The first pay cheque. The joy of drawing one’s first salary. The money that could be used to express gratitude towards family and friends by showering them with gifts and treats. Or to buy long coveted gadgets and goodies. But once the initial euphoria subsides, it is time to think about the future and how best the same monthly remuneration can help build long-term wealth.
“Young earners should spend their salaries as they wish for the first two or three months. After that, they should get down to detailed long-term financial planning,” says Melvin Joseph, Managing Partner, Finvin Financial Planners. Even when you are on the initial splurge mode, make sure you are only spending what you have in hand and not banking on EMIs and credit cards that eat into future earnings. In this week’s cover story, we will discuss the golden rules of managing money all first-time earners need to keep in mind. By adhering to these they can ensure that as their incomes rise, the accumulated wealth grows in tandem too.
Save as a habit
Once you are done with spending money on all your short-term needs like buying gifts and gadgets and clothes, get down to detailed financial planning to target mid and long-term goals. Remember, financial goals are your dreams that can be fulfilled with money. As a first step, compute your savings rate using an income and expenditure statement. Saving is defined as the difference between your salary and your regular expenses.
Ideally, the savings rate should be at least 30% of your pay. Analyse the reasons if it is less. It could be your starting salary is low or your expenses are very high. “Even if the income is low, create a savings habit by cutting down on expenses and try to save around 20% of your take home salary. In any case, savings should not be less than 10% of your take home salary,” says Suresh Sadagopan, Founder, Ladder7 Financial Advisories.
Amol Joshi, Founder, PlanRupee Investment Services, says creating a savings habit at this crucial juncture is very important. “Create a savings and investment habit from the beginning of your career, even if the amount you can keep aside now is very small, for example only Rs 1,000 per month,” he says. Even a small investment of Rs 1,000 per month can become Rs 29.42 lakh over 30 years, assuming a 9% returns.
The power of Rs 1,000
Even a small monthly contribution of Rs 1,000 can grow into a big corpus if invested regularly.
Assumption: Investments generate a return of 9%.
Should you be worried if you are saving more than 30% of your salary? Most definitely not. “Don’t fret if the savings rate is high at this stage. You could be saving as much as 70% of your pay if you are staying with parents and don’t have to bear establishment expenses,” says Rohit Shah, Founder & CEO, Getting You Rich. Instead you can use this golden period to accumulate maximum wealth. “Usually, savings potential is highest between the start of career and marriage. High savings and investments during this crucial stage will help you to achieve your financial goals comfortably later,” says Joseph.
For example, assume A starts investing Rs 10,000 towards her retirement from the age of 22. The amount becomes Rs 5,000 at 27 when she marries and she saves till the age of 60. Subject B, on the other hand, starts investing Rs 10,000 towards her retirement only from the age of 27 and continues till 60. Despite the lower total investments, A will have a bigger retirement corpus at 60 than B because she started investing early.
Early start pays off over time
Investing more in the initial years can reduce burden on income in future.
Assumptions: Started working at 22 and got married at 27; Investments generated a return of 9%
Don’t dream too big
The next step entails making a holistic financial plan. List all your financial goals and the time you give yourself to attain it. Experts ask you to target mid-sized goals—where the outlay is less than Rs 1 lakh—first. What if there are several such goals? “Space out these goals. Keep aside small amounts for each of these goals and then buy once the required amount is accumulated. Don’t buy everything together in instalments or with credit cards; you may get into a debt trap,” says Sadagopan.
Planning for mid-sized goals in the initial years of your career will also have a positive impact, demonstrating the power of financial planning. For example, assume that you want to buy a bike with an on road price of Rs 1 lakh and the same can be met by investing Rs 5,000 per month in a recurring deposit (RD) or systematic investment plan (SIP) in a liquid fund for the next 20 months. “Planning for mid-sized goals and achieving them through own savings will help you to understand how a small sacrifice now can lead to bigger goal fulfilment at a later age and this learning will lay the foundation stone for the planning of bigger goals later,” says Joshi.
