Presentation on theme: "Basics of Personal Financial Planning"— Presentation transcript:
1 Basics of Personal Financial Planning [date][venue][contact information]
2 Introduction About the PFP Section & PFS Credential The AICPA PFP Section provides information, resources, advocacy and guidance for CPAs who specialize in providing estate, tax, retirement, risk management and investment planning advice to individuals and their closely held entitiesThe CPA/Personal Financial Specialist (PFS) credential distinguishes CPAs as subject-matter experts who have demonstrated their financial planning knowledge through experience, education and testing
3 Today’s ObjectivesYou gain an enhanced understanding of the basics of financial planning and how a company’s compensation and benefits programs add to your financial well-beingYou gain an enhanced understanding of basic investing concepts and how to develop your investment planYou gain an enhanced understanding of how a Company’s compensation and benefits programs can contribute to the success of your investingYou identify and commit to taking the actions you can to significantly enhance your financial well-being
4 Life Events: Will You Be Ready? •Premature DeathRetirementSerious IllnessDeath of SpouseAged ParentsChildren Getting MarriedSecond HomeRemarriageStarting a BusinessPaying for CollegeDivorceJob LossRelocationHome PurchaseBirth of ChildrenMarriageTemporary Disability
5 Life’s Financial Trade-Offs CURRENT NECESSITIESFUTURE NECESSITIESCURRENT EXTRASFUTURE EXTRASBasic shelter, foodclothing, transportationand medical careclothing, cash for emergenciesand nursing home careLargerhome, privatecollege, retirement travel,bequests/charityNew kitchen, new car,vacation, family giftsTrade-offs
6 The Value of a Financial Plan A financial plan will help you to clarify:Your financial goalsStrategies to achieve the goalsSpecific steps to implement the strategies
7 Areas to Explore Saving Managing debt Insurance Investing Education fundingRetirement fundingPre-retirement planningIncapacitation planningEstate planningCompany stock ownership
8 The Financial Planning Process What do you want?What will you have?Will you have a shortfall?What strategy will you employ?What actions will you take?
9 What Do You Want? These are your financial planning goals Each goal will have its own horizonFor the period of accumulationFor the period over which it will be spentMake a list and refine as you go alongStart with broad ideas and work toward increasingly specific and measurable goals
10 What Will You Have? What you have now What you will save from future incomeFuture investment earnings on the above if investedExpected future benefits
12 What Managing Debt Means Conquering excessive debtUsing debt wisely:Credit cards401(k) plan loansHome mortgagesHome equity loansAutomobile debtMaintaining a good credit history
13 Debt Ratios Housing expense ratio Debt to income ratio Housing expenses (mortgage, taxes and insurance) should not exceed 28% of gross payGross pay is before taxes and deductionsDebt to income ratioTotal consumer debt (not including mortgage) should be less than 20% of take-home-payTake-home pay is after taxes and deductions
14 Warning Signs of Too Much Debt Unable to save 10% or more of gross incomeHabitually pay only the minimum monthly payments on your credit cardsBorrowed from one lender to pay anotherAsked a friend or relative to co-sign a loan because credit record is weakUnable to figure out how much you oweWould be in immediate financial trouble if you lost your job tomorrow
15 Conquering Debt Stop borrowing Start using a debit card Prioritize your debt repaymentSeek lower ratesDetermine the maximum you can payRepay highest cost debt firstContinue paying the maximum
16 Decrease Debt or Invest? Pay down debt when you can’t invest at a higher rate401(k)Match*Credit CardInvestmentMortgageInterest Paid / Received100.0%18.0%8.0%6.5%Tax 25%--0.0%-2.0%-1.6%Net Paid / Received6.0%4.9%* 100% of first 3% of your pre-tax regular contributions for ABC Company.
