Basics of Personal Financial Planning [date] [venue] [contact information] 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 entities • The CPA/Personal Financial Specialist (PFS) credential distinguishes CPAs as subject-matter experts who have demonstrated their financial planning knowledge through experience, education and testing Personal Financial Planning Section 2 Today’s Objectives You gain an enhanced understanding of the basics of financial planning and how a company’s compensation and benefits programs add to your financial well-being You gain an enhanced understanding of basic investing concepts and how to develop your investment plan You gain an enhanced understanding of how a Company’s compensation and benefits programs can contribute to the success of your investing You identify and commit to taking the actions you can to significantly enhance your financial well-being Personal Financial Planning Section 3 Life Events: Will You Be Ready? • Premature Death • Retirement • Serious Illness • Death of Spouse • Aged Parents • Children Getting Married • Second Home • Remarriage • Starting a Business • Divorce • Paying for College • Job Loss • Relocation • Home Purchase • Birth of Children • Marriage • Temporary Disability Personal Financial Planning Section 4 Life’s Financial Trade-Offs CURRENT NECESSITIES FUTURE NECESSITIES Basic shelter, food Basic shelter, food clothing, transportation clothing, cash for emergencies and medical care and nursing home care Trade-offs CURRENT EXTRAS FUTURE EXTRAS New kitchen, new car, Larger home, private vacation, family gifts college, retirement travel, bequests/charity Personal Financial Planning Section 5 The Value of a Financial Plan A financial plan will help you to clarify: Your financial goals Strategies to achieve the goals Specific steps to implement the strategies Personal Financial Planning Section 6 Areas to Explore Saving Managing debt Insurance Investing Education funding Personal Financial Planning Section Retirement funding Pre-retirement planning Incapacitation planning Estate planning Company stock ownership 7 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? Personal Financial Planning Section 8 What Do You Want? These are your financial planning goals Each goal will have its own horizon • For the period of accumulation • For the period over which it will be spent Make a list and refine as you go along Start with broad ideas and work toward increasingly specific and measurable goals Personal Financial Planning Section 9 What Will You Have? What you have now What you will save from future income Future investment earnings on the above if invested Expected future benefits Personal Financial Planning Section 10 Managing Debt What Managing Debt Means Conquering excessive debt Using debt wisely: • • • • • Credit cards 401(k) plan loans Home mortgages Home equity loans Automobile debt Maintaining a good credit history Personal Financial Planning Section 12 Debt Ratios Housing expense ratio • Housing expenses (mortgage, taxes and insurance) should not exceed 28% of gross pay • Gross pay is before taxes and deductions Debt to income ratio • Total consumer debt (not including mortgage) should be less than 20% of take-home-pay • Take-home pay is after taxes and deductions Personal Financial Planning Section 13 Warning Signs of Too Much Debt Unable to save 10% or more of gross income Habitually pay only the minimum monthly payments on your credit cards Borrowed from one lender to pay another Asked a friend or relative to co-sign a loan because credit record is weak Unable to figure out how much you owe Would be in immediate financial trouble if you lost your job tomorrow Personal Financial Planning Section 14 Conquering Debt Stop borrowing Start using a debit card Prioritize your debt repayment Seek lower rates Determine the maximum you can pay Repay highest cost debt first Continue paying the maximum Personal Financial Planning Section 15 Decrease Debt or Invest? Pay down debt when you can’t invest at a higher rate 401(k) Interest Paid / Received Match* Credit Card Investment Mortgage 100.0% 18.0% 8.0% 6.5% -- 0.0% -2.0% -1.6% 100.0% 18.0% 6.0% 4.9% Tax effect @ 25% Net Paid / Received * 100% of first 3% of your pre-tax regular contributions for ABC Company. Personal Financial Planning Section 16 Using Home Mortgages Wisely Determining whether buying is appropriate Choosing the right type of mortgage Deciding if you should refinance Knowing whether to pay points Deciding whether to prepay mortgage principal Personal Financial Planning Section 17 Is Buying a Home