Thursday, October 13, 2011


You must have heard the thumb rule of how much to invest in equity. It states that you should have (100 - Your Age)% of your net wealth in equity. So if you are 40, you should have 60% of your net wealth in equity.

But is this necessarily correct?

Your equity exposure depends on the proximity to your goals, and it is very doubtful that anybody has only 1 financial goal in their lives. So a single equity percentage based on your age cannot apply.

A generation or two ago, life was comparatively much simpler financially. You would go to school, maybe to college, get married in your 20s, have children by your 30s, work in one company for almost your entire working life, buy a home on retirement, and retire peacefully by 60.

Things are different now.

For starters, life is much more expensive. We are much more impatient. We job hop so often that even getting gratuity is not a given as it requires staying in the same job for atleast 5 years. Timelines for getting married and having children are delayed or extended, education is much more expensive, buying a home comes much earlier, and if we don't plan carefully, retirement can come much later. Healthcare is much better so life expectancy is longer. These factors are a few of many that contribute to the increasing need to plan your financial life.

So, creating a successful and powerful plan for your financial life in today's times has very little to do with your age and a lot to do with major life stages / events when you make the plan.

Let's see what these life stages / events are and what the best approach is to deal with your finances in each one.

Stage 1: Your First Real Job

* Low opening bank balance
* No financial dependents
* Starter salary
* Low tax incidence
* Unmarried, no children, so financial goals are limited to yourself and your parents

You've graduated and just got your first real job. You're most probably living a frugal life. A critical concern at this time is managing your cash flow.

Start saving
Although you might feel like you don't have the money, even saving 10% of your income per month is enough to start planning for your retirement. If you're 23 years old and in your first year of working you manage to save and invest Rs. 24,000 (Rs. 2000 a month for 12 months), then at a growth rate of 15% per annum this Rs. 24000 will grow to Rs. 36.75 lakhs by your age of 60.

You most likely have no financial dependents at this time so you might not need life insurance, but you should definitely opt for health insurance. This has dual benefits - firstly, your health is insured and this is most important. Secondly, you can claim a tax deduction of the premium paid, under Section 80D.

Tax Efficient Investments
If your salary brings you into the 10% or 20% tax bracket, the first thing you should do is avail of Section 80C deductions - invest into an ELSS fund (equity exposure) and into your PPF account (debt exposure). Check how much you are contributing to your EPF (debt exposure again) and invest accordingly. Your limit is Rs. 1 lakh under Section 80C.

Contingency Fund
Start building up a contingency fund for use only in case of emergencies. Typically this should be the equivalent of 6 to 24 months of your monthly expenses - depending on your personal risk appetite. Set this aside into a liquid or liquid plus mutual fund to earn a better rate of return than your bank account.

Note: Any equity investments done at this time and held for a period of 5 years plus will most likely yield a high rate of return, and therefore beat inflation. At this stage of life, equity can be taken for the long haul.

Stage 2: Getting Married, Having Children, Life Goals Increase

* Married, with or without children
* May have or take a home loan and/or a car loan
* Personal goals would include progressing in your career, caring for your family (parents, spouse, children if any), enhancing lifestyle (vacations, car, other regular lifestyle expenses)
* List of financial goals might include planning for children's education & marriage, house purchase, own retirement, providing for parents, purchasing a property as an investment to yield rental income
* May or may not have adequate life insurance, may not have adequate health insurance for the family
* Need to grow wealth, increase contingency reserve

The first thing you should do is check your life insurance requirement.Take life insurance by way of a simple term plan, not an endowment, or money back, or ULIP product. The premium for a term plan is the lowest, the cover you will get for this premium is the highest. This is the best way to protect your family in case of your untimely demise, especially if you also have any liabilities like a home loan or a car loan. A financial planner can help you accurately assess your insurance requirements and suggest the best policy from the many that are available in the market. Also, for health insurance - take a family floater that covers your dependents. Ensure that you have sufficient cover for each member of the family, considering that medical costs can be quite high these days.

Contingency Fund
Following this, you need to assess your contingency reserve. This should be 6 to 24 months of your monthly expenses, including EMIs if any. Hold this in a liquid or liquid plus fund. This should be used only in case of a financial emergency, which can strike at any time. Please refrain from using this for big ticket expenses like contributing to a new car or a vacation. You never know when an emergency might occur and how much cash you will need. Think credit crunch 2008.

