by Anand Saxena
What should a fiscally prudent parent do to plan this humungous expenditure towards child’s education? Plan to invest as early as possible, in an instrument which gives the maximum return over long periods, and we are looking at long periods ranging from 18 to 21 years. Any delay in commencing this important goal-based investing can prove catastrophic and push the parent/child towards an education loan which has its own pitfalls. The table below gives the monthly amount required to accumulate into ₹65 lakhs, assuming a rate of return of 12 percent.
Age of Child Years to Accumulate Monthly SIP
0 (Just Born) 18 ₹8,577
1 17 ₹9,829
2 16 ₹11,292
3 15 ₹13,011
4 14 ₹15,043
5 13 ₹17,463
6 12 ₹20,372
7 11 ₹23,906
8 10 ₹28,256
9 9 ₹33,698
10 8 ₹40,643
11 7 ₹49,743
12 6 ₹62,076
13 5 ₹79,589
14 4 ₹1,06,170
15 3 ₹1,50,893
16 2 ₹2,40,978
17 1 ₹5,12,517
The tyranny of compounding that we discussed in one of the earliest musing has come to fore in full bloom here. A prudent parent will start investing for his child’s education right from her birth and will find it relatively easy to do it due to lesser amounts required per month. The amounts become exponentially large as the parents lose time and soon get out of reach pushing the parents or child towards education loans. Remember, this calculation is to cater for only the first year of the UG course, and similar monthly amounts will be required to be invested with a lag of 1 and 2 years to cater for the fee of second and third year of UG course. Putting it all together, even the most fiscally prudent parent will be required to invest ₹25,731 (₹8577*3) by the time the child is 3 year old. And here we are catering for only one child. Similar or more amounts will be required for the second child as well.
So, our protagonist Anshreya, the fiscally prudent parent that she is, decides to start investing from the day she is blessed with a child. The dilemma is where to invest amongst the asset classes that she is well familiar with. In her case, she has a real long-term horizon, of 18 years, and hence the entire investment should be in equity through mutual funds. She can start an SIP of ₹8,500 in a good multi-cap or large-cap/mid-cap fund following the tenets she has learnt in the musings on equity investing. In the second and third year of childbirth, she should start one SIP each of ₹8,500 in a similar manner. One important thing she must remember is that 3 years before her child needs the college fee, she should start systematic withdrawal plan (SWP) to transfer from the equity to an appropriate debt fund, for safety.
Our other protagonist HoneyCool, as usual, takes a late call and realises about his child’s education expenses when she is 10 years old. Firstly, his monthly investment amount steeply rises to ₹41,000 and secondly, as per tenets of investing, he just has five odd years for equity exposure before he must shift the investment to debt. Remember, any investment for less than 5 years has to be debt predominant. He can then start SIP of ₹41,000 in a large-cap fund (more stable equity returns) or hybrid fund (good mix of equity and debt.) After 3-5 years, he needs to shift the SIP to appropriate debt funds (medium duration or medium to large duration.) The pitfall would be getting lower returns as his major investment is in debt instruments. But this is the price he must pay for procrastination.
Child Plans The ‘child plans’ being offered by mutual funds are nothing but a scam as there is no special tax break or any other benefit that investments in these vehicles are going to get vis-a-vis an investment in regular mutual funds. In fact in India, there is no plan akin to 529 plans available in the U.S., where the Government provides significant tax breaks. Similarly, insurance companies are also pedalling Child ULIPs and endowment plans. The advice for these is similar to as given before—stay away from these. The only sop these plans offer is to waive off the premium in case of the unfortunate demise of the parent. However, the same can be achieved in a more efficient and economical manner by going for a term insurance, of an amount which will cover child’s education expenses. We had flagged this issue earlier too under the musing on Insurance.
Education Loan
“Student loans are a cancer. Once you have them, you can’t get rid of them. They are like an unwelcome relative who comes to stay for a “few days” and is still in the guest room ten years later125.”
