The onset of COVID 19 has forced people to question several fundamental assumptions. Key among them are assumptions about our financial well-being. Were you saving to buy a house and now are not sure if you will sustain your job?
Did you buy the latest iPhone on a loan and now are not sure how to repay the loan? You never had a financial plan and are you now wondering if indeed you should have one? If these questions are on your mind, this article is for you.
Plan right to save right Maybe you were born with a silver spoon. Maybe you won a lottery. If yes then you may not want to either save or create a plan for savings. If you do not fall in any of these categories (and if you are still reading this article, then likely you do not), then you do need to. And to save right, you need to plan right. So how should you go about planning for savings?
Any financial plan should consider four elements:
1. Objective: The financial plan needs to have as its cornerstone a set of objectives. It could be to buy a house, it could be to enable you to go to the Michelin star restaurant once a month, it could be to fund your daughter’s higher education or it could be to create a fund to support your retirement. Be clear about the objective of your financial plan.
2. Amount: Know how much money you will need to achieve your objectives
3. Time: The time for your financial plan to fructify should be in line with your goal. If you wish to take the vacation next year and your financial plan delivers the money 5 years out, it is not of much use.
4. Risk appetite: This refers to how much risk are you willing to take. Risk appetite could differ by objective – for example, you may not want to take
a lot of risks to sustain basic expenses, as these are ongoing needs. On the other hand, when planning for a starter pot for your kids you may want to
consider slightly higher risk instruments as this is a long-term goal. Ok, so now how should you create your financial plan? Let’s take a simple yet
powerful framework to explain. We outline this below
Figure 1: The financial planning hierarchy
So what does the framework tell us? And what does that mean for my savings plan? Needs lower down in the hierarchy need to be taken care of first before satisfying needs that are higher up. Your financial planning then must align to the same hierarchy of needs. Let’s look at the hierarchy and what it means for financial planning across the four elements outlined earlier.
In more familiar language these are what we may call Roti, Kapda, Makaan - essential items to help sustain our basic life. These are the most basic needs we need to sustain and hence our first objective for the financial plan.
Objective #1: Sustain basic expenses in case of unforeseen events such as loss of job, unforeseen illness, etc. This is the objective. Now, how much amount is needed to meet this objective? The first step toanswer the question is to identify your monthly expense on essentials. Look at your bank statement and your credit card statement and for the last 3 months.
Identify how much you spent on groceries, food, rent/EMI and other essentials. It is critical to differentiate between “needs” and “wants”. Needs are fundamental
for your life, wants are those that make your life enjoyable. Needs are – food, clothing, rent and loan EMIs (which if you don’t pay, will impact your credit score creating problems for the future). Wants are – the meal at the restaurant, the designer dress you wanted to wear at the next party. For a typical Indian
household, basic expenses would be 40-50% of monthly post-tax income. This number could vary – for instance for those with home loans this number could be higher. A good ballpark on how much you need is 6-9 months of monthly expenses. So if your essential expenses per month are Rs. 50,000 – you need to save Rs 3-4.5 lakh to meet your objective. Now to question 3 – the timing or when do we need this money. Well, we need this money always – this pool is like an insurance against risk events and you do not know when the next COVID pandemic happens or when the next financial crisis takes over.
This takes us to the next question – what instruments should you use and what is the risk appetite you should have for this pool. Given the nature of this objective, the money needs to be in highly liquid and low-risk instruments. Ideal instruments to save for this objective are to keep money in your savings accounts, fixed deposits (1 year or less duration) or liquid mutual funds.
Security and safety needs Ensuring your and your family’s safety and security is next in the hierarchy of needs. While there are aspects of physical safety and security too, we will focus on the financial security aspect. Financial security for us and our loved ones involves spends on healthcare, life insurance, general insurance and health insurance. These are the second set of objectives our financial plan needs toachieve.
Objective # 2: Secure ourselves and our families
Typically, between 10 and 20% of income should be allocated to these needs. In
terms of timing and instrument of savings, healthcare expenses are similar to
basic expenses – they are required to be available always and hence one must
save for these in liquid instruments such as savings accounts, FDs or liquid MFs. One should also include in this life and health insurance-related products. Ideally, choose a combination of insurance and investment for your healthcare needs.
The next step of financial planning should involve your goals. Based on your life
stage, you may have any number of goals. Planning to buy a house in 5 years –
goal #1, buying a car in 3 – goal #2, foreign vacation – goal #3. Set your goals and
don’t forget to add retirement planning as one key goal. Given inflation an rising
life expectancy, this is a critical goal everyone needs to save for. Next, figure out
how much you need to meet each of your goals. Be prudent on leveraging –
taking debt to fulfil your goals. While responsible leveraging (e.g. taking a home
loan to buy a house) will likely help your financial position, overleveraging could
leave you in a spot of bother.
Next, based on your goal, set up a savings plan, where you put aside money every month towards your goal. For short-term goals such as a vacation or buying a car or for those for which certainty is critical, choose low-risk instruments – FDs, low risk mutual funds. For longer term goals you can invest in riskier asset classes such as equity mutual funds. Invest in equities only if you understand the asset class.
For FDs, low-risk mutual funds – you should expect a 5-7% annualised return posttaxes. While higher risk assets could yield you 10-15% returns. Higher the return, the higher the risk.
Objective #3: Build a savings pot each for each of your goals
Typically, one should invest 20% of their income toward such goals. This is in
addition to natural investments that happen via the PF route if you are employed.
The last set of needs one should cater to are discretionary consumption items.
These include entertainment, eating out, gym memberships, consumer durables
purchase and the likes. Typically 20-30% of income should be allocated to this
Objective #4: Discretionary consumption expenses
When planning your savings, move up the needs hierarchy – plan for basic
expenses first, security next, goal-based investments after that and for
consumption expenses at the end. So yes – the iPhone can wait for a few months,get insured first!
The reverse logic also applies equally – when you need to cut expenses go from
top to bottom. Should things go bad – e.g. you end up losing your job, the first cut in expenses should be in the consumption bucket and so on.
So, you are all set to create your financial plan. You can use FD or SIP calculators to measure the amount required to save for each goal and the likely returns you can expect. There are various products that can help you secure your financial well-being.
Mr. Sameer Shetty, Head- Digital Banking, Axis Bank.