Personal Financial Personal Financial PlanningPlanning

H. Swint Friday, Ph.D., CFPAssociate Professor of Finance

College of BusinessTexas 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 MeansHow 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 SavedMonthly 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 NumbersLook 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

ReturnStandard 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.

PeriodReturn

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 DepositTotal

Deposits PriceShares 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

InvestmentMonths

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 SlideH. Swint Friday, Ph.D., CFPE-01 Personal Financial Planning

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