How much should you save for your child's future?

Anil Rego outlines a clear cut financial plan for your child's bright financial future

Illustration: Dominic Xavier/Rediff.com

"But, isn't planning for your child's future like any other type of financial planning," asked Rahul Gautam who had just been blessed with a baby girl.

Actually, Rahul was surprised when his financial advisor, Dhawal Mehta, gave him a long sermon on how he needed to start planning for his child's future right away. Rahul being a financial professional himself fully understood the concept of time value of money and the power of compounding.

However, he was not very clear as to why planning for their child's future needed to be any different from his other goals like planning his retirement, planning for a house etc.

As Mehta, the financial advisor, put things in perspective there are three key reasons why planning for your child's future has to be dealt with as a unique project:

• Nowhere has the cost of a service gone up as much, in such a short period of time, as in the field of education. Increasingly, children prefer to study abroad and that costs anywhere between Rs 10-20 lakh per annum. This figure has gone up sharply in the last 10 years and one can safely assume that it will continue to go up sharply in the coming 10 years too.
• When it comes to child's planning always ensure to keep your insurance and investment components separate. There are products like ULIPs that offer both investment and insurance. But there is a catch! The returns on a ULIP will always be substantially lower than standard equity-linked investment products. The insurance cover on a ULIP will also be substantially lower than what a term insurance offers. It is therefore prudent to keep your insurance and investment separate.
• A child plan has to be sponsor-proof. Let us understand this little better! When you plan for your child's future, you undertake to invest a certain portion of your income towards securing your child's future. But what happens if your earning capacity was to be impaired due to an injury or your untimely demise? What happens to the child plan in the absence of its sponsor? That is why the child plan should have adequate insurance to ensure that the child's goals are not hampered by any exigency.

The 6-step process for planning your child's future…

To make things simple, Mehta outlined 6 simple steps for Rahul to enable him to plan his child's future effectively…

Step 1: Child planning must start early

That is the basic rule of compounding. The earlier you start, the more you earn interest and therefore the more your interest earns interest. That is the power of compounding. Starting at the age of 25 instead of 30 will make a vast difference to your final corpus. Additionally, when you plan for your first child, you need to make provision for the future of your second child too. Hence the earlier you start the process of planning, the better.

Step 2: Child planning must cover key event milestones

Financial planning is all about key milestones. Typically, there are two key milestones every parent needs to be prepared for. First, is the child's education and second is the child's marriage. Both are already expensive propositions and are only likely to get more expensive going ahead. Currently, planning your child's future typically revolves around these two key milestones.

Step 3: Child planning must give priority to protection

As stated earlier, your child plan needs to be sponsor-proof. Irrespective of whether the sponsor of the child plan is around or not, the plan needs to go on. Hence insurance component needs to be intelligently built into your child plan so that even in the event of any exigency, the insurance cover will put the plan in auto mode and ensure its fruition.

Step 4: Be conservative when estimating your return on investment

This is very important when it comes to child planning. If equity mutual funds have earned 15 per cent in the last year, do not take that as your benchmark. Take the last 10-year returns and adjust it for market volatility. Also assume a slightly higher inflation so that you do not end up overstating your real returns on your investments.

Step 5: Be liberal when calculating inflation in the cost of education

A very important part of your child planning involves inflating the cost of education and marriage. Be liberal in these cases. Remember, these costs do not conform to your standard inflation rates.

For example, the cost of an MBA used to be Rs 3 lakh some 10 years ago, but has now escalated to a minimum of Rs 15 lakh. That is substantially more than the standard inflation rate.

Step 6: The child plan must be monitored at least twice a year

Never forget to monitor your child plan at least twice a year. You don't need to look at it too frequently as it is a long term plan. But the idea here is to ensure that your existing plan is in tune with your goals. In case any of your investments or insurance covers do not sync with your overall plan, you need to intervene and make the necessary change immediately.

In a nutshell, therefore, the child plan needs to encompass the following four key ideas for it to be meaningful and effective:

• Planning your child's future must start early and must focus on key milestone events like education, marriage, career training etc.
• Never mix insurance and investments when it comes to planning your child's future. Avoid the lure of ULIP type of hybrid products. They are not the optimal choice
• Be conservative when estimating expected return on investments but you must be aggressive when assuming inflation in costs. That will protect your plan.
• A good child plan is one that is flexible to change with the changing times and circumstances. Review it continuously and test your assumptions.
• For Rahul, the real takeaway was that the process of planning for his child's future had to begin immediately

Anil Rego is the founder and CEO of Right Horizons, an investment advisory and wealth management firm that focuses on providing financial solutions that are specific to customer needs.