The rising costs of education especially for parents who are not that well off financially or like HoneyCool who don’t plan in advance drives many to avail education loans. The pros are that the child can pursue her aspiration, in India or abroad, without her parents having that kind of money which is required to fund the education. Secondly, the parents get tax rebates on the loan (which are explained below) which reduces the effective EMI burden. Thirdly, the repayment of principal amount does not start till after the child finishes her course and couple of years after that too. So, theoretically, the parents need not bother about repaying the loan and the child will be able to pay off her loan. It is here that I have some reservations about student loan concept. But before that, let’s see how taking an education loan reduces the tax burden.
Let’s assume that HoneyCool takes an education loan of ₹50 lakhs for his child at the interest rate of 10 percent, which is to be paid off over 8 years. He is in the highest tax bracket of 30.9 percent tax. As per the current tax rules, the interest paid on the education loan can be claimed as a deduction with no upper limit. The average EMI, which would have been ₹75,850 without any tax exemption, will work out to only ₹68,500 after it. Thus, the effective interest rate works out to only 7.1 percent126.
Is it a happy situation? Just look at the EMI amount, despite the tax exemption, again. Nearly ₹70,000 per month. What this education loan has done is to hang a millstone around the child’s neck for first eight years of her earning life. We have covered it already, but just to recap, all the loans put together should not be more than 50 percent of the net income, ideally within 40 percent (between 40 and 50 percent one will be financially stressed.) Now, the child has to get a job which pays her at least 1.5 lakhs per month starting salary to remain within these yardsticks. Hello, where are such jobs in India (or abroad) today? These are few and far between and go to the brightest of the children. Just take this reality check.
“Earlier this year, eighteen posts for peons in the Rajasthan State secretariat were advertised. There were 12,453 applicants, including 129 engineers127.”
Assuming that the child manages to get a job paying ₹1.5 lakhs per month, how is she supposed to settle down financially? How does she accumulate the breathing fund, how does she start to save for her marriage, her house and so on? She is likely to get married in this period and possibly be blessed with a child. What about these rising expenses including saving for her child’s education? Are we seeing the birth of another HoneyCool here?
It is not my pitch that education loan is bad. All I am trying to get at is that the entire gamut of repayment needs to be thought through before one takes the plunge. Taking an education loan for a qualification which does not guarantee a well-paying job is fraught with risk.
With all the gyaan (wisdom) in this Musing, wish you all Happy Parenting!
MUSING 39: SAVING FOR THE SUNSET YEARS
If Anshreya, HoneyCool or any youngster of their age is reading this book, they might be tempted to skip this musing. After all, retirement seems so far away at the age of 25 years. But trust me, time really flies and before you realise it, you might be staring at retirement which is barely 10 years away with a sinking feeling in your gut that probably you have not been able to save enough for a dignified retired life.
Some fundamental questions needs to be asked of ourselves before we can decide how much is an adequate retirement fund which not only allows one to live in comfort duly catering for rise in inflation and medical expenditure as
is bound to happen as one ages but also leave a decent legacy for our progeny or social causes. If we take the retirement age to be 60 (though it might be less in professions like defence forces) and average life expectancy of about 80 years, one has to cater for approximately 20 years of retired life. To put it further into perspective, an average earning span of 35 years (25 years to 60 years of age) has to cater for 20 years of non-earning lifespan. A tall order indeed, unless planned well.
The first step towards calculating the size of our retirement corpus is to estimate how much money will be needed per month (or annually) in retired life? Post-retirement, many expenditures do reduce—children’s education, EMI towards home mortgage (yes, you must absolutely have a mortgage free house when you retire,) office related expenses like commuting, dressing etc. and certain social obligations. But what will increase are your medical expenses (we have touched upon this issue in the musing on insurance.) A good rule of thumb is that one would need approximately 75 percent of pre-retirement income after retirement. So, if Anshreya retires with an annual income of ₹25 lakhs, she will require around ₹18.75 lakhs annually after retirement. It roughly translates to a monthly income requirement of ₹1, 56,000.