Right for You? Buying Renting Change location frequently No Yes Maintenance responsibilities Yes No Ability to customize Yes Perhaps Payment increases Perhaps Likely Investment element Yes No Tax benefits Yes No Initial costs Yes Yes Personal Financial Planning Section 18 Tax Benefits of Home Ownership Mortgage interest Property taxes Other itemized deductions Total itemized deductions Less: standard deduction you would have received had you not owned a home Extra amount you can deduct Times: your tax rate Your tax savings Personal Financial Planning Section $6,000 2,000 4,250 12,250 -4,750 7,500 25% $1,875 19 Types of Mortgages 10.0% 9.0% Rate 8.0% 7.0% Fixed Rate 6.0% Adjustable Rate 5.0% 4.0% 3.0% 1 5 9 13 17 21 25 29 Year Personal Financial Planning Section 20 Consider a Fixed Rate Mortgage When: You intend to live in your home for a significant period of time, or You anticipate rising interest rates in the future Personal Financial Planning Section 21 Consider an ARM When: Fixed rate is at least 2% points greater than adjustable rate You expect your income will increase enough to cover any potential payment increases You expect to move before the rate increases (beware of prepayment penalties) Personal Financial Planning Section 22 Prepaying Mortgage Principal 400 $170,257 360 350 300 250 210 $89,279 200 Standard Payment Standard Payment Additional $150 Per Additional $150 Per Month Month 150 100 50 360 210 $0 $0 0 NumberofofPayments Payments Number Total TotalInterest InterestPaid Paid Assumes a 30 year fixed-rate mortgage of $100,000 at 8.25% Personal Financial Planning Section 23 Consider Prepaying Principal When: You use the standard deduction You invest conservatively Personal Financial Planning Section 24 Maintaining a Good Credit History Establish a good credit history Obtain your credit report Understand your credit report Correct mistakes in your credit report Personal Financial Planning Section 25 Saving & Investing Importance of Saving and Investing If you don’t have the following • Sufficient assets fully devoted to your goal(s) • Expected future benefits from third parties • Expected future borrowing Then you will need the following to reach your goal(s) • Future savings devoted to your goals • Future earnings from investing the above if you invest those assets Personal Financial Planning Section 27 Key Saving and Investing Concepts Saving versus investing Combining saving and investing Saving and investing early Tax-deferred saving and investing Tax-deductible saving and investing Saving and investing using employer contributions Personal Financial Planning Section 28 Saving Versus Investing Saving Investing Means Not spending money Doing something with money to earn a return Needs to be done In a regular, disciplined manner Carefully and with due consideration Personal Financial Planning Section 29 Combining Saving and Investing Stan Saves $2,000 per year Starts at age 25 Saves in a non-interest bearing account Personal Financial Planning Section Vickie Saves $2,000 per year Starts at age 25 Invests and earns an 8.9% pretax and 6.68% after-tax return 30 Combining Saving and Investing Save Only Save and Invest $400,000 $367,307 $350,000 Stan $300,000 Vickie $250,000 $200,000 $120,748 $150,000 $80,000 $100,000 $50,000 $30,000 $49,018 $50,000 $0 In 15 Yrs Personal Financial Planning Section In 25 Yrs In 40 Yrs 31 Saving and Investing Early Stan Saves $2,000 per year Starts at age 35 Continues for 30 years Invests and earns an 8.9% pre-tax and 6.68% after-tax return Personal Financial Planning Section Vickie Saves $2,000 per year Starts at age 25 Stops after 10 years Invests and earns an 8.9% pre-tax and 6.68% after-tax return 32 Saving and Investing Early Save Later for 30 Years Save Early for 10 Years $198,000 Vickie $188,000 $178,227 $178,000 189,080 Stan $168,000 At 65 Personal Financial Planning Section At 65 33 Tax-Deferred Earnings Stan Saves $2,000 per year Starts at age 25 Continues for 40 years Invests in a taxable account and earns an 8.9% pre-tax and 6.68% after-tax return Personal Financial Planning Section Vickie Saves $2,000 per year Starts at age 25 Continues for 40 years Invests in a Tax-Deferred account and earns an 8.9% pre-tax return 34 Tax-Deferred Earnings Taxable Account Tax-Deferred Account $600,000 $493,435 $500,000 $400,000 $367,307 Stan Vickie $300,000 $200,000 $100,000 $0 At Age 65 Personal Financial Planning Section At Age 65 35 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? Personal Financial Planning Section 36 What Do You Want? Identify your specific savings goals