Personal Finance PDF

# Unit 1: Basics of Personal Financial Planning ## CONTENTS - Objectives - Introduction - 1.1 Meaning and Definition of Personal Financial Planning - 1.2 The Benefits of Financial Planning - 1.3 Importance of Personal Financial Planning - 1.4 Process of Financial Planning - 1.4.1 Old Personal...

# Unit 1: Basics of Personal Financial Planning ## CONTENTS - Objectives - Introduction - 1.1 Meaning and Definition of Personal Financial Planning - 1.2 The Benefits of Financial Planning - 1.3 Importance of Personal Financial Planning - 1.4 Process of Financial Planning - 1.4.1 Old Personal Financial Planning - 1.4.2 New Method of Personal Financial Planning - 1.4.3 Tips for making the most of the Financial Planning Process - 1.4.4 Features of a Good Financial Plan - 1.5 Scope of Personal Financial Planning - 1.6 Financial Planner - 1.6.1 Reasons for hiring a Financial Planner - 1.6.2 Functions of a Financial Planner - 1.7 Summary - 1.8 Keywords - 1.9 Review Questions - 1.10 Further Readings ## Objectives After studying this unit, you will be able to: - Explain issues and concepts related to overall financial planning process. - Understand the goals and objectives of personal financial planning. ## Introduction As one of the most rapidly developing service industries in India and aided by a world of economic, technological and social change, the role of financial planning is increasingly important in the Indian community. In India, we have endured major economic and regulatory change, including widespread changes in the banking system and, through the late '1990s, a reducing inflation rate in stark contrast to the double-digit inflation earlier. We have seen turbulent times in the stock market and adoption of the depository system, a transition to rolling settlement and the introduction of derivatives. A well-developed debt market still remains a distant dream forcing investors to hold on to illiquid instruments. Senior citizens are facing the brunt of the impact of these changes and as the average age of our population climbs, there is increasing pressure on an early introduction of a social security system for financial support. ## 1.1 Meaning and Definition of Personal Financial Planning Financial planning is the process of meeting your life goals through the proper management of your finances. Life goals can include buying a home, saving for your child's education or planning for retirement. The financial planning process consists of six steps that help you take a "big picture" look at where you are financially. Using these six steps, you can work out where you are now, what you may need in the future and what you must do to reach your goals. The process involves gathering relevant financial information, setting life goals, examining your current financial status and coming up with a strategy or plan for how you can meet your goals given your current situation and future plans. Personal financial planning is the process of managing your money to achieve personal economic satisfaction. This planning process allows you to control your financial situation. Every person, family, or household has a unique financial position, and any financial activity therefore must also be carefully planned to meet specific needs and goals. Personal Financial Planning also refers to short- and long-term financial planning by somebody, either independently or with the assistance of a professional adviser. It will include the use of tax-efficient plans such as Individual Retirement Accounts, ensuring adequate provisions are being made for retirement, and examining short- and long-term borrowing requirements such as overdrafts and mortgages. ### What is Personal Financial planning? Financial planning is the process of developing a personal roadmap for your financial well being. The inputs to the financial planning process are: - your finances, i.e., your income, assets, and liabilities, - your goals, i.e., your current and future financial needs, and - your appetite for risk. The output of the financial planning process is a personal financial plan that tells you how to use your money to achieve your goals, keeping in mind inflation, real returns, and taxes. In short, financial planning is the process of systematically planning your finances towards achieving your short-term and long-term life goals. ### Self Assessment Fill in the blanks: 1. CFP stands for _Certified Financial Planner_. 2. Personal financial planning is the process of managing your money to achieve _personal economic satisfaction_. 3. The output of the financial planning process is a _personal financial plan_. 4. The inputs to the financial planning process are finances, your goals and your _appetite for risk_. 5. _Financial planning_ is the process of developing a personal roadmap for your financial well being. ## 1.2 The Benefits of Financial Planning Financial planning provides direction and meaning to your financial decisions. It allows you to understand how each financial decision you make affects other areas of your finances. For example, buying a particular investment product might help you pay off your mortgage faster or it might delay your retirement significantly. By viewing each financial decision as part of a whole, you can consider its short and long-term effects on your life goals. You can also adapt more easily to life changes and feel more secure that your goals are on track. One of the commonly asked questions is "can you do your own financial planning?". Some personal finance software packages, magazines or self-help books can help you do your own financial planning. However, you may decide to seek help from a professional financial planner if: - you need expertise you don't possess in certain areas of your finances. For example, a planner can help you evaluate the level of risk in your investment portfolio or adjust your retirement plan due to changing family