It's (Not) Plain Common Sense

One of the most common things we hear being said about financial planning is that it is plain common sense. And therefore it is easy to take care of our finances and plan them out ourselves. But this is not the entire truth. This is because financial planning is extremely individualistic. Moreover, real world events are unpredictable. Their impact on our lives cannot be assessed beforehand with a reasonable degree of reliability.

There is definitely an element of common sense involved in financial planning. But effective financial plans can never be developed based on common sense alone. Therefore, in today’s post I’m going to talk about the nuances involved in major aspects of our finances. I will thereby attempt to show that financial planning can never be carried out effectively based on common sense alone.

Emergency Fund

Common sense would dictate that an emergency fund should provide for 6-12 months of living expenses. The amount is recommended to be parked in cash and near cash avenues such as savings accounts and liquid mutual funds. Constructing an emergency fund this way seems to be enough. But the approach does not take into account the finer nuances of an individual’s financial situation. These may include any EMIs the individual has to honour, insurance premiums that they need to pay, or the possibility of an extended layoff after a job loss. An emergency fund constructed on the basis of common sense would therefore prove to be thoroughly inadequate.

This is where the importance of following a nuanced approach comes in. It is upto the individual to understand the finer needs in their individual case and provide for them accordingly. Someone who has EMI payments to deal with should also provide for at least 3 months worth of EMI payments. This would ensure that they don’t have to face a significant debt burden during a financial emergency. Also, 2-3 years worth of life and health insurance premium payments may also be provided for.

That would ensure that our insurance cover does not get affected during an emergency. Those of us whose jobs are not secure may need to build an emergency fund worth 24 months of living expenses. This would prepare us to face an extended layoff in the eventuality that we lose our jobs. Constructing an emergency fund this way would mean that it would allow us to face almost any financial emergency life throws our way.

Term Insurance

Planning for our term insurance needs is an area where we have a number of nuances to consider. Common sense dictates that anyone who earns an income and has financial dependants, debt or both of these to provide for would need to get their lives insured. But, we would need to do a lot more to holistically provide for our term insurance needs. Firstly, it may be advisable for those of us with outstanding debts to purchase a separate term insurance policy to cover them. The value of the policy must be equal to the value of their total outstanding debt. A separate policy may be purchased to provide for their financial dependants. Both policies must run in parallel to each other until all outstanding debts are paid off. Later the policy covering the debts may be terminated.

Another issue that always pops up is whether to opt for a regular premium payment policy or a limited pay policy. A limited pay policy is one where premiums are paid only for the initial few years of the policy. After that the coverage would continue over the entirety of the term of the policy. Premiums on limited pay policies are significantly higher than regular premium payment policies. The differential amount saved can be invested more gainfully. This is borne out in the graphic below.

There is another thing that we must understand here. The basis of life insurance is the degree of dependence on an income. This means that we would no longer need life insurance once we are financially independent. Therefore, we must always choose the regular premium payment option. It allows us to terminate the policy once we no longer need it.

There may also be cases where non earning members in the family need to be insured. Consider the case of a couple with kids where only one parent earns. The other looks after kids on a full time basis. If the non earning parent were to pass away, the full time support the kids had been receiving would have to be replaced. This would obviously come at a significant cost. Insuring the life of the non earning parent would therefore be an effective contingency plan. Assume the non earning parent passes away. The death benefit recieved may be used to pay for a full time caretaker for the kids. The death benefit would obviously be a significant amount. This would allow the family to pay for the caretaker over a number of years.

Retirement Planning

Retirement planning is another area where a common sense approach can lead to highly inaccurate results. Most people assume that saving 30-40% of their monthly income would be enough to provide for retirement. But a nuanced understanding would help us appreciate that inflation and our spending patterns keep changing. Therefore most individuals would need to invest 50% of their post tax income or more each month for retirement. This based on the concept of zero real returns. I have written about this concept in detail in an earlier article Zero Real Returns : Seemingly Zero Logic, Definitely Very Real.

Coming up with a realistic estimate of life expectancy post retirement is essential to effective retirement planning. According to research data from the United Nations, India’s average life expectancy in 2025 is 70.82 years. Most of us work therefore tend to estimate a life expectancy of 70 to 75 years post retirement. But a look at the data would show why these estimates may be flawed. The life expectancy figures for the years leading up to 2025 are laid out in the graphic below.

There is a clear, steady rising trend in India’s life expectancy. Also, the 2025 life expectancy figure of 70.82 years is an average. We must remember that large parts of India’s population live in villages and towns. They are likely to lack access to good quality healthcare. Child mortality in these regions may also be high. These factors are likely to bring the average life expectancy figure down. Those of us who have access to a reasonable standard of healthcare can expect to live until the age of 85 or even more. It would therefore be best to assume a life expectancy of 90 to 95 for retirement planning. Working with an estimate any less than this leaves room for longevity risk.

In case of couples it is important to remember that the retirement corpus would support both partners or spouses. Therefore the age difference (if any) between the two parties plays a role in estimating life expectancy. The younger spouse is typically expected to live for longer. This means the retirement corpus would have to be that much more resilient to provide for the needs of the younger spouse. Therefore the younger spouse's age must be used as the base when estimating life expectancy. In other words the corpus must be built to last until the younger spouse's age of 90 or 95.

Asset Allocation And Return Expectations

Most individuals usually rely on thumb rules to decide the asset allocation of their portfolios. These thumb rules represent the common sense approach to defining the asset allocation of portfolios. A 60% allocation to equity is usually prescribed in the case of long term goals. But for someone who has no previous experience investing in equity investments an equity allocation of 60% may be too much. Therefore a more nuanced approach may have to be adopted.

The equity allocation for long term goals would need to be low to begin with. The allocation would have to be increased gradually over time. Most investors tend to expect long term returns of 15 to 20% from equity. Return expectations from debt tend to be pegged around 8 to 9%. This is because such returns are constantly publicised on various forums and media platforms for either asset class. A more nuanced understanding of these asset classes would reveal significantly different realities.

Equity as an asset class tends to offer returns in the range of headline inflation + 3-4% post tax anywhere across the world. Headline inflation in India averages around 6%. Therefore expecting 9-10% post tax from equity would be much more realistic. Debt as an asset class would offer returns worth headline inflation + 1-2% post tax. Therefore expecting 7-8% post tax from debt would be realistic.

What All Of This Points Towards

Basic financial planning is definitely about common sense. But as our needs and goals evolve, a more nuanced approach must be adopted. No two individuals face identical life circumstances and financial needs. So each individual would have different nuances applicable to them. And they would impact them to varying degrees. So it is up to each of us to understand the extent to which each of these nuances are applicable to us. We would then be able to create financial plans effectively.