Topic 9 fin.planning
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  • 1. Topic 9: Part 2Financial Planning HBC242N 1
  • 2. Demographic Trends• The proportion of the Australian older population is increasing rapidly. Low fertility rates and continuous increases in life expectancy have contributed to a decrease in the number of workers supporting retirees.• The predictions are that by the year 2030, two people in the working age group will support one retired person and this number will fall to 1.4 by 2050.• Today, the dependency ratio is 3.5 workers for every retired person.Source: Australian Bureau of Statistics 2
  • 3. Macroeconomic implications of ageing population• Due to low fertility rates, the labour force participation rate is predicted to fall. Smaller number of workers will produce less products and services. Thus, the shrinking workforce will negatively affect GDP growth.• The shrinking workforce combined with the growing number of older Australians, will put pressure on Australian fiscal sustainability.• As it is more costly to support an aged person than a young person, total expenditure associated with ageing is anticipated to rise in the future, creating a budgetary gap.• The workforce will also experience ageing, with an increase of workers aged 65 and over by around 50%.Source: Productivity Commission 2005. 3
  • 4. Government initiatives to improve fiscal sustainability• An introduction of the Superannuation Guarantee Charge - 9% of Gross earnings (contributions will be slowly increased to 12% starting from the year 2013) paid by employers to designated superannuation funds, and its reforms such as: 15% tax charged only at the point of entry and on earnings, no tax charged on withdrawals whether lump sums or pensions for people retiring at the age of 60 and over. Further, abolishment of RBL, ability of drawing on super while still at work, allowable deductions for employers on contributions paid to employees aged up to 70. Raising the accessibility age to draw super from 55 years to 60. 4
  • 5. Government initiatives to improve fiscal sustainability (continued)• Keeping fiscal expenses as low as possible by providing pensions at the equivalent of 1/3 of the average male salary which are means/asset tested.• Encouraging people to stay longer at work by the introduction of tax incentives for people staying at work beyond the ‘normal’ age of retirement (currently being 65 for men).• Increasing of the “normal” retirement age for women to 65 by 2014 and men to 67 by 2024. 5
  • 6. Life Cycle HypothesesFinancial planning has its roots in the “life cycle” theory of consumptionand saving ( Modigliani and Brumberg 1954, Friedman 1957) andconsiders paths of expenditure and income over a lifetime.• Friedman & Modigliani and Brumberg assumed that households save for future consumption.• According to Friedman (1957), households will save more and consume less if the level of income they currently earn is temporarily. However, they will save less and consume more if the level of income they earn is permanent, hence the term “permanent income theory”.• In the Modigliani-Brumberg model, the planning period is finite: people save only for themselves, hence consumption and saving patterns reflect an individual’s stage in the life cycle with saving for retirement being a primary motive for deferred consumption (Modigliani and Brumberg 1954; Ando and Modigliani 1963). 6
  • 7. The graphical depiction of the Modigliani’s and Brumberg’s model of the LCH 7
  • 8. The proposition of the Modigliani’s and Bloomerg’s model of the LCH• People depend on others to expend money on their behalf (e.g. children being dependent on their parents, young people obtaining loans) while they are in their infancy or at the beginning of their adult lives.• Later, during their working lives, people generate sufficient income to meet their current expenditure and to provide some savings for future expenditure at retirement.• At retirement, people draw on their savings when salaries and wages are no longer available. 8
  • 9. What is Financial Planning ?• Financial planning is a process that helps to set objectives and arranging financial means to satisfy those objectives.• Financial means are achieved by analysing financial and non-financial position and working out a suitable investment plan which is consistent with risk-return preferences.• Financial planning involves managing the portfolio to evaluate its actual behaviour in relation to expected performance. 9
  • 10. How a $1000 investment grows over time 50000 45000 45259 40000 35000 30000 8% rate of return 25000 21725 10% rate of return 20000 17449 15000 10000 10063 5000 6727 4661 2594 2159 0 1000 0 10 20 30 40• Source: Gitman, LJ. 10
