Personal financial planning

Ronald Wichner Develop a good financial plan for yourself atan early age and assure a secure future

uppose a friend told youthat he had made a10 percent return on hisinvestments in 1984. Isthat good? Bad? Shouldyou congratulate him or

laugh at him? It all depends on what hisgoals were and how much risk he waswilling to take. Compared to the in­flation rate of 4 percent in 1984 he didwell. Compared to one measure ofstock market performance, the S&P500 Index, which was up 6.3 percent ,he did well. Compared to long-termgovernment bonds , up 15.5 percent ,he did poorly. Maybe his expectationwas just to keep up with inflation; may­be he took an enormous risk hoping tomake a big killing. Your response de­pends on his investment goals.

The aim of personal financial plan­ning is to develop and implement a setof coordinated plans to achieve our fi­nancial goals both in the short and longterm. All too often, though, our fi­nancial goals are ambiguous . We wantto be "comfortable," or have a "nice"car or house, or have "enough" moneyto take a vacation to Europe everyother year. An early task, therefore, isto develop in reasonable detail one 'sspecific financial needs and goals.

The methodology of financial plan­ning is a systems approach followingthese five steps:

1. Gather personal financial data.2. Set goals and objectives .3. Analyze one 's present position

relative to those goals, and con­siders alternative courses ofaction.

4. Develop and implement a plan.5 . Review and revise that plan

periodically."Who needs it?," you ask. "I'm not

a fat cat." Well, we all need it to agreater or lesser extent. If you have alarge income and a substantial bank ac­count, it behooves you to use your fi­nancial resources efficiently. If youhave little income and/or a meagerbank account, then you need to makeevery dollar count.

Failure to plan can result in high per­sonal and financial costs. Your familymay be under- or unprotected in theevent of a personal catastrophe such asdeath, disability, prolonged unemploy-

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ment, or illness . There may not beenough money set aside for your chil­dren's education or your retirement , oryou may be paying more taxes thanyou should. Most important, failure toplan may cause your own personalgoals never to be realized.

As we will see later, the time to startthinking about financial planning isnow. The sooner you start, the morelikely it is that you will achieve yourgoals. Marrying into money is the onlyother financial planning process Iknow where you can meet your life­time financial goals . For most of us,unfortunately, that's not a reasonableexpectation .

Five major componentsPersonal financial planning involves

coordinated , realistic planning in fivevital areas of your financial affairs.

• Protection against personal finan­cial risks (death, income loss fromdisability and illness, propertyloss, claims of liability)

• Capital accumulation (emergen­cies, family needs, a desire for in­creased standard of living)

• Reducing the tax burden• Retirement income• Estate planning (for heirs)The professional financial planner

takes all of these issues into accountwhen developing the strategy to be ap­plied to a client's specific goals. Let'stake a brief look at each of these issues.

Protection from Financial Risk (In­surance): Most people protect them­selves against the personal financialrisks mentioned above through theuse of some form of insurance. Manyare aware of the various forms ofprotection available : car, home­owner's, renter's, life, health, unem­ployment , liability and casualty (prop­erty) insurance.

Disability insurance, however, tendsto be neglected in less-than-thoroughfinancial plans. Most people don'trealize that, prior to age 65, the proba­bility that you will suffer a disabilitylasting longer than 90 days is signifi­cantly greater than death. At age 22,for example, the probability is almostseven and one-half times greater; at 42,four and a quarter times. Many em­ployers provide disab ility insurance

0278-6648/85/1200·0020$01.00©1985 IEEE

coverage, but if yours does not, youwould be wise to take a look at thevarious policies available.

"Universal" life insurance contractsare typical of new products offeringhigher rates of return to the insured onthat portion of the premium which doesnot cover the actual cost of insuringagainst the death benefit.

Capital Accumulation: People wantto accumulate capital for a number ofreasons. They include an emergencyfund, for their children 's education , forretirement, for building up a generalinvestment fund to provide them withsecurity, as well as to increase theirstandards of living.