The next step would be to ascertain as to how much one will be receiving as an assured income after retirement in form of pension, annuity from pension plans or life insurance plans or dividends from equity investments. This amount should be deducted from the required retirement amount. In the current case, let’s assume that this amount is around ₹3.75 lakhs for Anshreya so the post-retirement net annual income requirement for her is ₹15 lakhs. Remember that this amount is not inflation adjusted and hence in actual the annual income requirement will keep on increasing each year due to inflation.
The next step is slightly more nuanced i.e. to calculate the total retirement corpus. One would be tempted to multiply ₹15 lakhs by 20 (number of years of retired life) and arrive at a figure of ₹3 crores, a formidable figure indeed but actually inadequate. Surprised? Don’t be, we’ll get there soon. The above calculation suffers from few fundamental mistakes, firstly, it doesn’t account for inflation which will keep eroding the value of money over time. Secondly, it assumes that the returns from your corpus will keep growing each year despite the size of the corpus decreasing due to regular withdrawals. Thirdly, it doesn’t account for market fluctuations over next 20 years by assuming an average return. In actual, the market goes up and down as we have discussed earlier and the sequencing of these fluctuations can prove catastrophic.
To take an example, let’s assume that Anshreya retires with a corpus of ₹3 crores and withdraws ₹15 lakhs first year (her annual net requirement.) She further increases this amount by 6 percent each passing year to cater for inflation. The market gives the following annual returns over next five years: 15 percent, 12 percent, 2 percent, -5 percent and -10 percent. The value of Anshreya’s corpus will be as follows: Year 1: ₹3.3 crores, Year 2: ₹3.8 crores, Year 3: ₹3.7 crores, Year 4: ₹3.32 crores, Year 5: ₹2.79 crores.
Now let’s reverse the sequencing of the market returns: -10 percent, -5 percent, 2 percent, 12 percent, 15 percent with other parameters remaining the same. The value of Anshreya’s corpus will now be as follows: Year 1: ₹2.55 crores, Year 2: ₹2.26 crores, Year 3: ₹2.13 crores, Year 4: ₹2.2 crores, Year 5: ₹2.34 crores.
We see here that the mere sequencing of market returns has made Anshreya poorer by ₹45 lakhs over five years. Clearly, one can not anticipate the market behaviour in advance. So, what should be an ideal retirement corpus which not only maintains one’s lifestyle but also leaves enough for market-linked contingencies?
The 4 Percent Rule Financial adviser, William Bengen, in his research in 1990s and subsequent follow-on studies at Trinity University opined that if one has to plan for a 30-year retirement and one’s corpus is split in stocks and bonds in a ratio of 60:40, one can withdraw 4 percent of corpus in the first year of retirement and then keep increasing it by the inflation rate each year. So, if Anshreya needs ₹15 lakhs in first year of her retirement, the size of her retirement corpus must be ₹3.75 crores (15 lakhs*25.) The 4 percent rule thus caters for the market behaviour, inflation as also related contingencies. It also ensures that Anshreya will not only have dignified and peaceful sunset years but will leave behind a sizeable legacy for her progeny and social causes.
Getting back to the power of compounding, if Anshreya decides to invest from age 25 (from her first pay check) and continue till age 60 (her retirement age,) she needs to invest only ₹6,000 per month assuming a return of 12 percent to amass this corpus. However, if she delays by 10 years, she will need to invest ₹20,000 per month to reach the required corpus. The power of compounding needs to be harnessed by investing at the earliest.
The 4 percent rule is a good yardstick to plan one’s retirement and has been recommended by most financial experts. Like all such rules of thumb, it is only a guideline and hence a withdrawal rate of 4 to 6 percent should be safe enough for most retirees.
Key Takeaways
After retirement, the monetary requirement is likely to be around 75 percent of one’s income at the time of retirement. One has to cater for around 20 years of retired life.
