Fun 4 PPT 1-4

1
Michael A. Dalton | James F. Dalton | Joseph M. Gillice | ThomasChapter

P. Langdon
2014 Money Education
Fundamentals of Financial Planning
CHAPTER 1:
INTRODUCTION TO
FINANCIAL PLANNING
Chapter 1
INTRODUCTION TO FINANCIAL PLANNING

Personal financial planning (financial planning) is the process of formulating,
implementing, and monitoring financial decisions into an integrated plan, which
guides an individual or a family to achieve their financial goals.
Chapter 1
THE FINANCIAL PLANNING PROCESS

Establish & Define
Client Relationship
Restart
Monitor Plan
Implement
Financial Plan
Recommendations
Gather Client Data
Financial
Planning
Process
Analyze &
Evaluate Clients
Financial Status
Develop & Present

Financial Planning
Recommendations
(Select 1 Set)
Chapter 1
CONTENTS OF THE PLAN

A financial plan considers the clients financial goals and values (internal data)
and the external environment (external data).
Financial planning concepts include:
An evaluation of the clients risk management portfolio
Financial statement preparation and analysis
Emergency fund and debt management
Long-term goal planning (Retirement, education, legacy)
Income tax planning
The investment planning portfolio
Chapter 1
ESTABLISHING AND DEFINING THE

CLIENT RELATIONSHIP
How does a planner effectively communicate with a client?
Address the client formally
Actively listen to the client
Respect the clients time
To establish a trusting relationship, the planner can generally share prior

experiences
Show empathy
Chapter 1

CLIENT RELATIONSHIP
Introductory Meeting
The planner should provide a list of documents and information that the client
needs to provide for the first meeting.
The planner should assist the client with establishing goals and discuss how the
clients values fit into those goals.
The client and the planner should agree as to how they will communicate, and
how often they will meet.
Discuss the planning process, fees, and answer questions that the client is likely
to have.
Chapter 1
ENGAGEMENT LETTER
An engagement letter is a legal agreement (a contract) between a professional or a
professional organization and a client that defines their business relationship.
Chapter 1

CLIENT RELATIONSHIP
Elements of an engagement letter
A description of the mutually agreed upon services
The time horizon for the work to be completed
A description of the fees and costs
The obligation and responsibilities of each party
Description of the understanding concerning the use of proprietary products

and/or other professionals or entities
Chapter 1

CLIENT RELATIONSHIP
The Scope of the Engagement
Activities that are typically part of a comprehensive plan would include:
Preparation and analysis of personal financial statements
A review of all risk management
An evaluation of short term financial goals
The establishment of long term goals
An evaluation of the current investment portfolio
An examination and recommendation regarding any special needs situation
Chapter 1
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GATHER CLIENT DATA

The Internal Data Collection Process
The planner must obtain sufficient information, both qualitative and quantitative
data.
Qualitative data is how a client feels about something.
Quantitative data contains specific measurable attributes.
Chapter 1
11
GATHER CLIENT DATA

Quantitative information collected will include:
The family
The insurance portfolio
Banking and investment information
Taxes
Retirement and Employee Benefits
Estate Planning
Personal financial statements if available
Chapter 1
12
GATHER CLIENT DATA

Qualitative information may include:
Education goals
Retirement goals
Employment goals
Savings goals
Risk tolerance
Charitable goals
General attitude towards spending
Chapter 1
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GATHER CLIENT DATA

The External Data Collection Process
The financial planner should identify and document the following external
information at the inception of the engagement:
Interest rates
Housing market
Job market
Investment market
Business cycle
Local insurance costs
Local cost of living
Expected inflation rate
Expected rate of increase in the prices of education and medical care
Legislation that may impact certain industry sectors
Current and expected income, gift, and estate tax rates

Chapter 1
14
REMAINING STEPS IN THE FINANCIAL PLANNING PROCESS

Analyzing and Evaluating the Clients Financial Status
There are many financial planning approaches to analyze, evaluate, and make
recommendations to the client.
Chapter 2 covers the remaining steps in the financial planning process, which
includes:
Analysis of the clients financial situation
The development and presentation of recommendations
Implementing the financial plan
Monitoring the plan
Chapter 1
15
THE BENEFITS FROM FINANCIAL PLANNING
The financial planning process helps identify risks and to establish and prioritize goals.
A financial plan anticipates where financial needs exist and where new risks may arise.
A financial plan establishes benchmarks within a finite time frame.
A financial plan can help keep the client focused.
A financial plan can give a client confidence that they can accomplish their financial
goals.
Chapter 1
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THE BENEFITS FROM FINANCIAL PLANNING

Why use a professional financial planner?
Most clients do not know how to prepare a comprehensive financial plan and do
not want to spend the time to learn how. Even where the client may have the
knowledge, he typically lacks the confidence to undertake this process and is
likely seeking confirmation of his own financial planning decisions.
A financial planner brings objectivity, whereas a client generally views their

financial position subjectively.
Chapter 1
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THE PRACTICE OF FINANCIAL PLANNING
Financial planning is largely unregulated; however, licenses must be obtained by those

engaging in the sale of insurance products and securities.
Financial planning is much broader than the sale of products or securities.
Chapter 1
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RECOGNIZED CERTIFICATIONS IN FINANCIAL PLANNING

The need for some form of self-regulation and the demand that a financial planner be
competent and trustworthy have prompted several independent financial services
organizations to introduce certifications and ethical standards.
CERTIFIED FINANCIAL PLANNER
Chartered Financial Consultant (ChFC)
European Financial Planner (EFP)
Chapter 1
19
EMPLOYMENT AND JOB OUTLOOK
Financial planners hold 208,400 jobs across the country (projected to be 271,200 in
2018).
Twenty nine percent of financial planners are self-employed.
Sixty three percent of financial planners work in the finance and insurance industries.
Chapter 1
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EARNINGS
Financial planners earn compensation in the form of:
An hourly rate or fee
A flat fee
A commission on investment and insurance products sold
A percentage of the assets managed
A combination of one or more of the above
Chapter 1
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CHAPTER 2:
INTERPERSONAL COMMUNICATION
AND BEHAVIORAL FINANCE
Chapter 1
SCHOOLS OF COUNSELING
There are three general and noteworthy schools of counseling.
Developmental
Humanistic
Cognitive-Behavioral
Chapter 1
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DEVELOPMENTAL SCHOOL OF THOUGHT
Referred to as the Developmental Paradigm
Believes that human development occurs in stages over time.
Chapter 1
24
HUMANISTIC SCHOOL OF THOUGHT
Referred to as the Humanistic Paradigm.
Dominated by theorists whose models have their origins from a shared philosophical
approach.
A Humanistic counselor would define mental health as having congruent and aligned
thoughts, feelings and behavior.
Goals in treatment are centered on establishing congruence and acceptance of personal