Identify your time horizon Quantify your saving goals Prioritize your saving goals Personal Financial Planning Section 37 Identify Your Specific Saving Goals Pay down existing debt Create an emergency fund Save for retirement Accumulate a down payment for a house Build a college fund for your children’s education Set aside money for a specific goal (vacation, fun and games, etc.) Personal Financial Planning Section 38 Create an Emergency Fund Set aside 2 to 4 months of living expenses Use it for a crisis (i.e., roof leaks) Use it and replace it Don’t use it for discretionary spending (i.e., vacation) Personal Financial Planning Section 39 Save for Retirement Do everything possible NOW Start early—you’ll end up with more Personal Financial Planning Section 40 Identify Your Time Horizon Identify number of months or years until goal Allow as much time as possible: • You can accept a lower investment risk • Your monthly saving and investing commitment will be less Personal Financial Planning Section 41 Examine Your Spending Habits Keep a list of all spending for one month Compare total spending to take-home pay Examine closely if you have a substantial unexplained gap Become highly knowledgeable about your expenses Personal Financial Planning Section 42 Identify Ways to Save More Save your next raise Save your next bonus Reinvest dividends and interest Save all cash gifts Rent instead of buying (books, videos, etc.) Personal Financial Planning Section Delay buying a new car upon paying off present car loan Save the “donut money”— and lose weight! Buy generic products Trim your spending by 5% Be creative 43 What About Investing? Combined with savings, a key resource for achieving your financial goals Investing skills are needed to prudently utilize • Company 401(k) investments • IRAs investments • Savings invested outside these plans All investments involve risks Approach investing carefully Personal Financial Planning Section 44 What Investing Carefully Means Phase I: Learn investing basics Phase II: Develop your investment plan Phase III: Implement your investment plan Personal Financial Planning Section 45 Investing Basics and Planning Why Learn Basic Investing Concepts? ALL investments involve risks • Even so-called risk-free investments like a cash As such, approach investing carefully Learning basic investing concepts is part of investing carefully Personal Financial Planning Section 47 What Are The Major Asset Classes? Major Asset Class Cash Characteristics Matures in less than one year Bonds Fixed income Stocks Varied maturities Company ownership Hard assets Asset ownership Goals Capital preservation Liquidity Income Capital preservation Possible dividend income Capital appreciation Capital appreciation Historical Average Returns* 3-4% 5-7% 10-13% Varies Inflation hedge * Pretax return over 75 years through 2008 Personal Financial Planning Section 48 What Risks are Involved in Investing? Primary long-term risk Inflation risk Loss of purchasing power Primary short-term risk Volatility risk Instability of investment Business risk Inherent risks of a particular business Market risk Likelihood that the market as a whole will fall Liquidity risk Risk of not being able to access money when needed Interest rate risk Loss of principal on fixed-rate investments due to rising interest rates Currency risk Investment’s value will be affected by changes in exchange rates Other risks Personal Financial Planning Section 49 How are These Risks Managed? Primary long-term risk Inflation risk Invest in stocks Primary short-term risk Volatility risk Hold investments for the longterm Business risk Diversify within an asset class Market risk Diversify among asset classes Liquidity risk Diversify among asset classes Other risks Have an emergency fund Interest rate risk “Ladder” portfolios Currency risk Diversify among countries or hedge Personal Financial Planning Section 50 However, Stocks Have More Volatility Risk Higher Return 20% 15% Annual Return Small Company Stocks Large Company Stocks 10% 5% Cash Intermediate-Term Government Bonds Lower Return Lower Deviation Personal Financial Planning Section Degree of Volatility Higher Deviation 51 Manage Volatility Risk by Investing Over Time 150% 125% Volatility Risk Over Time Ranges of Return 100% One-Year Holding Periods Five-Year Holding Periods Twenty-Year Holding Periods Average Return 75% 50% 25% 12.7% 0% 10.4% 3.7% 5.4% -25% -50% -75% Small Company Stocks Large Company Stocks Long-Term Government Bonds Cash Range of compound annual returns over the period 1926-2002. Source: Ibbotson Associates, 