Achieve your life goalswith the right asset allocation
For this, you should speak with a financial planner who will take into account your risk appetite and tolerance, your cash inflows and outflows, your life goals and their priorities, your existing assets and liabilities, and create the optimal financial plan for you. Your planner will tell you how much to invest into each of the asset classes - equity, debt, gold and cash, and in which specific instrument, so that you achieve all your life goals like purchasing property, your children's educations and marriages, your own retirement, family vacations and so on. Your planner will also ensure that as your goals approach, your goal corpus exposure is shifted from equity (unsafe, high risk) to debt (safe, low or no risk) instruments. This protects the corpus that you have built.
Thus your equity exposure depends on the proximity to the goal and will be different for each goal that you have.

Follow your plan and remember to invest regularly into the markets, through ups and downs. Staying in the market is the key to successful long term investing.

Make a Will
It is also prudent to have a Will in place in case of your untimely demise so that the transfer of your wealth happens without causing any further trauma to your loved ones.

Stage 3: Financial Freedom

* Children are financially independent
* More free time to spend with your family and on your hobbies
* No salary or business income, income is by way of dividends and interest from your investments
* Inflation is a concern, you don't want to outlive your net worth
* Long term health care needs must be met

Know Where You Stand
At this stage in your life, you have retired from your job or from the business and should have built up a portfolio of investments that will tide you over your golden years. If this has not yet happened, the other option is to reduce your lifestyle expense to a level that is sustainable. If your lifestyle expenses are not within your means, you might find that you outlive your wealth, and that is not a situation you should be in. Your planner will crunch the necessary numbers to see what level of expense is safely sustainable and can suggest various alternatives to live within your means if the level of wealth required is higher than the level of wealth available.

Your Contingency Fund
At this age, you might want to have a separate contingency fund set aside for only health emergencies. This can be a few lakhs, and can be used to supplement your health insurance in times of medical emergencies.
The medical contingency fund is over and above your contingency fund for other emergencies. Better safe than sorry.

Your Asset Allocation
At this time, your invested assets should not be at any risk, so equity exposure should be kept to an absolute minimum, or preferably brought down to 0. This again depends on the level of wealth available. If you have built the required corpus, you need not take on any risk whatsoever. If not, and your expenses are already brought down to the basic requirements, you might need to consider opting for a reverse mortgage on your home, and/or taking on minimal equity exposure, such as by way of a Monthly Income Plan or a Balanced Fund.

There are not many options for health insurance for senior citizens. Your best option is to continue with an existing health insurance policy, provided it is a useful one for you. If the policy is not suitable to your specific health requirements, you can consider switching health insurance providers, but this can be an expensive proposition so assess the available policies carefully.

A mistake most people make is they don't read the insurance policy document and rely on their agent to tell them anything relevant. Don't do this. It is your own responsibility to read the necessary documents and educate yourself on the investments or products you opt in to. Your financial planner can help you assess various policies and suggest the best one for you.

Making Tax Efficient Investments
If your income is above the tax free limit allowed to senior citizens (currently Rs. 2.50 lakhs per annum), the following options can be utilized:

a) PPF - this 8% return earned is tax free. Keep in mind there is a lock in period after which you can withdraw within certain limits. This is suitable for your longer term investments.

b) Dividend option in balanced mutual funds (the dividend earned is tax free)

c) Dividend option in debt mutual funds (if you fall in the 20% bracket this makes sense for you as the tax on the dividend is approximately 14%)

d) Fixed Maturity Plans of more than 1 year duration (you can avail indexation benefit on these funds and the expected rates of return are reasonably high)

e) Senior Citizen Savings Scheme (SCSS) gets you a tax deduction on invested amount, however interest earned (9% p.a., paid out quarterly) is completely taxable. This option is good for safe, guaranteed, regular income

f) A high yielding 5 year FD will give you an additional 0.25% or 0.50% as a senior citizen, and the invested amount is tax deductible. However, interest will be fully taxable in your hands.

At the age of 60, achieving safe and regular income is a major goal. This can be done via the investments given above. Your Planner will be able to assess your unique situation and advise you on the best course of action.

The bottom line is your equity exposure has very little to do with your age and a lot to do with the life stage / event you are facing. Also please note, the advice given in this article is general and need not apply to every individual. Your financial situation is unique and should be assessed by a professional for you to achieve the most optimal financial results.
Source : personalFN

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