responsibility.
Chapter 1
25
COGNITIVE-BEHAVIORAL SCHOOL OF THOUGHT
Referred to as the Cognitive-Behavioral Paradigm
Humans are beings that are subject to the same learning principles that were
established in animal research.
The counselors challenge lies in performing a sound evaluation of how reinforces are
maintaining problematic self-talk behaviors.
Chapter 1
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COMPARISON OF COUNSELING PARADIGMS
Chapter 1
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ELEMENTS OF COMMUNICATION
Human communications are compromised of fundamental elements.
Societal groups use a system of signs in their communication process.
A sign could be a word, object, gesture, tone, quality image, substance or

other reference according to a code of shared meaning among those who use
that sign for communication purposes.
Chapter 1
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NONVERBAL BEHAVIOR OR BODY LANGUAGE
Nonverbal cues, or body language, can communicate feelings and attitudes from the
client to the financial advisor.
Nonverbal behaviors are mainly provided from the body and the voice.
Body position and body movement are important while voice tone and voice pitch are
also telling.
Chapter 1
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ACTIVE LISTENING VS. PASSIVE LISTENING

The financial advisors relationship with the client should be dominated by active
listening on the part of the advisor, not passive listening.
Chapter 1
30
PASSIVE LISTENING
Passive Listening
Listening in the normal or usual conversation or conversational setting to which

most people are accustomed at seminars, in class, or social gatherings, or at
sermons.
Invoked when communication rests entirely on another person and the person
receiving the information sits back and listens.
Chapter 1
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ACTIVE LISTENING
Active Listening
Requires the listeners undivided attention.
Involves concentration of what the speaker is saying.
Listener must put aside irrelevant thoughts.
The advisor should not think about what to say next, but should be listening and
observing the speakers body language.
Chapter 1
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OPEN AND CLOSED QUESTIONS
Open Question
One that will result in a person answering with a lengthy response.
Closed Question
Seeks a response that is very specific and commonly involves an answer that
can be accomplished with a single word or two.
Chapter 1
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CLIENT DATA COLLECTION

Collecting Client Data
More than reviewing bank statements and papers
Advisor needs to learn about who the client is and what are the clients personal and
financial goals, needs, and priorities.
Chapter 1
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BEHAVIORAL FINANCE
Traditional Finance
Also referred to as Modern Portfolio Theory
Some of the concepts of the theory are not necessarily modern and have been subject to
much debate and change over recent decades.
Chapter 1
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ASSUMPTIONS & BUILDING BLOCKS OF TRADITIONAL

FINANCE
Traditional Finance is premised on four basic premises:
Investors are rational
Markets are efficient weak form efficiency (price reflects all historical information.. Cant use
technical analysis), semi-strong form efficiency (price reflects all publicly available
information), strong form efficiency (price reflects all public and private information).. Market
is weak and semi strong form. We are unable to consistently predict overvalued or undervalued
securities.
The Mean-Variance Portfolio Theory governs
Returns are determined by risk (Beta)

Chapter 1
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BEHAVIORAL FINANCE
Does not fully reject Traditional Finances views or methods
Contains much of the scientific framework and lessons learned from Traditional
Finance
Amends some of it with basic assumptions based on normal, more human-like

behavior
Supplements other aspects of it with notions from psychology and sociology
Chapter 1
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BEHAVIORAL FINANCE ASSUMPTIONS
Investors are normal
What makes investors normal instead of rational: Cognitive biases, errors,

and being human
Markets are not efficient
The behavioral portfolio theory governs
Risk alone does not determine returns (Risk = BETA). Other things can drive the
market such as momentum or size effect (smaller stocks outperform larger stocks),
or value effect (growth stocks outperform value stocks)
Chapter 1
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PATTERNS OF COGNITIVE BIASES
Anchoring
Confirmation Bias
Gamblers Fallacy
Herding
Hindsight Bias
Overconfidence
Overreaction
Prospect Theory
Chapter 1
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PATTERNS OF COGNITIVE BIASES - ANCHORING

Anchoring
Attaching, or anchoring, ones thoughts to a reference point even though there may be
no legal relevance or is not pertinent to the issue in question.
Also known as conservatism or belief perseverance.
Fairly common in situations where decisions are being made in situation that are
novel or new to the decision maker.
Chapter 1
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PATTERNS OF COGNITIVE BIASES CONFIRMATION BIAS

Confirmation Bias
A common phrase to explain the confirmation bias is that you do not get a second
chance at a first impression.
People tend to filter information and focus on information supporting their opinions.
Chapter 1
41
PATTERNS OF COGNITIVE BIASES HERDING

Herding
People tend to follow the masses, or the herd.
Believed that herding is based on:
A persons desire to conform or be accepted by a certain group.
People believe that if such a large group of people believe something to be
correct, then the chances are that the conclusion or decision they have made
is also correct.
Chapter 1
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PATTERNS OF COGNITIVE BIASES HINDSIGHT BIAS

Hindsight Bias
Looking back after the fact is known.
May lull the investor into believing they can perform better or more efficiently
when armed with this bias.
Chapter 1
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PATTERNS OF COGNITIVE BIASES OVERCONFIDENCE

Overconfidence
Usually concerns an investor that listens mostly to himself or herself.
An investor with overconfidence usually mostly relies on their skill and capabilities
to do their homework and make their own decisions.
Underperform by buying losers and selling winners.
Chapter 1
44
PATTERNS OF COGNITIVE BIASES OVERREACTION

Overreaction
A common emotion towards the receipt of news or information.
The overweighting of sample information.
Chapter 1
45
PATTERNS OF COGNITIVE BIASES PROSPECT THEORY

