Focus on setting goals
Running a start-up is a challenge, but your future financial goals are not daunting if you plan for it
Ram N Kumar is 34 and co-founder of Nirogstreet.com; a unique healthcare platform which came into being a year ago. It provides access to the Indian traditional medicine and healing system. Ram, his wife Aradhna and their 2.5 year old son Shiv complete the family picture.
Like any start-up, cash-flows in Ram’s case are unpredictable and not regular, but he is confident that he will earn Rs 20 lakh a year, apart from the Rs 7.2 lakh that his wife earns each month. They have their financial goals listed—Shiv’s education and their own retirement. Both these goals are 20 years ahead. They are also looking for an income of Rs 2.5 lakh each month when he retires at 55. All the savings they had so far, have gone into setting up Nirogstreet, which has left them with only two insurance policies.
His current savings and investments include two LIC policies bought in 2009 and 2010 for which he pays an annual premium of Rs 41,500 and Rs 25,000 respectively. As a prudent tax planner Ram could invest about Rs 1 lakh in NPS this year and has recently started a recurring deposit of Rs 15,000 which will earn him 8.25 per cent interest. Similarly, his wife makes a PPF contribution of Rs 75,000 annually, since the past three years. The family has recently started a fixed deposit for Rs 7 lakh. Kumar also has a health insurance policy for the entire family for which he pays a sum of Rs 50,000 annually.
Ram had a bad experience of investing into equities earlier and feels the start-up itself is very risky. Therefore, he is averse to any high risk financial products. His monthly household expense is about Rs 1 lakh and he is comfortable to invest with 20-year tenure in mind. Given these characteristics, his risk profile is moderate, preserving capital first with less volatility over a three year period.
In my assessment, if he needs Rs 1.5 crore after 20 years, assuming 9 per cent return on investment (ROI), he needs to save Rs 22,300 per month for the next 20 years. Similarly, if he needs to draw Rs 2.5 lakh a month post retirement then he should have a corpus of Rs 4.75 crore to meet this goal given an inflation rate of 6 per cent and ROI of 9 per cent.
In order to design a comprehensive plan, we followed a four pillar approach: asset allocation, right investment vehicle, efficient tax planning and planning for contingency. As Kumar is relatively new to investing and 20 years is a long period, it is to difficult to expect that fiscal discipline and choice of products will always be consistent.
Assuming a gross yield of 8 per cent and 14 per cent on debt and equity investments, respectively and an effective tax rate of 20 per cent on debt investment while no tax on equities, I could arrive at a debt allocation of 65 per cent and equity allocation of 35 per cent to begin with. I expect to achieve a 9 per cent post tax post expense return on investment over 10 years with minimal fluctuations. A pre-defined asset allocation will also help Kumar to deal with excess funds that he may generate sometimes. He could bring in lump sums as per the same asset allocation in due course.
Efficient tax planning
Both the LIC policies are covered under Section 80C and can claim tax exemption. The NPS offers additional tax benefit up to Rs 50,000 per annum under section 80 CCD hence it is suggested to continue with NPS with a reduced exposure per annum to Rs 48,000 only. A recurring deposit (RD) that earns 8.25 per cent and a fixed deposit paying interest are both taxed at marginal tax rate. The PF contribution earns 8.1 per cent, but this can change. All these are treated as debt investments. Moreover, debt based mutual funds attract capital gains tax of 10 per cent without indexation and 20 per cent with indexation benefit after they complete three years. Equity based mutual funds attract 15 per cent tax on gains if they are less than one year and no tax on gains exceeding one year, as of now.
Planning for contingency
Since Kumar is the main bread earner for the family and is running a relatively new venture, I figured out two most important risks to our strategy—what if Kumar is not there for 20 years and the regular infusion of cash into the new business.
Based on these two factors, I propose a term plan of Rs 2 crore to cover Ram’s life for an annual premium of about Rs 23,000. Essentially, their house hold expenses come to Rs 1 lakh a month, so, from everything else remaining, if we were to invest Rs 2 crore with a bank or mutual fund at 6 per cent annual interest; we will get Rs 12 lakh in a year to take care of household expenses for the family in case he is not there.
I also suggested a liquid fund to Kumar which he can use to park any additional surplus liquidity that he intends to generate from time to time. This will help him build a sort of contingency fund that he may depend upon for meeting any short term cash flow requirements. We can further include this pot of money in our review and utilise any sum which he may think can be taken away for long term. By following this advice, Kumar will be on the path to achieve his financial goals, which he could reassess a few years from now to align it with his changing needs and any other circumstantial change that he may experience.
Choosing the right vehicle
From Kumar’s current investments, LIC should be continued. Both the policies are for 20 year tenure and if discontinued, may not fetch anything at all. These will be considered as part of his debt portfolio. Likewise, the NPS proceeds can only be withdrawn at the age 60 and only 20 per cent of it could be withdrawn as lump sum, the balance amount has to be used to purchase annuity. Annuity IRR works out much lower than 9 per cent yield that we have assumed on the portfolio even after retirement hence a large allocation in NPS will be detrimental to his goals. Therefore I propose to restrict NPS investment to Rs 48,000 annually.
I suggest adding mutual funds to Kumar’s portfolio, because these can add diversification at relatively lesser risk compared to investing directly in securities. They are also more tax efficient compared to traditional investment products like recurring and fixed deposits. Along with the existing two LIC policies, he can add monthly SIP of Rs 10,000, each going into ELSS for him and his wife. This will suffice for the permissible tax saving limit of Rs 1.5 lakh under Section 80C.
They should discontinue the recurring deposit for now. Interest on recurring deposit is 8.25 per cent, which is fully taxable, plus it does not offer benefit under Section 80C. Re-directing savings from recurring deposit into ELSS will also not constrain monthly savings requirement. I suggest Kumar invest Rs 48,000 annually in the NPS just to claim the additional tax advantage.
Kumar wanted to continue with the FD for now for various reasons, so I have chosen to leave that aside. He should continue with his LIC policies, NPS, SIP and FD, besides his existing investments, which will collectively take care of his two goals—Shiv’s education and his own retirement, which come into effect two decades from now.
As the available liquidity is pretty much utilised, the scope for planning the goal for his retirement is a bit challenging at this stage. However Kumar is confident of managing the cash flow for it as well but he is not clear whether he will be able to invest regularly. Therefore, I am suggesting him to start a fresh SIP of Rs 10,000 per month.