2004. Personal Financial Planning Section 52 Managing Business and Market Risks Portfolio Risk Portfolio Risk= Market Risk + Business Risk Business Risk Market Risk Number of Holdings 3 Personal Financial Planning Section 5 7 9 11 13 15 53 Manage Liquidity Risk by Diversifying Return Current Deferred Real Estate Bonds Money market funds Convertible bonds Certificates of deposit Small-company stocks Large-company stocks Utility stocks Lower Personal Financial Planning Section Liquidity Risk Zero coupon bonds Higher 54 Managing Interest Rate Risk Price Interest Rates Bonds Managed by “Laddering” Portfolio of Bonds Personal Financial Planning Section 55 Risk / Return Trade-Offs: Example 1 Degree of Volatility Higher Return 20% 15% Annual Return Small Company Stocks Large Company Stocks 10% 5% Cash Intermediate-Term Government Bonds Lower Return Lower Deviation Personal Financial Planning Section Degree of Volatility Higher Deviation 56 Risk / Return Trade-Offs: Example 2 Cash vs. Bonds vs. Stocks Current yield Appreciation Total return Estimated income taxes @ 30% After-tax return Inflation rate After-tax “real” rate of return Relative risk Personal Financial Planning Section Cash Bonds Stocks 3.3% 0.0% 3.3% (1.0)% 2.3% (3.1)% (0.8)% 4.8% 0.0% 4.8% (1.4)% 3.4% (3.1)% 0.3% 2.2% 6.5% 8.7% (2.6)% 6.1% (3.1)% 3.0% Low Medium High 57 Risk / Return Trade-Offs: Example 3 Sub-Categories Within Major Asset Classes High Risk/ High Return Potential Hard Assets Stocks Bonds International Small Company Stocks Large Company Stocks Long Term Intermediate Term Short Term Low Risk/ Low Return Potential Cash Personal Financial Planning Section 58 Risk / Return Trade-Offs: Example 4 Taxable vs. Tax-Exempt Investments Tax-Exempt Returns Tax-Rate 3.0% 4.0% 5.0% 6.0% 7.0% Tax-Equivalent Returns 10.0% 3.3% 4.4% 5.6% 6.7% 7.8% 15.0% 3.5% 4.7% 5.9% 7.1% 8.2% 25.0% 4.0% 5.3% 6.7% 8.0% 9.3% 28.0% 4.2% 5.6% 6.9% 8.3% 9.7% 33.0% 4.5% 6.0% 7.5% 9.0% 10.4% 35.0% 4.6% 6.2% 7.7% 9.2% 10.8% Personal Financial Planning Section 59 Risk / Return Trade-Offs Between Differing Portfolios Portfolio A Portfolio B Portfolio C Portfolio A Portfolio B 6.61% Return 7.06% Return Risk 4.25% 6.61% Return Risk 4.25% Risk 3.6% Return Risk* 6.61% 3.60% Return Risk* 6.61% 4.25% Cash 25% Cash 0% Large Cap Eq. 25% Fixed Inc. 58% Fixed Inc. 25% Inter'l Eq. 0% Portfolio C Small Cap Eq. 25% ReturnRisk* 7.06% 4.25% Cash 0% Large Cap Eq. 22% Small Cap Eq. 6% Inter'l Eq. 14% Large Cap Eq. 27% Fixed Inc. 48% Small Cap Eq. 7% Inter'l Eq. 18% * Risk = one standard deviation Personal Financial Planning Section 60 What One Factor Most Influences Your Return? Your Asset Allocation Asset Allocation (91%) Specific Bond & Stock Selection (6%) Market Timing (2%) Other (1%) Source: Brinson, Singer, Beebower Personal Financial Planning Section 61 What Most Influences Your Asset Allocation? Your desired rate of return Your risk tolerance Your time horizon Stan Stan and Vickie are different…their asset allocations will be different too. Personal Financial Planning Section Vickie 62 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 take Desired Return Personal Financial Planning Section Likely Risk 63 Importance of Your Risk Tolerance The higher your risk tolerance the more aggressive you can be Be More Aggressive Risk Tolerance Be More Conservative Personal Financial Planning Section 64 Importance of Your Time Horizon Longer time horizons (5 or more years) can absorb the ups and downs of investing more heavily in stocks Shorter time horizons warrant investing more heavily in less volatile investments Use more volatile stocks Use less volatile investments Time horizon Personal Financial Planning Section 65 Developing Your Investment Plan 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 Personal Financial Planning Section 67 What Do You Want? • Your goal in today’s dollars • Take into account • Number of years to your goal • Expected inflation rate • What you want • To arrive at Be sure to include important others in deciding what you want. Personal Financial Planning Section 68 How do You Define Your Goals? Each goal will have its own time horizon • For the period of accumulation • For the period over which it will be spent Make a list and refine as you go along Start with broad ideas and work toward increasingly specific and measurable goals Personal Financial Planning Section 69 What Will You Have? • Current assets set aside for your goal • Take into account • Number of years to your goal • Future saving • Expected return on your invested assets • Expected future benefits • What you will have • To arrive at Personal Financial Planning Section 70 Where Should You Save First? 