Prospect Theory
Provides that people value gains and losses differently and will base their decisions
on perceived gains rather than perceived losses.
Chapter 1
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THE DISPOSITION EFFECT (1 OF 2)
The reluctance of an investor to realize a loss in a Behavioral framework stems from a

combination of 2 cognitive biases and an emotion.
The cognitive bias was faulty framing, where normal investors do not mark their
stocks to market prices.
Investors create mental accounts when they purchase stocks and continue to mark their
value to purchase prices even after market prices have changed.
They mark stocks to the market only when they sell their stocks and close their mental
accounts.
Chapter 1
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THE DISPOSITION EFFECT (2 OF 2)
Normal investors do not acknowledge the loss in value (referred to as paper loss)
because an open account means that there is still a chance that the stock price will
rise, and the stock is not necessarily a loser, but may still turn into a gain.
The normal investor does not consider the stock a loser until the stock is sold, at
which time the loss is technically realized in the mind of the normal investor.
Interfacing with the faulty framing bias is the cognitive bias of hindsight.
Chapter 1
48
CHAPTER 3:
FINANCIAL PLANNING APPROACHES:
ANALYSIS AND RECOMMENDATIONS
Chapter 1
INTRODUCTION
The planner and client should mutually define the clients personal and financial goals, needs
and priorities.
The planner must keep the clients values, attitudes, expectations, and time horizons in mind
as they affect the goals, needs, and priorities of the client.
Goals and objectives provide a roadmap for the financial planning process.
Goals tend to be broad.
Objectives are more narrow and can be subjected to measurement.
The planner must collect and analyze both internal and external data.
Financial planners have a fiduciary responsibility.
Chapter 1
50
APPROACHES TO FINANCIAL PLANNING
The life cycle approach
The pie chart approach
The financial statement and ratio analysis approach
The two-step/three-panel approach
Risk tolerance and asset allocation
Chapter 1
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COMMON PROFILES
Chapter 1
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THE LIFE CYCLE APPROACH

This approach gathers and analyzes the following information:
The ages of the client and spouse
The clients marital status
The number and ages of children and grandchildren of the client
The family income by each income contributor
The family net worth
Whether the client is self-employed or is an employee or unemployed or retired
Chapter 1
53
THE LIFE CYCLE APPROACH
Chapter 1
54
THE PIE CHART APPROACH
A pie chart forces the client to focus on the fact that there is only one pie.
People can only spend what they have, and visualizing where the money goes is
often a sobering lesson.
The pie chart is an effective analytical and illustrative tool for financial planning
clients.
Chapter 1
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Other Living
Expenses
29%
Housing Costs
25%
Insurance
9%
Savings
12%
Taxes
25%
Chapter 1
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Assume a client has gross pay of $100,000 and expenses as listed in the table below.
The data can be reflected in an income statement pie chart, allowing the client to
visualize his financial situation as pertains to income and expenses.
Amount
Percentage
Gross Income
$100,000
100%
Taxes
$25,000
25%
Savings
$12,000
12%
Insurance
$13,000
13%
Housing Costs
$28,000
28%
Other Debt Payments (ODP)
$8,000
8%
Other Living Costs (OLC)
$10,000
10%
Discretionary Cash Flow (DCF)
$4,000
4%
Chapter 1
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Example Income = $100,000
Other Debt
Payments
8%
Other Living
Expenses
10%
Discretionary Cash
4%
Housing Costs
28%
Insurance
13%
Savings
12%
Taxes
25%
Chapter 1
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Income Statement Targeted Example Benchmarks
Targeted Example
Benchmarks
Taxes (Income & Payroll)
15 30%
Savings (Future)
10 18%
Protection (Insurance Past)
5 12%
Living Present
40 60%
Housing (Rent or Mortgage Payments)
< 28%
Housing & Other Debt Payments
< 36%
Chapter 1
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Balance Sheet Pie Chart
Assets
Liabilities & Net Worth
Cash & Cash

Equivalents 25%
Personal
Use Assets
50%
Investment
Assets 25%
Net Worth
25%
Current
Liabilities
15%
Long-Term
Liabilities
60%
Doesnt work if you have

negative net worth.
Chapter 1
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Client Sample Balance Sheet Pie Chart
Assets = 100%
Cash & Cash Equivalents
Liabilities & Net Worth = 100%

$30,000
10%
Current Liabilities
Investment Assets
$120,000
40%
Long-Term Liabilities
Personal Use Assets
$150,000
50%
Net Worth
$300,000
100%
Cash & Cash

Equivalents
10%
Personal
Use Assets
50%
$75,000
25%
$150,000
50%
$75,000
25%
$300,000
100%
Net Worth
25%
Investment
Assets
Current
Liabilities
25%
Long-Term
Liabilities
50%
Chapter 1
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An Estimate of Balance Sheet Targeted Benchmarks by Ages
Assets*
Liabilities
Net Worth*
20s 30s
40s 50s
60s 70s
Cash & Cash

Equivalents
5 20%
5 20%
5 20%
Investment
Assets
0 30%
30 60%
60 70%
Personal Use
Assets
55 90%
25 60%
15 30%
Current
Liabilities
10 20%
10 20%
0 10%
Long-Term
Liabilities
40 72%
16 48%
8 24%
Net Worth
8 50%
32 74%
66 82%
*More detailed description of each category is provided in Chapter 4.
Chapter 1
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THE FINANCIAL STATEMENT AND RATIO ANALYSIS

APPROACH
The approach uses four types of financial ratios:
Liquidity ratios
Debt ratios
Ratios for financial security
Performance ratios
Chapter 1
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LIQUIDITY RATIO - EMERGENCY FUND RATIO
Emergency Fund Ratio
Emergency Fund Ratio =

Monthly NonDiscretionary Cash Flows
= 3 - 6 Months
Discretionary cash flows are those expenses which can be avoided in the event of
loss of income.
Non-discretionary cash flows are mostly fixed expenses which are required to be
met regardless of loss of income.
Chapter 1
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LIQUIDITY RATIO - CURRENT RATIO

Current liabilities represent those liabilities that will be paid within the next year.
Current Ratio =

Current Liabilities
Chapter 1
65
DEBT RATIOS
There are four debt ratios:
Housing ratio 1 (basic)
Housing ratio 2 (broad)
Debt to total assets ratio
Net worth to total assets ratio
Chapter 1
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DEBT RATIOS - HOUSING RATIO 1 (BASIC)

