Do you need an investment advisor, at all?

Or Why you do not need an investment consultant !

If you need bypass surgery, you should find the most qualified surgeon available. If you’re getting sued, you should hire the best defense lawyer in town.These 2 are fairly obvious and I do not think you can do your own root canal surgery, brain surgery or heart surgery. Come to think of it, it is so inconvenient, is it not!Likewise, some people argue that if you’re planning to live well in retirement, you should hire the most expensive financial advisor you can find.

To me this causes a twitch!

I do sessions on financial planning and these sessions are reasonably well attended. Mostly at the end of the session the participants are unable to decide whether they can do their own financial planning or they need an outsider.And while people ask me questions on everything from momentum investing, auditor integrity, mutual fund loads, broker integrity, insider buying, etc. one question uppermost on people’s mind is

Can I do my own financial planning?

And

Can I do my own investing?

If you’re an investor who is seeking long-term capital gains, it’s crazy to pay a lot of money for a high-priced financial advisor who gives you an economic outlook and short-term market forecast with all sorts of commission-based solutions attached. To the best of my knowledge there are only a few (so few you cannot spot them) pure financial planners.Nor do investors generally need a “personal investment plan” based on their individual circumstances…

There’s Only One Objective for Long-Term Investors

A growth portfolio is designed to keep you from outliving your money. It should give satisfactory returns for a 25-year-old just beginning an investment plan, as well as a 55-year-old who may live three decades or more.

To quote Sir John Templeton, “For all long-term investors, there is only one objective – maximum total return after taxes.”

Of course, some advisors take generic advice and selling it as customized plans. For that reason, whenever I hear an investment advisor tell a client that he is drawing up a long-term growth portfolio based on that client’s “unique profile,” I’m invariably reminded of the Head of HR who tells his audience, “Never forget that you’re special… just like everyone else.

But, as is fondly said, “It’s 97% of investment advisors that give the other 3% of us a bad name.”

In the Indian context the commission structure is too badly designed – it is a design fault rather than a sales fault. But there is no body who really wishes to complain. After all in a bull run the manufacturer (called Mutual funds, Life insurance companies, PMS providers) need sales guys who go and get them money from the “client” for these guys to manage.So if it is a 70% upfront commission in a unit linked plan or the 6% asset management charges or the 2.4% amc in a debt fund, well there is no one to protest!

So you may need a financial planner (whose functions are so comprehensive) that I shudder to think why would somebody want to be a financial planner on a just fee basis.

Frankly if you wish to create wealth in the long term put your money in the cheapest index fund, buy the cheapest term life insurance, and go fishing.

Leave your mobile, TV, broker…in the city and play with nature. You will return fresher and richer.

Life insurance simplified

The idea of life-insurance will probably first come your way when you are planning your tax returns. That’s how it is for most Indians – insurance is a tax saving device. Well, there is a lot more to life insurance that it pays to know. Let’s begin by looking at every step of getting insurance.

(By the way did you know that filing your tax returns can be done by just a simple (FREE) download that is available at www.myirisplus.com do try it)

Selecting the right life insurance plan:

Life Insurance in India is offered by a number of players, including:

• Aviva Life Insurance
• Bajaj Allianz
• Birla Sun Life Insurance
• Future Generali India Life Insurance Company Limited
• HDFC Standard Life Insurance
• ICICI Prudential
• Kotak Life Insurance
• Life Insurance Corporation of India
• Max New York Life
• MetLife
• Reliance Life Insurance
• Sahara India Life Insurance
• SBI Life Insurance
• Shriram Life Insurance.
• Tata AIG Life

Each of them offers many different types of policies. Broadly, you can choose from Term Insurance or Endowment policies. In addition, there are Unit Linked Insurance Plans that offer the twin objectives of risk protection and capital appreciation.

Term Insurance

A term insurance policy is the most inexpensive type of insurance policy. As the name suggests, it covers the policyholder only during the term of the insurance. The benefit gets paid only if the holder dies during that period. So what happens if he lives beyond the term period? Well, the holder gets nothing.

Perhaps the simplest form of life insurance, the only purpose of this type of insurance is protection. It was developed to provide temporary life insurance on a limited budget. Since a large amount of cover can be purchased for a small initial premium, term insurance is good for short-term goals such as providing extra protection during child raising years.

Within term insurance, you can opt for either an annual renewable term or a level term life insurance.

