A key approach to reaching your financial goals is through financial planning and adopting a model portfolio approach. Financial planning begins with laying out your long term and medium term financial goals and creating and implementing an investment plan to achieve these goals. Let us focus on financial planning and see what it should include.

Components of a Financial Plan for Customers

The million dollar question is how to go about creating a financial plan and what are the essential components that it must include? Here are 7 key steps.

Begin with a statement of goals

To fructify dreams we need financing. Whether you want to educate your child abroad, leave a legacy for them, secure your retirement or plan an exotic holiday, you need to plan for them. The first step in your financial plan is to set out your financial goals. Lifetime goals must be backed by a monetary implication with milestones.

Draw up a statement of your net worth

Take stock of the value your existing investments. It could be in the form of bonds, equities, mutual funds or even in the form of land and property. Put a value to loans and payables. The difference between your assets and your liabilities is your net worth. Figure out how much this wealth will be worth in the future. To fund the balance, you need to plan through systematic investment plans (SIPs) pegged to clear cut goals.

Put an elaborate retirement plan in place

The retirement plan is your gateway to financial freedom in the future. Nobody wants to work all their lives. But retirement means you need to meet expenses without proportionate income flows. You need to plan for that. Your retirement plan begins by working out the future value of your retirement and then planning backwards through the efficient use of SIPs in equities.

Now plan for your child’s education

You need to plan for your child’s education with two sets of assumptions. Your child needs to have a good education assuming that you are around and also assuming that you are not around. Therefore you also need to build insurance into your child plan. Again, this is a long term goal so make the best use of risk equities as an asset class.

Tax plan must be integrated into financial plan

The Income Tax Act offers a variety of tax benefits like Section 80C, Section 80D, Section 24 etc. But, often these tax plans are not aligned with the financial plans. The idea is to integrate the two. To simplify this integration; look at your entire financial plan in post-tax terms! The financial plan will determine the outer limits of your tax plan.

Insurance planning is an important aspect

It is essential to keep your insurance planning and investment planning separate. Products like endowment policies, money-back policies, ULIPs are out. For insurance take a pure risk cover (term policy). Use the power of mutual funds for investment and creating wealth and regular income in the future. Ensure every aspect is insured including life, health, assets and liabilities.

Have a contingency plan in place

Contingency plan has two key implications. For example, you could meet with an accident or you could lose your job. Ensure that you have enough emergency cash with you to take care of the transition. Secondly, your financial planning assumptions could go wrong. Have a Plan-B as a back-up in place so that your core goals are not impacted!

Why Mutual Funds Fit Perfectly Into Your Financial Plan

In financial planning, the investment portfolio must combine returns, risk, tax efficiency and liquidity. Here are 6 reasons why mutual funds fit best into your financial plan

You get automatic diversification

Diversification in mutual fund can be by default or design. You can allocate your funds across equity, debt, liquid and gold to reduce your concentration risk. The mutual funds also reduce your risk by diversifying across asset classes.

Mutual funds are highly liquid

The big advantage in mutual funds is that they are highly liquid. Disengaging with other assets can be quite expensive. In case of mutual funds, all the categories of funds are highly liquid and involve minimum impact cost.

MFs score in terms of tax efficiency

Assuming that you have to pay 10% tax on LTCG on equity funds, the net impact on the CAGR yield is less than 2%. Even debt fund returns can be structured as capital gains with the benefit of indexation benefit for long term gains. This makes mutual funds more tax efficient compared to other asset classes.

Get the mutual fund according to the goal tenure

Tenure matching is one of the key reasons why mutual funds naturally fit into your long term financial goals. You can get an overnight 1-day debt fund to 20-year equity funds and you can just peg such products directly into your goals. This will also reduce the risk of maturity mismatch in your long term financial plan. To simplify your task, you can peg specific funds to specific goals.

SIP approach fits perfectly into long term planning

Systematic investment plan is an option for equity and debt funds, especially when you are trying to build wealth over the long term. SIPs add a lot of value as there is no need to worry about timing the markets. It is time that works in your favour and reduces your average cost of holding over a period of time. That is the power of rupee cost averaging.