Housing costs include principal payments on the mortgage (or alternately rent),
interest, homeowners insurance, property taxes, and association dues, if applicable.+
Housing Ratio 1 =
Housing Costs
Gross Pay
28%
Chapter 1
67
DEBT RATIOS - HOUSING RATIO 2 (BROAD)

Housing ratio 2 combines basic housing costs with all other monthly debt payments,
including automobile loans, student loans, bank loans, revolving consumer loans, credit
card payments, and any other debt payments made on a recurring basis.
Housing Ratio 2 =
Housing Costs+Other Debt Payments

Gross Pay
36%
Chapter 1
68
DEBT RATIO - DEBT TO TOTAL ASSETS RATIO

The debt to total assets ratio is a leverage ratio reflecting the portion of assets owned
by a client that has been financed by creditors.
Debt to Total Asset Ratio =
Total Debt
Total Assets
= Benchmark Depends on Client Age
Chapter 1
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DEBT RATIO - NET WORTH TO TOTAL ASSETS RATIO

The net worth to total assets ratio provides the percentage of total assets owned or paid
for by the client.
Net Worth to Total Assets Ratio =
Net Worth
Total Assets
Chapter 1
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RATIOS FOR FINANCIAL SECURITY
These ratios assess the progress that the client is making toward achieving long-term
goals.
The two most common ratios used are the savings rate and the investment assets to
gross pay ratio.
Chapter 1
71
FINANCIAL SECURITY RATIO - SAVINGS RATE

An appropriate savings rate is critical to achieving long-term goals including retirement,
education funding, large lump sum expenditures, and legacy plans.
Savings Rate =
Savings+Reinvestments+Employer Match
Gross Pay
= Benchmark Depends on Client Goals
Chapter 1
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SAMPLE RETIREMENT ACCOUNT BALANCES AND

NECESSARY SAVINGS RATES
40 years of savings, real rate of return 5%, wage replacement 80%, and retirement life
expectancy 30 years.
Chapter 1
73

Chapter 1
74

Chapter 1
75
FINANCIAL SECURITY RATIOS

INVESTMENT ASSETS TO GROSS PAY
A saving rate of 10-13 % of gross pay would be sufficient to achieve the retirement goal only if
the client begins saving at age 25.
Investment Assets to Gross Pay =
InvestmentAssets +(Cash & Cash Equivalents)

Gross Pay
The investment assets to gross pay benchmark is calculated according to age and is generally
reliable for a wide range of income levels (e.g., $40,000 to $400,000 annual income). Thus the
client needs both an appropriate IA/GP ratio and a sufficient savings rate to achieve all
financial goals.
Chapter 1
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INVESTMENT ASSETS TO GROSS PAY

Investment Assets to Gross Pay
Benchmark for Investment Assets as a Ratio of Gross Pay by Age
25
0.2:1
30
0.6 0.8:1
35
1.6 1.8:1
45
3 4:1
55
8 - 10:1
65
16 20:1
A continued savings rate of 10 to 13% of gross pay until retirement age 65 will achieve these ratios
if invested in a balanced fund that produces reasonable returns. Inflation and pay raises are included
in the analysis.
Thus the client needs IA/GP and a sufficient savings rate to achieve goals.
Chapter 1
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PERFORMANCE RATIOS
The most common three performance ratios used to determine the adequacy of returns
on investments for the risks taken are:
Return on investments
Return on assets
Return on net
Chapter 1
78
PERFORMANCE RATIOS RETURN ON INVESTMENTS (ROI)
Return on Investments (ROI) ratio calculates the rate of return on invested assets.
The ratio is calculated by taking the end balance of investments (I1) minus the
initial beginning balance of investments (I0) plus the annual savings (S), which is
divided by the beginning balance of investments.
Benchmark is 8-10%.
Return on Investments =
I1 (I0+Savings)
I0
Chapter 1
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PERFORMANCE RATIOS - RETURN ON ASSETS (ROA)
Return on Assets (ROA) ratio measures total asset returns by calculating the
difference between ending assets (A1) less beginning assets (A0) plus any savings
(S), divided by beginning assets.
Benchmark is 2-4%.
A1 (A0+Savings)
A0
Chapter 1
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SUMMARY OF FINANCIAL STATEMENT RATIOS (1 OF 2)
Chapter 1
81
SUMMARY OF FINANCIAL STATEMENT RATIOS (2 OF 2)
Chapter 1
82
PERFORMANCE RATIOS RETURN ON NET WORTH (RONW)
The Return on Net Worth (RONW) ratio calculation takes ending net worth (NW1)
less the sum of the beginning net worth (NW0) and savings (S), divided by
beginning net worth.
NW1 (NW0+Savings)
NW0
Return on Net Worth =
Benchmark is the higher the better.
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HESS CASE EXAMPLE

Jack Hess is a 45-year old marketing manager for a national pharmaceutical company. His annual salary is
$73,000. He participates in his companys 401(k) retirement plan and his employer matches three percent
of his salary. Jacks wife, Marilyn, is a 43-year old make-up artist with an annual salary of $36,000. There
are no company retirement plans available for Marilyn. Jack and Marilyn have been married for 18 years
and plan to retire in 20 years. They have a 13-year old daughter, Melba. Melba is in the 8th grade at a
private school in their area. Jack and Marilyn anticipate that Melba will attend a private university with
tuition of $21,000 annually in todays dollars. Jack and Marilyn have a moderate level of risk tolerance
and rank their financial objectives, by priority, as follows:
Save for retirement
Save for private college education for Melba
Have an adequate insurance portfolio
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BALANCE SHEET DATA AND PIE CHART

Assets = 100%
Liabilities & Net Worth = 100%

$30,000
7%
Investment Assets
$177,000
39%
Personal Use Assets
$245,000
54%
$452,000
100%
Current Liabilities
$11,000
2%
Long-Term Liabilities
$161,000
36%
Net Worth
$280,000
62%
$452,000
100%
Cash &
Cash
Equivalents
7%
Personal
Use Assets
54%
Investment
Assets
39%
Current
Liabilities
2%
Long-Term
Liabilities
36%
Net Worth
62%
Chapter 1
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INCOME STATEMENT PIE CHART

INCOME = $109,000
Other Living
Expenses, 24%
Charitable, Tuition,
& Entertainment ,
11%
Debt Payments,
20%
Insurance, 4%
Savings, 13%
Taxes, 28%
Note: Discretionary cash flow is not listed because it is negative $1,125 or -1%.
Chapter 1
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LIQUIDITY RATIOS WILL BE ON EXAM!!!!!!!!!!!!!!!!!!!!

