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Overview
The process of personal financial planning is both a challenge and an opportunity. A challenge because of the need to sometimes perform
rigorous financial calculations, and an opportunity because of the ability to grow, often significantly, your wealth (or, in financial-planning
language, your net worth). This chapter introduces a new way to engage in personal financial planning: the Protect Accumulate Defend
Distribute (PADD) process. More broadly, the book describes, in depth, the challenge of the process and the opportunity that comes from
effectively engaging in it.
Wealthy, as defined by Merriam-Webster's Collegiate Dictionary, is the state of "having wealth" or becoming "extremely affluent." There is no
mention of actual money in this definition, but most people can't become wealthy without also being rich. In other words, the number of dollars
you have (either in your pocket or invested in financial or real assets) is equivalent to wealth. This book attempts to go beyond the standard
definition of monetary accumulation (or what most people think of when they hear the word rich) to characterize wealth as a process of
achievement involving not only financial independence, but also an emotional and psychological state of looking forward to and being
comfortable with the future. Indeed, when we substitute the word successful for wealthy, we see that what most individuals want is a successful
and fulfilling future that involves much more than purely monetary riches!
So how do you achieve wealth? This question has both a hard (monetary) and a soft (psychological) answer, but certainly having financial
affairs that are not in order complicates the summative belief that you've achieved a wealthy life. Thus, implementing a financial plan to
manage the future is important. If you have not assembled such a plan, or even if you have not thought about how best to manage the future,
don't worry—you're not alone! Americans are notoriously bad planners (and notoriously good procrastinators), but the important point to
understand is that financial planning and wealth accumulation are a journey and not a destination!
You need to begin the financial-planning process and then (hopefully) continue it as best as possible, with or without professional assistance.
This book is designed to help you do both—that is, as a do-it-yourself planner (as many individuals are inclined to be, either by conscious
decision or by default of circumstances) or by becoming an educated consumer when seeking the help of a financial planner. In addition, the
book introduces you to a simple way of thinking about the financial-planning process: the PADD approach to achieving lifetime wealth. The
steps in this approach are as follows:
n Distribute this wealth during your lifetime for the benefit of yourself and your family (and for the benefit of your heirs after your death).
Let's begin!
3. Determining the client's financial status by analyzing and evaluating client information
4. Developing and presenting the financial plan
Although these steps are intended for the professional Certified Financial Planner (CFP) certificant, there are several tasks that you, as an
individual intent on beginning the financial-planning process, should also undertake.
The first task is to gather your financial and personal records. Appendix A includes a formal, detailed data-gathering form and personal
financial-planning questionnaire to help you with this undertaking. Keeping good personal records has one obvious advantage: it lets you know
where and how you are currently spending your money. In turn, these records will assist you in constructing a budget for your monthly income
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and expenses—a critical money-management tool for most individuals. (We talk about budgets shortly.) Record keeping also assists you in
determining where you are financially today. You can't begin the journey of personal financial planning without knowing your starting point.
What type of financial and personal records should you keep, and for how long should you keep them? In most instances, there is no single
answer to these questions, because the type and number of records you need depends on personal preference. Some of us keep everything
(for as far back as we can imagine), whereas others try to rid ourselves of paper almost as soon as we receive it. However, documents such
as copies of insurance policies, brokerage account statements, mortgage statements, deeds and leases, notes receivable, and current
statements of vested amounts in 401(k) plans or other company-sponsored retirement plans should be kept indefinitely. Moreover, it is
important to keep personal income-tax returns for at least three years.
No single document can tell you more about your financial life than your annual income-tax return. Think about it: this return forces you to not
only disclose the amount of your income, but also identify the source of that income—an extremely important part of the budgeting and
financial-planning process. Under law, you are required to keep (unless you're committing fraud) your income-tax return and supporting details
for only three years from April 15th of any given year. However, because of the wealth of information provided by the return and its importance
as a guide to your financial past, you may wish to consider retaining it for much longer.
Once you have determined what type of financial and personal records you should keep, the next step is to determine where to keep them.
Again, there is no single answer to this question, but I tell my estate-planning clients (for more on wills and estate-planning documents, see
Chapter 19) to keep these documents somewhere in their home where they can easily be obtained in the event of an emergency. The reason
that I advise them in this way is to encourage them to consider the disadvantages of a safe-deposit box. In addition to the often high fees
charged for safe-deposit box rentals, many individuals make the mistake of listing only their name as a signatory for access to the box. In the
event of an unanticipated injury or death, no other individual can access the important documents stored in it. You should consider instead a
locked desk or fireproof case kept in your house or apartment for storing all your important records.