Equity funds are great wealth creators in the long run

For an investor they are passive investments but create tremendous wealth over the long run. Even with conservative returns, equity funds can generate substantial wealth if the discipline of SIP is sustained over long periods of time. Consider the table below:

SIP	5-Year SIP	10-Year SIP	15-Year SIP	20-Year SIP	25-Year SIP
Monthly SIP	Rs.10,000	Rs.10,000	Rs.10,000	Rs.10,000	Rs.10,000
Yield (%)	14%	14%	14%	14%	14%
Total outlay	Rs.6.00 lakh	Rs.12.00 lakh	Rs.18.00 lakh	Rs.24 lakh	Rs.30 lakh
Final Wealth	Rs.8.72 lakh	Rs.26.21 lakh	Rs.61.29 lakh	Rs.1.32 crore	Rs.2.73 crore
Wealth Ratio	1.45 times	2.18 times	3.41 times	5.50 times	9.10 times

Mutual funds offer the best variety and dynamism to meet your long term financial goals. It is this flexibility of mutual funds that makes them best suited to your financial plan.

Will LTCG Tax On Equity Mutual Funds Impact Your Financial Plan?

Union Budget 2018 had announced a flat 10% tax on long term capital gains on equity investments and on equity fund investments. Until March 2018, LTCG on equities and equity funds were entirely tax-free in the hands of the investor. This LTCG becomes specifically relevant because most investors rely on equity funds to create wealth in the long term and to meet their long term goals like retirement, child education plan etc.

How will the LTCG tax be imposed?

When it comes to equity funds, the definition of long term capital gains is a holding period of more than 1 year. In this case, the benefit of indexation will not be available even if you hold shares for longer periods of time. The only benefit is a basic exemption of Rs.1 lakh and any capital gains above Rs.1 lakh will be taxed at a flat rate of 10%. Let us see how LTCG impacts the financial plan?

LTCG tax and the impact on investment corpus

You will end up paying 10% tax on LTCG when you redeem your equity fund corpus, assuming LTCG tax will still be in existence. Your final corpus will be reduced to that extent. Here is how.

Pre LTCG Tax	Amount	Post LTCG Tax	Amount
Retirement SIP monthly	Rs.10,000	Retirement SIP monthly	Rs.10,000
Tenure of SIP	25 years	Tenure of SIP	25 years
Invested in	Equity Funds	Invested in	Equity Funds
CAGR returns	14%	CAGR returns	14%
Amount Contributed	Rs.30,00,000	Amount Contributed	Rs.30,00,000
Final Corpus	Rs.2,72,72,777	Final Corpus	Rs.2,72,72,777
Long Term Capital Gain	Rs.2,42,72,777	Long Term Capital Gain	Rs.2,42,72,777
Basic Exemption	Not Applicable	Basic Exemption	Rs.1,00,000
Taxable LTCG	Not Applicable	Taxable LTCG	Rs.2,41,72,777
Tax on LTCG	Nil	Tax on LTCG at 10%	Rs.24,17,278
Net Corpus on hand	Rs.2,72,72,777	Net Corpus on hand	Rs.2,48,55,499

Effectively, if the investor had a corpus of Rs.2.72 crore in mind that assumption needs to be reduced to Rs.2.48 crore. Your regular income post retirement will also be impacted.

How to tweak your savings to adapt to the LTCG tax

If you are not comfortable with a reduced corpus for retirement, then the other option is to increase your contribution accordingly. If you have started your SIP in the last 2 or 3 years then it simple! The thumb rule is to equate the SIP hike to the percentage of your corpus reduction i.e. 10% lower corpus can be offset by 10% higher SIP contribution.

How Financial Planning Differs From Investment Planning

Here are 5 important aspects that put the financial planning versus investment planning debate in perspective.

Financial planning is the framework, investment planning is the detailing

The financial plan lays out the broad framework to reach your financial goals. When do you retire and how much fund you require? What is the rate of inflation you consider? How do you plan for your short term goals and your long term goals? What is your risk appetite and how much risk you should take to meet your goals? Are your financial goals crisis-proof? These are the kind of framework related questions that financial planning answers. Investment planning is a lot more into the nitty-gritty of asset mix, asset returns and diversification and is your pathway to your financial plan.

Financial planning looks into the distant future

The financial planner asks you to think retirement that is due after 30 years or your child’s education due after 20 years. You may wonder; is it possible to look so far into the future? That is what financial planning is all about! It is based on the premise that a good approximation is better than not planning. Investment planning, on the other hand, takes a much shorter and smarter perspective. It looks more at how different classes like equity funds, debt funds, liquid funds and gold funds will perform in the next few years.

Investment planning is about investments; financial planning is a lot more

When you talk of investment planning, the focus is more on asset classes. You focus on equity, debt, gold, liquid assets etc. The whole focus here is to tweak your asset mix in such a way as to get close to your financial goals in the most predictable way. Financial planning is a lot more. It is about everything that is essential to help you meet your dreams. So financial planning has a major role to play in helping you reduce your debt, especially your high cost debt. It also focuses on other products that reduce your risk like life insurance, health insurance, asset insurance, liability insurance etc.

