by Anand Saxena
Anshreya starts to put this 20 percent money aside (₹10,000) from the day she gets her first pay check and increases it by the inflation percentage (6 percent.) Assuming that the financial instrument earns her a return of 4-5 percent, within 21-22 months (say two years,) her breathing fund is fully stocked up. Notice what all this fund has achieved? It has inculcated a saving discipline in Anshreya right from the beginning of her career which gives her a goal-based focus, an important factor which will help her in future life. This solid asset has given a spring in her steps and confidence in her life. Most importantly, should any financial emergency strike her, she need not run for a credit card or a personal loan – both having prohibitive interest rates.
It is very important to define what would constitute a financial emergency for which this breathing fund will be used? Her parents’ marriage anniversary will not be one because that falls on a fixed date for which she should plan from her want bucket, nor an annual vacation in Ladakh, which also should be a planned event funded out of her want bucket.
What happens when some real financial situation arises where she needs to utilise part of this breathing fund? She should immediately start to recoup it by putting full or part of her 20 percent saving bucket towards it in a manner that it gets recouped within 12-15 months. In this interim period, if required she must pause her long-term investments to attain short-term peace.
You would notice that the financial instruments selected to build the breathing fund are providing higher safety albeit with low rates of return. The breathing fund is for your peace of mind and not a long-term investment, so you would not like it to be reduced to half if the stock market tanks (which will invariably happen—remember Mr. Murphy). So, be content with safety here even at the cost of growth.
Key Takeaways
A breathing fund, catering to 3-6 months’ expenses, must be created the moment one starts earning by putting the entire 20 percent savings in a high safety and low-risk financial instrument.
If exhausted for an emergency, (define it deliberately for yourself), immediately take steps to recoup it even at the cost of pausing your long-term investments.
This breathing fund obviates the need for a credit card or personal loan.
MUSING 7: FIRST THINGS FIRST
INSURANCE: THE ESSENTIAL FIVE
For effective and efficient financial management, a regular income stream is a prerequisite. If the sole source of income is the breadwinner of the family, his or her well-being becomes absolutely vital for the financial security and indeed survivability of the family. All the tools and concepts put forth in this book will come to naught if the income stream gets interrupted due to the reasons of loss of life or health of the breadwinner. The breadwinner thus needs protection against his or her inability to earn for whatever reasons. Similarly, the financial assets that we accumulate over the years also need protection against a loss. Risk management through insurance thus becomes a sine qua non for the financial well-being of any individual or family.
I must hasten to add, however, that not all kinds of insurance are necessary or desirable. There are in fact a few, five to be precise, insurances which are totally unavoidable. Let’s take a look one by one.
1. Life Insurance
The first and the most important form of insurance is life insurance which protects against loss of the life of the breadwinner. Anshreya, who has just started earning, is also contemplating life insurance. How should she go about it?
First question to be asked is – does she require a life insurance at this stage? She is not married and is not planning to marry for next 4-5 years. This decision will depend upon the fact whether she has dependents like retired parents or a sibling who is studying and banks on her pay for sustenance and survival. If yes, she must take life insurance the moment she starts earning. I would recommend though, that she should go for a life insurance irrespective of the fact whether she has dependents at this stage or not. If she goes to purchase life insurance after her marriage (maybe 5 years later,) the same amount of coverage will cost her more. Also, she is absolutely fit right now. God forbid, if she gets afflicted by an ailment in the times to come, the life coverage is going to cost her more.
To take an illustrative example, if Anshreya takes a term life insurance cover of ₹1 crore at the age of 25 years, it may cost her only ₹7,000 to ₹10,000 per year. If she delays it by five years, the same cover may cost her ₹9,500 to ₹14,000 per year, assuming that she retains her medical fitness or else it will cost her even more. Essentially, every 5 years of delay pushes up the premium by 40-50 percent10.
The next question to be asked is how much of life cover does one need? Let’s try and calculate for Anshreya.
A good rule of thumb figure is ten times the annual income. So, if Anshreya is earning ₹6 lakhs per annum, she must get a term insurance of ₹60 lakhs. However, keep in mind that this is the amount required when she is still unmarried, which is bound to go up as she moves along in life with marriage and childbirth. The logic of ten times the annual income? “The ten-time rule of thumb is not an arbitrary number. Remember, life insurance is designed to replace your income. If your surviving spouse invests that $400,000 (assuming annual salary of $40,000) in good mutual funds at an average 10–12 percent return, he or she could peel off $40,000 a year from that investment to replace your income without ever cutting into the principal11.”
This coverage amount takes into account the surviving spouse. We also need to factor in other liabilities of Anshreya. Let’s say she has taken a home loan of ₹20 lakhs and a car loan of ₹8 lakhs. In case of a mishap, paying off these two liabilities itself will polish off half of the coverage amount. This amount of ₹28 lakhs (₹20 lakhs + 8 lakhs) must, therefore, be added in the required coverage amount.