Moderate career growth expectations
Along with mid-sized goals, you should also start planning for big ticket medium term goals like buying a house, making provision for marriage expenses, etc. and long-term goals like retirement planning. Financial planning calculations are based on expected future salaries. Younger people tend to make the mistake of assuming very high future salaries by extrapolating the huge initial salary or high increment they get in the initial years of their career.
To make this point clearer, let us split the first-time salary earners into two. The first set is lucky to get big offers through campus placements and a fancy pay packet as starting salary. Though a big starting salary is good, it can be a double-edged sword if not managed well. Developing high spending habits is one of the biggest problems of high initial salary earners. Since expectations of companies from these high earners will also be high, there is a chance of early burnout.
The people in the second group are not lucky enough to land big offers. They start their career with low salaries. Low savings rate is the biggest problem for such individuals. “Low salary earners will get into big problems if they don’t have control on their expenses. They should learn to live within their means,” says Sadagopan.
Since their base is small, low salary earners usually get higher annual increments in initial years, which can be in the range of 20-30%. However, it will be a grave mistake to assume that such high increment rates will continue till retirement and make financial plans based on them. “Ideally, you should not consider more than 5% as the ‘average annual increment’ till retirement. The years of high increments will be negated by no increments or even pay cuts in some other years,” says Joseph. A modest salary of Rs 6 lakh will become Rs 14.24 crore in 30 years if you get an increment of 20% every year. Someone who takes loans based on high annual increments assumption will be in trouble during periods of no increments or pay cuts. The job scenario after the pandemic is a case in point.
Temper your increment expectations
One can’t earn high increments throughout one’s career. An annual 20% hike would mean a Rs 6 lakh salary will become Rs 14.24 crore in 30 years.
Assumption: Starting salary of Rs 6 lakh per annum.
Low salary is not end of the world
There is no need to lose heart if you start with a low salary. Be patient and upskill to get a better job. “Since the employability in our education system is low, youngsters may have to invest initial salaries in new courses to learn more than what is taught in their colleges,” says Shah. In fact, upskilling should be undertaken by all. “Don’t be under the impression that you are going to retire from a company just because you got a confirmed job. Getting the first job is only the first step and you should not get into a comfort zone of ‘having a job’ and stop learning further,” says Joseph.
Pay off debt
Ideally, you should pay off your debts before planning for goals. The most likely debt at this stage will be the education loan. Since interest paid on education loans are allowed as deduction under Section 80E, the effective interest cost will be lower and therefore, assess if you should prepay it. “Prepaying any debt makes sense. Never forget that you get tax deduction because you are paying interest and the longer you keep on paying, bigger will be the interest outgo,” says Joshi.
Unlike housing loans, default rates are higher for education loans and therefore, banks usually charge higher interest rates. Your decision to prepay or not should be based on the effective costs of these loans after adjusting tax benefits.
Education loans can be very costly despite the tax benefits
Consider the net cost after tax benefits while deciding on prepayment.
Rates considered with 4% cess.
Special plan for global dreamers
How should those who want to study further after working for a couple of years plan their finances? “If you are planning to pursue higher studies in a foreign university in the medium term, it makes sense to avoid very long term products like NPS and PPF. Till there is clarity, you can use ELSS for tax planning because the lock-in period is only three years,” says Rohit Shah, Founder & CEO, Getting You Rich. While the tenure of PPF is 15 years and lock-in for NPS is till retirement, these are suitable only if you are planning to come back to India after higher studies. While NRIs are allowed to continue with their investments in NPS, they can’t invest fresh money in PPF. However, you can keep the existing investments in PPF and keep on earning tax free interest on them.
Build emergency corpus
We are living in troubled times and thus creating a contingency corpus, which should cover at least six months’ expenses, assumes high importance. Contingency corpus will help those with education loans to avoid default in case of job loss. “Default on education loans will impact your credit score badly and reduce the prospect of several other loans in future,” says Gaurav Mashruwala, Sebi RIA. Since it will be difficult for first-time earners to postpone small and mid-sized dreams till a contingency fund is created, they can try to achieve both simultaneously.