BENCHMARK - 3 TO 6 MONTHS
Emergency Fund Ratio =
$30,000
=
($66,098 12)=$5,508.17
5.44 Months Coverage (good)
$26,000 Ordinary Living Expenses

$21,468 Total Debt Payments
$4,800 Total Insurance Payments
$10,000 Tuition & Education Payments
$2,895 Residence Property Taxes
$935 Charitable Contributions (considered non-discretionary by client)
$66,098 Total Non-Discretionary Cash Flows
Current Ratio =
$30,000
=
$11,000
2.73 (good)(2014)
Current Ratio =
$28,174
=
$11,000
2.56 (good)(2015)
Chapter 1
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DEBT RATIOS
Debt Ratios
Housing Ratio 1
Housing Ratio 2
Debt to Total Assets Ratio
Debt to Total Assets Ratio
Net Worth to Total Assets

Ratio
Net Worth to Total Assets

Ratio
$12,768 + $1,600 + $2,895

$109,000
$12,768 + $1,600 + $2,895
+ $3,300 + $5,400
$109,000
$172,000
$452,000
$165,389
$452,774
$280,000
$452,000
$285,385
$450,774
15.8%
(very good)
23.8%
(very good)
38.1%
(good)(2014)
36.7%
(good)(2015)
62%
(good) Benchmark
depends on age (2014)
63%
(good) Benchmark
depends on age (2015)
Chapter 1
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RATIOS FOR FINANCIAL SECURITY

Savings Rate =
$2,190+$14,600
= 15.4%
$109,000
Investment Assets to Gross Pay =
(good) ($2,190 = Employer Match)
$177,000+$30,000
=
$109,000
1.90 times (weak)
401(k) Savings
Employee Elective Deferral
Employer Match
Total
$14,600
$2,190
$16,790
Chapter 1
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PERFORMANCE RATIO
Return on 401(k) =
$89,600 ($86,000+$16,790)
= (-15.5%)(poor)
$86,000
$175,600 ($177,000+$16,950+$2,190)
=
$177,000
(-11.6%)(very poor)
Chapter 1
90
THE TWO-STEP APPROACH
The two-step approach is to cover the risks and then save and invest.
It looks at personal risks as potentially leading to catastrophic loss or dependence

on someone else for financial well being.
The two-step approach considers savings and investments as the path to financial
security or independence.
Chapter 1
91
THE TWO-STEP APPROACH

THREE-PANEL METHODOLOGY
Panel 1
Panel 2
Panel 3
Risk Management of
Personal, Property, &
Liability Risks
Short-Term Savings &

Investments & Debt
Management
Long-Term Savings &

Investments
Evaluate the need for &

quality of personal
insurance:
Evaluate the adequacy

of:
Evaluate the adequacy of

progress toward:
1. The emergency fund

2. The proportion of
income spent on
housing
3. The proportion of
income spent on debt
other than housing debt
repayments
1. The retirement goal

The savings rate
Investment assets
2. The education funding
goal
3. Any large purchase
goal
4. Legacy goals
Documents
Financial
1.
2.
3.
4.
Life Insurance
Health Insurance
Disability Insurance
Long-term care
insurance
5. Property Insurance
Homeowners
Auto
Other property
6. Liability Insurance
Chapter 1
92
METRICS APPROACH
The metrics approach provides quantitative example benchmarks for the financial
planner and client to use as guidance for achieving comprehensive financial goals
and objectives.
The following slides present common benchmarks for:
Risk management
Short-term Savings
Long-term Savings
Chapter 1
93
RISK MANAGEMENT DATA

Metric
Comment / Recommendation
Life Insurance
12-16 times gross pay, if needed
See Ch. 4 for more info.
Health Insurance
Lifetime benefits > $1,000,000
Disability Insurance
60-70% of gross pay and at least

guaranteed renewable
Covering both sickness &

accident & a hybrid or own
occupation definition &
appropriate elimination period
Long-Term Care Insurance
If needed, daily or monthly benefits

< average for appropriate facility
Benefits inflation adjusted & a

benefit period > 36-60 months
Homeowners Insurance
< full replacement value on both

dwelling & content & coverage for
open perils
Automobile Insurance
< fair market value for

comprehensive & collision
Liability Insurance
At least a $1,000,000 personal

liability policy
Need sufficient underlying

homeowners & auto liability to
satisfy PLUP issuer
Chapter 1
94
SHORT TERM SAVINGS AND INVESTMENT GOALS

Short-Term Savings and Investment Goals
Emergency Fund
Equals to 3 6 times the

monthly nondiscretionary
cash outflows.
Housing
Housing ratio 1 should be

< 28% of gross pay.
Housing ratio 1 should

decline to < 5% of gross
pay at retirement.
Housing and Debt
The total paid for housing

costs and other debt
payments < 36% of gross
pay.
Other debt payments

include, but not limited to,
credit cards, auto loans,
and student loans.
Chapter 1
95
LONG TERM SAVINGS AND INVESTMENT GOALS

Long-Term Savings and Investment Goals
Financial Security
(Retirement)
Save 10-13% of gross pay

(include employer match)
Have an appropriate amount

of investment assets relative
to gross pay for the clients
age.
College Education
Funding
Save $1,000 / $3,000 / or