17 Using Home Mortgages Wisely Determining whether buying is appropriateChoosing the right type of mortgageDeciding if you should refinanceKnowing whether to pay pointsDeciding whether to prepay mortgage principal
18 Is Buying a Home Right for You? RentingChange location frequentlyNoYesMaintenance responsibilitiesAbility to customizePerhapsPayment increasesLikelyInvestment elementTax benefitsInitial costs
21 Consider a Fixed Rate Mortgage When: You intend to live in your home for a significant period of time, orYou anticipate rising interest rates in the future
22 Consider an ARM When:Fixed rate is at least 2% points greater than adjustable rateYou expect your income will increase enough to cover any potential payment increasesYou expect to move before the rate increases (beware of prepayment penalties)
23 Prepaying Mortgage Principal $170,257Standard Payment$89,279Additional $150 PerMonth360210Number of PaymentsTotal Interest PaidAssumes a 30 year fixed-rate mortgage of $100,000 at 8.25%
24 Consider Prepaying Principal When: You use the standard deductionYou invest conservatively
25 Maintaining a Good Credit History Establish a good credit historyObtain your credit reportUnderstand your credit reportCorrect mistakes in your credit report
27 Importance of Saving and Investing If you don’t have the followingSufficient assets fully devoted to your goal(s)Expected future benefits from third partiesExpected future borrowingThen you will need the following to reach your goal(s)Future savings devoted to your goalsFuture earnings from investing the above if you invest those assets
28 Key Saving and Investing Concepts Saving versus investingCombining saving and investingSaving and investing earlyTax-deferred saving and investingTax-deductible saving and investingSaving and investing using employer contributions
29 Saving Versus Investing MeansNot spending moneyDoing something with money to earn a returnNeeds to be doneIn a regular, disciplined mannerCarefully and with due consideration
30 Combining Saving and Investing StanVickieSaves $2,000 per yearStarts at age 25Saves in a non-interest bearing accountSaves $2,000 per yearStarts at age 25Invests and earns an 8.9% pretax and 6.68% after-tax return
32 Saving and Investing Early StanVickieSaves $2,000 per yearStarts at age 35Continues for 30 yearsInvests and earns an 8.9% pre-tax and 6.68% after-tax returnSaves $2,000 per yearStarts at age 25Stops after 10 yearsInvests and earns an 8.9% pre-tax and 6.68% after-tax return
34 Tax-Deferred Earnings StanVickieSaves $2,000 per yearStarts at age 25Continues for 40 yearsInvests in a taxable account and earns an 8.9% pre-tax and 6.68% after-tax returnSaves $2,000 per yearStarts at age 25Continues for 40 yearsInvests in a Tax-Deferred account and earns an 8.9% pre-tax return
36 The Saving Process What do you want? What will you have? Will you have a shortfall?What strategy will you employ?What actions will you take?
37 What Do You Want? Identify your specific savings goals Identify your time horizonQuantify your saving goalsPrioritize your saving goals
38 Identify Your Specific Saving Goals Pay down existing debtCreate an emergency fundSave for retirementAccumulate a down payment for a houseBuild a college fund for your children’s educationSet aside money for a specific goal (vacation, fun and games, etc.)