circumstances. - you want to get a professional opinion about the financial plan you developed for yourself. - you don't feel you have the time to spare to do your own financial planning. - you have an immediate need or unexpected life event such as a birth, inheritance or major illness. - you feel that a professional adviser could help you improve on how you are currently managing your finances. - you know that you need to improve your current financial situation but don't know where to start. Here's a list of the benefits that a well chalked out financial plan can bring about: - Helps monitor cash flows and reduces unnecessary expenditure. - Enables maintenance of an optimum balance between income and expenses. - Helps boost savings and create wealth. - Helps reduce tax liability. - Maximizes returns from investments. - Creates wealth and ensures better wealth management to achieve life goals. - Financially secures retirement life. - Reviews insurance needs and therefore also ensures that dependents are financially secure in the unfortunate event of death or disability. - Lastly, it also ensures that a will is made. ## 1.3 Importance of Personal Financial Planning Can you manage without financial planning? Many people do, but they may find-often when it's too late- that they don't have the means to achieve their life goals. For example, people today realize the importance of living life to the fullest. Consequently, many opt for early retirement from full time jobs, as compared to a few decades ago, when most people worked until the maximum retirement age of 58-60 years. The average person can, today, expect to live a healthy life well into his or her seventies or eighties, which means that retirement life is almost as long as working life. Financially, it implies that savings (after taking into account inflation) should be enough, not just to maintain the same lifestyle for almost 25-30 years, with no new income, but also to take care of medical expenses, which are usually high the older a person gets. Planning for all this is a tall order for anyone. That's why it's critical for everyone to plan their finances from an early age. Over the last few years, terms like financial planning and personal finance have emerged as buzzwords of sorts. Newspapers, magazines, television channels and just about every one under the sun seem to be talking about the importance of financial planning. So what is financial planning; more importantly, does it merit the attention that it is being given? Financial planning is a process through which an individual can chart a roadmap to meet expected and unforeseen needs in life. Simply put, the intention is to take necessary steps to ensure that the individual is equipped to accomplish what he has set out to achieve and is prepared to deal with contingencies as well. And yes, the importance of financial planning (especially in the present scenario) cannot be overstated. Among others, two factors are responsible for the same i.e. inflation and changing lifestyles. Inflation is a situation where too much money chases a limited number of goods. This leads to a fall in the value of money. It is also expressed as a rise in the general price level. For example, a product that costs 100 at present would cost 105 a year from today, assuming that prices rise at 5 per cent. This is the impact of rising prices over one year; over a 30-Yr period, assuming that inflation continues to rise at 5 per cent, the same product will be available at 432! Financial planning can ensure that one is equipped to deal with the impact of inflation, especially in phases like retirement when expenses continue but income streams dry up. The second factor is changing lifestyles. With higher disposable incomes, it is common for individuals to upgrade their standard of living. For example, objects like cars that were considered luxuries not too long ago, have become necessities today. Financial planning has a role to play in helping individuals both upgrade and maintain their lifestyle as well. Finally, there are contingencies like medical emergencies or unplanned expenditures that an individual might have to cope with. Sound financial planning can enable him to easily mitigate such situations, without straining his finances. Financial planning can help you achieve peace of mind since: - Identifying your financial goals enables you to focus your investments towards achieving those goals. - Focusing your investments ensures that you create wealth through timely and appropriate investments. It also ensures that you protect your wealth. - Creating wealth ensures that you are financially secure and on track to achieving your financial goals. - Financial security means you are prepared to overcome expected and unexpected ups and downs that life throws at you, such as sudden illnesses, retirement, etc. - Lastly, financial planning, when properly done, ensures that your investments are inflation proof. ### Self Assessment State True or False: - Financial planning is a process through which an individual can chart a roadmap to meet expected and unforeseen needs in life. _True_ - Financial planning cannot ensure that one is equipped to deal with the impact of inflation. _False_ - Financial planning has no role to play in helping individuals both upgrade and maintain their lifestyle as well. _False_ ## 1.4 Process of Financial Planning ### 1.4.1 Old Personal Financial Planning Earlier the people used various financial advisors such as an insurance agent to manage their insurance policies, a stock broker for managing their equities and stocks, an attorney and a CPA for managing their taxation etc. This method of financial planning led to more complexity and difficulty because of following reasons: - The person or the client has to reveal his financial soundness to all the financial advisors. - Each financial advisor may give different suggestions for financial planning and many