$6,000 per child per year for 18
yrs. in a balanced portfolio
(60% stocks/4o% fixed
income).
Savings is dependent on
where the child is expected to
attend college (in state/midprivate/elite-private).
Lump-Sum Goals
Goals like 2nd home, airplane,

or boat require savings of at
least 20% of the total price as a
down payment.
This additional goal will

increase the overall savings
rate required to achieve all the
goals.
Legacy Goals
Every client under age 50 needs

basic documents. Those 50 and
over may need trust & estate
planning.
Basic documents include a

will, durable power of
attorney for healthcare,
advanced medical directive
(living will).
Chapter 1
96
RISK TOLERANCE AND ASSET ALLOCATION (1 OF 5)
Financial Planners employ tools to assess the clients willingness to accept investment
risk, thus helping to determine the clients risk tolerance as part of the investment
planning process.
Dr. William Droms, CFA, the Power Professor of Finance in the McDonough School
of Business at Georgetown University and a principal at Droms Strauss Advisors, Inc.
has granted us permission to use his Global Portfolio Allocation Scoring System
(PASS).
PASS considers both time horizon and risk tolerance in determining an appropriate
asset allocation.
Chapter 1
97

Step 1: Have the client answer the following questions, which have scores ranging from 5 to 1.
Chapter 1
98

Step 2: Determine the time horizon of the investment goal and then to use the PASS
score to determine the appropriate asset allocation.
Chapter 1
99

Asset classes with corresponding expected returns and expected standard deviations:
Expected Rates of
Return
Standard Deviation of
Returns
Cash and Money Market Fund
2.5%
2.0%
Treasury Bonds / Bond Fund
4.0%
4.0%
Corporate Bonds / Bond Fund
6.0%
5.0%
International Bond Fund
7.0%
6.0%
Index Funds
9.0%
14.0%
Large Cap Funds / Stocks
10.0%
16.0%
Mid / Small Funds / Stocks
12.0%
18.0%
International Stock Funds
13.0%
22.0%
Real Estate Funds
8.0%
12.0%
Chapter 1
100

This chart reflects the condensed asset classes and weightings with the corresponding
expected return and estimated standard deviation for each portfolio.
Chapter 1
101
THE PRESENT VALUE OF ALL GOALS APPROACH

The Present Value of All Goals Approach
Takes each short, intermediate, and long-term goal, determines each individual
present value, then sums these present values together and then reduces them by
current resources (investment assets and cash and cash equivalents) and then treats
the net PV as an obligation to be retired over the remaining work life expectancy at
a discount rate equal to the expected portfolio rate of return.
Chapter 1
102
PRESENTATION OF THE PRESENT VALUE OF ALL GOALS

APPROACH (1 OF 2)
When presenting the Present Value of All Goals Approach, it is useful to present values
at various times and both the overall savings requirements and specific goal savings
requirements.
Chapter 1
103
PRESENTATION OF THE PRESENT VALUE OF ALL GOALS

APPROACH (2 OF 2)
Present Value
Annual
Savings
Required*
Annual
Savings
Required**
#1 Retirement
$300,000
$28,926.65
$28,926.65
# 2 Education
$195,000
$18,802.32
$23,652.89
# 3 Second Home****
$100,840
$9,723.21
$9,732.21
TOTAL
$595,840
$57,452.18
N/A
($200,000)
($19,284.43)
N/A
$395,840
$38,167.75
N/A
Goal
Current Resources***
Net Needs
* Savings on an annual ordinary annuity basis over the remaining work life expectancy.
** Savings required to the beginning of the draw down.
*** Current resources include investment assets and cash and cash equivalents.
**** Assume the money is needed in 14 years.
Chapter 1
104
EXAMPLES OF INSURANCE RECOMMENDATIONS

Insurance Recommendations (Impact on Cash Flows)
No Cash Flow Impact

Change name of beneficiary
Assign policy to another
Stop driving uninsured vehicle
Clarify the lifetime benefits of an employer provided health plan
Positive Annual Cash Flow Impact

Raise deductibles (e.g., auto)
Eliminate duplicate coverage (e.g., disability)
Reduce coverage (e.g., home value declined)
Replace one policy for another (e.g., term life)
Negative Annual Cash Flow Impact

Purchase life, health, disability, long-term care, property, or liability
insurance
Increasing the amount of current coverage
Lowering deductibles
Chapter 1
105
DEBT MANAGEMENT
Frequently people have too much debt, or debt that has high interest rates, and debt that
is generally not well managed.
Good debt has two components:
The interest rate is relatively low in comparison to expected inflation and

expected investment returns.
The expected payback period is substantially less than the expected economic life
of the asset.
Reasonable debt is where the payback period is longer or the returns on the debt are no
doubt positive, but less certain.
Bad debt can involve high interest rates or when the economic life of a purchase is
exceeded by the associated debt payback period.
Chapter 1
106
SAVINGS AND INVESTING MANAGEMENT
The savings and investing management recommendations usually require both an

increase in savings and an increase in the emergency fund.
There are other areas of recommendations such as:
Estate planning documents (e.g., will, durable power of attorney for health
care, advanced medical directive).
Managing the withholding of taxes (W-4).
Adding income from part time jobs or changing jobs to earn more.
Annuitizing an annuity to create recurring income
Taking required minimum distributions from IRAs and qualified plans.
Beginning to draw Social Security retirement benefits.

Chapter 1
107
THE STRATEGIC APPROACH
The strategic approach is characterized by a client mission statement, a set of goals,

and a set of objectives.
A needs-driven list of client goals is created.
A detailed list of objectives is established that when taken in the totality, will result
in the accomplishment of the mission of the clients financial planning.
The strategic approach takes into consideration needs versus wants.
Chapter 1
108
MISSION STATEMENT
Achieving financial security is a formal statement of the purpose of the clients

financial planning.
Goals (broadly conceived goals):
Adequate risk management portfolio
Adequate savings rate for retirement and education
Adequate emergency fund
Adequate debt management
Adequate investment portfolio
Adequate estate plan
Chapter 1
109
OBJECTIVES
Risk Management
Debt Management
Tax Management and Emergency Fund
Savings and Investments
Estate Plan
Chapter 1
110
CHAPTER 4:
PERSONAL
FINANCIAL STATEMENTS
Chapter 1
PERSONAL FINANCIAL STATEMENTS
Primarily used as a scoring mechanism for capturing and analyzing an

individuals financial position and performance.
Financial statements include:
Balance Sheet
Income and Expense Statement
Statement of Cash Flows
Statement of Changes in Net Worth
Chapter 1
112
BALANCE SHEET
Listing of:
Assets
Property owned or partially owned by the client
Stated at the fair market value
Liabilities
Debt obligations owed by the client
Stated at principal outstanding balance
Net Worth
The difference between assets and liabilities
Balances are stated at a Moment in Time
Fixed date
Chapter 1
113
BALANCE SHEET
Assets fall into one of three categories on a personal balance sheet:
Cash, checking, money market, current assets (12 months or less to
maturity)
Includes any asset that the clients expects to convert to cash within one
year.
Investment Assets
Assets used to achieve client goals.
Stocks, bonds, mutual funds, retirement accounts, businesses.
Personal Use Assets

