Managing child education expenses – Laddering approach

Rahul Singh has a well-diversified investment portfolio. He has followed financial planning principles to the core, and has always invested with a goal in mind. His next big goal: funding his Child education expenses. He has one son Vihaan and he wants to plan for his higher education.

Singh has a public provident fund (PPF) account under his guardianship in the name of Vihaan, specifically mapped towards his education goal. Singh has been saving Rs. 1.50 lakhs every year in this PPF account to save tax but wants to achieve Vihaan’s higher education goal partly from this corpus. He does not want to touch his equity investment till retirement as it has given much better returns than PPF.

Singh figures he needs Rs. 26 lakh for Vihaan’s education – Rs 4 lakh each for the first four years of graduation and Rs 5 lakh each for the next two years of post-graduation. But he is unsure where to invest the Rs 26 lakh, to account for education inflation during this phase. He is familiar with wealth accumulation strategies which are frequently featured in newspapers, financial blogs and TV shows but is clueless about the plan of action to follow during the distribution phase – the period post accumulation.

Should he maintain a status quo on his PPF investment or withdraw money and invest elsewhere to meet his child education expenses?

In technical terms, we can say that Singh is looking for a money distribution strategy. Different distribution strategies are used when the money requirement is spread over more than one year. ( Also Read: Retirement distribution strategy – Bucketing approach)

As Vihaan’s education is spread across six years and Singh wants to plan three years in advance, he has eight to nine years before him. This requires a definite strategy, wherein education inflation is managed with a low tax burden on the investor.

Let’s see what distribution strategies Singh can opt for his child education expenses.

Before he begins, Singh has to consider two things – education inflation and taxation on returns. Assuming 10 per cent per annum education inflation, Singh has two options to meet his goal.

One, extend his PPF for a block of another five years, with or without contribution (his PPF investment has already completed 15 years). PPF has a provision of continuing the same account without any further contribution, with one withdrawal of any amount per year from it. For “with contribution” accounts, withdrawal up to 60 percent of the balance at the beginning of each extended period is permitted.

In this way, Singh can keep earning tax-free income yet take care of the education inflation. But this approach has two hitches. One, since the PPF is generating 8 per cent plus returns and inflation rate is at 10 percent plus, the approach may require more funding, which means Singh will have to stretch his budget.

Two, the PPF is no longer a fixed rate instrument and is benchmarked against the 10-year government bond yield. So, in future, if government bond yields fall, PPF rates will be impacted, widening the gap between the PPF rate and education inflation. This may call for additional funding, throwing the entire plan off track.

Singh has a second option to manage his child education expenses. He can employ a laddering strategy with mutual funds, wherein the total investment amount is spread into a number of funds, to be redeemed one fund at a time to pay for that year’s education expenses. This distribution strategy is generally used in fixed income investments where bonds of different maturities and interest rates get purchased to manage the interest rates and reinvestment risk and to maintain a steady cash flow.

Since Singh’s requirement is spread across several years and has to take into account inflation and taxation, mutual fund laddering may suit him best. His choice of funds can range from the very short-term liquid funds to mid-cap equity funds, which are meant to be held for a long term.

To create a ladder in this specific case, where the first installment is due after three years and last eight years, Singh can invest in a combination of medium-term bond fund, debt oriented and equity-oriented hybrid funds as well as a large cap equity fund.

Child education expenses – Mutual funds laddering distribution strategy

To manage the taxation part, he can invest in medium term bond and debt-oriented hybrid fund in the name of Vihaan. By doing so, the taxation will fall on Vihaan at the time of maturity or redemption as he would have become a major by then. Equity-oriented hybrid and pure equity funds generate tax-free returns. (Check the table above)

Laddering through mutual funds to manage child education expenses may require less funding overall, as some part of the allocation will go into equity-oriented funds which has the potential to deliver much better returns in the long-term. Even in debt funds, good returns are expected as interest rates are expected to fall in future, benefiting bond funds.

This distribution strategy, though, may have to be constantly reviewed, to allow for the necessary switching and redemption, considering the volatile nature of the funds and the changing economy in general.

This article by me was originally published in Business Standard January 17, 2015

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