Don’t ignore retirement planning
We know that retirement is the last thing that comes to the mind of those in their 20s. However, planning at a young age is critical because retirement planning pans out well if started early. “New employees should learn to save a portion for long-term goals, like retirement planning, along with saving for short-term goals. So, start investing for retirement, even if the amount is small, in products like PPF and NPS now itself,” says Sadagopan.
Retirement planning tools should include NPS
Investing in the pension scheme provides tax benefits. Returns vary due to presence of multiple fund managers.
Returns as on 18 Mar 2021 | Assets as on 28 Feb 2021 | Source: Value Research
Moderate equity allocation
Once you decide the goals, decide on asset allocation—how much you need to invest in each asset class like equity, debt, etc. This decision depends on several factors and time period to goals is one of them. Since most of the investment by first-time salary earners will be for short-term goals, it has to be parked in short-term debt funds. “Use debt mutual funds for short-term goals and split the investment for long-term goals between equity funds and PPF,” says Joseph.
Age is the next important factor and experts usually suggest the thumb rule of ‘100 minus age’ for equity allocation. The logic behind this rule is that youngsters have enough time in their hand and therefore, should be able to withstand market volatility. As per this rule, a new employee of 22 years can have 78% in equities. However, experts want to twist this rule a bit for first-time earners because most youngsters may not have enough experience with stock market volatility. In other words, go with the 100 minus age rule only if you were already investing in equities. How much should be the equity exposure for others? “Not just age, the risk profile and investment experience are also important. So, first time equity investors should start with around 40-50% only in equity and increase the equity allocation as per the 100 minus age rule after experiencing the equity market for a couple of years,” says Dinesh Rohira, Founder & CEO, 5nance. com.
Invest in equities slowly
Even this moderate equity allocation should be done slowly. “Investments in equity should be done in a calibrated manner. First start with balanced funds, then slowly diversity into large-caps funds and only later to mid- and small-cap funds,” says Vikram Dalal, Managing Director, Synergee Capital Services. A similarly slow approach is needed when you decide to shift from equity mutual funds to direct stocks. “After gathering experience with equity mutual funds, you can also start investing directly, provided you have enough time to read and understand about companies. However, do that slowly. First restrict yourself to Nifty stocks and invest in high risk mid-cap stocks only if you are able to withstand the volatility,” says Rohira.
Select right products
Once you decide the asset allocation, the next step is selecting the equity and debt products to invest in. While taking advice of parents on important matters is a good virtue, it may not be a great idea when it comes to investment options. “Since most parents were investing through old fashioned and inefficient products like bank FDs, chit funds, endowment insurance plans, etc., the chances of them suggesting the same to you is high. However, you can continue with PPF,” says Joseph. Dalal concurs with this view. “Since PPF enjoys the 80C benefit and also offers 7.1% tax free interest, PPF is the best debt product available for long term investing now,” he says.
Voluntary Provident Fund (VPF), the additional investment you make to your EPF, is another good option for new employees who want to start investing for long-term goals. VPF now offers 80C benefits and 8.5% tax-free interest. However, the government has made the interest taxable if your annual contribution is beyond` 2.5 lakh. Ideally, you should have a professional adviser to tell you about the best products. However, it will be difficult for new salary earners to identify the right adviser. “If you don’t have a dedicated financial planner, start investing based on publicly available curated equity and debt fund lists,” says Sadagopan.
Tax planning a must
Money saved in taxes is equal to money earned. Concentrate on investment options that provide tax benefits. For example, you can invest in a normal equity fund or tax saving equity funds. While the return and risk profiles of ELSS funds will be similar to that of a flexi-cap fund, you get additional benefits under Section 80C. However, these come with a three-year lock-in. Do not consider investing in equity funds if your holding period is less than three years. Among debt options, you can consider PPF, VPF or other fixed income options like bank FDs with 80C benefit, post office schemes like NSC etc. Unlike PPF or NSC, NPS schemes are managed by several fund managers and therefore, their returns will vary.
Popular 80 C options
Decide on tax saving product based on investment time period.
*Returns on PPF,VPF, etc. are historical returns and may come down in future; Returns on NPS and ELSS are market linked Note: NPS offers additional window of Rs 50,000 beyond 80C.