  • 11. Reasons for seeking financial advice• Changes in personal circumstances such as: - marriage or divorce; - birth of a child; - buying a home; - changing jobs; - death or illness of a family member.• Investment of a windfall gain such as an inheritance, compensation payment or redundancy payment.• Saving for retirement. 11
  • 12. Why retirement financial planning?• Retired people will no longer be able to rely on the government to provide financial support.• As a rule, most of people do not start thinking about retirement until well into their 40s or 50s, which results in a substantially reduced level of retirement income.• People do not save adequately. The introduction of compulsory super should help but we still have to wait to see its full impact.• The sooner retirement saving starts (coupled with compounded interest and salary sacrifice arrangements), the better off retirees will be. 12
  • 13. Attitudes towards retirement planning• Comments of some planners regarding financial understanding of retirement issues in the community. For example, their clients: - were surprised at how low the Age Pension is; - generally had poor funding for retirement; - thought that a lump sum of $50,000 to $60,000 constituted ‘substantial’ funds in super; and - under estimated the cost of what they want to do in retirement. 13
  • 14. Will the projected superannuation payout on retirement be sufficient to meet lifestyle requirements?• According to government estimates, saving of 12% of annual income for the 40 years of working life would give an income equal to 40% of pre-retirement salary. However, 60-80% is preferred.• According to the LCH, people want to smooth their consumption over their life cycle (keep the same life style before and after retirement), thus 40% of pre- retirement salary might not be enough.• People usually need more savings to support them in retirement than they anticipate. The outcome of under- provision is to retire later or work part-time after retirement. 14
  • 15. Six Steps Financial Planning Process• Step 1: Gathering data• Step 2: Setting goals and objectives• Step 3: Identifying any financial issues• Step 4: Preparing a financial plan• Step 5: Implementing the financial plan• Step 6: Reviewing the financial plan(Source: “Good Advice – for Peace of Mind”, Financial Planning Association of Australia, 2006.) 15
  • 16. Step 1: Gathering data• Personal details• Details of children/dependants• Employment details• Income from all sources and expenditure details (including investment income or other such as distribution from a trust)• Asset and liabilities schedule• Superannuation details• Details of existing insurance and information of further insurance needs• Tax rates 16
  • 17. Step 2: Setting goals and objectives• Goals can be short (<1 year), medium term (2-5 years) and long term (>5 years).• Establishing financials goals and objectives which will determine the types of investments made: – saving for major expenditures; – accumulating retirement funds; – being free of personal debt in retirement; – non-specific goals such as: utilise surplus income to accelerate investment capital without sacrificing the current life style. 17
  • 18. Life cycle requirements or life strategies• Consumption phase - young single people and married couples with a desire to save for the future consumption.• Wealth accumulation phase - people with established careers and with no or small mortgages seeking to establish well structured retirement plans.• Approaching retirement phase - people at the age 55 - 65 seeking to maximise their retirement funds.• Post-retirement phase - people with desire to provide satisfactory income during their retirement and seeking to preserve their savings for the long life expectancy. 18
  • 19. Step 2: Setting goals and objectives (continues)• Other issues: accessibility and liquidity As circumstances change throughout a life, liquidity and accessibility of investments need to be considered. Investing a small proportion of portfolio (around 5% of the total holding) in easy accessible investment vehicles such as term deposits should be recommended. 19
  • 20. How financial goals change with a person’s life situationPersonal Long term Intermediate- Short-term goalsSituation goals (5+ term goals (2-5 (1 year) years) years)1. University Repay Undertake Find a jobStudent university student and other exchange loans program or travel overseas2. Single, Buy a home Save enough for Attendmid 20s a deposit for a investment home seminars  Travel overseas Begin to invest 20
  • 21. How financial goals change with a person’s life situation (continued)3. Married Build a Begin an Seek a financialcouple with substantial education fund planner advicechildren diversified and begin to investment invest portfolio Buy a larger Increase Implement tax home superannuation minimisation contribution strategies (salary sacrifice)4. Married Retire at age Travel overseas Shift investmentCouple with 62 portfolio intogrown growth securitieschildren, mid50s Take long Reduce expenses holiday Increase superannuation contribution (salary sacrifice) 21
