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6 financial tools to secure your child's future

Last updated on: September 27, 2010 08:19 IST
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The arrival of a baby is probably the best thing that can happen to a family.

The initial euphoria, however, wanes as the parents start pondering on issues like financing the child's education and marriage when she grows up.

This is especially true for Indian middle class families struggling to cope with soaring costs.

Investing for a child's future is, therefore, an issue that parents should devote a lot of time and effort towards.

The following is a list of six financial instruments which parents can consider for building enough financial resources to take care of their child's future.

Savings account: This is the most used and least effective way of investing for a child's future. Savings account offers the lowest return among all financial instruments.

In fact the return is so low that it cannot even offset the erosion in value caused by inflation, let alone generate a real return.

Stock market: The Indian economy is the fifth largest (in PPP terms i.e Purchasing Power Parity) in the world. 

There is consensus among analysts regarding the strong positive medium and long term outlook of the Indian economy.

The Sensex has grown from a base of 100 in 1979 to 18,000 in 2010, translating to an annualized return of 18 per cent over the past 31 years.

Investing in index funds is an option that is expected to generate handsome returns while mitigating the risk arising out of investing in individual stocks.

Additionally, stock market investments are highly liquid and have low transaction cost.

However, to succeed in this investment, extensive knowledge of financial markets is necessary. Parents not possessing that knowledge can still invest in them, via the financial instrument illustrated next.

Mutual fund: A child plan mutual fund usually has both stocks and bonds in the portfolio.

When the stock market goes up, the equity (stock) portion of the fund generates returns. When the stock market goes down, there is the debt portion which generates assured (assuming the debt issuer doesn't default) returns.

There is also tax advantage associated with investing in mutual funds which are taxed only at maturity.

Insurance: The market is flooded with a number of child insurance plans offered by firms like LIC, Metlife, AVIVA and HDFC, among others. Besides providing risk cover that is the core requirement of a long term financial plan, the child insurance plans also provide tax advantage.

The risk cover in these policies is on the earning parent(s) and not on the child.

The plans work on the beneficiary concept, where the beneficiary is the sole person to receive the benefit (usually the child).

The fixed term payment and maturity benefits continue irrespective of the death of the life insured. Additionally, many insurance companies offer the advantage of customizing the policy to the requirements of the child.

ULIPs: Unit Linked Insurance Policy provides the dual benefit of life insurance solution as well as investment of the policyholder's fund in the equity market, thus generating good returns at reduced risk.

When the stock market moves northward, the value of the policyholder's investment fund increases, while during a downturn, he has the insurance in hand.

Policyholders can choose from different types of funds like equity funds, fixed interest funds, cash funds and balanced funds, depending on their financial goals.

They have the option to switch funds in a policy for a limited number of times.

There are, however, high upfront charges including fund management fees, cost of insurance coverage, commission expenses and premium allocation charges. This is where mutual funds score over ULIPs.

Currently ULIP products are undergoing a revamp of sorts post regulations introduced by IRDA and is expected to be better and more transparent.

Commodities: Investing in commodities is done by some families, especially for a girl child.

It is a good idea because of two reasons. One, returns generated by commodities in the current scenario is higher than the inflation rate. Two, commodity based funds are on the anvil and is set to add another dimension to investors' portfolios.

However, care should be taken to ensure that there are no conversion costs. For example, investors should buy gold coins and biscuits and not gold ornaments.

How much to invest for a child? Parents can ascertain the amount they are saving every month and based on that they can determine the quantum of monthly investment to put in.

Alternatively, parents can estimate the total amount of money required for their child when she grows up, and then back calculate the monthly installment.

A combination of the two approaches is also used. Once the amount of monthly investment is determined, parents can decide on the type of financial instrument(s) they want to use.

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