Annual renewable term means you renew the term every year and you pay an increasing premium every time, since obviously the likelihood of dying will increase with age. Sooner or later, the premiums paid will become unviable and exceed the cost of a permanent policy. But of course the likelihood of payout will also increase commensurately.

Level term life insurance makes the same costs more even on your pocket by averaging them out over the entire term, which means the higher costs do not accumulate towards the end.

Endowment Insurance

An endowment policy helps you meet the twin goals of savings and protection. You get life cover for a certain period here too, but if you do not die during the term, you still get certain the sum assured plus any bonuses, upon maturity. Premium is generally higher than term insurance.

Unit Linked Insurance Policy

ULIPs are a fairly new entrant in the insurance space. They are plans that offer a mix of protection and investment. Meaning, part of your premium goes towards mortality charges and the rest gets invested in an investment plan of your choice. This investment plan is a mix of debt and equity, and you get to choose what percentage each will be.

The good news about ULIPs is the two-in-one package, plus flexibility in altering your premium and sum assured. But the bad news is that the charges for a ULIP plan often far exceed what you would have paid if you had invested separately in a term insurance plan and a mutual fund scheme.

In mutual fund investments, expenses charged for various activities like fund management, sales, marketing and administration are subject to pre-determined upper limits as prescribed by the Securities and Exchange Board of India.

When it comes to ULIPs though, insurance companies do not have an upper limit and have complicated expense structures. The percentage of your premium allocated to investment in the first two years is typically anywhere between 20% to 80%, given the high premium allocation charge during these years. This means, all your money is not invested, and this is something you ought to know, even if your agent might not inform you.

Tax benefits under section 80 c are available to both ULIPs and mutual funds, but you should take a call only after you carefully study all charges associated with the ULIP and determine if it is more profitable than a pure insurance plan in combination with a mutual fund investment.

A combination of plans

Always remember though, you can mix and match plans till you have adequately covered risk and invested well. You don’t need to confine yourself to a single type of policy. You could take a term insurance policy from the cheapest source for a short period, and then add endowment policies every year as a way to keep up with the inflation.

Deciding on coverage

Don’t use ‘thumb rules’ while deciding insurance cover. If you are going to be paying hefty premiums, you might as well spend some time calculating how much insurance you need rather than multiplying your income by 7, and buying approximately that amount of insurance, like most people would suggest.

Here are a couple of ways you could do it.

The Human Life Value Approach

This approach calculates how much life insurance a family will need based on the financial loss the family will incur if a person passes away. Using the insured individual’s age, gender, planned retirement age, occupation, annual wage, employment benefits, as well as the personal and financial information of the spouse and/or dependent children, one can determine the financial contribution from the insured to the family. This approach is usually used for a working member of the family.

In the human life approach, one tries to replace all of the income that’s lost when an employed family member dies. The income will include after-tax pay, less expenses incurred while earning that income. Health insurance or other employee benefits also help in augmenting income, and need to be factored in as well.

Once the income is determined, you need to decide the sum assured based on assumptions of return on the corpus. Suppose you decide an income stream of Rs 80,000 has to be generated in a year for your family to get by. Assuming a 5% return per annum on your corpus, after taxes, you can aim for a sum assured of Rs 1,000,000. This corpus will allow withdrawals of Rs 80,000 every year for at least 20 years, a comfortable situation.

The Needs Approach

The needs approach contrasts with the human life approach, in that it calculates how much life insurance is required by an individual/family to cover their needs (i.e. expenses). You work backwards from the required expenses to arrive at the income stream needed to support this, rather than track previous income streams and seek to maintain it, like in the human life approach.

Needs include funeral expenses, legal fees, estate and gift taxes, business buyout costs, probate fees, medical deductibles, emergency funds, mortgage expenses, rent, debt and loans, college, child care, private schooling and maintenance costs.

It is crucial in the needs approach to overestimate your needs a little. After all, the cost of being over- insured is not so substantial compared to the risk in being under-insured and being left with an inadequate income stream.

Also read How much you should insure for?

Selecting your nominee

Once you have decided on your sum assured, you will need to select a nominee who will receive the sum assured in the event of death. This has to be a very careful exercise, leaving no room for misinterpretation, given the money involved.

Indicate your beneficiaries by name and designation and review your choices regularly, at important occasions in your life – marriage, childbirth, divorce, career change, economic change, etc. Your nominee list, for example, might need to expand to include the newest addition to your family.