Financial planning requires occasional structural shifts; not regular monitoring

You cannot keep reviewing your financial plan regularly and keep making changes to it. Once the financial plan is done and signed off, its sanctity must be respected. The only valid reason for reviewing a financial plan is when there are major structural shifts in asset class returns or when your financial situation undergoes a major shift. The investment plan, on the other hand, needs to be constantly reviewed. In fact, it is advisable to review your investment plan at least once a year and set a target of rebalancing the investment plan based on some fixed external stimuli.

Financial plan is unique like your biometric fingerprint

A single financial plan cannot be replicated for anybody else. The investment plan can be largely like a template. Your asset mix will either be 70:30 in favour of equities or the other way round. To that extent, the investment plan is more generic while the financial plan acts like a framework!

Model Portfolios for Risk Baskets

Is it possible to have model portfolios for unique combinations of risk and returns? As mentioned earlier, the financial plan is like a biometric fingerprint but the investment plan can be adapted broadly from a template. Normally, your risk appetite is higher when you are young and have fewer liabilities. This risk appetite reduces along with age and responsibilities. Here are some possible model portfolios under different scenarios. You need to adapt the scenario that best suits you; albeit with modifications.

Young software engineer with no dependents currently
Diversified Equity Funds	Sector Funds	Gold ETFs	Debt Funds	Liquid funds
50%	20%	10%	10%	10%

Young, married with 2 school going children
Diversified Equity Funds	Sector Funds	Gold ETFs	Debt Funds	Liquid funds
35%	10%	15%	30%	10%

Single Income family with grown up children
Diversified Equity Funds	MIPs	Gold ETFs	Debt Funds	Liquid funds
35%	10%	15%	30%	10%

Couple in their seventies with limited family support
Diversified Equity Funds	MIPs	Gold ETFs	Debt Funds	Liquid funds
15%	30%	10%	30%	15%

It needs to be reiterated that the above combinations are just indicative and not an exhaustive model. But they surely give a broad template for allocation. Between these four options there could be a plethora of possibilities to look out for.

Triggers for Shifts in Financial Plan

There are various macro triggers that can set off a shift in the financial plan. Here are some guidelines on how to go about.

Shifts in commodity risk

If the market is at the peak of a commodity cycle, it is a sensible decision to reduce exposure to commodity stocks and commodity oriented funds. This money can be reallocated either to debt funds for a short period of time or can be reallocated to less vulnerable equities.

Shifts in Systematic risk

Systematic risk of the market is measured by Beta. A stock with a beta of more than one is classified as an aggressive stock while if the beta is below 1 it is classified as a defensive stock. Monitor your portfolio for the overall beta as that is impacted by the betas of individual stocks. Based on your target equity beta, tweak your equity funds portfolio.

In an economic upturn

In an economic upturn, can look to increase your exposure to stocks that are likely to benefit from higher demand, higher products, turn around in the capital market cycle etc. Your equity portfolio within the financial plan can be tweaked accordingly.

In an economic downturn

In an economic downturn, equities can lose value rapidly. Even bonds tend to become volatile. The answer may be to temporarily park funds in liquid funds or ST/UST funds and then look to use the liquidity when the equity opportunities arise. It is in such circumstances that the power of a phased approach (SIP) works best in favour of your financial plan.

When inflation trends higher

If inflation is going up on a structural basis you need to tweak your plan. For example, you must have assumed your future goal requirements based on a certain inflation assumption. If the inflation is going to average higher then you must either reduce your eventual goal amount or increase your monthly saving.

When inflation trends lower

There are two interesting sides to this argument. Low inflation is good for equities as it means that the real returns on equity are going to be higher. However, you need to be cautious about very low inflation or inflation going into negative territory. Very low levels of inflation or negative inflation are a sign of economic stagnation.

When interest rates trend higher

A higher exposure to liquid funds and short term funds will be a better idea. When it comes to equities, higher interest raters will lead to future cash flows discounted at higher cost of capital. That is negative for valuations of equity. Floating rate funds are also fine.

When interest rates trend lower

Look to tweak your debt portfolio to include more of long dated securities to benefit from the bond price appreciation. The case applies to equities too. When rates go down, the future cash flows are discounted at a lower cost of capital. That means; your current valuation of equity goes up and can position accordingly.

Module V

CHAPTER 7 - Helping Investors with Financial Planning and Recommending Model Portfolios and Financial Plans