Personal residence, car, furniture, boat, clothing.
Assets used to maintain the clients lifestyle.
Chapter 1
114
BALANCE SHEET
Liabilities are classified according to the timing of when they are due.
Current Liabilities
Obligations that are due within the next 12 months.
This section excludes interest unless already incurred.
Examples of current liabilities include credit card and unpaid bills.
Long Term Liabilities
The remaining balance on any outstanding debt due beyond 12 months
is a long term liability.
Examples include mortgage on house, car loan, or boat loan.
Chapter 1
115
BALANCE SHEET EXAMPLE
Chapter 1
116
BALANCE SHEET
Examples - Impact on Net Worth
A client purchases $5,000 of furniture with cash.
No impact on net worth personal use assets (PUA) increase as cash

decreases.
Important Formula:
Assets Liabilities = Net Worth
Chapter 1
117
BALANCE SHEET
A clients stock portfolio increases in value by $3,000
Increased investment values increases net worth by $3,000.
Chapter 1
118
BALANCE SHEET
A client buys dinner on his credit card for $500
Current liabilities increase, therefore net worth decreases by $500.
Chapter 1
119
BALANCE SHEET
A client purchases a new car for $40,000 with a down payment of $5,000 in cash
No immediate impact on net worth, unless car depreciates immediately.
Cash decreases by $5,000.
Personal use assets increase by $40,000.
Liabilities increase by $35,000.
+35,000 (+35,000) = 0 change
Chapter 1
120
BALANCE SHEET
Limitations on the usefulness of the Balance Sheet
The Balance Sheet does not explain:
Why or how an asset increased.
Why or how an asset or liability was acquired.
Did the client buy more or did the asset appreciate?
Did the client purchase an asset or inherit the asset?
Change in net worth.
Was the change a result of added savings, inherited asset, appreciation of

assets, or debt retirement?
Chapter 1
121
STATEMENT OF INCOME AND EXPENSES

Listing of:
Income
Includes salary, interest, dividends, and business income
Savings
Deposits to retirement plans, education savings, and other savings
Expenses
Both variable and fixed expenses
The statement of Income and Expenses presents income and expenses Over a
Period of Time
Example: For the year ending 12/31/2015
Chapter 1
122
Chapter 1
123
Chapter 1
124

Limitations on the Statement of Income and Expenses
It does not consider:
The purchase or sale of an asset.
Only recurring income and expenses are included.
Typical budget line items, not asset purchases or sales.
Budget line items are monthly recurring expenses such as utilities,

mortgage, insurance payments, etc.
Asset purchases include stocks, mutual funds, car.
Chapter 1
125

Limitations on the Statement of Income and Expenses (continued)
It does not consider:
Employer contributions to retirement plans which can be significant.
Only employees contributions are captured and reported
It does not record the receipt or disbursement of gifts or inheritances.
Giving or receiving of gifts is excluded.
Receiving of inheritances is also excluded.
Chapter 1
126
STATEMENT OF CHANGES IN NET WORTH
Explains changes in net worth that do not affect cash and have not been recorded on the
Statement of Income and Expense or the Cash Flow Statement.
Essentially, this statement explains changes in net worth that do not affect cash.
Examples of transactions that appear on the Statement of Changes in Net Worth:
Assets that appreciated in value.
Assets that depreciated in value.
Gifts of assets other than cash that were given or received.
Inheritances of assets other than cash.
Chapter 1
127
STATEMENT OF CASH FLOWS

It explains how cash and cash equivalents were used or generated between two balance
sheets.
Essentially it captures transactions that impact cash.
The Statement of Cash Flows is an accounting tool to help explain changes in net
worth between two years balance sheets. The statement of cash flows captures
transactions that are not part of the balance sheet or income and expense statement, but
affected cash.
Chapter 1
128
IMPORTANCE OF BUDGETING
There are three important tips to being successful in preparing and using a budget:
Be realistic with spending behavior.
Budget a line item expense for miscellaneous expenses and unforeseen

expenses.
Being successful with a budget takes practice.
Chapter 1
129
BUDGET PROCESS
The budgeting process consists of the following steps:
Establish goals with the client.
Determine the clients income for a time period.
Determine expenses, both fixed and variable.
Determine whether the net discretionary cash flow is positive or negative.
Present expenses as a percentage of income for the time period being presented.
Chapter 1
130
FINANCIAL STATEMENT ANALYSIS

Financial statement analysis provides insight into a clients financial strengths and
weaknesses.
Allows planners to answer questions related to:
How well does the client manage debt?
How well is the client progressing toward financial goals?
What is the clients ability to meet short-term obligations?
Limitation to financial statement analysis:

Only provides planners with a historical perspective, it is not predictive of
the future.
Chapter 1
131
FINANCIAL STATEMENT ANALYSIS

Financial statement analysis includes:
Vertical analysis
Horizontal analysis
Ratio analysis
Chapter 1
132
VERTICAL ANALYSIS
Vertical analysis lists each line item on the income statement as a percentage of total
income and presents each line item on the balance sheet as a percentage of total assets.
Chapter 1
133
HORIZONTAL ANALYSIS
Horizontal analysis lists each item as a percentage of a base year and presents multiple
years over time.
Year
2010
2011
2012
2013
2014
2015
Income
100%
105%
115%
125%
127%
128%
Year
2010
2011
2012
2013
2014
2015
Income
100%
105%
115%
125%
127%
128%
Golf Expense
100%
110%
120%
130%
140%
150%
Chapter 1
134
RATIO ANALYSIS
Financial statement ratio analysis is both art and science. The science is in calculating
the ratio, but the art is actually in deriving meaning and insight from the ratio.
Objective of ratio analysis:
Gain additional insight into the financial situation and behavior of the client.
Generate questions for the client to answer to further gain insight.
Chapter 1
135
CATEGORIES OF RATIOS
Liquidity Ratios
Measure ability to meet short term or current liabilities.
Debt Ratios and Debt Analysis
Indicate how well a person manages debt.
Performance Ratios
Assess the financial flexibility of the client, as well as the clients progress
towards goals.
Chapter 1
136
LIQUIDITY RATIOS
Emergency Fund Ratio:
Emergency Fund =