39 Create an Emergency Fund Set aside 2 to 4 months of living expensesUse it for a crisis (i.e., roof leaks)Use it and replace itDon’t use it for discretionary spending (i.e., vacation)
40 Save for Retirement Do everything possible NOW Start early—you’ll end up with more
41 Identify Your Time Horizon Identify number of months or years until goalAllow as much time as possible:You can accept a lower investment riskYour monthly saving and investing commitment will be less
42 Examine Your Spending Habits Keep a list of all spending for one monthCompare total spending to take-home payExamine closely if you have a substantial unexplained gapBecome highly knowledgeable about your expenses
43 Identify Ways to Save More Save your next raiseSave your next bonusReinvest dividends and interestSave all cash giftsRent instead of buying (books, videos, etc.)Delay buying a new car upon paying off present car loanSave the “donut money”—and lose weight!Buy generic productsTrim your spending by 5%Be creative
44 What About Investing?Combined with savings, a key resource for achieving your financial goalsInvesting skills are needed to prudently utilizeCompany 401(k) investmentsIRAs investmentsSavings invested outside these plansAll investments involve risksApproach investing carefully
45 What Investing Carefully Means Phase I: Learn investing basicsPhase II: Develop your investment planPhase III: Implement your investment plan
47 Why Learn Basic Investing Concepts? ALL investments involve risksEven so-called risk-free investments like a cashAs such, approach investing carefullyLearning basic investing concepts is part of investing carefully
48 What Are The Major Asset Classes? CharacteristicsGoalsHistorical Average Returns*CashMatures in less than one yearCapital preservationLiquidity3-4%BondsFixed incomeVaried maturitiesIncome5-7%StocksCompany ownershipPossible dividend incomeCapital appreciation10-13%Hard assetsAsset ownershipInflation hedgeVaries* Pretax return over 75 years through 2008
49 What Risks are Involved in Investing? Primary long-term riskInflation riskLoss of purchasing powerPrimary short-term riskVolatility riskInstability of investmentOther risksBusiness riskMarket riskLiquidity riskInterest rate riskCurrency riskInherent risks of a particular businessLikelihood that the market as a whole will fallRisk of not being able to access money when neededLoss of principal on fixed-rate investments due to rising interest ratesInvestment’s value will be affected by changes in exchange rates
50 How are These Risks Managed? Primary long-term riskInflation riskInvest in stocksPrimary short-term riskVolatility riskHold investments for the long-termOther risksBusiness riskMarket riskLiquidity riskInterest rate riskCurrency riskDiversify within an asset classDiversify among asset classesHave an emergency fund“Ladder” portfoliosDiversify among countries or hedge
51 However, Stocks Have More Volatility Risk Lower DeviationHigherDeviationDegree of VolatilityReturnLowerAnnual5%10%15%20%CashIntermediate-Term Government BondsLarge Company StocksSmall Company Stocks
52 Manage Volatility Risk by Investing Over Time 150%125%One-Year Holding PeriodsVolatility Risk Over TimeFive-Year Holding Periods100%Twenty-Year Holding PeriodsAverage Return75%50%Ranges of Return25%12.7%10.4%5.4%3.7%0%Assessing riskFor many people, risk is the overriding factor in developing an investment strategy. In selecting investments, risk must be reviewed in several ways, such as measuring the likelihood of achieving a desired outcome.As you seek to build your wealth through investing, consider these additional areas of risk. Overall, risk can be divided into two main categories - systematic (non-diversifiable) and unsystematic (diversifiable) risk. This distinction is fundamental to investment planning and portfolio management.Market riskSystematic risk, which is due to such factors as the market in general, interest rates, purchasing power and currency fluctuation, is unavoidable. You must live with this type of risk, coping as best as possible. Bear in mind that, although it is invisible, it can decimate your wealth. Inflation, in particular, can be devastating. Some of the safest and most conservative investments (such as Treasury bills) may not protect your principal from inflation. They promise to return the same number of dollars you invest, with interest of course, but the purchasing power of these dollars may be reduced, perhaps sharply, by the time you get your money back.For these reasons, a structured investment program, in which stock, mutual funds or other investments are purchased steadily over a period of time, can help reduce risk. This technique, generally known as dollar-cost averaging, can take advantage of price declines because you will purchase more shares when the price is low and fewer shares when the price is high. This strategy tends to produce a portfolio with a lower average cost than one assembled through a limited number of large block purchases. This risk management technique keeps you focused on being invested versus trying to time the market peaks and valleys before deciding on investment purchases and sales. Timing the market is difficult, if not impossible, and introduces more risk to the investment process.-25%-50%-75%SmallCompanyStocksLargeCompanyStocksLong-TermGovernmentBondsCashRange of compound annual returns over the period Source: Ibbotson Associates, 2004.