To calculate the requirement of one’s retirement corpus, going by the 4 percent rule, one should endeavour to accumulate 25 times the annual income requirement.
In the first year of retirement, one can withdraw 4 percent-6 percent of the corpus and then keep withdrawing annual amounts duly adjusted for inflation. This should leave behind a sizeable corpus for the progeny or social causes.
Ideally, at the time of retirement, the corpus should comprise of 40 percent equity and 60 percent debt.
Having calculated the requirement of retirement corpus, one should start investing from the first pay check itself to build up this corpus. A long-term expected return of 10 to 12 percent is a fair one for calculation.
MUSING 40: PENSION AND ANNUITY MANAGEMENT
One of the biggest charms of government services in India, despite their ‘not so great’ pay scales, is undoubtedly the assurance of a pension post-retirement. As we have seen in the previous musing, the kind of corpus that one requires for a dignified retired life is indeed large and if one doesn’t manage his finances well, accumulation of this corpus may prove to be difficult. Another issue is that despite having a sizeable corpus, lack of a fixed income akin to a pension may not be comfortable to few.
For persons in non-governmental jobs too, there are plans one can opt for to receive pension post-retirement or from a particular age. We will discuss few of them.
National Pension Scheme (NPS)
NPS is a tough riddle to crack. Despite its low charges, good returns and tax benefits, the scheme has not really caught on the fancy of investors. Essentially, NPS is a pension scheme guaranteed by the government and managed by eight pension fund managers (like ICICI and SBI) that one can choose (or switch amongst them.) On retirement, the fund manager takes over the accumulated corpus and provides the annuity (pension). NPS has tier I and tier II accounts. Tier I is the default NPS account where every investor must deposit ₹6,000 per year and offers tax benefits under sec 80CCD. Tier II is a voluntary account which can only be opened by a tier I account holder. It is akin to a savings bank account from where one can deposit, withdraw or shift money to tier I any time.
The good points of NPS are:
An additional tax benefit of ₹50,000 per year under IT sec 80CCD (1b) which is over and above ₹1.5 lakhs under sec 80C (tier I account only.) Eventually though, one ends up paying tax at the time of withdrawal, as we will see in NPS drawbacks.
At the time of retirement, 40 percent of corpus can be withdrawn which is tax-free.
Very low charges (NPS does not have expense ratios like mutual funds) –0.7 percent128.
A long lock-in period (tier I account) – one can’t withdraw till age 60, subject to certain exceptions (yes, this is good as retirement planning
is a long-term project and one can reap the true power of compounding only over longer periods.)
One can remain invested till 70 years of age by spreading his withdrawals.
Multitude of options of investment-equity heavy (up to 50 percent in equity) called asset class E, asset class C (invests in fixed income instruments except government securities) and asset class G (invests in fixed income government securities). An investor can also opt for auto or life cycle option where fund manager makes these choices. An investor can change his choice once a year including change of fund manager.
The drawbacks of NPS are as under:-
The NPS corpus is not fully tax-free unlike other retirement products like EPF or PPF. Only 40 percent of corpus is tax-free. In a way, NPS only defers tax, which is actually detrimental. “If you were a farmer, would you rather pay tax on the seed of your crop or on the entire harvest once you have grown it? If we first pay tax on the seed, that’s when the value of what’s being taxed is smallest. A big harvest means a bigger tax.129”
NPS mandates that minimum 40 percent of corpus be used for buying annuity which then becomes tax-free. This takes away flexibility from the investor while providing relatively poor returns. “An investment of Rs 50 lakhs will yield a monthly pension of about ₹30,000-32,000. If the person lives for 20 years in retirement, the returns work out to around 6.2 percent130.” This rate of return will barely beat the inflation. This annuity too is fully taxable as income at the normal rates.
The balance 20 percent of corpus is taxed unless utilised to buy annuity. This is the most annoying part for the investors. Despite locking in their money for long periods they don’t get full tax benefits.