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Transcript of Personal Financial Planning H. Swint Friday, Ph.D., CFP Associate Professor of Finance College of...
Personal Financial Personal Financial PlanningPlanning
H. Swint Friday, Ph.D., CFP
Associate Professor of Finance
College of Business
Texas A&M University – Corpus Christi
Island Views
Why Plan?
“If you don't know where you are going,
you'll probably end up somewhere else.”
Yogi Berra
Millionaire Success Factors
Allocate time, energy and money efficiently Strive for financial independence rather than
social status by Living below your means Investing 20% of your annual income
Choose the right occupations
*The Millionaire Next Door
The Benefits of Financial Planning
Get control of your time, energy and finances Improved financial position Increased future financial security Accumulate wealth for heirs Reduced stress and better state of mind
The Financial Planning Lifecycle
Age
Income
10 20 30 40 50 60 70 80
Income Stream
Retirement/Estate
Tax
Savings/Investment
Benefits
Employment Periods
The Financial Planning Process
Assess current financial condition Develop realistic and measurable goals Prioritize financial goals Identify strategies to achieve goals Enact goal achieving strategies in rank order Monitor financial progress Reassess goals and priorities at different life
events
Controlling Expenses
"Diligence is the basis of wealth,
and thrift the source of riches."
Chinese proverb.
Living Below Your Means
How We Spend Our Income
Food 13.5%
Housing 33%
Transportation 18.6%
Apparel & services 4.7%
Health care 5.4%
Entertainment 4.9%
Personal insurance 1.1%
Pensions/Social Security 8.4%
Other 10.4%
A $ Spent is a Lot of $’s Not Saved
Monthly spending choices from age 30 to 65 One soft drink a day ($15) @ 8% return
$34,408
Dinner for 2 once a month ($60) @ 8% return $137,633
A Café Latte a day ($100) @ 8% return $229,388
The monthly payments on a Intrepid versus a Navigator ($348) @ 8% return $798,271
The Law of Large Numbers
Look to the large numbers to find savings Big Ticket Items
Housing Transportation
• Buy less than you can afford• Diversify portfolio by investing the difference
High Volume Expenditures Dining and Café Latte’s Entertainment and Clothing
• Cut back on the numbers• Find more cost effective substitutes
Pitfalls in Retirement Planning
Starting too late.
Putting away too little.
Investing too conservatively (especially when you are younger).
Investing too aggressively (at any age) Rule of Thumb at retirement (7 to 10 years of low
risk investments to cover living expenses)
Sources of Retirement Income
10%
29%
20%
41%
Government stillprovides the largestportion—right now.
Government Assistance, including Social Security
Income-Producing Assets
PensionsOther
Don’t Count on Social Security
The Baby Boomers Born between 1945 and 1964 The largest population segment Median Age of workforce is rising fast
• 1980 – Just below 35 years of age• 2005 – Projected to be 41 years of age
The Social Security Trust fund is projected to run out of funds within the next 3 decades
Long-term care and healthcare costs will continue to rise as population ages
Be Prepared for a Long Retirement
Life Expectancy and Retirement Age for the Average American Early 1950s
• Retire in late 60s• Live another 1.6 years
Late 1990s• Retire in Early 60s• Live another 14 years
Source: “Stocks for the Long Run” by Jeremy Seigel
Time is Money $$$
Who will have the most at retirement (65)? Little Lisa: Parents put $3000 into retirement
account at birth with no additional contributions
Prudent Paul: Starts investing $3000 a year at 18 making his last contribution at age 25
Procrastinating Pete: Pete waits until age 26 to start putting away $3000 a year until age 65.
• Assume 10% tax deferred return on investments• What about at a 7% tax deferred return?
It’s About Timing Too
Which investment will provide the best return?
Fund Annual Return
Standard Deviation
Growth of $10k over 20 Years
A 16.69%
18.19% $172,813
B 7.86% 15.74% $36,341
Things Are Not Always Rosy
News from the Financial Times When the index broke 10,000 points, investors
celebrated, brokers toasted each other … economist talked about new market paradigms where stocks could achieve unheard of valuations
Just months later, the dream ended as the index plunged a stomach churning 80% destroying the hopes of thousands of amateur investors drawn to the markets by years of easy profit.
• Taiwan during the bubble
Sound Familiar? (Nasdaq)
The Secret is Time
And Controlling Risk
Volatility creates uncertainty and eats up returns
Which Investment has the highest compound return?
Fund 1 2 3 4 Mean Std. Dev.
Period
Return
A 10% 10% 10% 10% 10% 0% 46%
B 20% 0% 20% 0% 10% 12% 44%
The Answer - Asset Allocation
The process of putting your eggs into a number of carefully selected baskets
– When some baskets fall as inevitably occurs, other baskets still have eggs
Source: Standard & Poor’s Micropal
1970s 1980s 1990s
U. S. Stock 5.88% 17.55% 17.90%
Bonds 5.52% 12.62% 9.70%
Foreign Stock 8.80% 21.99% 5.00%
Commodities 21.25% 10.67% 0.48%
Performance of Global Stock Index: 1921-1996
(Nominal Returns in U. S. Dollars, Percentage per Annum)
Index Arithmetic Return
Risk Monthly
Sharpe Ratio Geometric Return
Ending Wealth
U. S. Index 8.04% 16.19% 0.1433 6.95% $171.20
Non-U. S. Index - All Markets
7.28% 12.08% 0.1740 6.75% $146.20
Global Index - All Markets
7.76% 12.14% 0.1728 7.25% $211.20
Arithmetic Return: The monthly average return multiplied by 12.
Risk: The monthly standard deviation multiplied by the square root of 12.