Another critically important task to launch you on the path toward financial independence is to specify in writing your long-term (more than ten
years), medium-term (five to ten years), and short-term (one to five years) financial goals. Be as specific as you can with respect to these
goals. For example, "to become wealthy" not only is hard to quantify for most people but, as mentioned previously, may not even mean the
accumulation of actual dollars. If monetary wealth is important to you (as it is for many people), determine how many dollars you need to
accumulate in order to satisfy your written financial goals.
Here are some of the most common financial goals mentioned to financial planners:
n To reduce debt service (for example, to pay off credit cards with an outstanding balance)
n To buy a luxury car
You may add other objectives to this list, depending on your own personal and financial situation, but it is important to recognize that these
goals should be quantified and monitored. In other words, you should establish a plan to meet these goals and then track how you are doing.
As with determining an investor's time horizon, it is important to match your goals to a specified time frame and categorize them according to
a long-term, medium-term, or short-term planning period.
What about the possibility that your goals cannot be achieved with your current financial resources? In that event, you have one of three (or a
combination of three) choices:
n You can prioritize away the meeting of some financial goals (in other words, recognize that only some, but not all, of your specified financial
goals are achievable in the specified time frame).
Until you have determined your financial goals and specified a time frame for their achievement, you likely won't know how to begin planning,
which may keep you from planning at all!
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resources. For example, if you are in your peak wage-earning years (typically age 45 to 55), you should establish a goal of at least a 10
percent increase in your net worth annually. When we apply the Rule of 72 to this increase (72 divided by 10), your net worth will double in a
period of only 7.2 years.
An example of a statement of personal financial position is produced in Table 1-1. Before you examine it closely, you should keep a few
considerations in mind when preparing and interpreting such a statement:
1. Be sure to list all assets at their current fair market value without reducing them to reflect any outstanding indebtedness; for example, list
your personal residence at the value you believe it will sell for in the local market without taking into account the mortgage balance you
may currently owe.
2. Break down your assets into cash equivalents, investments, and use assets. Cash equivalents are those assets that you can access
quickly to pay ongoing expenses (bills) or, in the event of a financial emergency, without fear that they may be worth less than when you
purchased them. Alternatively, investments are longer-term assets (greater than one year in maturity or holding period) that may
experience a fluctuation in daily value.
3. List liabilities at their current balance or what you owe to the creditor as of that given point in time.
There is no right or wrong answer when preparing your statement of financial position. Certainly, as you proceed along the path of wealth
building, the objective is that the value of your assets will exceed the balance of your liabilities (thereby increasing your net worth), but do not
become too judgmental of yourself as you construct your first statement. The danger is that you will become discouraged (or even give up),
which runs counter to the reasons for preparing the statement in the first place—as a tool to help you assess your current financial situation and
what you want to see happen in the future.
Table 1-1: Statement of Personal Financial Position (as of 12/31/2017)
Bonds $______
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Other $______
Use Assets
Primary $______
Residence
Vacation Home $______
Automobiles $______
Jewelry $______
Artwork $______
When planning your estate, it is helpful to identify on the statement of personal financial position how each asset is titled. For example, if your
primary residence is held in joint tenancy with right of survivorship between you and your spouse, place a JT for joint tenancy next to Primary
Residence. Note, however, that retirement accounts, such as individual retirement accounts (IRAs), may be owned only individually, even in
community-property states such as California or Texas.
n The cash-flow statement lets you see where you are spending your money. (It will tell you whether you are living within or beyond your
means.)
n It gives you an idea of your ability to save.
n It pinpoints your financial strengths and weakness with respect to your current standard of living.
n It can serve as a practice document before preparing a budget for future cash-flow management. (The cash-flow statement reviews past
financial performance, or looks backward, whereas the budget looks forward.)
Just as the statement of personal financial position has three general categories (assets, liabilities, and net worth), so does the personal cash-
flow statement. On the cash-flow statement, you should separately identify cash inflows (sources of income), cash outflows (ongoing
expenses), and any resulting cash surplus or cash deficit. A cash surplus or deficit is merely the difference between your cash inflows and cash
outflows. Of course, what you want at the end of the quarter (or month) is a cash surplus, sometimes known as discretionary income, because
that amount is available for saving. A little mental trick to help you save: include a fixed savings amount or percentage of income on the first line
of the Cash Outflows column. In other words, pay yourself first, and treat the savings amount the same as you would any other fixed expense.
You should strive to save at least 10 percent of your gross income monthly.
