk since on premature withdrawals penalty charge is applicable.

In summary bank deposits are not really as risk free as common perception tells us. They carry inflation risk, reinvestment risk and liquidity risk. Amongst these inflation risk is most serious and has heaviest implication. When selecting bank deposits be aware of these risks and plan your investments accordingly. If you are not sure seek advice from your financial planner.