Why only term insurance make sense

There are so many reasons why endowment policies and ULIPs don't make a good financial investment decision. Mainly if you browse the net for an hour or two, you would come across reasons like:

• Keep insurance and investment separate 
• They under perform market
• Keep it simple

Actually most of the above are not important points in my opinion. If some body is happy with 5% returns LIC gives, let them be happy. Many people anyway don't buy insurance. If LIC can arm twist govt and come up a product where there is no insurance and the mature value is tax free and still give only 5% returns, many of these guys will buy that thinking they are saving maturity charges.

For financially savvy guys it is altogether different matter. But theoretically at least ULIPs can match term insurance + investment in MF options if the policy runs through its term. of course practically an average ULIP NAV is lagging an average MF NAV. But theoretically ULIPs are like separating insurance and investment and they are very transparent in terms of the charges.

So ideally you should not be that bad off if you are investing in ULIPs (especially the new ones where charges came down quite a bit). But there is one reason you find which makes only the term insurance a viable option. 

• Under insurance

You will be terribly under insured. Say you need a 4 crores cover. Assuming ULIPs give 10 to 20 times the annual premium as cover, you will need to pay 20Lakhs to 40Lakhs per annum as premium. A term cover will need 40000 per annum. The later is manageable but the former is not. ULIPs stop being good investment vehicles once the cover to premium ratio increases beyond a point. So under insurance is the main reason for making a case for term insurance. But again in a country where people think they don't need insurance  under insurance is not really an issue.

Calculation of Capital Gains Tax on Foreign stocks

In http://kaipathoughts.blogspot.com/2013/02/rsu-stock-options-and-spp-taxation.html I exlpored the taxation for RSUs and other stock benefits given by employees. For Indian stocks most of the calculattions are simple. but many of us work for MNCs where stocks are valued on foreign currency and traded in foreign exchanges. The tax treatment of these gains will be like those shares for which STT is not paid. But the value of transactions calculation is not straight forward.

The calculation of gain needs to be computed in the foreign currency before convering to INR. The gains thus computed needs to be converted to INR based on the exchange rate published by SBI/RBI on the last day of the preceding month of the sale transaction. For e.g., if the purchase price of stock is $10000 and sale price is $12000, the capital gain is $2000 and say the sahres were sold in January 2013.. This $2000 needs to be converted to INR based on the exchange rate published for last day of December 2012. Note that this may result in different income from the actual income. Following table captures the situation where the actual income is different from the taxable income due to currency fluctuations.

 

No of Shares	Sell Date	Cost per share in USD	Exchange  Rate	Sell Date	Cost per share in USD	Exchange Rate on Last day of preceding month	Exchange  Rate	Taxable gain	Actual gain	gain type
10	05-Jan-11	10	50	05-Mar-11	12	55	60	1100	2200	ST
10	05-Jan-11	10	50	05-Mar-12	12	55	60	1100	2200	LT
10	05-Jan-11	10	50	05-Mar-11	12	45	40	900	-200	ST
10	05-Jan-11	10	50	05-Mar-12	12	45	40	900	-200	LT

RSU, Stock Options and SPP taxation

In India any stocks given to employees are treated as perks and taxed as such. While selling you incur capital gains taxes. Generally the tax for perks are taken care of by employer and the capital gains tax by employee. Here are the way the taxes need to be computed.

You get stocks from employer in generally 3 ways.
RSU Stocks are alloted to you with a vesting schedule. As and when the vesting date approaches you get full stocks. Here the market rate on the day of vesting will be treated as the perk given to you by the company. For e.g., if you get 100 shares at Rs10 per share, your perquisite is Rs1000. Company will pay tax on this Rs1000 depending on your tax slab. Generally most companies recover this by selling a portion of your shares in the market. If the tax you need to pay is Rs300, the company might sell 30 shares and give you 70 shares. For those 70 shares your cost of acquisiton will be Rs10. For the 30 shares that were sold, there might be capital gain consideration. If 30 shares are sold at Rs11 due to gain in the market by the time the sale is initiated, you have a capital gain of Rs30. This is short term capital gain as the period of acqisition starts from the day of vesting. If the company recoversthe tax from your salary, then you will get all 100 shares and the cost of acqisition will be Rs10 per share.