Several factors need to be consid­ered when developing a strategy toaccumulate capital. These include:a) how much and when do you needit?, b) how much do you have to in­vest , both now and in the future?,c) what are the constraints and lim­itations of the various financial vehi­cles?, and d) is the plan one which hasa reasonable chance of meeting most ofyour goals?

Many different financial vehiclescan result in capital appreciation .These are generally categorized asfixed-dollar and variable-dollar orequity investments . Fixed-dollar in­vestments are those in which the prin­cipal and/or income are contractuallyset in advance : savings accounts,bonds, preferred stocks and the cashvalues in life insurance policies.Equity investments have neither theprincipal invested nor the incomeguaranteed: stocks, real estate , limitedpartnership tax shelters (oil and gas,real estate, cattle, . . . ), ownership ofa business interest, commodities andcollectibles (art, oriental rugs, an­tiques, coins , . .. ) and other assetssuch as gold and silver.

Each one of these investment vehi­cles has virtues and limitations whichmust be evaluated as to the appropri­ateness of their inclusion in a financialplan. Your goals, age, income level,possible inheritances, your own assess­ment of the future U.S. economy, yourability to tolerate risk, knowledge ofspecific investments and willingness toparticipate in the management of theseinvestments all have a bearing on the

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Accumulation of IRA Funds with a $2000 annual investment

TABLE I

* Six percent annual salary increase assumed** Assumes no income first year; incrementa l schooling cost of $4000 borrowed at

12 percent interest, repaid with interest at end of second year*** Assumes no income first four years ; incremental schooling cost of $4000

per year, repaid after graduation in four yearly installments

Annual return 6% 9% 12%

Deposited at year's end:Total after 20 yrs 74k$ 102k$ 144k$Total after 44 yrs 400k$ 963k$ 2,424k$

Deposited at 1st of year:Total after 44 yrs 423k$ 1,050k$ 2,714k$

TABLE II

Ph.D.

43.2(***)k$131 k$529 k$

8412 k$

MS

34.2(**)k$104 k$419 k$

6793 k$

The Effect of the Difference in Sal­aries for BS/MS/Ph. D.'s: One of thequestions facing the new graduate iswhether to pursue a graduate degree orimmediately enter the work force fulltime. Obviously, there are many thingsto consider, but let's look at the finan­cial effect such a decision can have atthe end of a career, i.e ., at retirement.The calculations shown in TABLE II arebased on reasonable assumptions, andI have been conservative. Also, whilethe numbers may look huge in today'sdollars, remember that 44 years agothe cost of going to the movies was50 cents, not five dollars . You canexpect a similar relationship to hold44 years from now.

each year's investment at the beginningof the year rather than at the end. Also,at a 9 percent compounded rate, theincreased interest earned from just thefirst year 's $2000 deposit, made atthe beginning rather than at the end ofthat year is, by the end of 44 years ,over $7300!

Since time has such a strong effecton investment income, it is instructiveto look at how an absence of income(and savings) the first year(s) affectsthe funds available at retirement. Wesaw the significant effect $2000 thefirst year had on the IRA after 44years , so we can expect that the in­vestments made the first year(s) aftergraduation with a BS can overcomesome of the disadvantage of a lowerstarting and (in our simplistic example)continuing salary when compared to

BS

30.0k$91 k$

367 k$5993 k$

The Effect of Starting Salary on Lifetime Income *

Current (1985) Start SalarySalary @ 20 yrsSalary @ 44 yrsCumulative Income @ 44 yrs

where

FV is the future value of the origi­nal amount

Retirement Planning: Retirementawaits us all. But at age 21, that is thefurthest thing from our minds. Unfor­tunately, inadequate financial planningmay cause unhappiness and even seri­ous distress in retirement. I'll try toshow you below how, with just a littleplanning (and action), you can provideyourself with some assurance of a rea­sonable source of funds in your lateryears.

The key to well-funded retirementis a concept of "the time value ofmoney ."

