What is financial planning? What are the steps involved in financial planning?
Of late, we are hearing a lot about financial planning in newspaper. Is financial planning is just planning of finance or is it much more than that? Let us have a close look at “what is financial planning” with an example.
We all have various financial goals. It can be buying of a car, house or planning your children higher education, marriage, planning for retirement etc. There can be goals like annual vacation, investing on a farm house etc.
What is the definition of Financial Planning?
Financial planning means identifying your financial goals, prioritizing them and achieving them with a clear focused plan.
What are the Steps in Financial Planning Process?
- Identifying your financial goals.
- Quantifying the financial goals.
- Calculating the future value of the goal with inflation.
- Current position in relation to goals.
- Plan for the goal with the right kind of instruments.
- Review the plan periodically and suggest changes.
- Ensure proper life insurance & Health insurance.
- Ensure an emergency fund for emergency.
Manoj aged 30 is working with TCS and his wife aged 28 is an officer with a PSU bank. They had a baby last month. Their combined take home salary is 80,000. They are staying in a rented house and spend around 40,000 in a month including rent. This leaves them with a surplus of 40,000 per month.What are their financial goals?
(* This is an example covering basic financial goals. A person can have more goals like going to vacations, buying a car etc.)
Types of Financial Planning
Buying a House
Their top priority is to buy a house and save the rent of 15,000 per month. They have around 15 Lakhs in the bank, which is their saving for the last 3-4 years, for the down payment for the home loan. They are looking for a flat worth 40 lakhs for which they have to pay a minimum of 8 lakhs as down payment.
Manoj can apply for a joint home loan with his wife as a co applicant, so that both can claim the income tax benefit for the interest paid on home loan. For 32 Lakhs loan for 20 years @10.5%, the EMI works out to 32,000. They can pay 16,000 each from their respective accounts and both of them can claim tax deduction under section 24 upto 1.5 Lakhs in a year. They can try to pre close the home loan utilizing their annual bonuses etc. Though the term of the loan is 20 years, they can easily close the loan in 15 years. Manoj and wife will be the real owners of their home in 15 years.
Planning for Child Higher Education & Marriage
They want to plan for an amount equivalent to today’s 10 lakhs for child’s higher education and marriage. With 8% inflation, the higher education will cost around 40 lakhs after 18 years. The cost for marriage at 6% inflation will be around 43 Lakhs after 25 years.
Since these are long term goals, they can plan for these through equity mutual funds. Historically, such funds have given returns above 18% in the long term. Assuming a CAGR of 12%, manoj has to invest 6000 & 2500 every month for these goals. So, he can select 2 good funds and start SIPs for 4250 in each of them.
He has to review the fund performance atleast yearly and make necessary changes if required.
Why is it Important to Plan for your Retirement?
As per their standard of living, they want to ensure a monthly cash flow equivalent to today’s 30,000 for their post retirement days.
With 6% inflation, the value of 30,000 will be 1, 72,000 when Manoj is aged 60. He has to plan for atleast 20 years of retired life assuming longevity of 80.
Post retirement, the investment should be in safe, less risky avenues, which will offer less return. Assuming a 2% return over inflation during the post retirement period, the money to be accumulated at age 60, for this monthly cash flow is 3.4 Crores.
Don’t get alarmed seeing this big figure. Since both of them are employed and have 30 years of working life ahead, they can manage this easily. Their retirement benefits including PF and gratuity will give around 1.4 Crore for their retirement.
Manoj can invest 32,000 per month from his age 45 for this goal, because he will be free from the EMI by that time. If he invests 32,000 for the next 15 years in good mutual funds, he can create around 1.5 Crore when he is aged 60.
In the last 15 years, their salary would have atleast doubled. Part of it will go towards spending for increase quality of life and in child educational expenses. But still, they can start investing another 10,000 per month for the next 15 years. This can contribute around 50 Lakhs in 15 years. So, they will have 1.4 Cr from PF & Gratuity, 1.5 Crores and 50 Lakhs from the 2 SIPs. This is exactly what they require for their retirement.
Both of them can start PPF accounts and start investing any amount in between 500 – 1 Lakh every year. They can start with small contributions now. As they are nearing retirement, they can increase the contribution to PPF and reduce the equity. This way, they can do the rebalancing.
After retirement, they can keep around 15-20% of the total savings in equity and balance can be invested in debt mutual funds. They can opt for a systematic withdrawal plan, which will ensure the regular monthly pay out.
Since both of them are earning, their insurance need is less. As per the cost replacement method, they need an insurance cover of 1.6 Crore. Manoj can take a cover of 1 Crore for 30 Years while his wife can go for 60 Lakhs.
Also,online Term policies offer better rates for insurance.
Though they are covered for 5 Lakhs through their employer sponsored mediclaim, it is better to take a health insurance policy of their own. Such a policy will come to their rescue in case of a job shift and after retirement.
There are policies which offer life time renewal facility. Therefore,Go for policies where there are no sub limits and no loading based on claims. Better to avoid PSU companies because of the above mentioned reasons.
Financial Planning Goals
Manoj is now aware about what is financial planning and furthermore he knows exactly how much he requires for each of his goals.
What are the Basic Components of a Financial Plan?
Manoj knows the basic components of a financial plan
- How much he need to invest?
- Where to invest?
- How long to invest?
Finally It is clear for manoj now – an EMI of 32,000 and SIPs worth 8,500 for the next 15 years. After 15 years, SIPs for 42,000 for the next 15 years. By age 60, he will have all goals in place.But Manoj need to ensure the insurance cover to take care of any unforeseen.
Therefore, After allotting amount to these goals, any excess in income can be allotted for other goals like car purchase, annual vacations etc. If they can manage atleast 6% annual increase in salary, they can lead a comfortable life before and after retirement.
In Conclusion, This is how financial planning can help an individual.
Is it even worth to know about what is financial planning? The answer to this question is up to you. You can either do it yourself or you can approach a fee only financial planner for financial planning.