22 Jan 2018 15:11 IST

Save more next year, the year after and...

To improve the chances of meeting your life goal, increase your savings and invest smartly

You decide to save ₹50,000 every month for the next 10 years to fund your child’s college education. The stock-bond portfolio should earn 9.5 per cent compounded annual return because you require ₹1 crore in 10 years. But there is more to meeting your goal than just saving ₹50,000 every month. We discuss why you should increase your savings every year to improve your chances of meeting your life goal. We also discuss the process to invest this incremental savings.

Save more

To accumulate the required ₹1 crore, you have to necessarily earn 9.5 per cent every year for 10 years. What if your equity investment performs poorly, say, for two-three years? Also, what if education inflation is more than what you assumed? Your portfolio may earn the required return, but you will still fail to meet your child’s inflation-adjusted education cost.

True, you will be able to arrange alternative sources of funding should you face any shortfall in your child’s education portfolio 10 years hence. One such source is an education loan with your house as collateral. But you should keep such choices as standby. You must instead improve the chances of your goal-based portfolio achieving the accumulated amount to meet the life goal.

One way to do so is to increase your savings amount every year in line with the increase in your annual income. How much should you increase your savings by every year?

If you are repaying a mortgage, your ability to save for other goals is limited. If you do not have a mortgage, you can typically save 30-40 per cent of your post-tax monthly income. Suppose you earn ₹1.5 lakh per month. So, your initial savings of 30 per cent amounts to ₹45,000 per month. The next year, assuming you get an increase of 10 per cent, your monthly income will be ₹1.65 lakh. In addition to saving ₹45,000, you should set aside 25-35 per cent of your incremental monthly income of ₹15,000. If you do this every year, your savings will increase substantially through the time horizon for your life goal.

This gives you the opportunity to reduce the downside risk in your portfolio. How? Suppose you have an asset allocation of 65 per cent equity and 35 per cent bond, yielding 9.5 per cent total return. Thanks to the increase in your savings, you can now afford to earn lower return. So, you can move some of your equity investments to bank fixed deposits as you approach the date when your child has to enter college. But how should you set up the incremental investments?

Forward SIP

Suppose your salary is due for revision in April every year, payable fifth of the next month. You should then set up systematic investment plans (SIP) a week before May 5, but starting from May 5. The SIPs for the incremental investment should be on the same products as your initial SIPs — equity mutual fund and recurring bank deposit.

The incremental amount should maintain your current asset allocation till you near the time horizon for the life goal. That is, if your portfolio has 65 per cent equity and 35 per cent bonds, the incremental savings should also be invested likewise.

There is a reason to set up the SIP in anticipation of the salary increase. Once you experience the luxury of spending more in the first month after your salary revision, you may be reluctant to increase your savings thereafter! You can cancel the SIPs if you do not receive the expected increment.

The incremental SIPs need to be set up once every year. That is a small price to pay to improve your likelihood of funding your child’s college education, spending an exotic vacation or retiring comfortably.

(The writer is the founder of Navera Consulting. The article first appeared in The Hindu BusinessLine.)