1. Your Employer 401(k) Plan (at least to the % that gives you the maximum employer match – free money for you) 2. Roth IRA using after-tax contributions or Traditional IRA using pre-tax contributions, depending on your circumstances* 3. 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. Personal Financial Planning Section 71 Why These Priorities? Vickie Salary $50,000 Roth IRA Using After-Tax Contributions $50,000 Pre-tax $ $2,667 $2,667 Tax at 25% $667 $667 After-tax $ $2,000 $2,000 Employee contribution $2,000 $2,000 $2,667 $2,667 Taxable Account Traditional IRA Using Pre-Tax Contributions $50,000 Employer 401(k) Plan $50,000 $2,667 $2,667 Employer match – assume 3% Total contribution n/a n/a n/a $1,500 $2,000 $2,000 $2,667 $4,167 % of salary contributed 4.00% 4.00% 5.33% 8.33% Outcome $178,227 Personal Financial Planning Section What Happens? 72 Why These Priorities? Vickie Account Balance in 30 Years $600,000 $557,504 $500,000 $400,000 $356,819 $267,580 $300,000 $200,000 $178,227 $100,000 $0 Taxable Account Roth IRA Using After-Tax Contributions Personal Financial Planning Section Traditional IRA Using PreTax Contributions Employer 401(k) Plan 73 Why These Priorities? Vickie Available After-Tax in 30 Years $500,000 $418,128 $400,000 $300,000 $200,000 $267,580 $267,614 $178,227 $100,000 $0 Taxable Account Roth IRA Using After-Tax Traditional IRA Using PreContributions Tax Contributions Personal Financial Planning Section Employer 401(k) Plan 74 Consider Tax-Advantaged Accounts First Features Available Tax-Deferred contributions Tax-Deferred earnings Employer contributions Unlimited contributions Automatic saving and investing Wide-array of professionally managed funds Self-direction of fund allocation Immediate penalty-free withdrawal Employer 401(k) Plan No IRAs (1) (1) No No 529 Plan No (2) No (3) Varies No No (1) No No (1) Depends on the type of IRA used. (2) Some states allow you to deduct your contributions. (3) Some states limit contributions. Personal Financial Planning Section 75 Then Consider Taxable Accounts Features Available Tax-Deferred contributions Tax-Deferred earnings Employer contributions Unlimited contributions Automatic saving and investing Wide-array of professionally managed funds Self-direction of fund allocation Buy Emplyr stock at a discount Buy Emplyr stock without fees Immediate penalty-free withdrawal Employer DESPP (1) No No No No Employer DTP (2) No No No No No Mutual Funds No No No Brokerage Accounts No No No No No No No No No No No (1) Discounted Employee Stock Purchase Plan (2) Direct Transaction Program Personal Financial Planning Section 76 Now Develop Your Preliminary Plan Question Answers = Plan Your 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)? Personal Financial Planning Section 77 Then Calculate Your Expected Return* Major Asset Class Cash Asset Allocation __________% Historical Return X 4% Estimated Return __________% Bonds __________% X 6% __________% Stocks __________% X 12% __________% Hard assets __________% X 8% __________% Total 100% __________% * Calculated for each account you are using to invest your savings. Personal Financial Planning Section 78 And Then the Future Value of These Items* Contribution Toward Goal Current assets set aside for your goal Future periodic savings/investing Expected future benefits Future Value Calculation Calculate the future value of this amount invested at your expected rate of return over your time horizon Calculate the future value of these payments at your expected rate of return over your time horizon Calculate 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. Personal Financial Planning Section 79 The Result is What You Will Have • Current assets set aside for your goal • Take into account • Number of years to your goal • Future saving • Expected return on your invested assets • Expected future benefits • What you will have • To arrive at Personal Financial Planning Section 80 Key Points to Remember Financial planning will help you clarify goals, strategies and action steps Determine whether you have too much debt and develop a plan to conquer it Make wise decisions about using debt Commit to saving and investing Save and invest early Pay yourself first Learn as much as you can about investing to develop a plan and invest according to your “comfort level” Personal Financial Planning Section 81 Questions? [insert contact information here] Special thanks to Kevin Roach, CPA/PFS of Texas A&M University for contributing content.