Monthly NonDiscretionary Expenses
Measured in number of months, how long the client can meet living expenses, using
only current or liquid assets.
Target benchmark of 3 to 6 months is appropriate.
Current assets are listed on the balance sheet.
Monthly nondiscretionary expenses are those expenses that continue, even if you
lose your job.
Mortgage, car loan, food, utilities, gas, insurance premiums
Chapter 1
137
LIQUIDITY RATIOS
Current Ratio:
Current Ratio =

Current Liabilities
Measure clients ability to meet short term obligations.
Target of 1.0 to 2.0 is appropriate.
Current assets and liabilities are listed on the balance sheet.
By increasing the emergency fund (current assets), a client may improve the current
ratio as well.
Chapter 1
138
DEBT RATIOS
Housing Ratios
28% Ratio measures how much of current income is spent on housing.
36% Ratio measures how much of current income is spent on housing and debt
repayments.
Housing ratios are used by lenders to determine if a borrower qualifies for a

conventional mortgage.
Chapter 1
139
DEBT RATIOS
Housing Ratios 1 (Basic) 28% Target Benchmark
HR1 =
Monthly Housing Costs (P+I+T+I)

28% Target
Monthly Gross Income
P = Principal
I = Interest
T = Taxes (Property)
I = Homeowners Insurance
Chapter 1
140
DEBT RATIOS
Housing Ratios 2 (Broad) 36% Target Benchmark
HR2 =
Monthly Housing Costs (P+I+T+I)

+ All Other Recurring Debt Payments
36% Target
Monthly Gross Income
P = Principal
I = Interest
T = Taxes (Property)
I = Homeowners Insurance
Chapter 1
141
DEBT RATIOS
Importance of 28/36 ratios
Consider a client earning $250,000 per year, with a combined marginal tax bracket of
40% and 28/36 ratios of 35/45%:
100% Salary
(40%) Taxes
(45%) 36% Ratio
15% Net % remaining after taxes and broad housing ratio
Only 15% of income is available for education, retirement savings, living expenses
such as food, utilities, clothing. This client could be one catastrophic event away from
bankruptcy.
Chapter 1
142
PERFORMANCE RATIOS
Savings Rate
Annual Savings (Employee + Employer Contributions)
Annual Gross Income
Target of 10-13% depending on the age when the client starts saving.
If a client waits to begin saving at 45 or 50, the rate may be 15-20%.
Its important to include employer contributions to 401(k), profits sharing plans,

etc.
Chapter 1
143
INVESTMENT ASSETS AS A % OF GROSS PAY BENCHMARK

Benchmark:
(Invested Assets
Gross Pay)
Description: Measures an individuals

progress towards retirement based upon
current age.
Age
Ratio of Invested Assets

Gross Pay
25
0.20 : 1
30
0.6 0.8 : 1
35
1.6 1.8 : 1
45
34:1
55
8 10 : 1
65
16 20 : 1
Chapter 1
144
RETURN ON INVESTMENTS (ROI)

The return on investments (ROI) ratio is a critical performance ratio, which:
Measures the compounded rate of return on a clients investments.
I1 (I0+Savings)
I0
I0 = Beginning Investments
I1 = Ending Investments
S = Savings (include employer match)
Benchmark 8-10% or 6-8% depending on risk tolerance and time horizon.
Chapter 1
145
LIMITATIONS OF FINANCIAL STATEMENT RATIO ANALYSIS

Inflation
Makes it difficult to compare financial statements from one period to the next.
Use of Estimates
Any type of net worth calculation includes personal use assets. Typically the
value of these assets is only an estimate.
Benchmarks
Very few benchmarks have been established for personal financial ratios.
Very few benchmarks have been established for individuals.
Always important to conduct sensitivity analysis.
Conduct Monte Carlo Analysis

Chapter 1
146

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1

Michael A. Dalton | James F. Dalton | Joseph M. Gillice | ThomasChapter

Fundamentals of Financial Planning

Fundamentals of Financial Planning

INTRODUCTION TO FINANCIAL PLANNING

Fundamentals of Financial Planning

THE FINANCIAL PLANNING PROCESS

Gather Client Data

Develop & Present

Fundamentals of Financial Planning

CONTENTS OF THE PLAN

Financial planning concepts include:

An evaluation of the clients risk management portfolio

Financial statement preparation and analysis

Emergency fund and debt management

Long-term goal planning (Retirement, education, legacy)

Income tax planning

The investment planning portfolio

Fundamentals of Financial Planning

ESTABLISHING AND DEFINING THE

Address the client formally

Actively listen to the client

Respect the clients time

To establish a trusting relationship, the planner can generally share prior

Fundamentals of Financial Planning

ESTABLISHING AND DEFINING THE

Fundamentals of Financial Planning

Fundamentals of Financial Planning

ESTABLISHING AND DEFINING THE

A description of the mutually agreed upon services

The time horizon for the work to be completed

A description of the fees and costs

The obligation and responsibilities of each party

Description of the understanding concerning the use of proprietary products

Fundamentals of Financial Planning

ESTABLISHING AND DEFINING THE

Activities that are typically part of a comprehensive plan would include:

Preparation and analysis of personal financial statements

A review of all risk management

An evaluation of short term financial goals

The establishment of long term goals

An evaluation of the current investment portfolio

An examination and recommendation regarding any special needs situation

Fundamentals of Financial Planning

GATHER CLIENT DATA

Qualitative data is how a client feels about something.

Quantitative data contains specific measurable attributes.

Fundamentals of Financial Planning

GATHER CLIENT DATA

The insurance portfolio

Banking and investment information

Retirement and Employee Benefits

Personal financial statements if available

Fundamentals of Financial Planning

GATHER CLIENT DATA

General attitude towards spending

Fundamentals of Financial Planning

GATHER CLIENT DATA

Local insurance costs

Local cost of living

Expected inflation rate

Expected rate of increase in the prices of education and medical care

Legislation that may impact certain industry sectors