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"The Fallacy of Goal based Investment ' Tagging ' "

In recent times, there is a surge in the promotional campaigns of most of the financial services providers such as life insurers, mutual fund houses, banks and broking houses who highlight the importance of buying their investment tools for the planning of specific goals in an individual's life. A typical advertisement may look like 'Buy this insurance plan for fulfilling your child's education goal' or 'Start an SIP in this mutual fund for the purpose of your daughter's marriage' etc. All these promotions lead us to believe that we should be segregating our investments into different baskets and allocate each basket towards a particular goal! However practically it can be found that such an approach would be very inefficient.
This write up aims to highlight this very point and provide you with an alternative point of view about building efficiency into the most critical step of financial planning, 'cash flow analysis' through creating a broader perspective.

First of all let us see what happens when the concepts of 'time value of money' and 'goal based' planning is used by a financial advisor and gradually track his learning curve as he matures in the business.
At first, when he gets introduced to these concepts, he learns to find out how much constant amount needs to be invested every year, to accumulate for a particular goal, given a rate of return. This generally gets translated into the premium payable for a life insurance cum investment policy! However, based on his current income, the premium seems to be unthinkable for the client and hence he settles for a lower premium. A policy gets sold, but without any possibility of achieving the goal that they set out to achieve!

He further learns that if the contributions are increased consistently in sync with his income growth, the amount required to be invested in the first year becomes very affordable to accommodate seemingly unachievable goals! However since most life insurers don’t provide with such a facility, he graduates into selling mutual funds, where he recommends to go for an SIP(Systematic Investment Plan) and further increment the contribution to match up with the income growth rate of the client in the following years. Let me illustrate with an example.

Mr. X wishes to plan for his son's higher education which is due 15 years from now and would cost him Rs. 15 lacs as on today. Assuming an inflation rate of 8% p.a. on educational expenses, this amount would be Rs. 47.58 Lacs. If the planner were to recommend a constant annuity for this goal, assuming a rate of return of 10% p.a, the amount thus calculated would be Rs. 1.36 Lacs! This however gets reduced to Rs. 0.81 Lacs, if he is able to increase the contribution by 9% p.a. in sync with his average salary growth rate.

Let us now develop this case to include more goals as follows and see if this method is efficient enough:
  • Higher education provision for daughter due 17 years from now, today's cost Rs. 12 Lacs(she's a new born now)
  • Marriage of his daughter which is due 23 years from today with current cost as Rs. 10 Lacs and inflation @5% p.a.
  • His retirement which is due 25 years from now. Current expenses amount to Rs. 3 Lacs p.a., household inflation 8% p.a. through out life, rate of return pre and post retirement at 10% p.a. and life expectancy post retirement is a further 25 years. He's willing to take a one time expense cut of 25% at the time of retirement.
  • A trip to the Disneyland 5 years from today, current cost 5 Lacs, inflation 6% p.a.
  • Buy a car worth 4 Lacs currently, 3 years from today. Inflation 6% p.a.
  • Make provision for a 20% down payment for a flat, current cost 20 Lacs, inflation 8% p.a. and due 6 years from now.
  • Make provision for repayment of loan at the end of every year for the next 10 years. Interest rate on loan assumed to be 10% p.a. compounding annually. (This could be done from the respective year's income and need not be provided for through investments)

Let us also understand his cash flows; his current post tax take home salary is 5 Lacs p.a. and his wife's corresponding figure is 2 Lacs. p.a. Assuming a growth is salary of 9% p.a. for the couple, the respective growing annuities for investment into a 10% p.a. yielding instrument can be tabulated as follows: (all annuities for investments are taken at the beginning of the year in this example)

Year Goal Title Goal Amount Investment in year 1
if incremented
by 9% every year
2014 Car 476406 120401
2016 Trip to Disneyland 669113 84618
2017 Down payment for flat 793437 76360
2026 Son' higher education 4758254 80889
2028 Daughter's higher education 4440022 55534
2034 Daughter's marriage 3071524 16460
2036 Retirement 41574127 170891

Total investment in
year 1

  Total income in year 1   700000
  Household expenses in year 1   300000
  Net surplus   400000
  Shortfall for goals   205153

The general tendency in this case is to assume that some of the goals are still beyond the reach of the family and should be dropped. Typically a 'practical' and 'well informed' suggestion on setting the right priority is given to the client and the apparently more sensitive goals, such as education, marriage, retirement, and flat are kept in tact and the trip to Disneyland and the car get dropped as they seem to be luxuries. This reduces the investment requirement by Rs. 205019/- (120401+84618) which is approximately the amount of shortfall. The remaining money is locked into specific investments such as ULIPs or mutual fund SIPs and are allocated for each goal!