An ongoing issue with respect to the preparation of the cash-flow statement is whether to show income and Social Security taxes as a
separate expense or cash outflow (alternatively, you would show the after-tax amount among your cash inflows because your paychecks reflect
this). The better practice is to list these taxes as a cash outflow, because (again) one of the purposes of the cash-flow statement is to show
how you are spending your money. Including a separate line item for income and Social Security taxes among the cash outflows forces you to
account for what may be an otherwise invisible expense.
Table 1-2 is an example of a properly prepared personal cash-flow statement.
Table 1-2: Personal Cash-Flow Statement (for 2017)
CASH INFLOWS
Salaries $_________
Bonuses $_________
Self-Employment Income $_________
Interest Received $_________
Dividends Received $_________
Capital Gains (from sale of assets) $_________
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Savings $_________
Rent/Mortgage Payments $_________
Repairs, Maintenance, Improvements $_________
Utilities $_________
Auto Loan Payments $_________
Credit Card Payments $_________
Food $_________
Clothing $_________
Insurance Premiums:
Life $_________
Health $_________
Long-Term Care $_________
Disability $_________
Auto $_________
Homeowner (if not included in mortgage payment) $_________
Umbrella Liability $_________
Total Insurance Premiums $_________
Medical Expense $_________
Property Taxes (if not included in mortgage payment) $_________
Income Taxes $_________
Social Security and Medicare $_________
Taxes
Child-Care Expenses $_________
Recreation and Entertainment $_________
Other Expenses $_________
Total Cash Outflows $_________
CASH SURPLUS (OR DEFICIT) $___________
You may be wondering how both statements (the statement of personal financial position and the personal cash-flow statement) tie together. A
cash surplus from the cash-flow statement at the end of the year (or for whatever period you choose to list your income and expenses)
increases your net worth, as reflected on the statement of personal financial position. Conversely, a cash deficit decreases your net worth.
Increasing net worth is a financial strength, whereas decreasing net worth (particularly if the decrease continues over a long period of time) is a
financial weakness. In other words, if a cash deficit continues (you are spending more than you are earning), you need to do something to
reverse the situation. If you don't, your financial goal of future wealth accumulation is impossible.
Budgeting
For many people, putting together and sticking to a budget is one of life's little burdens. Sometimes the thought of limiting their spending (and
therefore their lifestyle) is so threatening that people refuse to even think about preparing a budget. I have heard it said, "What budget? I spend
what I make, so that's my budget!" However, living without a budget damages your long-term financial health. Look at a budget as an
opportunity to prove your own financial self-discipline. You could even pay yourself (and add to your savings) if you come in under budget each
month and show that you can live within your means. Over time, that practice will significantly increase your net worth.
As mentioned, a budget looks forward and is a benchmark for what you plan to spend. It may take you a few months to get it right, but get it
right you must if you want to accumulate wealth! If you are just starting to prepare (and comply with) a budget, be conservative in the
assumptions you make. For example, an underlying assumption of any budget is that your current employment is secure; if it is not (if you
anticipate a job change or layoff), you probably need to set aside even more savings and spend even less. This will help you build up an
emergency or contingency fund—another financial-planning practice that is critical to your long-term financial well-being.
Normally, a budget is developed in several steps. First, it is helpful to have determined your financial goals and the amount of savings
necessary to accomplish them. Next, be as realistic as you can when estimating your future income and forecasting your anticipated expenses
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for the budget period. Finally, a well-developed budget should be flexible enough to accommodate financial emergencies or one-time major
expenses (hence the need for the emergency fund).
A sample of a detailed budget is included in Appendix B, but take this to heart: a budget has value only if you intend to use it. If you do not
use it, you are likely better off attempting to meet your short- and long-term financial goals by focusing on some other planning technique (say,
by hoping to win the lottery)!
We read a great deal in the media about the negative savings rate of many Americans. Is that bad? It depends. There is both good and bad
debt. Good debt is generally any debt incurred for the purchase of an asset that is likely to appreciate—for example, your home or real estate
in some parts of this country. More specifically, good debt is any interest rate assumed on an obligation where you are paying less than what
you can make, in terms of investment return, on the asset for which you have borrowed the money. Another example (in a rising stock market)
is the margin interest incurred on the purchase of an individual stock or mutual fund from which you can potentially earn a far greater return than
what you must pay the broker to make the purchase.
Bad debt is any debt incurred on an asset that is likely to depreciate in value, such as a new car or automobile. Another type of bad debt is
credit card debt, which not only carries extremely high rates of interest (18 to 21 percent annually, on average), but also "revolves" from month
to month so that it is difficult to completely satisfy the obligation. Both automobile and credit card debt share the income-tax disadvantage:
because they are considered personal or consumer debt, the interest paid generally is not deductible and therefore won't reduce your annual
income-tax liability.