The time value of money is one ofthe most powerful forces in financialinvestments . The earning of interest oninterest (compounding) over a longperiod can yield results that aresurprisingly nonintuitive. The funda­mental formula is a simple one whichwe all learned in high school algebra :

FV = A(l + d In

In the examples below, the 44-yearperiod was selected since it is the num­berofyears between the ages of21-65.

TABLE I shows the result of depos­iting $2000 each year into an IRA for20 and 44 years at different com­pounded interest/investment returnrates . Note the effect of depositing

A is the original amountr is the rate of interest or investment

return per period and,n is the number of periods.

type and distribution of investmentsput into a financial plan.

There is the so-called, "OrangeJuice Analogy" used in financial cir­cles, which says that no matter howyou slice and squeeze it, you can getonly so much juice out of an orange.Any investment vehicle also has onlyso much "juice." You can pour the"juice" into any or all of four glasseslabeled, a) Safety, b) Cash flow,c) Appreciation, and d) Tax savings.What goes into one glass cannot alsogo into another. If you want a highdegree of safety, you cannot also gethigh appreciation or cash flow or taxsavings. If you want lots of appre­ciation, the other elements suffer.

It is the financial planner's job torecommend the proper distribution ofvarious investment vehicles in a port­folio given his/her overall view of theclient's goals and current situation.

Another issue facing you as you be­gin to accumulate capital is that ofmanaging your investments and/orproperty.

Some people love 'playing the mar­ket' while others will not buy anystocks because they feel it's pure gam­bling, just like roulette. Some wantprofessional management of their in­vestments, e .g ., mutual funds and thevarious types of limited partnerships.Similarly, one has the option of placingthe majority of one's assets in thehands of a professional manager, be ita financial advisor (who mayor maynot be the financial planner), a lawyer,or trustee.

Reducing the Tax Burden: Tax Re­form Act '76, Revenue Act '78, ERTA'81, TEFRA '82, Tax Reform Act '84 ,flat tax, modified flat tax . The Federalgovernment uses the income tax codefor social and economic purposes andchanges (not simplifies) the rules aspolitical winds change . Since taxes in­fluence our investment decisions , thefinancial planning process must takeinto account current and possible fu­ture tax consequences.

There are four basic tax-savingstechniques :

• Tax elimination (e.g ., municipalbond interest)

• Long-term capital gains• Postponing taxation (e.g ., Indi­

vidual Retirement (IRA»• Shifting taxes to others (e.g . , gifts

of income-producing property toone 's children)

There are a number of texts whichexplain in reasonably simple termssome techniques for minimizing taxes .Your local librarian can help you, ifyou are interested .

DECEMBER 1985 21

TABLE IV

TABLE III

Annual Investment Income as a Percent of Salary forDifferent Annual Percentages of Salary Saved and Invested'

, Assumes annual salary increase of six percent, annual investment return of ninepercent compounded.

After 44 Years17%33%55%83%

fessional qualifications, experience,and your comfort level in discussingissues which most people find to bevery personal.

The financial planner is not a sub­stitute for accountants, tax preparersor estate attorneys , unless that is his/her area of expertise. In particular, un­less the planner is licensed to practicelaw, he cannot give legal advice andwill refer a client to a lawyer, whenappropriate.

Professional Designations: The Cer­tified Financial Planner (CFP), a certi­fication conferred by the College ofFinancial Planning (Denver), haspassed a series of formal financialplanning courses and examinations inthe topics discussed above and hasvowed to adhere to a strict code ofethics . The American College's (BrynMawr, PA) Chartered Financial Con­sultant (ChFC) is similar.