Options They work similar to RSUs but generally you need to pay the option price for owning the shares. Say if you are granted 1000 shares at an option price of Rs5, there will be a fixed duration in which you can exercise your option. If the price reaches Rs15 and you decide to exercise, You have to pay Rs5000 to get those 1000 shares. Since the actual value is Rs15000, the difference is treated as perquisite and tax will be paid by employer in a way similar to RSUs explained above. So you will have few shares given to you and few shares sold to cover tax. You will have capital gains consideration for the shares that are sold. For all the shares the cost of acquisition will be Rs15 (the market price). If the tax is recovered from salary you will be given all the shares and capital gains consideration will be there only when you sell the shares. An important note here is the taxes are deducted only when you exercise the option. If you never exercise the option, you never receive any shares and pay any tax.

ESPP Purchase plans work by collecting some money from employees and alloting shares at a fixed time during a year. generally these shares are given at a discount to market price. This discount is treated as perquisite and company pays tax over it. If the company recovers the tax from you, it will be similar to the way as explained for RSU and Options.

Important thing to remember is that the cost of acquistion is always the market price which will be notified by the company while alloting the shares to you. If the company sells few shares to recover tax, there will be short term capital gains considerations for those stocks that were sold. there might even be capital losses which you can use to offset any other capital gains you may have.

Once you have those shares in your hands, the treatment will be like any shares. When you sell, if you pay STT, the short term capital gains will be taxed at 15% (in FY 2012-13 when this was written) and at 0% tax for long term capital gains. If you don't pay STT (for foreign shares and off market transactions), STCG will be added to the salary and taxed as such and LTCG will be taxed either at 10% or at 20% after indexation applied.

For foreign stocks, the cost of acquisiton and sale amounts need to be computed in a specific way which I will address in next post.

EPF passbook updation

It is good that now we can see our EPF passbooks on line at http://members.epfoservices.in/
But is the passbook going to be upto date every month? I see that the pass book is not updated with latest contributions from my employer after I accessed it for the first time.

Types of Spending

I think spending can be categorized as

• Essential
• Improving Quality of Life
• Entertainment
• Ego/Showing Off

Essential:  Food, Clothes, Living Space, Education etc

Improving Quality of Life:  These expenditures can be of type enhancing the spending above it (Essentials) or the type covering the basics of spending below it (Entertainment). Eating Sonamasuri rice enhances food taste but would you eat basmati rice every day? Having a car is nice but which car? Vacation but how often and to where? You see, there are no questions for essential expenditure. But now the expenditure planning needs answering questions, deciding what you can afford and what you need. Generally expenditure in this segmentcan be avoided but makes life difficult. You need to strike a balance between your networth and what you spend here.

Entertainment: This expenditure also involves both categories above and below it. If you or any of your dependants are fans of music, buying a good music player and speakers can be part of either improving quality of life or entertainment. How much you spend on that will decide which category you want to keep it in. Having a basic phone is improving quality of life. Having a smart phone which can do everything and you don't use those features is entertainment. Having the higher end of a smart phone when your real requirement is talking or texting is showing off. Buying jewellary is entertainment. Buying some thing which you can't afford but must buy as your neighbour or relative has it is showing off.

Ego/Showing Off: In your inner mind you know this category even if you try to rationalize the expense. Going for a vacation taking a loan or worth 3L when your networth is 10L is showing off. This category can be strictly avoided. There are some exceptions on making networth to expenditure comparisons. If you are starting in your career, you may be starting with zero networth but if you are highly qualified your potential networth might be high like say for a doctor. So you may go for a big vacation but even there, spending on a loan should be absolute no no.

All these categories are subjective. I think a tata nano is entertainment where as some body else might think Honda City is improving quality of life (I am sorry no car can be essential but there is nothing wrong is spending to improve quality of life). May be it will help to keep tabs on these categories individually. Like spending not more than 5% of your cash flow in showing off, 10% on entertainment and 25% on essentials and improving quality of life. Unfortunately the essentials cost very less than the second category and so on with showing off costing the most.

