For a while, the logic seemed elusive. Usually, the Pay Commission revises the salaries of government employees about once in 10 years. However, according to squadron leader Lokesh Rao, the increment is more than sufficient only for the first five years. “Then the money seems to dry up. We (including his colleagues) start waiting for the next Pay Commission hikes,” says the 29-year-old air force officer.
The reason that the pay cheque seems to get smaller with time is explained by a single word—inflation. The period of five years is incidental. For the first few years, the arrears and steep increments accommodate the rise in prices and expenses. However, unlike the Pay Commission increments, inflation is continuous. Eventually, the impact of inflation supersedes that of the salary increase and Rao and his colleagues begin to feel that their budgets are overstretched.
This is the reason Rao has rushed to the doctor on receiving the increment: to know where to invest the money while it is still around.
Clearly, the counter-offensive against inflation must be equally persistent. Our ammunition: disciplined investing, ideally in instruments that are likely to beat the inflation rate.
The only asset class that qualifies for the job is equities, but Rao has no investment in mutual funds and stocks. In fact, he has no portfolio at all. “It is only after the implementation of the Sixth Pay Commission recommendations that my income has started generating a surplus,” he explains.
Till now, Rao has salted away about Rs 1 lakh in his provident fund and owns jewellery worth approximately Rs 20,000. In 2008, he bought a postal life insurance policy (PLI), for which he pays a premium of Rs 5,500 a month. The sum assured is Rs 10 lakh and the maturity amount at the end of 15 years will be Rs 21 lakh.
Why has he chosen a PLI instead of equities or a fixed deposit? “I bought it for my son’s education. I think it will give better returns than my provident fund and other debt instruments. Also, I don’t understand equities,” he says.
Rao’s calculation is correct. The PLI will give him an annualised return of 9.1% (assuming he pays the premium at the end and not the beginning of every month), which is slightly more than the current provident fund interest rate of 8.5%.
Nevertheless, no debt instrument can match up to equity, which is indispensable for wealth creation. Rao realised this and has started dabbling in stocks in the past few months (with about Rs 5,000) “to get a feel of how things work”. His lesson: investing in direct equity requires “a lot of time and hard work”. True. This is why we suggest that he invest in equities only through mutual funds.
Before we construct his portfolio, let’s assess the resources at hand. Rao’s take-home income is Rs 40,000 a month. On an average, his monthly expenses are 50% of his income, Rs 20,000. This is rather steep considering that the couple has been recently blessed with a son, which means expenses are going to surge. The good thing is that Rao has already included onetime expenses in the monthly average, so there shouldn’t be any nasty surprises in budgeting.
Last year, Rao took a personal loan of Rs 5 lakh at 9% interest to help his father build a house. The EMI is Rs 5,200. Besides, he took another loan of Rs 5 lakh to buy a car. The loan rate is 8% and the EMI Rs 4,800. After subtracting his expenses, EMIs and premium, Rao’s cash flow generates a surplus of only Rs 4,500. This is very low. Unfortunately, there is no way to increase this amount as Rao does not have enough debt investments to repay even one of his loans.
Iris suggests that Rao apportion 55% of his portfolio to equities. To do so, he must invest only in mutual funds for a few years. The premium for the PLI is enough to build the debt component.
Iris has chosen three funds to help meet his goals: HDFC Top 200, Reliance Growth and Benchmark CNX 500. Of the three, HDFC Top 200 can form the core of his collection as it is an equity diversified fund which offers relatively stable returns at a lower risk. Rao can invest 20% of his total equity investments in each of the other two funds. The Benchmark CNX 500 is an index fund and, hence, low on risk. Reliance Growth is a mid-cap fund that will accelerate the growth of his money.
Regarding insurance, Rao is well covered by the mandatory policy for air force officers. Combined with the postal life insurance policy, Rao’s cover is Rs 40 lakh. Medical facilities for him and his family are available at a subsidised rate which does away with the need for a health insurance policy.
The most important relief is that Rao needn’t save for a hefty nest egg as he will be paid about half of his last drawn salary as pension. In addition, he will be eligible for gratuity. Hence, Rao can focus on other goals such as his son’s education and purchase of a house.
At first glance, it seems that the goal to buy an apartment in the next two years is unachievable. The required monthly investment to accumulate Rs 22.5 lakh in two years is about Rs 80,000. However, as Rao will take a home loan to finance the apartment, this amount will reduce drastically.
Even though the monthly investment towards other goals is small, Rao’s surplus is still smaller. If he can reduce his mortgages as soon as possible, our financial plan promises a smooth flight.
The Inflation Hydra
Rao doesn’t fully understand the impact of inflation. We list out the three significant ways in which it can affect your financial plan:
If you spend Rs 20,000 today, after five years, you will be spending Rs 26,765 for the same things. Remember, the rate of inflation differs across products and services. So, though the price of your toothpaste may go up by 6% a year, school fees might shoot up by 15% p.a.
Similarly, your savings of Rs 20,000 a month will reduce to Rs 13,235. This is why salary increments must match inflation.
A five-year fixed deposit earns an interest of 9% p.a. But inflationadjusted returns are only 2.83% p.a. So calculations of how much you should invest must be based on inflationadjusted cost of the goals.