So how do you go about reducing bad debt? The obvious answer is not to incur it in the first place (by paying cash for a new car, for example),
but often this is impractical. Here are some tried-and-true debt-reduction techniques:
n Focus on one type of bad debt to the exclusion of others. For instance, adopt a payment schedule and amount to pay off on your credit
card debt—and stick to it! Consider it another form of paying yourself: if the interest rate on the card is 18 percent annually, it is similar to
earning 18 percent on an investment. (That does not mean, however, that credit cards are a good investment.)
n Consolidate or restructure your debt. The most common example of this is a college or graduate student who consolidates several smaller
loans into one larger loan. Although this does not eliminate the debt, it often reduces the total amount of debt service (interest).
n Borrow from your cash-value life insurance or 401(k) plan. The advantage of these alternatives is that you are, in essence, borrowing from
yourself. But be careful: you need to repay this money in a timely manner, or you will reduce the amount of your life insurance coverage and
retirement plan benefits payable in the future. If you die and still owe a balance on the life insurance policy loan, the insurance company will
pay only the policy proceeds less the outstanding loan balance to your named beneficiary or beneficiaries. Similarly, if you leave your
employer with an outstanding 401(k) loan balance, the company will likely pay only a net amount in your final paycheck or severance
payment. Alternatively, the company will require payment of the outstanding loan balance before it remits your final paycheck.
n Switch to debit cards. Debit cards work much like ATM machines, because the money comes out of your checking account immediately.
Although a debit card does not stop you from excessive spending, it does make you account for the cash-flow consequences much more
quickly than would a traditional credit card.
Finally, it cannot be stressed enough that poor cash-flow and debt management can put you on the path to financial ruin. Fortunately, credit
counselors and some financial planners can assist you in reducing your debt load. If you think you have a problem with debt, you probably do! If
you can't solve the problem, the wealth-building techniques discussed in this book will take much longer to work for you—if they work at all.
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n Have these goals remained the same throughout the review period?
n Are you living at or below your means?
n How much money did you save during the review period?
n With respect to your savings, are you earning the investment rates of return you need to meet your goals?
n Has anything changed in your personal and financial situation that may cause you to reconsider either the priority of the financial goals you
established or the time frame in which you anticipate meeting them?
It is generally agreed that there are four financial-planning life cycles. Although there are no hard-and-fast ages at which an individual
transitions from one life cycle to the next, certain financial goals are typically more important than others during each stage.
The first of these stages is the accumulation stage (between ages 25 and 45 for most consumers). In this stage, individuals are usually in the
early-to-middle years of their employment career and often raising young children. Typically, their net worth is relatively small, and their debt
load may be excessive, normally due to student or personal loan obligations. Their major financial goals are likely to be reducing their debt,
buying a house, and beginning the financing of their children's higher education.
The next of the financial-planning life cycles is the consolidation stage (ages 45 to 62 or other normal retirement age). In this stage, individuals
are typically past the midpoint of their careers and are likely approaching their peak wage-earning years. Most, if not all, of their debts have
been paid off and their net worth is growing rapidly. Their children are in college or graduate school, and those expenses have also been
satisfied or are in the course of payment. Financial goals for individuals in the consolidation stage of life are likely to include making home
improvements, taking a dream vacation, buying a luxury car or vacation home, and minimizing income taxes.
The third life-cycle stage, the spending phase (ages 62 to 90), is sometimes combined with the fourth phase, the gifting phase. The spending
phase is characterized by the individual's approaching retirement or the early years of retirement. In this phase, their peak earning years have
likely concluded and, from an investment perspective, the focus turns from growth to income. The individual's children have likely begun their
own careers and have moved from the family home. Financial goals for individuals in the spending stage shift to early retirement, retirement
with adequate income, and, perhaps, the starting of their own business.
Finally, the fourth and final life-cycle phase, the gifting phase, is synonymous with an individual's retirement years. Excess assets, if any, may
be used to benefit family members during life or in the event of the individual's death. Estate planning becomes important in this phase, and as
such a primary financial goal is the minimization of transfer (estate and gift) taxes. Also characteristic of this phase is a conservative
investment approach and withdrawal rate, due to the fear of outliving the amount of retirement monies the individual has saved.
Now, let's proceed to an often-asked question: Do I need a professional financial planner to help me get control of my financial life, or can I do
it myself? The answer to this question is the focus of the next chapter.
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