  • 22. Step 3: Identifying any financial issues• Analyse financial position to determine the current net worth, the current cash flow situation, and the saving capacity now and in the future.• Identify goals that are unattainable such as: a desire to retire early but having insufficient funds to achieve this goal.• Categorise trade-offs e.g.: increase saving, accept higher level of risk (invest in growth assets), retire later, or accept lower accumulation of funds (lower income at retirement). 22
  • 23. Risk profiling and asset allocation1. Very conservative investors – defensive investments such as cash and bonds (government or carrying high credit ratings).2. Conservative investors – aiming to reduce risk of loss and therefore accepting a lower return over the long term, mixed defensive and growth investments such as blue chips but substantial higher weighting (around 60-70%) is given to cash and bonds holdings (capital stable).3. Balanced investors – aiming to achieve reasonable returns, but less than growth funds, equal exposure to both growth (shares and property) and income investments (cash and fixed interest). 23
  • 24. Risk profiling and asset allocation (CONTINUE)4. Growth investors – aiming for higher returns over the long term but accepting a higher risk of losses in bad years, mostly growth assets such as shares and property with small proportion of portfolio shifted towards defensive/income assets.5. Aggressive investors – portfolio constructed from growth and speculative assets such as futures, options, warrants and other derivatives. 24
  • 25. Step 4: Preparing financial planAfter careful analysis of the information gathered, andidentifying goals and any issues, a financial plan will beprepared outlining the current position, goals, andrecommended strategies and investments.A good financial plan should recommend the mostappropriate strategies which will meet the client’s goalswithout substantially sacrificing their current lifestyle.A good financial plan should contain strategies that will deferand minimise an individual’s level of taxes over the long rune.g. negative gearing, salary sacrifice, income splitting. 25
  • 26. Step 5 and 6: Implementing and reviewing financial plan• The implementation occurs once the plan has been presented to the client and subsequently agreed to.• On at least an annual basis the plan should be reviewed to ensure that recommendations remain appropriate given changes to personal circumstances and external factors (e.g. changes to legislation, changes to economic conditions).• Please note: for the purpose of this subject, we only discuss the first 4 goals. 26
  • 27. What is a Statement of Advice?• Under the Financial Services Reform Act 2004 (FSRA) a financial plan/Statement of Advice (SOA) must be provided to a client whenever personal advice has been given by the planner.• The Australian Securities and Investments Commission (ASIC) views the plan as a document that outlines to the client how their goals and objectives can be met (suitable to their risk profile), while providing all information required for any reasonable person to make a decision regarding that advice. That is, not only should the plan outline the recommended strategies and investments, but also explain to the client why these have been recommended, any risks associated with the recommendations, the costs of the advice/recommendations, and how the planner/dealer group is remunerated for this advice. 27
  • 28. Statement of Advice (SOA)1. Scope of advice – are there any limitations to the advice?2. Executive summary – what is recommended and what is the outcome of the recommendations?3. Existing position – personal and financial details, current cash flow analysis.4. Goals and objectives.5. Investor risk profile – how should the client’s assets be allocated given their tolerance to risk?• Strategic recommendations – what are the strategies recommended to meet the client’s goals and objectives and why those strategies are recommended? 28
  • 29. Statement of Advice (continued) 7. Investment recommendations – what are the investments recommended to meet the client’s goals and objectives? 8. Revised position – what are the changes to cash flow after the recommendations, and what is the projected capital due to the recommendations? 9. Services – what level of service does the planner offer?10. Fees and interests – what is the cost of the advice, and how is the planner compensated?11. Disclaimer – what are the legal limitations of the advice, and what should the client be aware of prior to implementing the advice?12. Appendices – usually include further information relating to recommended strategies and investments. 29
