I recently read that one of the main reasons that the majority of consumers did not do any financial planning was the perception that they did not have sufficient money to justify a financial plan. Add to this to the existing perception that financial planning is a really onerous and complex process and it is no wonder that many people are scared off.
Certainly there are many players with massive hidden agendas that would have us believe that financial planning is incredibly complex and that you need significant funds and complicated models to do it. However, as the title suggests, this article aims to expose the perception that financial planning is only for the wealthy and super intelligent! Everyone should have a financial plan.
So what is financial planning? Simply put, from a financial planner’s point of view, it is about objective (measurable) advice that results in a plan to manage current and achieve future financial needs and goals. It is not about product or sales! These come right at the very end of the process and could be used to flesh out the plan. It is also quite possible that the plan identifies that no products are needed or appropriate.
From a financial planning point of view, most people face 4 or 5 common risks. They are:
- Dying too soon and leaving debt or dependents
- Living too long (insufficient funds on which to retire)
- Disability (over a short or extended period)
- Funds for short term emergencies.
A financial plan should identify the potential impact of any of these areas (as well as any others) and should be designed to minimize its impact.
Dying too soon
Life insurance is not an investment – it pays when you die! As such, it is my opinion that it should only be used to cover risks that you can not (or do not want to) take. These could include leaving debt on a bond and to provide liquidity for your estate. No debt, sufficient cash/investment reserves and no estate duty problems and you probably don’t need any life cover.
Living too long (insufficient funds on which to retire)
Again there is little rocket science involved here. Remember the power of compounding, so the sooner you start saving for your retirement the better (even if it is in the very distant future). In order to determine the capital lumpsum you will need at retirement you will need to determine your (equivalent) income at retirement. This is a simple future value calculation and is dependent on your current income and inflation over the period. The future income value will allow you to determine the capital required. The longer the period to retirement, the greater the effect of changing inflation and investment returns over the period so you will need to review it on an annual basis (at least)!
Disability (over a short or extended period)
This is a tough one. The Life Offices Association (LOA) has set the limits on the amount of disability cover anyone may buy. Disability is also unfortunately often a very subjective matter. Suffice to say, if you work for a (large) corporate then you will most probably be covered through their group scheme. This usually consists of an income replacement benefit which is paid after an initial waiting period (usually 3 months) – by implication the company will look after you during that initial 3 month period. It is the self-employed and those who don’t belong to a group scheme that are most at risk. Find out what you have before you rush out and buy – you don’t want to over insure.
Funds for short term emergencies.
It is good financial planning practice to have ±3 month’s income in a cash account. This is to cover all those unforeseen expenses which seem to pop up with such regular frequency that they should not be unexpected. If you have an access bond you should use it for this purpose. If the bond is paid off then you should use a money market unit trust account (higher interest rates).
Debt is the most expensive thing you can buy! Don’t make the classic investor error of compartmentalization. You should probably not be investing while you are paying off debt because the rate of return you are likely to receive from the investment will most probably be significantly less than the rate of interest you are paying on the debt. Once your debt is paid, you will also most probably be able to pay for the things for which you were saving (e.g. school fees) in cash each month!
Because there are so many different variables that can (and do) impact on the plan, a financial plan needs to be seen as dynamic – financial planning is a process and not an event. Your financial plan needs to be revisited on (at least) an annual basis. If you choose to use the services of a financial planner then he or she should follow the internationally accepted best practice 6 step process which is:
- Establish and define the client planner
- Gather data and information
- Analyse the data
- Present the plan
Each of these steps as well as each of the financial planning risks will be addressed in greater detail in future articles in this series.