Musings of a (Financially) Illiterate Father

by Anand Saxena

  If one wishes to withdraw before 60 years of age, 80 percent of corpus needs to be annuitised, thus one gets access to only 20 percent of his corpus, taking away flexibility further.

  An investor with higher risk appetite can’t take equity exposure higher than 50 percent. This, in the long run, can result in smaller corpus.

  NPS, in its current form, may not be a right investment choice for your sunset years. Like Vipin Khandelwal, founder Unovest writes in The Economic Times Wealth, “Don’t send your money to life imprisonment.” However, an intelligent investor should keep an eye on the future developments.

  But what about the pension plans offered by other players in the game. Let’s analyse them too. We first come to annuities. “An annuity is a financial product that pays out a fixed stream of payments to an individual, primarily used as an income stream for retirees131.” In a way, annuity is a pension that a person receives having accumulated a corpus during his earning years. There are basically two kinds of annuities—immediate and deferred.

  Immediate annuities are for those who are nearing retirement age. The person hands over his accumulated corpus to the insurance company and in return keeps getting a fixed annuity for a stipulated time period or till he passes away (either of the spouses). He thus covers the risk that one might outlive his savings. However, the capital or corpus gets locked with the insurance company. The second issue is that a fixed payment can’t fight inflation. As more and more years pass, the fixed annuity will prove inadequate to sustain oneself due to inflation. The plus side is assurance of a fixed income for as long as you live irrespective of market conditions as also not having the trouble of managing one’s corpus.

  Deferred Annuity

  In this case, you either hand over your corpus to the insurance company in one go or over a period of years and instead of receiving an immediate annuity, the company reinvests your money which grows tax-deferred and you start getting annuity when you want it. NPS comes under this category. Deferred annuities can be further subdivided into the following:

  Fixed Annuities: These promise a regular fixed annuity to the investor, irrespective of the market conditions.

  Variable Annuities: Variable annuity doesn’t provide a regular fixed cash flow which gets linked to the performance of the corpus fund. So, a higher annuity may be received in rising market and lesser one in falling market. In a way, these are mutual funds wrapped in an insurance gift wrapper. “Hence, they incur charges akin to equity mutual funds and in addition charges like mortality charges, administration charges, which can be as high as 1.6 percent132.” In a nutshell, variable annuities are best avoided.

  The via media probably lies in annuitising only a portion of your retirement corpus so that you keep receiving a minimum assured sum. For the balance of the corpus, investing in mutual funds (armed with the knowledge that you have now) with a prudent asset allocation will result in a larger cash flow, more flexibility and peace of mind. In the periods during which the market goes down and your 4 percent withdrawal rate is insufficient to meet your expenses, the annuity will come handy.

  THE PSYCHOLOGY

  MUSING 41: THE ARRT OF CREATING WEALTH

  No, it’s not a spelling mistake. The ARRT is an investing paradigm, an acronym for the four techniques-yes just four techniques, which will create long-term wealth for you. All these techniques have been earlier discussed in various musings but it’s always good to summarise the key ones to internalise this investing paradigm. Before we dwell any further – ARRT stands for: Amount, Risk, Return and Time, and what better way to see the power of this technique than following our protagonists-Anshreya and HoneyCool, for one last time.

  Amount

  The amount of money that one invests every month and year remains the most important ingredient of the ARRT paradigm. We read in the musing on SI balance that an amount equal to 20 percent of your take-home pay was adequate for your retirement needs, children education and other obligations. Anshreya and HoneyCool, both with similar liabilities and a monthly pay of ₹50,000 embarked on their life journey. Anshreya was more diligent and started investing 20 percent of her pay (₹10,000) from her first pay check onwards. HoneyCool was pretty cool and needed more money for his wants and hence invested only ₹8,000 per month. Both invested for 35 years, age 25 to 60, with 6 percent increase in investment amounts, to cater for inflation. Both managed a long-term return of 12 percent on their investment.