53 Managing Business and Market Risks Portfolio RiskNumber of Holdings3579111315Portfolio Risk= Market Risk + Business RiskBusiness RiskMarket Risk
54 Manage Liquidity Risk by Diversifying CurrentBondsReal EstateMoney market fundsConvertible bondsSmall-company stocksCertificates of depositLargeUtility stocksZero coupon bondsReturnDeferredLowerLiquidity RiskHigher
55 Managing Interest Rate Risk PricePriceInterestInterestRatesRatesBondsManaged by “Laddering” Portfolio of Bonds
56 Risk / Return Trade-Offs: Example 1 Degree of Volatility Lower DeviationHigherDeviationDegree of VolatilityReturnLowerAnnual5%10%15%20%CashIntermediate-Term Government BondsLarge Company StocksSmall Company Stocks
57 Risk / Return Trade-Offs: Example 2 Cash vs. Bonds vs. Stocks Current yieldAppreciationTotal returnEstimated income 30%After-tax returnInflation rateAfter-tax “real” rate of returnRelative risk3.3%0.0%(1.0)%2.3%(3.1)%(0.8)%Low4.8%(1.4)%3.4%0.3%Medium2.2%6.5%8.7%(2.6)%6.1%3.0%High
58 Risk / Return Trade-Offs: Example 3 Sub-Categories Within Major Asset Classes CashBondsStocksHard AssetsInternationalSmall CompanyLarge Company StocksLong TermIntermediate TermShort TermHigh Risk/High Return PotentialLow Risk/Low Return Potential
59 Risk / Return Trade-Offs: Example 4 Taxable vs. Tax-Exempt Investments Taxable or tax-exempt investmentsAs a result of income taxes, you require significantly greater investment returns to reach a particular goal. For example, if you are in the 28 percent tax bracket, you would need to purchase a taxable investment earning more than 6.9 percent to outperform a 5 percent tax-exempt investment.Taxable Tax-exemptInvestment $1000 $1000Rate of return 6.9% 5.0%Investment incomeLess taxes N/AInvestment income after taxes $ $ 50In the 33 percent tax bracket, you would need a 10.4 percent taxable return to be able to keep 7 percent after taxes.The best outcome where taxes are concerned, of course, is not to have to pay them. That's a major reason why many investors favor municipal bonds. Interest on municipal bonds is not generally subject to Federal income taxes, although state or local income taxes may be due if you own municipal bonds issued outside your home state. (Capital gains on municipal bond investments are subject to Federal capital gains tax.) Municipal bonds, however, may not be suitable for your investment strategy. For example, you may need the long-term growth offered by common stocks. Unfortunately, all earnings from common stocks are taxable. This brings us to the next-best outcome where taxes are concerned, and that is to delay or defer them as long as possible. The longer you can keep your money from being taxed, and leave all your earnings free to compound, the easier it will be for you to reach your goals.Tax-equivalent returnYou can use the following formula to calculate the tax-equivalent return on a municipal bond:Tax equivalent return = tax-exempt return/(1-marginal tax rate)To learn more about tax exempt investments, see the Tax Planning online course in PwC eAdvisor.
60 Risk / Return Trade-Offs Between Differing Portfolios Portfolio A6.61% Return4.25% Risk*Portfolio B6.61% Return3.60% Risk*Portfolio C7.06% Return4.25% Risk** Risk = one standard deviation
61 What One Factor Most Influences Your Return? Your Asset AllocationSource: Brinson, Singer, Beebower
62 What Most Influences Your Asset Allocation? Your desired rate of returnYour risk toleranceYour time horizonStan and Vickie are different…their asset allocations will be different too.VickieStan
63 Importance of Your Desired Rate of Return The higher the rate of your desired return, the higher the risk you will most likely will have to takeDesired ReturnLikely Risk
64 Importance of Your Risk Tolerance The higher your risk tolerance the more aggressive you can beRisk ToleranceBe More AggressiveBe More Conservative
65 Importance of Your Time Horizon Longer time horizons (5 or more years) can absorb the ups and downs of investing more heavily in stocksShorter time horizons warrant investing more heavily in less volatile investmentsTime horizonUse more volatile stocksUse less volatile investments
67 Use This Investment Planning Process What do you want?What will you have?Will you have a shortfall?What strategy will you employ?What actions will you take?Note: this process is applied to each of your investing goals
68 What Do You Want? Take into account Your goal in today’s dollars Number of years to your goalExpected inflation rateTo arrive atWhat you wantBe sure to include important others in deciding what you want.