About the authorRonald Wichner holds a BChE from

the Cooper Union and a Ph. D. in Nu­clear Engineering from UC-Berkeley.Until recently, he was leader of theEngineering Services Division, Elec­tronics Engineering Department at theLawrence Livermore National Labora­tory. Dr. Wichner is now associatedwith Berkeley Hills Realty Corp., andis a Certified Financial Planner. 0

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After 20 Years6%

11%18%28%

Salary Invested3%5%

10%15%

Income From Annual Investments . k$'

as MS" PhD'"Investment Income: - - -@ 9% return:

@ 20 years 16.7 16.5 12.7@ 44 years 203 214 216Cumulative Investment Incomeafter 44 years: 2084 2156 2045

(g) 15% return:@ 20 years 42.4 39.6 26.1@ 44 years 1102 1084 895Cumulative Investment Incomeafter 44 years: 8854 8631 6878

Note: Cumulative values are part of the 9% and 15% results.,Six percent annual salary increase . 10 percent of salary invested yearly assumed

" Assumes no income or investment 1st year; incremental schooling cost of $4000borrowed at 12 percent interest, repaid with interest at end of 2nd year

'" Assumes no income first four years; incremental schooling cost of $4000 per yearrepaid after graduation in four yearly installments; no investments made until theninth year. after loans and interest are repaid

gram, "Financial Planning," is avail­able in a few locales. For those inter­ested in using a computer to help youto quantify your present and future fi­nancial situation , spreadsheet tem­plates as well as dedicated programsare on the market, ranging from $150to over $1000.

Professional Help: In the last fewyears, personal financial planning hasbeen 'discovered' by many in the per­sonal and financial service industryincluding stockbrokers, insurancecompanies, banks, lawyers, CPA's,investment advisors and others. Manyhave entered this field with a viewtoward enhancing the service they canprovide to their clients. They considerfinancial planning as a tool to providea broader view of the needs of theclient and in doing so can give him/hera more personalized set of recom­mendations. Some, however, look atfinancial planning as a bandwagonto ride to simply attract more clients totheir business.

You need to make sure that the per­son(s) to whom you trust your financialaffairs is both competent and holdsyour interests above his/her own .Unfortunately, a conflict of interest ispresent in most interactions between afinancial planner and the client. Selecta planner only after you have donesome homework regarding his/her pro-

What can I do now?Self-help: Your local library has a

number of recently published bookson financial planning. Several uni­versities, Adelphi, Brigham Young,Golden Gate and the University ofCalifornia, among others, provide de­grees and/or adult education in thisfield. A recently syndicated TV pro-22

the MS and Ph. D. TABLE III shows theeffect of investing 10 percent of one'sincome each year and reinvesting theproceeds of those investments.

The fraction of your salary that yousave and invest each year has a largeeffect on the relative amounts that youget from your salary and investments inlater years . The amount you save eachyear is more easily determined by youthan the rate of return you get on yourinvestments . Besides, a consistentsavings and investment program cangreatly affect the total income you re­ceive over your lifetime.

TABLE IV shows how you can posi­tion yourself to be financially secure inyour later years with relatively littleimpact on your early standard of liv­ing. I have been conservative in usingonly 3 percent investment return overinflation (9 percent vs . 6 percent) .Employer-sponsored retirement!pension plans generally meet thiscriterion and a new employee shouldinvestigate these plans with his/heremployer as soon as possible aftersettling in.

The return on investments obviouslyhas a strong effect on these percentagesin TABLE IV, especially after 44 years.If we assume a 15 percent compoundedafter-tax return instead of 9 percent ,saving 10 percent of one's salary eachyear provides an annual income frominvestments of three times that of one'ssalary at retirement! It does take disci­pline, however, to consistently live10 percent below one's "potential"standard of living.

Estate Planning: Estate planning isthe art of creating and managing one'sassets while alive so that their transferto a wife, children, and others afterdeath is done as one wishes. The fi­nancial planner advises his clients onthe methods of estate transfer beforeand after death, the effect of differentforms of ownership and various taxconsequences .

Transfers of estates worth less than$400,000 by people dying in 1985 willgenerally not incur any Federal estatetax liability, so the only advice I willgive you now is to write a will so thatyour estate will be distributed asyou wish , rather than according tostate law.