How to plan and achieve your financial goals

In the first of this four-part series N R Ramakrishnan demystified the tedious process of financial planning. In the second installment today, he explains how you can plan and achieve your financial goals by using the power of compounding to your advantage.

The nature of financial planning was discussed in the first article of this series and we had looked at the answer for 'what is financial planning'. In simple terms financial planning was stated as the process of meeting life goals expressed in monetary terms, through proper management of finances.

The process of identifying the goals and estimating the monetary value of the expenses (Life goals expressed in monetary terms) will require an understanding as to how the costs increase over time generally referred to as inflation. The first step is to therefore clearly identify the goals and put a value/cost to be incurred at the relevant time estimating the increase in the cost of the goals over the current value based on past trends.

If a person wants to save say for a goal to be achieved after 5 years which currently costs Rs1,00,000, s/he will have to envisage a cost of Rs 1,33,822 at the end of 5 years given a level inflation of 6 per cent per annum. The sum has been worked by utilising the compound interest formula i.e. A= P*(1+R) ^T where A is the sum payable at the end of the term T (5 years here), R is rate of inflation (6 per cent here) and P is the current cost (Rs 1,00,000 here).

If one looks at only having Rs 1,00,000 in say a saving account there will be a shortfall as saving returns are at 3.5 per cent per annum which is much below the inflation rate. It is therefore imperative to grow the savings to meet the cost at the material time in future.

Part 1: Demystifying financial planning: One step at a time

The author is head of knowledge management at Money Bee Institute Pvt Ltd., Nagpur. Money Bee is a corporate training firm associated with NIFM (Ministry of Finance, GoI), SEBI, NSE, BSE, SBI and leading mutual funds in India. He can be reached at ramkiraj@hotmail.com.

Financial planning therefore helps one to focus on the cost estimation in a rational manner which in turn can help in properly assessing the amount required to be saved periodically. Let us see the validity of this statement through an example.

Assume I require Rs 1,00,000 at the end of 5 years and I can earn, say 12 per cent, per annum or 1 per cent per month on my investment. How much per month I will have to save can be calculated using a calculator or an excel sheet function as Rs 1,225. We can also calculate the amount using the annuity equation as under:

A = 1,00,000/ [ ((1+1 per cent) ^60) 1 /1 per cent]

In other words we can see that to save an amount of Rs 1,00,000 we have to earmark Rs 1,225 per month assuming that the investments earn 1 per cent per month. The contributions made by us will total to Rs 73,000 (60*1,225) and when regularly invested will yield a total of Rs 1,00,000.

If we assume that the cost of Rs 1,00,000 has been estimated in a rational manner and the return expectation are estimated in a rational manner then we can see the truth in the above statement as without a planning perspective it would have been difficult to undertake estimation of cost and also the accumulation of resources.

Further, we can also see that planning perspective helps us in looking at avenues available in a manner suited to raise the required finances and in case of shortfall the alternative finance resources can be also thought. The financial planning can bring in focus the need to systematically put aside sums as savings to meet future goals.

The resource raising not only depends on systematic savings but also a perspective of saving for long term increases the accumulated value by enabling the person to harness the power of compounding. That is the income earned on investment also reaps the benefit of reinvestment when the investments are held for a longer period.

Let us look at this through an example. Amit & Balu (both 35-years old) are two friends who understand the need for savings to meet their post retirement expenses by building a corpus of Rs 45,00,000 to be available when they reach the age of 60.

Amit starts immediately by setting a sum of Rs 1,00,000 every year and investing the same in an asset yielding a return of 8 per cent per annum. This he undertakes for a period of 10 years till the age of 45 and thereafter allows the investments to grow at a compounded growth of 8 per cent per annum.

Balu who was not very enthusiastic early realises the need to focus on savings and decides to save from the age of 45 till 55 a sum of Rs 2,00,000 per year to grow at the rate of 8 per cent per annum and thereafter allows the corpus to grow at 8 per cent per annum till the age of 60.

The amount available with Amit at age 45 is Rs 14, 48,656, and Rs 31, 27,540 when he reaches 55. The amount available with Balu at age 55 is Rs 28, 97,312 and Rs 42, 57,103 at 60. The sums can be calculated using the compound interest formula and annuity equation discussed above.

This brings in focus the power of compounding and the need to start savings early & for long term as the money with Amit despite saving only Rs 10,00,000 against Rs 20,00,000 by Balu, is more at age 60. The results are presented in graphical mode below:

Amit's case study described in the part I has two goals: Car and education expenses. In case of car we have taken the current cost at Rs 5,35,000 expected to increase at 6 per cent per annum. Education is currently costing Rs 9,00,000 and is expected to increase at the rate of 9 per cent per annum.

The cost of car after 2 years will be Rs 6,00,000 and education after 8 years will be Rs 18,00,000.

Savings for purchase of car will be in bank deposits yielding 5.5 per cent per annum and for education expenses the savings will be the ratio of 70 per cent in equity and 30 per cent in debt yielding an average of 10.80 per cent per annum. The surplus available monthly is Rs 25,000 and the same is expected to grow at 2 per cent every year (Increase in income minus increase in expenditure) (10 per cent minus 8 per cent). If we calculate the amount required to be saved using the growing annuity equation then:

Future value cost = 1st year annuity*((1+ g) ^n (1+r) ^n) / (g-r) where r = rate of return on investment, g = growth rate of savings.

Using for car the figures of n = 24, r = 5.5 per cent/12, g = 2 per cent, FV = Rs 6,00,000, monthly savings = Rs 18,780 leaving approximately Rs 6,220 to be applied for other savings.

Similarly using the figures n = 72, g = 2 per cent, r = 10.80 per cent/12, FV = Rs 18,00,000, monthly savings = Rs 8,780 leaving approximately Rs 16,220 to be applied for other savings.

In Amit's case if we assume that the surplus of Rs 6,220 for the first two years and Rs 16,220 for next three years are invested in equity fund then together with current balance the equity assets will grow to approximately Rs 27,00,000 in 5 years of which Rs 15 lakh can be used towards margin money for a house costing Rs 30 lakh and the balance borrowed from a bank for a tenure of 15 years with approximate EMI of Rs 16,200 at an interest rate of 10.25 per cent per annum.

We can see that a financial planning perspective enables us to objectively view the goals as well as the resource-raising plan. Here we may also understand that the inflation, return rates on assets are dynamic and hence the plans have to be continuously monitored and periodically reviewed. Financial planning helps to keep these aspects in focus.

In the next part of the article next week we will look at the spectrum of investment opportunities and their return perspective. Estimating the right amount to be saved and for the right length of time, based on the requirements worked for the financial goals, is the first objective of financial planning.

In short, financial planning helps the investors to focus on their goal achievement.