You could consider naming beneficiaries by class or group – for example, ‘All children of insured’ could be your specification. But if this is not such a homogenous class – the case if you have had more than one marriage – well, remember to specify who exactly you are referring to. For a complete understanding of implications your nominee designation might have, discuss the laws applicable to you with your consultant and get specific recommendations on what to do

Does my family need Rs. 4 crore on my death?

“Does my family really need Rs. 4 crore on my death?” 

When I suggested Rs. 4 crore as sum assured for a customer, this was his immediate reaction. Typical of us, I thought. When a sales person gives us a product/scheme our first thought goes to the ‘commission’ he or she makes. I keep wondering why.  Even our vegetable vendor has to assure us that the last rupee that we try to squeeze out of him is what he makes. It makes us feel happy. We completely forget that we need tomatoes, which we can afford, and which we like. Why should it be our concern how much he makes? So, I set out to tell the client the following. 

We buy life insurance to replace income lost due to the death of the breadwinner. The amount of life insurance you need depends on the ‘income stream’ you would want to continue for your family if anything happened to you.

Let’s say you earn Rs.1,800,000 a year. This money provides your family’s lifestyle and standard of living. As long as you are alive and well, your loved ones will remain financially secure.  What happens when the breadwinner (read ‘You’) are no longer able to earn this money?

Bluntly, if you died tonight, what would your family do?

How would they pay the home loan EMI, car loan, society charges, utilities, taxes and other bills? Where would the money come from for new clothes for your children, for college fees, or even for your spouse to enjoy an evening out with friends?

Very few people are comfortable answering this question. They live like they will never die and most will die like they never lived. When you have lived a good life, and have a family that you ‘love’ your answers have to be far, far better than these… That’s why we buy life insurance. So that the answer to that question is, without hesitation or doubt: “They’ll be provided for.”How much life insurance do you need? The chart below shows the annual income the insurance proceeds can generate based on the following assumptions:

The beginning amount will earn a 5% return after taxes, with principal and interest depleted in 20 years by withdrawing an amount equal to 8% of the original principal every year. Note that different assumptions will generate different results.

Example: A life insurance death benefit of Rs.10,000,000 would provide your family with an income stream of Rs.800,000 a year for a 20-year period, after which the entire amount would be depleted. So, if you earn Rs.800,000 a year, you may wish to consider Rs.10,000,000 of life insurance. How expensive is that? That depends on a number of factors, including your age, health and personal habits (such as whether or not you smoke), and type of insurance.You have several insurance options, depending on need, budget and situation:

• Term life insurance provides pure death benefit protection, generally for the smallest cost. It is ideal for the person who needs a high amount of coverage but cannot afford endowment for now.  
• Endowment policies can provide lifelong protection for a fixed, level premium. Additionally, it combines death benefit with cash value accumulation. However, the initial cost is generally higher than for a comparable amount of term life insurance.

You can have both!

Let me tell you what my customer did. Without worrying too much about the premium he took a term insurance policy of Rs. 2 crore about 4 years back from the cheapest source. Every year he has been adding Rs. 5 lakhs of endowment policies – a nice way to keep up with the inflation, and the fact that the booming economy has taken his income from earth to stratosphere he is more inclined to save.    Contrary to his first reaction his wife and children wouldn’t be rich.

However, they would be able to continue to enjoy the financial security and standard of living he has worked so hard to build for them.Life insurance can replace income lost due to the death of an income earner. It is a cost-effective way to make sure your dreams are completed if you die and are unable to complete them yourself.

You may not need Rs 4 crore of life insurance. You may need less. You may need more. The important thing is to make sure you have the amount that’s right for you.  Remember your dreams are joint dreams. Do not leave your spouse to fend for herself. Give her the confidence to tell the kids,

“Papa has become a star, but nothing will change for us”. Give conviction to her voice. Let the 6^th birthday be at the same hotel as the 5^th birthday.

Let the interior decorator be told, yes the plans remain the same.

Let the kids dream of an Ivy League education.

Let the father, father-in-law, and brother-in-law not decide where your wife should stay.  

Let not the kids who lost one parent to fate lose the other parent to a full time job.

Simple, insurance is not because you will die. It is because they will live.

We in the financial planning industry cannot protect lives. We try to protect lifestyles. The odds favor us over doctors who try to protect lives.

The author, PV Subramanyam is a financial domain trainer and can be contacted at pvsubramanyam@gmail.com.