If Anshreya has children, their expenses (education, marriage etc.) as they grow up and settle down in life also need to be catered for. As far as child education is concerned, the method of calculation is given under the relevant musing. For marriage, a figure could be assumed, which will differ from person to person. For our example, let’s assume Anshreya has one child; she should cater for ₹70 lakhs for her education and marriage (₹50 lakhs for education and ₹20 lakhs for marriage.)
The total amount thus works out to ₹1.58 crores (₹60 lakhs + ₹28 lakhs + ₹70 lakhs.) These covers are obviously not required in one go and should be added as the major milestones are crossed in life by Anshreya like when she gets married, is blessed with a child, takes on a major financial obligation like a home loan or car loan and so on.
The next issue to be tackled is what kind of life insurance should one opt for? There is a plethora of options out there: Endowment plans, whole life policy plans, unit-linked insurance plans and money back plans. All are avoidable. The only plan one should go for is a pure term insurance plan. A term insurance plan is for a pre-designated term, say 40 years. So, if you buy a ₹1 crore term insurance plan for 40 years and pass away during this period, the insurance company will pay your next of kin, ₹1 crore. If you survive 40 years, you get nothing. Always go for a term insurance plan even if you are taking insurance to cover your house mortgage, car loan, personal loan and so on. It works out the cheapest and most effective.
2. Health Insurance
This is the second most important insurance that one needs. In India, there are various kinds of health insurance plans: individual plans, family floater plans, maternity insurance plans, personal accident cover plans, critical illness insurance plans and senior citizen plans. The thing to be remembered is that as you age, you will be paying more and more for a health plan. In general, buying a health cover after 40 years of age will be costlier. For a family of six including two senior citizens, two adults under 40 and two children, a 10-lakh health cover will cost around ₹25,000 per annum today12.
The factors to be considered for a health insurance plan follow.
How much should be the ‘sum insured?’ In a small town, an am
ount of 3-5 lakhs may suffice but in a metro, 5-10 lakhs may be a better figure to plan13.. Corporate health insurance is being offered by many companies today. Its coverage must be factored in the calculations.
The insurance plan must offer ‘lifetime renewability’ as health-related expenses tend to rise with age and buying a new plan will be prohibitive in terms of premium in middle or old age. This simply means that you can keep renewing your health insurance coverage each year irrespective of your age or ailments. This is mandated by Insurance Regulatory and Development Authority of India (IRDAI) and can’t be denied by the insurance companies.
Your policy must have a ‘top up’ or ‘restore limit’ meaning that if you are afflicted with a critical illness which requires an expenditure beyond the sum insured, that can be topped up by paying an additional premium.
Critically look for ‘sub-limits’ and ‘co-payment’ options in the plan which should be none or minimum. Sub-limits mean that your insurer specifies a limit for an expense and anything above that needs to be borne by you (co-payment). Room rent, diagnostics and doctor’s fees are the most commonly introduced sub-limits14.”
Pre-existing diseases must be honestly declared. Most Insurance companies have a waiting period for starting coverage for pre-existing diseases, which may be between 2 and 5 years. Look for minimum waiting period and do disclose your existing ailments or else the insurance company will retain the right to reject your claim.
Daycare and OPD expenses must be covered in the policy. Most insurance plans cater for only overnight admission or minimum hospital admission of 24 hours. Many medical and surgical procedures, however, require admission of less than 24 hours, which will be excluded by default by the insurance company.
3. Accident and Disability Cover
This cover will protect you against a temporary or permanent disability which results in your loss of job or reduction in earning capacity. The thing to note is that one should not go for a ‘short-term disability plan’ meaning a plan that covers less than five years of disability. Instead, go for a longer duration disability plan.
There are policies that pay out a lump sum to one’s nominee in case of death due to accident and pay a monthly sum in case of a disability due to an accident.
4. Home and Content’s Insurance
Your home and its contents are invariably your most precious possessions which you can’t afford to lose in a natural or manmade catastrophe. Yes, earthquakes, fires, cyclones, floods and burglary can occur with no notice and cause devastation to your home. This is one type of insurance that people shy away from and this could be a big mistake in case of a mishap.
You don’t have to insure the house for the “value of the property” which includes the cost of the land, locality and construction costs but only for the reconstruction cost in case of a mishap.
Even if you are living in the house as a tenant, do insure the contents of the house against any mishap.
5. Vehicle Insurance
Your vehicle insurance should not only cover the cost of repairing or replacing the vehicle but also have a ‘third party insurance’ clause which protects you against claims made by the accident victims. Also, go for the cashless repair clause wherein your vehicle gets repaired in the designated workshops without you paying for it.
Key Takeaways
The ‘essential five’ insurance policies discussed above along with your breathing fund will give you a solid foundation to build your financial future without worrying about emergencies and mishaps. Most importantly, peace of mind will follow you and your family.
