How can you save to meet a predefined target in the future? For example, if you want to save to hit a future target sum for the education of your child, how can you implement a target Saving Plan? There is a step by step process for this.
Imagine this Scenario
The Makinde family (Makinde and Ijeoma) have a daughter named Hawa aged 5 years old. They plan to send Hawa to University when she is 18. Therefore, they want to begin saving in order to ensure they are able to fund this project.
To save for a child’s education, the steps are as follows:
- Determine the investment tenor
- Determine the current cost of the project, (in this case education)
- Calculate a rate of growth in the cost of the project is education cost over estimated investment tenor
- Agree plan to meet the target amount
1. Determine the investment horizon
Hawa is aged 5 and will pay her tuition to the university when she is 18 years. Thus, we have an investment horizon of 13 years to work with (18 yrs. minus 5 years). In other words, the investment tenor will terminate in 13 years.
2. Determine the current cost of the project (education)
This is simple enough. Select target school, determine their cost of tuition, lodging, etc. The Makinde’s want their daughter to attend the University of Nigeria Nsukka. Advised costs as at today are N100,000 a year for accommodation, and N200,000 for tuition plus N50,000 for textbooks. Every year, the total cost would amount toN350,000. Assuming She wants to become an Engineer, that’s 5 years in school; making the total cost N1,750,000.00.
Please note costs are for illustrative purposes. When calculating the cost, be clear on whether costs are set or will go up automatically by a multiplier.
3. Calculate the rate of growth on the current cost of education
The next thing is to project how much that current cost figure will grow over the next 13 years due to inflation or even administrative price increases. This is the tricky part because we cannot be completely certain about the direction of inflation rates in 13 years. So, we project a series of estimated price hikes due to inflation. Specifically, we build scenarios to forecast how different inflation rates will affect our result.
A scenario is a necessary risk management process to adopt towards ensuring that we have the optimistic picture (with low inflation) and a pessimistic scenario (with higher inflation)
We can assume, for illustrative purposes, that the cost (inflation) today will rise with the optimistic scenario, ie the cost will grow by 2% every year, using this assumption, the total sum due in 13 years will be N2.2 million.
This N2.2 million becomes the target amount required to pay Hawa’s tuition in the university. It is simply the Future Value of N1.75 million growing at 2% for 13 years. So assuming we agree the rate of school fees will go up by 2% every year for 13 years, we need to have N2.2 million in our education account in 13 years.
4. Agree plan to meet Target amount
If we divide N2.2 million for 13 years, we get N169,230 per year or N14,102 every month. This is what goes into our budget, in the Non-Discretionary part of the budget. Non Discretionary meaning we are committed to saving this amount before we spend on Discretionary expenses like holidays. The key point is that we are funding an amount that has been inflation-adjusted.
The contributions should be invested in an instrument that is safe but beats inflation projected rate of 2%. The first objective here is safety. Even if we buy equity, we must wind down those equity positions as the fund nears the 13 years period.
Open a dedicated account for this. Be consistent, set up a standing order debit arrangement where your debits are swept into a dedicated account, they invested to compound
It’s very important that every year you review your plan, ask the school the current school fees and adjust your plan so that your contributions are well ahead of inflation. What happens if inflation goes up? This means we go back to our scenario and increase the cost of the Future Value Calculation. This will translate to more deductions going from Income to the Non-discretionary Budget
Lots of maths? Yes indeed. But the good news is that there are lots of online Future Value calculators that can do this for you. This means as parents all you focus on is getting the correct variable to key into the scenarios. If you understate inflation, your plan will be skewed off.
It’s also important that before you commerce your plan you speak to your financial adviser or banker and ensure you agree jointly a plan.
Question: Retirement v Child education
If you had only N100,000 and two choices (either child’s education or retirement contribution), which should you choose? Pick the Retirement. Why?
Your retirement fund is perhaps your most important investment fund. During retirement, the income earned is mostly passive income (income earned without actively being at work). So, take every opportunity to make sure you contribute to a retirement plan and allow your contributions compound an ear and great fund before investing for your child’s education…
Financial Jargon: What is the TSA?
TSA means Treasury Single Account, its an account that collects all of the Government’s accounts under one “manager”. The point of TSA is that the Government can determine how much it has cumulatively in all its accounts and as such, be able to better manage its cashflow. The TSA improves transparency and increases efficiency in the management of public funds
You can also set up your own family TSA, track and funnel all income to one single account and then make payments from that account based off your budget