The client, though unhappy that he is shown his place with respect to his aspirations, feels that he has taken the right decision in the interest of himself and his family's financial future! The financial advisor on the other hand feels very important, proud and 'fulfilled' since he 'helped' some one to make the right decision!!

There are two major errors in this judgment. They are:
  • There is no weight given to the timing of the two goals which got scrapped. There is a utility value for the car to this young 4 member family.. There is a utility value for the trip to Disneyland only when the children are still small!
  • Secondly there is no feasibility study done as to whether the increased income after 6 years would be sufficient to pay for the yearly installments of the home loan taken.
Now, the million dollar question is how to include these goals as well into the current scheme of things. The solution is to scrap the idea of such goal based investment planning! Shocked? Let me explain..

The two goals which are scrapped were due in the very near future and the contributions towards these would have gotten over in the next 3 and 5 years respectively. The loan would also have gotten over in the next 16 years, leaving the remaining 9 years exclusively for the marriage and retirement goals. However the question still remains as to how can proper planning be ensured with such a staggered approach. The key to the new approach is that once the required rate of return is known(in this case it is 10% p.a.), the investment portfolio would be created independent of the goals!

Money would be pulled out of this portfolio as and when the goals get due from this common pool of investments without disturbing the portfolio balance. Here is how the cash flow structure would look like in this approach: (The assumption here is that the net surplus generated in each year is deployed at the end of the year. However the goals are provided for at the beginning of the year itself. Both are conservative assumptions).

Year Corpus @ beginning of the year Fresh Income Expenses Yearly install-
the flat
Net surplus Goals due Goal amounts due Corpus @ end of
the year
with 10% return
2011 0 700000 300000 0 400000 Nil 0 400000
2012 400000 763000 324000 0 439000 Nil   879000
2013 879000 831670 349920 0 481750 Nil   1448650
2014 1448650 906520 377914 0 528607 Car 476406 1598075
2015 1598075 988107 408147 0 579960     2337843
2016 2337843 1077037 440798 0 636238 Trip to
669113 2471841
2017 2471841 1173970 476062 387385 310523 Down payment
for flat
793437 2156767
2018 2156767 1279627 514147 387385 378095     2750539
2019 2750539 1394794 555279 387385 452130     3477723
2020 3477723 1520325 599701 387385 533239     4358735
2021 4358735 1657155 647677 387385 622092     5416700
2022 5416700 1806298 699492 387385 719422     6677793
2023 6677793 1968865 755451 387385 826030     8171601
2024 8171601 2146063 815887 387385 942791     9931553
2025 9931553 2339209 881158 387385 1070666     11995374
2026 11995374 2549738 951651 387385 1210702 Son' higher
4758254 9171535
2027 9171535 2779214 1027783 0 1751431     11840120
2028 11840120 3029343 1110005 0 1919338 Daughter's higher
4440022 10059446
2029 10059446 3301984 1198806 0 2103178     13168569
2030 13168569 3599163 1294710 0 2304453     16789878
2031 16789878 3923088 1398287 0 2524800     20993667
2032 20993667 4276165 1510150 0 2766015     25859049
2033 25859049 4661020 1630962 0 3030058     31475012
2034 31475012 5080512 1761439 0 3319073 Daughter's marriage 3071524 34562910
2035 34562910 5537758 1902354 0 3635404     41654605
2036 41654605 0 0 0 0 Retirement 41574127 88525

This method gives us the complete picture, where we can see that the two goals which were scrapped earlier(highlighted in red) can also be accommodated in a 'timely' manner leaving a surplus of Rs. 88525/- after fulfillment of ALL goals. This method also checks the feasibility of the loan repayments which could not have been checked in the goal based investment planning method.

Thus we can understand that the utility of cash flow analysis/goal analysis does NOT lie in creating multiple investments each 'tagged' to a particular goal, but to verify or derive the required rate of return on investments! Once the required rate is known, a single investment portfolio should be created and maintained in a 'goal independent' manner and appropriate amounts should be fished out of the common pool as and when the goals become due, without disturbing its balance.

(The author can be contacted on for any further clarification, or for a fruitful debate)