69 How do You Define Your Goals? Each goal will have its own time horizonFor the period of accumulationFor the period over which it will be spentMake a list and refine as you go alongStart with broad ideas and work toward increasingly specific and measurable goals
70 What Will You Have? Take into account Current assets set aside for your goalNumber of years to your goalFuture savingExpected return on your invested assetsExpected future benefitsTo arrive atWhat you will have
71 Where Should You Save First? Your Employer 401(k) Plan (at least to the % that gives you the maximum employer match – free money for you)Roth IRA using after-tax contributions or Traditional IRA using pre-tax contributions, depending on your circumstances*Taxable accounts* Only Traditional IRAs can accept pre-tax contributions. Although both Traditional and Roth IRAs can accept after-tax contributions, it is generally preferable to use Roth IRAs. We will be covering IRAs in more detail later. You can use a Financial Calculator to determine which type of IRA is best for your particular situation.
72 Why These Priorities? Vickie Taxable Account Roth IRA Using After-Tax ContributionsTraditional IRA Using Pre-Tax ContributionsEmployer 401(k) PlanSalary$50,000Pre-tax $$2,667Tax at 25%$667After-tax $$2,000Employee contributionEmployer match – assume 3%n/a$1,500Total contribution$4,167% of salary contributed4.00%5.33%8.33%Outcome$178,227What Happens?
75 Consider Tax-Advantaged Accounts First Features Available Employer 401(k) PlanIRAs529 PlanTax-Deferred contributions (1)No (2)Tax-Deferred earningsEmployer contributionsNoUnlimited contributions (3)Automatic saving and investingWide-array of professionally managed fundsVariesSelf-direction of fund allocationImmediate penalty-free withdrawalNo (1)Depends on the type of IRA used.Some states allow you to deduct your contributions.Some states limit contributions.
76 Then Consider Taxable Accounts Features Available Employer DESPP (1)Employer DTP (2)Mutual FundsBrokerage AccountsTax-Deferred contributionsNoTax-Deferred earningsEmployer contributionsUnlimited contributionsAutomatic saving and investingWide-array of professionally managed fundsSelf-direction of fund allocationBuy Emplyr stock at a discountBuy Emplyr stock without feesImmediate penalty-free withdrawal(1) Discounted Employee Stock Purchase Plan (2) Direct Transaction Program
77 Now Develop Your Preliminary Plan QuestionAnswers = PlanYour goal?Your risk tolerance?Your expected rate of return?Your time horizon?Current assets set aside for your goal?Future periodic savings/investing?Expected future benefits?Types of account(s) you’ll use?Asset allocation within account(s)?
78 Then Calculate Your Expected Return* Major Asset ClassAsset AllocationHistorical ReturnEstimated ReturnCashBondsStocksHard assets__________%X 4%X 6%X 12%X 8%Total100%* Calculated for each account you are using to invest your savings.
79 And Then the Future Value of These Items* Contribution Toward GoalFuture Value CalculationCurrent assets set aside for your goalCalculate the future value of this amount invested at your expected rate of return over your time horizonFuture periodic savings/investingCalculate the future value of these payments at your expected rate of return over your time horizonExpected future benefitsCalculate the future value of this amount invested at your expected rate of return from the date of receipt to the end of your time horizon* Calculated for each account you are using to invest your savings.
80 The Result is What You Will Have Take into accountCurrent assets set aside for your goalNumber of years to your goalFuture savingExpected return on your invested assetsExpected future benefitsTo arrive atWhat you will have
81 Key Points to RememberFinancial planning will help you clarify goals, strategies and action stepsDetermine whether you have too much debt and develop a plan to conquer itMake wise decisions about using debtCommit to saving and investingSave and invest earlyPay yourself firstLearn as much as you can about investing to develop a plan and invest according to your “comfort level”
82 Questions?[insert contact information here]Special thanks to Kevin Roach, CPA/PFS of Texas A&M University for contributing content.