Never mix insurance with investment. Don’t look for returns from your insurance policies.
MUSING 8: ASSETS AND LIABILITIES
The SI balance teaches us the art of money management but leaves another question unanswered: Can one go ahead and spend money on anything one fancies, as long as the SI balance is maintained? There are competing needs for various things in life with only finite amount of money at our disposal. How do we go about prioritising our needs and wants? Is there a guideline or precept one can follow? Well, actually there is one and is explained very beautifully by Robert Kiyosaki in his book ‘Rich Dad Poor Dad.’ The mantra is to understand the difference between an asset and a liability and then endeavour to acquire more number of assets while keeping the liabilities to a minimum.
As per Kiyosaki, “An asset is something that puts money in your pocket, whereas a liability takes money out of your pocket.” Let’s try and understand this with example of a smartphone which straddles the space between a want and a need. For our communication and social needs, a smartphone is definitely required and hence a functional and decent looking smartphone could be construed as an asset. It helps you remain in touch with your family, friends and other near and dear ones. It keeps you abreast of and alive to happenings in the world. One can read, watch movies, do banking and other tasks which save time and money, both in the short and long-term. However, does it really put money in our pockets? If we decide to sell our smartphone the very next day of its purchase, we might get just about half the price. So its price keeps going down with time as also it requires periodic expenditure on maintenance like for replacing the battery. It is thus difficult to slot it into the category of an asset.
The deduction is that if one spends a small sum of money to buy a smartphone which has all the basic required functions and is decent looking, it is still an asset. However, spending ₹1 lakh to buy iPhone X could firmly put this purchase in the category of a liability, especially if the purchase is out of our regular income or pay. Does this mean that we should not aspire to buy iPhone X? Definitely not, but the money must not come out of our regular income, but instead from our assets itself. To understand this point, let’s first summarise what all could be clubbed under the category of assets?
Your investments which generate a cash flow in the short or long-term are your assets. So stocks (including mutual funds,), bonds, income-generating real estate (house or commercial property on rent), intellectual property like book or music and gold come under the category of assets. Notice that assets also take money out of your pocket initially to be acquired but over time appreciate in value and return not only the original amount but grow it manifold. Getting back to our aspiration to buy iPhone X, we should invest the money in assets and when these assets appreciate to give us ₹1 lac, we should go ahead and buy. But that will take time and hence we need to write down our wants and aspirations, prioritise them, assign an amount to them and then go about saving or investing towards acquiring them. The ‘present bias15’ must be ruthlessly curbed.
Liabilities not only take money out of your pocket to be acquired initially but thereafter on maintenance too. They also depreciate in value over time. So everything from a car to furniture items and other consumer goods could be put under this category. Obviously, most of these things will also overlap the space of a want and a need. One way to acquire them has already been discussed with the example of a smartphone. The other way is to do a VED (Vital, Essential, Desirable) analysis, prioritise them and then buy out of the want or need money (remember the 30 percent and 50 percent buckets.)
The 20 percent saving and investment bucket will be utilised to build assets which cover your long-term goals like retirement, children’s education and marriage; and not short-term needs or wants as discussed above. They have to be managed under ‘needs’ (50 percent) or ‘wants’ (30 percent) money. A special case is of a house which is an aspirational need for most of us and often the biggest investment which runs for the longest period of time. The subject of real estate also generates fair bit of controversy about it being an asset or a liability. For these reasons, we will tackle this issue subsequently as a separate musing.
Kiyosaki also discusses the cash flow quadrants of a rich, middle class and poor person, which are instructive. These basically bring out that, Rich persons use their income to build assets whereas middle class and poor persons acquire liabilities
which they think are assets. To continue with our example, a rich person will buy iPhone X out of money generated by his assets whereas a middle-class person will buy it out of his pay or regular income. I will urge you to read this wonderful book, “Rich Dad Poor Dad” and internalise the cash flow quadrants16. The link is provided below.
https://www.youtube.com/watch?v=q0Dwa7Bh-zE
Key Takeaways
Understand the difference between an asset and a liability and acquire as many assets as you can while keeping the liabilities to bare minimum.
A dispassionate VED analysis will help put the liabilities in correct perspective and priority.
Over time, how much your regular income increases will become immaterial if you manage to increase income from your assets. This income should also cater for the time you will have no regular income coming in after retirement.
MUSING 9: THE LATTE FACTOR
The latte is a metaphor made popular by David Bach in his book ‘The Automatic Millionnaire.’ The latte factor essentially refers to small but regular spending on things which appear trivial in the short run, but counted over a period of few years and decades, have the potential to seriously impede one’s financial freedom. In the book, Bach talks about a woman who is fond of having a tall latte from Starbucks every day ignoring the cheaper alternatives available at her workplace. If invested over a decade, this seemingly trivial amount of $3-4 per day on a latte could have grown to a substantial sum.