Good vs Bad investment

In http://kaipathoughts.blogspot.com/2013/02/the-financial-mistakes-i-did.html I have talked about the mistakes I did. Due to which I generally don't criticise any body doing anything with their money especially investment vise.
There is no good or bad investment. It is just probability of being good. Direct investment in stocks does the best follwed by equity mutual funds followed by debt funds and savings. This is what many will preach. But the stock you invested in might lose entire capital and somebody keeping money in savings bank might be earning a compound 4% interest on his money. It is just that the probability of a well researched stock beating any other class is significant so it is worth taking the risk with some part of your money. So when I see some body investing in an endowment policy, I see some body earning 4, 5 or 6% on a long term. Yes he will get more if he invests in term insurance + FD but such person will never buy a term insurnace. So some insurance is better than no insurance. Just that he will be paying a steep price for the insurance.
Mostly anything beats the default strategyif the default is keeping the money in savings account which was the case for me for long time. Some action is better than no action and the action will move the person towards thinking about better investments.

The financial mistakes I did

Taking an endowment policy. This is the first major financial decision I have taken and it turned out to be bad. It was almost 7,8 months into my work life. I took the policy thinking insurance policies can not go wrong. I did not even calculate what I will be getting. Even a lakh was big number for me at that time and looking at 6,7 lakhs of money with 4Lakhs insurance I went for it. I will be paying more than 5 Lakhs as premium but as I said I did not do any calculations. If I did calculations or spent more on financial blogs I would have avoided the mistake. I still have the policy and it has around 4 more years to run. Finally last year I ran calculations and decided against surrendering or making it paid up as at this stage I have to earn more than 10% on the rest of the premiums and surrender value. 10% tax free is good enough so I am continuing with. I am expecting around 5% to 6% IRR on the polciy and considering the further mistakes I did, it pains me to say that it actually turned out to be one of the better investments I did in the earlier days on my financial life.
Policy: ICICI Prudential Cash bak, 15 years endowment policy.

Taking an ULIP. Citibank offered to sell this and I took this again without much research.This is around 1.5 years after I started working. By this time I should have learnt pros and cons of insurance and how to take insurance. But I learnt soon but implemented late some of the financila learnings I did. This policy form Birla Sunlife is one of the costliests at that time with rediculously high premium allotment charges. I surrendered it with some loss after 3 years and surrendering was a good decision.
Policy: Birla sunlife ULIP, Dont remember the name of the plan.

Stock Market: I invested/traded money a lot in the first 4,5 years of my job. Without any analysis and research. Due to boom periods I generally did well overall escept with one stock. that stock I increased my holding at every drop and still have the stock trading at around Rs8. I saw it coming down from Rs.150. By the time I brought everything in order, the stock is already low and my networth compared to the investment is so high that I decided to keep it. I know there is opportunity cost but the holding is so little and the risk reward is so high (The company is showing some signs of life) that I am keeping it. This stock lost everything I gained and a lot more over that making my stock market investing a big joke. I am a lucky guy that I realized that I dont have time and aptitude for stock market before major catastofe. Inspite of this I still keep around 30% in equity and plan to increase it to 50%. Only that I invest in mutual funds and they generally did ok for me. The mutual funds gained more than what I lost on the stock market.

Derivatives: For some body who did that badly in the market, derivatives could have ruined the life. Fortunately from the begining I was afraid and kept only small amounts and it was a zero sum game for me by the time common sense prevailed. I am very lucky to have this resulted in zero sum game than losses. Only winner was ICICI with those huge brokerages I paid.

Now I invest only in mutual funds. I have 70% debt and 30% equity protfolio which within one year will turn 50% equity, debt. I will be continuing my sips for rest of my work life and I am reasonably confident that this will result in better gains for me. If and when I have enough money to invest in a good real estate for 25% of my investments I will diversify to that space. In principle I don't keep more than 5% of my networth in Gold and the gold component of the jewellary my wife has is more than 5%. So I may not be investing in Gold also for a long time.