times conflict each other resulting in confusion(for client) as to which advice to follow. - The client has to pay service charges or fees to all the advisors separately resulting in increased cost of management. ### 1.4.2 New Method of Personal Financial Planning Most people want to handle their finances so that they get full satisfaction from each available dollar. Typical financial goals include such things as a new car, a larger home, advanced career training, extended travel, and self-sufficiency during working and retirement years. To achieve these and other goals, people need to identify and set priorities. Financial and personal satisfaction is the result of an organized process that is commonly referred to as personal money management or personal financial planning. The specific advantages of personal financial planning include: - Increased effectiveness in obtaining, using, and protecting your financial resources throughout your lifetime. - Increased control of your financial affairs by avoiding excessive debt, bankruptcy, and dependence on others for economic security. - Improved personal relationships resulting from well-planned and effectively communicated financial decisions. - A sense of freedom from financial worries obtained by looking to the future, anticipating expenses, and achieving your personal economic goals. ## 1.4.3 Tips for making the most of the Financial Planning Process 1. Start now. Even if you are in your mid thirties or forties, it's better to start now than dawdle for another five years. Every day counts. 2. Be honest with yourself. Seek help when needed. 3. Set sensible, measurable goals for yourself. Be realistic in your expectations of the results of financial planning. 4. Review your plan and financial situation periodically and adjust as needed. 5. Always review the performance of your investments; pull out if needed and reinvest the money elsewhere. 6. Be hands-on. It's your money and no one else will do your work for you. ## 1.4.4 Features of a Good Financial Plan How do you evaluate the quality and effectiveness of your financial plan? Well, here's a checklist you can use: - Does it indicate your current financial situation? - Does it list out all your goals in measurable terms? - Does it lay out an investment strategy? If professional help is sought, your financial planner will ensure that your financial plan also contains the following: - List of possible risks and a risk management plan. - Expected returns from each investment. - A mapping between the investments and goals, i.e., how each investment helps you achieve your goals. - Details of one time and recurring fees charged by him. ## 1.5 Scope of Personal Financial Planning Personal financial planning covers all areas of an individual's financial needs and should result in the achievement of each of the financial goals. The scope of personal financial planning would usually include the following: 1. Risk Management and Insurance Planning: Managing cash flow risks through sound risk management and insurance techniques. 2. Investment and Planning Issues: Planning, creating and managing capital accumulation to generate future capital and cash flows for reinvestment and spending. 3. Retirement Planning: Planning to ensure financial independence at retirement including 401Ks, IRAs etc. 4. Tax Planning: Planning for the reduction of tax liabilities and the freeing-up of cash flows for other purposes. 5. Estate Planning: Planning for the creation, accumulation, conservation and distribution of assets. 6. Cash Flow and Liability Management: Maintaining and enhancing personal cash flows through debt and lifestyle management. 7. Relationship Management: Moving beyond pure product selling to understand and service the core needs of the client. 8. Education Planning for kids and the family members. ## 1.6 Financial Planner A financial planner or personal financial planner is a practicing professional who helps people deal with various personal financial issues through proper planning, which includes: cash flow management, education planning, retirement planning, investment planning, risk management and insurance planning, tax planning, estate planning and business succession planning (for business owners). The work engaged in by this professional is commonly known as personal financial planning. In carrying out the planning function, he is guided by the financial planning process to create a financial plan; a detailed strategy tailored to a client's specific situation, for meeting a client's specific goals. The key defining aspect of what the financial planner does is that he considers all questions, information and advice as it impacts and is impacted by the entire situation of the client. ### 1.6.1 Reasons for hiring a Financial Planner People enlist the help of a financial planner because of the complexity of performing the following: - Finding direction and meaning in one's financial decisions; - Understanding how each financial decision affects other areas of finance; and - Adapting to life changes to feel more financially secure. The best results of working with a comprehensive financial planner, from an individual client or family's perspective are: - To create the greatest probability that all financial goals (anything requiring both money and planning to achieve) are accomplished by the target date, and - To have a frequently-updated sensible plan that is proactive enough to accommodate any major unexpected financial event that could negatively affect the plan, and - To make intelligent financial choices along the way (whether to "buy or lease" whether to "refinance or pay-off" etc.). Before working with a comprehensive financial planner, a client should establish that the planner is competent and worthy of trust, and will act in the client's interests rather than being primarily interested in selling the client financial products for his own benefit. As the