  When they looked at their retirement accounts at age 60, HoneyCool had a cool sum of ₹7.7 crores while Anshreya was way ahead with ₹9.6 crores133. A difference of nearly ₹two crores is nothing to be scoffed at, right? Let me recount the steps which will give larger investible amounts in your hands.

  • The rule of thumb of 20 percent savings (pay yourself first) which should increase by 6 percent each year to cater for inflation must always be followed.

  • The amount must be invested wisely to give inflation-beating returns (we have covered all the asset classes and their peculiarities.)

  • Maintain correct SI balance by sensible budgeting.

  • Being conscious of one’s ‘latte factor.’

  • The discipline of tracking one’s net worth (not income) and other financial ratios.

  • Being pragmatic about acquiring assets while eschewing liabilities.

  • Astute credit and debt management.

  • Looking through the chimera of returns.

  Tax Management

  The readers would notice that I have not covered the all-important topic of tax management in this book. This is due to two reasons; firstly I lack expertise on this subject and secondly, I consider tax payment a sacred duty of all the citizens, irrespective of their earnings. Yes, even a person earning ₹5000 per month should pay Income Tax— it may be a token amount of ₹100. This will make him feel like a stakeholder in the national growth and economy. The tax base in our country is abysmally low and that is the reason that we, the taxpayers, end up paying a higher percentage of our income as tax. I am an eternal optimist and hope that things will improve over time and all of us will start taking pride in being honest taxpayers, thereby increasing the tax base.

  As a common investor, you must save tax wherever it is legally permitted by the government. Towards this, do acquaint yourself with section 80 C of Income Tax Act, which allows you to save on tax up to ₹1.5 lakhs of investment in a financial year. Then there is section 80 D, which allows deductions on health insurance (remember the musing on essential five insurances?). Also learn sections 24 (interest payment on home loan), section 80 E (education loan), 80 G (donations to funds and charities) and section 80 CCD (1b), which allows additional ₹50,000 deduction if investing in National Pension Scheme (NPS.) I have covered all these issues individually in various musings in the book. Please don’t miss the forests for the woods though by investing in financial instruments with the aim of saving tax. Tax saving should be a corollary to your investing paradigm. To repeat an example, if you are in a position to clear off your home loan, do that and not hold on to it merely to save tax under section 24.

  Returns

  We move ahead with our story and introduce a twist – HoneyCool was not as investment savvy as Anshreya was and could manage a rate of return of only 10 percent as compared to 12 percent that Anshreya managed. Now, what is the retirement corpus of both? Anshreya has ₹9.6 crores and HoneyCool barely ₹5.2 crores.

  Though we have already discussed the ways to increase one’s returns in various musings but let me compile them at one place. You can go back and read the relevant musings for details.

  • Understanding risk and reward paradigm.

  • Prudent asset Allocation.

  • Diversification.

  • Cutting the costs including due to taxes.

  • Staying invested in all market conditions (SIP.)

  • Rebalancing.

  Time: The T in the acronym is for ‘time’ and not ‘timing,’ meaning remaining invested for re
ally long-term. Continuing with our example, HoneyCool decided that he had earned a right to live his life for first five years of his earning and hence started to save at age 30, with a lag of five years. All other parameters being the same as in last example, what is his retirement corpus now? A princely sum of ₹3 crores. He truly lived his life. Remember Anshreya is at ₹9.6 crores.

  • Goal-based long-term investing remains the panacea for financial freedom.

  • Markets will go up and down, as they must. However, once you— intelligent investors, have thoughtfully made a financial decision, stick to it through thick and thin. SIP will help you in overcoming emotions.

  • Equity investments must have a minimum time horizon of five years.

  • Long-term goals like retirement and children’s education must be invested for at the earliest lest the tyranny of compounding makes them prohibitively costly.

  Risk

  I have purposely brought in this R at the end of ARRT paradigm. Anshreya had understood the musing on risk-reward paradigm and hence was very careful about her asset allocation and rebalancing. It was only due to following these tenets that she could manage the returns that she got. Five years before she was due to retire; she had started to shift her corpus from equity to debt in a manner that at retirement she had 40:60 equity to debt portfolios.