Keeping the money in savings account: Worst type of mistake one can do. for around 4,5 years most of my money was lying idle in savings account waiting for that killer stock which is going to grow 10 times in 2,3 years. thankfully it never came. Money lying in the bank account, not even FDs.

My estimate is if I did what I am doing now from the start of my financial life, my networth would have been atleast 1.5 times what it is now.

How much for retirement

I see so many calculations on net where people try to predict what you need to save by the time you retire. As inflation in India was high and expected to be high for some time these figures tend to be very high. You get numbers like 5 crores if your annual expenses are 5 Lakhs and you are in mid 30s. But I find targeting a number difficult. There are so many parameters involved that you know what is sufficient only when every thing is over.

It is like batting first in a one day match. You set out to score runs. How many you need? You will know only after match is over. from prior experience you know that scoring 300 gives you a safe margin. But it is never guaranteed. A team scoring 400+ lost a match. At the same time around 25 years ago that safe number used to be 250. So even the safe number changes over time. So what do the batsmen do? They score as much as they can. They don't stop when they reach 300. If they lose a few wickets early they don't stop trying thinking 300 is not possible. What works most of the time is enjoy the time in the middle, maximize the runs you get. First point is important as otherwise your getting out is more likely. So do that, play for 50 overs and hope for your defense (bowling) to do what is needed.

Something similar is needed for retirement.

1. Earn as much as you can. 
2. Spend as much as you need. 
3. Try to maximize the returns on the savings taking risk according to your appetite

Each of these requires further learning. But it is like cricket again. You still need to have goals. Like a batsman plans for next 5 overs plan for reaching a number in say next 2 years. Sometime a good bowler comes and survival is priority (like investment in recession times), a junk bowler comes and need to score runs (bull market) but don't throw away wicket. Most on the time accumulate runs (Range bound market) etc. The batsman still needs to have skill (your investment acumen).

Now the second point spend as much as you need is the tricky one. What you need depends on you. I would say never compromise on what you need. But if you think that 20 Lakh car or 50 thousand watch is what you need, I only wish they are not significant percentage of your savings. I have my own rules.

• Don't upgrade a car on loan and whose cost is more than 5% your liquid wealth. (May not apply for the first car but even for that keep a limit)
• Don't upgrade a home whose cost is more than 25% of your liquid wealth. Take a loan only if you get good deal as it may turn better due to tax advantages. ( May not apply for first home but keep a reasonable limit)
• A second home is always investment and make sure you are diversifying properly. My rule of thumb is the real estate should not be more than 25% of your wealth. If you are selling your home and buying a better one, remember the 25% liquid wealth rule (this time strictly as you already have a home)
• Jewellary is not investment. They are commodity like your phone or car. Only thing is they are better if you need money but the goal is to have enough wealth to not need money. If you think jewellary is investment and invest a good percentage in it, you will never reach enough wealth.
• Gold is investment but personally I will not invest more than 5% of my wealth in it but always remember Gold and Jewellary are different. Antique jewellary is different. It is like investing in art. If you have aptitude and eye for it, go for it.

Avoid Pension Plans

This is one mistake I never did in my financial life. While it requires some study and understanding to see why typical insurance policies offered by Insurance industry are junk, there is no ambiguity in pension plans. the way they are structured, they are shouting at your face that they are junk.

1. While section 80 benefits are there, they are clubbed with other investments so no special advantage for pension funds.
2. You get only 1/3rd of your money (even assuming that the plan you invested is performing as good as any decent mutual fund (debt or equity depending on your chosen asset class), this is bad)
3. You have to buy annuity with only the company you invested in. No flexibility to shop around for better annuity plan. I think this is new rule, previously you were free to choose the annuity plan.
4. Killer is your annuity is totally taxed. No option of investing in tax efficient schemes. Even a decent debt fund with its indexation option and lower long term capital gains beat this.
5. finally interest rate is locked when you buy annuity of which you have no idea. But looking at the annuity rates offered, they don't even beat the best FD rates offered at that time.

There is the scheme NPS. But most of the above points apply there also. There is a talk of making the annuities tax free but the points 1,2 and 5 still apply for NPS.