relationship unfolds, an individual financial planning client's objective in working with a comprehensive financial planner is to clearly understand what needs to be done to implement the financial plan created for them. So, in many ways, a financial planner's step-by-step written implementation plan of action items, created after the plan is completed, has more value to many clients than the plan itself. The comprehensive written lifetime financial plan is a technical document utilized by the financial planner, the written implementation plan of action is just a few pages of action items required to implement the plan; a much more "usable" document to the client. ### 1.6.2 Functions of a Financial Planner A financial planner specializes in the planning aspects of finance, in particular personal finance, as contrasted with a stock broker who is generally concerned with the investments, or with a life insurance intermediary who advises on risk products. Financial planning is usually a multi-step process, and involves considering the client's situation from all relevant angles to produce integrated solutions. The six-step financial planning process has been adopted by the International Organization for Standardization (ISO). Financial planners are also known by the title financial adviser in some countries, although these two terms are technically not synonymous, and their roles have some functional differences. Although there are many types of 'financial planners,' the term is used largely to describe those who consider the entire financial picture of a client and then provide a comprehensive solution. To differentiate from the other types of financial planners, some planners may be called 'comprehensive' or 'holistic' financial planners. Other financial planners may specialize in one or more areas, such as insurance planning (risk management) or retirement planning. Financial planning is a growing industry with projected faster than average job growth through 2014. ### Case Study: Financial Planning isn't just for the Rich A lot of people feel that financial planning is only for the rich and it isn't at the top of mind of many first jobbers. After all, if one does not have a lot of money what is there to plan? But eventually you may want to buy that first house, get married, travel the world or retire early. Where will that money come from if you did not plan? Financial planning does not have to be complicated but neither is it a monthly budget plan. Although a monthly budget is a component of the bigger picture. Start by thinking how you can save. An investor must remember the line, 'it's not how much you earn but how much you safe that matters.' Then how you can protect that wealth, think of yourself as a wealth making machine hence, insurance medical, life and general insurance is important to protect your capability to continue to build wealth. Start thinking and understanding about building wealth via investments be it real estate, mutual funds or shares. What are the keys to financial planning a newbie at work should know? Do not squander away your hard earned money. Do not think you are young hence you have a lot of time to save for your retirement and that dream home. Money does not work that way. It has its own set of rules and if you do not obey it, you will pay for it in double. What are some of the keys to good financial planning? 1. Pay Yourself First: It basically means when you get your pay, put some aside for yourself immediately. Better yet, siphon it to an account where withdrawing is tough. Almost always you will still have money to take care of other bills when you pay yourself first. This money is for a rainy day, emergency cash and cash for investment opportunities that may crop up. 2. Living Expenses: You can then start to pay off all your living expenses bills. There are the cell phone, rent, student loan, car loans, utilities bill, etc. to pay off. Of course the grocery bills and transportation costs. I like to keep leisure out of these living expenses because to me these are priorities, if these aren't taken care of, it can lead to debt accumulation. Especially paying off loan installments where interest can compound one month after another. 3. Save for the Future: Under save for the future, lump the desired lifestyle you want for your family in here. It means taking into account what you want for your future. Is it a house, paying for your children's education, etc?. Financial freedom starts when you know how to manage your money. Think about investments in this category. You do not just save this money in the bank, you use it to invest in order to hedge against inflation and also to grow your money. This is an important part of keys to financial planning as it helps grow the money. Inflation is a money virus that will shrink the value of your money. Use investment as an antidote for this. 4. Personal Development: You need to continually improve yourself. I know at a young age you may not think about this too much. Start this habit early and allocate, even if it is a small sum for personal development. For example, something as simple as reading about managing money and investments. What about work related books to help you improve your work quality? All these go a long way in making you a better person. 5. Leisure: Of course, you must reward yourself. There is no sense in working so hard for the money but not being able to enjoy it. Use this pool of money in moderation though. Allocate some money for leisure weekend breaks, movies, or even the yearly traveling. 6. Charity: You do not exist in this world alone. You need to know you are truly blessed and one way to show gratitude is to contribute the money you have earned. Rich are those who can give, for one who is poor has nothing to give. Of course, for the purpose of this article I am talking about giving money, but you can go beyond that like giving your time and energy.