  HoneyCool, at age 55, had realised that he was lagging behind Anshreya in accumulation of his retirement corpus and hence decided to be aggressive in his allocation. He increased his equity allocation to 80 percent with only 20 percent in debt. He hit a bull market which coincided with his portfolio churn which lasted for five years. In the year 2053, when both our protagonists were to retire, Israel attacked Iran with Iran openly threatening the use of nuclear weapons in retaliation. As expected, the U.S. and Russia rushed to the defence of their allies. A trade war followed which shot up the crude prices by 100 percent. The stock markets across the globe tanked with Indian markets following suit with a fall of 50 percent.

  HoneyCool, who with his portfolio churn towards 80 percent equity had built up his retirement corpus to ₹9 crores, found it dropping to ₹5.4 crores (his equity portion of ₹7.2 crores fell to ₹3.6 crores while the debt portion of ₹1.8 crores maintained its value.) HoneyCool had imbibed the 4 percent rule of withdrawal well and was banking on an annual withdrawal of ₹36 lakhs (calculated on the corpus of ₹9 crores,) which he reckoned was the minimum required amount for his needs. The sudden drop in his corpus meant that his 4 percent withdrawal could give him only ₹21.6 lakhs which was ₹1.2 lakhs per month less than his needs. This was too less for the needs of HoneyCool and hence he continued to withdraw ₹36 lakhs.

  The bear market lasted for full three years in which the portfolio of HoneyCool gave returns of minus 50 percent, minus 20 percent and 5 percent respectively during which HoneyCool continued to withdraw ₹36 lakhs per annum from his corpus. After three years his corpus of ₹9 crores had dwindled to ₹3.8 crores. His 4 percent withdrawal limit now amounted to only ₹15 lakhs, much below his minimum requirement of ₹36 lakhs. Well, the exact math is not very important but the overall concept is.

  The fall from grace for HoneyCool is not difficult to demystify. Not being a very savvy investor, he defied the paradigm of ARRT which landed him in a precarious retirement. He didn’t begin his investment journey well, saving less than the 20 percent amount; he delayed his investments to fulfil his ‘needs,’ acquiring liabilities; he didn’t show acumen of correct asset allocation and rebalancing during his investing lifetime thus earning lesser returns. As a fatal flaw, close to his retirement, he threw the principles of asset allocation to the wind and went aggressive on equity allocation. To make matters worse, he insisted on a withdrawal of more than 4 percent from his corpus. It goes without saying that he had not purchased any annuity to give him a steady income in sunset years. I sincerely pray to God that HoneyCool has got the ‘essential five’ insurances for himself and his spouse or else he is in a deep financial hole.

  As HoneyCool stares at a sad retirement and Anshreya is off to Europe with her children and grandchildren for a vacation the cost of which she is paying, the stark contrast in their fortunes is difficult to be missed by a savvy investor like you. The ARRT is indeed powerful, isn’t it?

  MUSING 42: IS YOUR RECEPTACLE LARGE ENOUGH?

  THE PSYCHOLOGY OF RETAINING WEALTH

  The ARRT paradigm gives us the blueprint for creating wealth but equally important is to retain this wealth. To begin with, there is a distinct difference between money and wealth; between being rich and wealthy; wealth being an overarching umbrella containing various subparts like family, health, relationships, money and so many more. Hence a monk, with little financial means and living a frugal life in Himalayas can feel much wealthier than a millionaire in Delhi who is on medication for hypertension and diabetes due to stress. But does it mean that financial aspects have no bearing on overall happiness? Absolutely not, as a study by Princeton University proves. This study puts a Dollar amount to happiness—$75,000 per year. “The lower a person’s annual income falls below that benchmark, the unhappier he or she feels. But no matter how much more than $75,000 people make, they don’t report any greater degree of happiness134.” Translated to INR, the amount is approximately ₹49 lakhs per year or slightly more than ₹4 lakhs per month.