  • 30. Timing in the market• Deciding what to invest when the world is heading for a recession, or at least an economic slowdown, is difficult. A financial planner in order to provide the best advice, should be aware of the economic cycles and its impact on investment.• A tool which people could use to understand the likely repercussions of a changing economy and how it might impact them is called an economic clock.(source:http://www.wealthtipsonline.com.au/innercircle/hotopic1.html) 30
  • 31. The Economic Clock 31
  • 32. What is the economic clock?• The economic clock demonstrates that as an economy moves through its economic cycle there is a time to buy certain types of investments and possible a time not to buy. That does not mean sell, because one of the most important investment habits to develop is a long-term investment horizon.• The economic clock identifies that the return a particular investment will generate depends on what time it is in the economic cycle.• The economic clock provides a guidance but there is no guarantee that the economy will go through the whole cycle. 32
  • 33. The Six O’clock Recession• Recessions mark the peak of a downward swing in an economic cycle.• A recession is defined as a period of two or more successive quarters of decreasing production. Production is usually measured in terms of Gross Domestic Product (GDP), so in laymans terms, any two consecutive periods of negative GDP will constitute a recession.• Recessions are characterised by high unemployment, caused by employers shedding staff as production levels fall, cutting profitability and the need for labour. With less employment comes a drop in the average weekly earnings and with fewer dollars to spend, consumers demand less, resulting in even lower consumption. 33
  • 34. Recovery Till Midnight• A recovery from recession begins with a fall of interest rates.• It is an excellent time to invest in the stockmarket as companies are well placed to obtain higher earnings from growth in target markets resulting in higher share prices and bigger profit distributions.• Share prices move through a period of gradual increases as the hour hands pass between six oclock until about eleven oclock when those who have missed out on the stockmarket gain start buying leading to more aggressive market highs. A frenzy begins which marks the beginning of the end of the recovery cycle, which peaks when the economy is booming.• Just before midnight a phenomenon known as the greater fool theory begins. The greater fool theory suggests that no matter what price an investor pays for a share, someone (the greater fool), with less education and less understanding of the market, will buy it at a higher price. You know you are in the great fool period when you hear that investors with little or no knowledge of the fundamentals of investing believe they cant lose. 34
  • 35. Midnight Boom Before The Impending Correction• Well before the clock strikes midnight the wise investors have exited stocks and are looking for the next opportunity. They have left because they understand that there is likely to be a correction in the market, since share prices cannot be justified by traditional stock valuation methods.• As investors leave the market, supply become higher than demand triggering a sell off and a slump in share prices. Investors who were too slow (or greedy) are burned, particularly those that have leveraged (via margin lending facilities) and the market is in a fall. 35
  • 36. Property Till Three OClock• The smart investors that got out at the top move into property with reliable bricks and mortar.• Extra demand in property pushes demand above supply and results in higher prices.• This itself isnt a problem, except that the government sees the economy is overheating and looks to introduce measures to enable a soft landing through increasing interest rates to flatten demand by consumers.• With higher interest rates comes less profit in real estate since most investors have leveraged their property purchases. Rises in interest rates continue until it is no longer viable for purchasers to continue investing in property and soon there are more sellers than buyers. Property prices, like share prices, correct. 36
  • 37. Decline Back To Six OClock• Decline begins as business confidence begins to fall. Investors find little value in either stocks or property and with impending trouble on the horizon fixed interest securities become very popular again.• Lower business confidence means that new capital ventures are postponed.• Less spending and higher interest rates result in lower demand, which results in less production. With fewer sales there is a squeeze on earnings, resulting in profit downgrades.• The economy slows to the point where productivity stalls and then declines. When this happens for two periods in a row, the economy is said to be in a recession. 37