Ensure your children invest right

Create ‘commitment savings devices’ that will help them build wealth steadily

As a parent, are you forcing your son or daughter to buy a house early in his or her career? Your intention may be to inculcate disciplined savings; for the EMI paid on the mortgage every month is forced savings that translates into home equity. Such forced savings is called commitment savings. And the product or process that enforces such commitment savings is called the commitment savings device.

In this article, we discuss why buying a house may not be an optimal commitment savings device for someone starting his career. We also discuss alternative commitment savings devices that you should consider for your children.

Commitment savings

Creating a commitment savings device is meaningful from a behavioural perspective. Why? Consuming current income gives an individual instant gratification. Buying an expensive electronic gadget, for instance. Whereas saving will defer happiness to a later date when the individual uses the accumulated money to consume goods and services at that point in time. Clearly, individuals prefer instant gratification to deferring happiness. And that means consuming income as against saving. This argument is especially true if an individual has just started his or her career. That is why as parents, you should create commitment savings devices for your son or daughter. But real estate may not be an optimal commitment savings device. Why?

As someone who has just started working, your daughter is yet to settle down in her career. What if her professional work takes her to another city? Would you let the apartment on rent? The problem is that rental yields are typically lower than the interest rate on the mortgage. The commitment savings device will earn negative cash flow. In addition, by forcing your daughter to buy a house, you may have unintentionally skewed her asset allocation. She may have to pay about 40 per cent of her post-tax monthly income as EMI for the next 10-15 years, depending on the home loan tenure. That means you have converted a significant proportion of her future income into a lumpy, illiquid, single immovable investment today. Is that optimal? Why not look at other commitment saving devices?

Lockbox investments

You want your daughter to invest regularly. You also want to ensure that such investments are difficult to liquidate so that she is committed to accumulating wealth. We call such investment as “lockbox”. You can choose among three types of lockbox. The first is the product lockbox, where the product structure is such that your daughter cannot easily liquidate the investment. Public Provident Fund (PPF), for instance. Your daughter has restricted access to the money invested in PPF before its 15-year maturity. The maximum investment in any year is capped at ₹1.5 lakh. You can, therefore, also look at recurring deposits with banks that charge a premature withdrawal penalty. The penalty acts as a deterrent to withdrawing money before maturity.

Then, there is regulatory lockbox — investment with restricted access because of regulatory reasons. Equity Linked Savings Scheme (ELSS), for instance. The amount that your daughter invests each year in ELSS is locked for three years under the Income-Tax Act. Of course, ELSS is subject to downside risk. But unlike other equity funds, you cannot redeem your units even if the stock market declines sharply.

The last type is the process lockbox. If you are comfortable assuming market risk, you can also encourage your daughter to set up a systematic investment plan on an equity mutual fund with you as the investor! Why? That way, money will be debited from her account every month, but you have to sign the application to redeem units. Do not share the login and password to the fund account with your daughter! You should preferably align these commitment savings devices with life goals that you want your daughter to achieve.

The writer is the founder of Navera Consulting. Send your queries to portfolioideas@thehindu.co.in

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