  Before we start to feel sad as most of us don’t make this kind of money especially in our younger days, read my opening lines of this musing again. The richest person on this planet can be unhappy than a daily wage labour who is content with his overall wealth—may be his family, health and ready laughter. The GDP (PPP) of India is $7174, which translates to ₹4.66 lakhs (per annum and not month.) The happiness figure of earning per month as given in the above-mentioned study can’t be achieved by an average Indian in the entire year. Are most Indian unhappy? Or, is it that all Americans earning more than $75,000 annually happy? The answer to both questions will be an emphatic ‘no.’ A minimum level of earnings and riches are required for happiness but beyond a level, money stops to add to overall happiness. Just look at our neighbouring country, Bhutan, who has been working on a concept of Gross National Happiness (GNH) for decades now replacing the concept of GDP.

  To attain true wealth, we have to change our overall orientation to life. I can narrate an interesting anecdote to substantiate my point. I am a voracious water drinker needing 12 to 16 glasses every day. While sleeping I keep two water bottles of 1 litre each next to my bed and by the morning, generally, one is finished. Once I was in Mumbai for a tour and staying in a hotel. While retiring for the night, I didn’t realise that there was just one 1 litre water bottle available. The moment I closed my eyes, this realisation hit me and I started feeling worried for likely lack of water at night. I slept fitfully that night feeling water-deprived, though I had 1 litre of water available which was my normal consumption at night. Why did I feel deprived though I had my normal water requirement next to me? It was due to the fact that I didn’t have my ‘water breathing fund.’

  To obviate the feeling of money deprivation, I can recommend a few things.

  Don’t allow thoughts of financial deprivation to enter your mind. It should never be, “I can’t afford it” but rather, “How can I afford it135?”

  Always maintain a breathing fund equal to 3-6 months of expenses. However, have a mindset of abundance towards this fund (it is the first step towards your financial freedom) and not a fear that it might be required for a financial emergency. “If your goal is to be comfortable, chances are you’ll never get rich. But if your goal is to be rich, chances are you’ll end up mighty comfortable136.”

  Always keep sufficient cash in your wallet, yes cash, not cards. How much of cash will depend on person to person but a figure of 5 to 10 thousand should be adequate.

  In the excel sheet of your net worth and other financial ratios (revisit musing 12, if required), enter your dream figure of financial freedom (don’t restrain yourself.) As you t
rack your net worth every quarter, which should keep growing if you have internalised the tenets of all the musings, keep reinforcing the belief that you are slowly but steadily, moving towards that magic number.

  At least once every month, go out and do a thing that you consider a luxury—having dinner in an expensive restaurant (without looking at the prices on the menu,) watching a director’s cut movie reclining on a lounge, a leisurely massage in saloon and so on. Of course, you do it out of your ‘want bucket’ (30 percent bucket) but the idea is to feel abundant and wealthy.

  Don’t let your expenses rise with the rise in your income. Every pay raise, every bonus are additional seeds available for you to grow your wealth with. Commit at least 50 percent of them towards your ‘save’ bucket. I hope you know that one of the richest men in the world, Warren Buffet still lives in the same house that he had purchased in 1958. And that Azim Premji, Chairman of Wipro, always buys 1 or 2-year-old used cars.

  Start to share your wealth, whatever stage of life and earnings you may be at. I also made this mistake for a major portion of my life where I thought that I will share with the society when I have enough. The problem with this mindset was that one was convinced that one didn’t have enough at that moment – feeling of deprivation. Whatever be your income, share few percent with the society—2 percent, 5 percent or 10 percent, the call is yours as also the manner in which you wish to do it. Contribute to the orphanage, to a child’s education or a social cause which is close to your heart. The more you give, the more you will receive.

  And finally, I would like to leave you with the thought that personal finance is not rocket science which needs understanding of complicated and complex concepts. It is sheer common sense and consists of few eternal principals which I have distilled from my reading, learning or experience and tried to lay them out for you, a common investor.