Monthly Sharpe Ratio: The ratio of the monthly average return to the monthly standard deviation.
Geometric Return: Annualized holding period rate of return (Effective annual rate).
Ending Wealth: Reports value of $1 invested on December 1920 and held to December 1996.
All Markets: To account for the closure of several international stock exchanges during the sample period, a 75% loss is imputed in the month a market permanently disappears.
Table 7: Goetzmann and Jorion, (Journal of Finance, 1999)
**This is for illustrative purposes only and not indicative of any investment. Past performance is no guarantee of future results.
Gather Little By Little
“Wealth hastily gotten will dwindle, but those
who gather little by little will increase it.”
King Solomon
Dollar Cost Average Out the Bumps
Year Deposit
Total
Deposits Price
Shares
Bought
Total
Shares
Acct.
Value
1 $3,000 $3,000 $10 300 300 $3,0002 $3,000 $6,000 $7 429 729 $5,1003 $3,000 $9,000 $4 750 1479 $5,9144 $3,000 $12,000 $7 429 1907 $13,3505 $3,000 $15,000 $10 300 2207 $22,071
An Easy Solution - Mutual Funds
Dollar Cost Average Out the Bumps Mutual funds pool investor money and have a professional money manager invest for their benefit Financial returns
Advantages of mutual funds Diversification Convenience Generally low fees Professional management ???
Mutual Fund Categories
Aggressive Growth Growth Value Growth & Income Balanced Bond Money Market
Index International Global Sector Socially
Responsible
Mutual Fund Fees
Loads = sales commissions Front load – Max 8.5% Back load and CDSC – Max 6% No Load fund
12(b) – 1 Fees: Advertising and promotion Max: 1% of assets
Management and Operating Fees: Cover manager and ongoing expenses of operation funds Typically 0.25% to 1.5%
The Cost of Mutual Fund Fees Bill plans to invest $500 a month for his
retirement in 30 years and is considering the following funds.
Fund Load 12b - 1 Mgt Fee Gross E(R)
A 5% .25% 1.00% 10%
B 0% 1.00% 1.00% 10%
NL 0% 0% 1.00% 10%
And the Results are
Fund A Fund B Fund NL
Investment
Months
360 360 360
Monthly Return 8.75%/12 8.00%/12 9%/12
Monthly Contribution
$475 $500 $500
Future Account Value
$825,603 $745,180 $915,372
Basic Retirement Accounts
Roth IRA Contribution: $3,000 max per person up to earned
income. Increase in the future No deduction but tax free withdrawals Phase-outs: 95k-110k single & 150k-160k married 10% penalty and tax on earnings for early
withdrawal before age 59 ½ or permanent disability
Penalty free withdrawal for first time home buyer or higher education expenses
Rule of thumb: Current tax rate < Retirement tax rate
Basic Retirement Plans - continued
Regular IRA Contribution: $3000 max per person up to earned
income. Increases in the future Contribution tax deductible; withdrawals fully taxed Ineligible if company offers retirement plan unless
lower income 10% penalty and taxes on all withdrawals for early
withdrawal before age 59 ½ or permanent disability Penalty free withdrawal for first time home buyer or
higher education expenses Rule of thumb: Current tax rate > Retirement tax rate
Basic Retirement Plans - continued
SEP (Simplified Employee Pension) Tax rules basically the same as a Regular IRA For small business owners Contributions: Up to lesser of 25% of income or
$40,000 401k
Tax rules basically the same as a Regular IRA For employees of companies Contributions: Up to $12,000 rising to $15,000 in
2006 Some have employee matching or loan features
Risk Management
Shield family from economic loss resulting from unanticipated events through insurance Life
• Key considerations– Income and debts
– Dependants and marital status
• Rule of Thumb– 7 times annual income
• Financially Prudent– Provide for last expenses and grieving period
– Eliminate major debts
– Replace income until dependants are self sufficient
» Assume reasonable return (5% to 6%)
Risk Management - continued Health
• Major medical expenses• Disability• Optional coverage
– Comprehensive medical– Eye, dental, and dread disease (adverse selection)
Home and Auto• Necessary coverage
– Minimum required by lender– Amount required to maintain similar lifestyle in tragedy
Liability• Needs depend on assets to shield• Cover reasonable levels of potential liability
Taxes, Taxes and More Taxes
"Excessive taxation ... will carry reason and reflection to every
man's door, and particularly in the hour of election.“
And
"Taxes should be proportioned to what may be annually spared by
the individual."
Thomas Jefferson
Tax Planning Strategies
Practice tax avoidance not evasion Employ all appropriate deductions or credits. Use tax-sheltered and deferred savings vehicles
• 401K• Roth and Regular IRA• Municipal bonds and variable annuities
Shift income to family members in lower tax brackets
Start a business in your spare time
Estate Planning
Accumulating assets for Dependents in event of death Family in event of disability Special considerations include
• Dependent ages• Education needs
Provide plan for family in event of Death Disability
Your Counsel Is Key
"The wisdom of a ruler is measured
by the wisdom of his counsel..."
King Solomon
Don’t be a horror story, select your advisor carefully
The broker of a disabled teacher traded her account while she was incapacitated after surgery holding many positions less than a week Churning losses exceeded $100,000
Advisor selection Must be qualified with the appropriate education,
designations and licensures Come with good recommendations and
credentials
Steps to Success
Seek competent financial advice or become educated regarding money management and investing
Set realistic performance expectations and understand rationale behind strategies
Review your plan to make sure your portfolio has the appropriate risk levels and is on track
Closing Slide
H. Swint Friday, Ph.D., CFP
E-01 Personal Financial Planning
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