Personal Finance Planning for the Layman

The Need

Modern science has increased the life expectancy of humans by decades. At the same time, it has also ushered in a plethora of temptations garbed as necessities – needless to say, these temptations do not come cheap. The ever-increasing avenues of spending give today’s man a wholly different perspective on wealth, as compared to even those of just a century ago. While earlier wealth referred to tangible objects such as land and jewelry, today a wide range of tangibles and intangibles have crept into the picture – while owning a Monet is wealth, so is owning a yacht. And the means to achieve either are the greenbacks. However, while money remains a constant to define wealth, destiny is forever fluctuating – what appears as an immense pool of money today may just dry up tomorrow. In such a situation, one needs to plan years ahead to hedge the uncertainty of the future.

The most common situations, which call for financial planning for the average middle class person, are:

For any salaried individual, retirement is an eventuality. While many countries provide social security to retired people, the real income that one earns from such schemes may be severely hit by inflationary trends.

For example, over a ten year period considering an average inflation rate of 4%, $1225 would fetch the same value as $1000, provided the growth in prices of all commodities remain fixed at 4%. Thus, a person who subsists on an amount of $10000 today would need to earn at least $12254 to maintain his current living standard ten years hence. In other words, if a person retires with a capital of say $100000 and earns 10% on this capital through investment in bonds, etc, he/she would require a capital of $122540 to earn the same value ten years hence. That, at an age when he/she may not mentally or physically be in a position to engage in constructive, income generating employment. Obviously, such depreciation of real income/capital calls for long-term planning.

Children’s Education
With the steep rise in unemployment the world over, people need to acquire special skills to be assured of even a moderate living. And as the demand for such skills is increasing, so is the cost of acquiring such skills getting pushed up. A person whose child is say ten years old today would require a substantial amount of money a decade hence for his college education, and planning for the same needs to done from today to avoid complications at the last moment.

Medical Contingencies
Medical contingencies have become so much a part and parcel of everyone’s lives, that they can no longer be termed as contingencies. Again, while newer and better medical tools are being developed everyday, the cost of medical treatment is unfortunately on an upward spiral. Thus, while a person can expect to live longer thanks to the modern-day medicine, it is not a very comforting thought when one takes a look at what effect it could have on one’s finances. Even planning ahead may at times not suffice, but it can at least provide a cushion to fall back on when ailments hit.

Apart from the above, sudden cash flow mismatches may occur for numerous reasons – an impulsive tour to Hawaii, for instance. While every such eventuality cannot be anticipated in advance, the least a sensible person can do is to create a buffer for himself for the rainy days. And that buffer can only be created through proper planning of one’s finances while the going is good.

The Planning Aspect
The planning structure may vary widely from person to person. However, there are a few common factors that everyone needs to consider while planning his/her finances:

The age of the individual is an important factor to be weighed in. For example, an executive in his early twenties may not wish to spend too much on his retirement funds; the dreaded day, after all, is a long way away. On the other hand, a person in the forty-something age bracket can see his retirement looming over the horizon; he would naturally have a stronger desire to save. Unfortunately, the time value of money is forever on an upward curve, and saving nominal amounts at an early age is wiser than saving huge amounts at a later age.

Thus, if an investor starts saving at the age of thirty, then at a 10% rate of return on capital, and an annual saving of say $6000, the investor shall have roughly a capital of $1.1 million at the age of sixty when he retires. However, if he begins saving at the age of forty, he would be required to make an annual investment of $18000 to have a similar amount at his disposal at the age of sixty. Thus, if he starts saving at a later age, the annual saving burden is thrice the amount that he would need to forgo every month if he starts saving ten years earlier.

Again, if we assume that at age forty, our investor is in a position to save $15000 annually and not feel the pinch (as against $18000 which he is required to invest), then we find that if he starts saving $6000 per annum at age thirty and thereafter saves $15000 from age forty, at the retirement date he would have a capital of around $1.7 million, half a million more than what he would have if he starts saving at age forty at the rate of $18000 per annum (which would also cause him undue hardship to the extent of $3000 per annum). Therefore, the bottom line is that you should start keeping aside some amount, (no matter big or small) as savings at the end of the month. Ideally, you should be saving 25 percent of your income every month.

Investment Avenues
The available avenues of investment also play a major role planning one’s finances. While different countries have differing rate structures for investment products, the mode of operations and the nature of the investment avenues are generally the same. Thus, while the United States and India, countries at two ends of the economic spectrum, have differing bank rates (the rates in India being almost four times that of the US), the underlying product is essentially the same.

However, the preferred investment mode is certain to vary amongst the two countries owing to the difference in rates, as is observed in the US where the preference is towards mutual funds while in India people are more comfortable with bank deposits. Again, the various investments provide varying tax benefits, ranging from zero to a handsome percentage in the form of tax rebates. One also needs to keep this factor in mind to work out the time value of the savings parked in a particular investment.

Investment Horizon
Probably the most important aspect of financial planning is chalking out the investment horizons for the various requirements. The need to plan for different time horizons arises from the fact that financial requirements vary widely over any given length of time.

For example, the finances required for retirement planning call for a long term, substantial accumulation of funds; children’s college education, on the other hand, provides a much smaller time frame and calls for a relatively lower capital accumulation. While money for all such requirements may be accumulated in a common pool, it is ideal to have separate investments for separate requirements, as this would hedge against the risk of inadvertent mismanagement.

To exemplify, if there are separate retirement and children’s education funds, our investor, in case of any shortfall in the college fund at the time of withdrawal, would prefer to resort to some other, external revenue source such as a bank loan rather than break his retirement fund as well, thereby keeping his retirement money intact. While this may not work out in every case, it does mitigate the chances of mishandling the savings.

Other Planning Tools
Besides personal savings, one needs to try to provide for contingencies through other avenues as well, such as insurance. While our investor might be having all his future income and expenses planned out to a “T”, a freak accident could upset the apple cart, leaving himself and/or his dependents high and dry. To avoid such a situation, one should try to keep as much of self, family and property insured as possible. It is true that the premia paid on insurance seem to be a waste of hard-earned money since they carry little or no returns, but what is a small sacrifice today might yield handsome dividends in times of need.

The Final Word

While planning and monitoring ones finances to provide for as many contingencies and necessities as possible is cumbersome indeed (after all. spending is so much more fun than saving!), the benefits far outweigh the trouble taken. As the old adage goes “A Stitch in Time Saves Nine”; all that is called for is a little disciplined “stitching”. With disciplined planning and regular status reviews, this seemingly daunting task can be expected to become a part of everyday life, thereby providing for a reasonably secure future.

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