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 ₹15 lacs as on today. Assuming an inflation rate of 8% p.a. on educational expenses, this amount would be ₹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 ₹1.36 Lacs! This however gets reduced to ₹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:
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
by 9% every year
|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|
|Total investment in year 1||605153|
|Total income in year 1||700000|
|Household expenses in year 1||300000|
|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 ₹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:
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-
|Net surplus||Goals due||Goal amounts due||Corpus @ end of
with 10% return
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 ₹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.