Financial plan A case study - Free Essay Example

FINANCIAL PLAN FOR DR. MARK TAYLOR To: Dr. Mark Taylor From: Financial Consultant Date: 16 May 2007 Introduction The purpose of a personal financial plan for Dr. Mark Taylor is to define his individual financial goals and find ways to achieve them. To identify goals for Dr. Taylor, it is essential to first understand what is important to him. But before doing that, Dr. Taylorà ¢Ã¢â€š ¬Ã¢â€ž ¢s current state of affairs are examined (Refer Appendix A for Dr. Taylorà ¢Ã¢â€š ¬Ã¢â€ž ¢s Current State of Affairs) a) Financial Needs of Dr. Taylorà ¢Ã¢â€š ¬Ã¢â€ž ¢s Family Based on Dr. Taylorà ¢Ã¢â€š ¬Ã¢â€ž ¢s personal situation at this point in life, all or just a few of the following may be his goals. Retire comfortably and have a reasonably good lifestyle post- retirement Provide for Davidà ¢Ã¢â€š ¬Ã¢â€ž ¢s college education. Be adequately covered for risk While some of these goals would be desirable, others are essential. Besides, goals can change over time. Deciding how to achieve the goals of Dr. Taylor is the crux of this financial plan. Assumptions: Financial plan is a plan for the future and future is uncertain. Therefore, certain assumptions have been made for defining the financial plan: Both Dr. Taylor and his wife have a life expectancy of 90 years Dr. Taylor will retire at an age of 65 years There is a single digit inflation of 3% Earnings as well as expenses will be affected by the same rate of change. Therefore, the change in income or expenses will be nullified Dr. Taylorà ¢Ã¢â€š ¬Ã¢â€ž ¢s premature death will result in a 20% reduction of annual living expenses Dr. Taylor will be practicing good financial habits such as having a spending plan, investing regularly, and using credit wisely (Source: Garner et al (1999) Defining Timeframe for Goals ((Source: Yamanda Louisa )) Following a discussion with Dr. Taylor, a time frame has been defined for accomplishment of the main goals Short Term ( 2 years or less) Mid Term ( 2-10 years) Long Term ( More than 10 years) Comfortable retirement* 2024 onwards Childà ¢Ã¢â€š ¬Ã¢â€ž ¢s Education 2014 Adequate Insurance 2007-08 *Comfortable retirement will also imply having own assets like a car at the time of retirement which is currently provided by the hospital. Dr Taylor needs to consider whether the time frame for a specific goal is flexible or has a fairly strict schedule. For instance, if he expects David to graduate from high school in 2014, he will want to make sure he has the money at that time to pay his college expenses. On the other hand, some goals like providing insurance coverage may be flexible. On the basis of these assumptions and the time frame, financial needs of Dr. Taylorà ¢Ã¢â€š ¬Ã¢â€ž ¢s family have been worked out. Dr. Taylorà ¢Ã¢â€š ¬Ã¢â€ž ¢s Family Needs To determine the amount that Dr. Taylor will need in the future, it becomes imperative to put a price to Dr. Taylorà ¢Ã¢â€š ¬Ã¢â€ž ¢s goals. Like the goals themselves, the costs too may change over time. This is because some things may grow increasingly expensive while others may become more affordable with the passage of time. Cost of most of the short-term goals can be anticipated by checking current prices. It is reasonable to assume that the cost will not be significantly different from what it is in the current year. (Source: Garner et al 1999) Retirement Planning Looking at Dr. Taylorà ¢Ã¢â€š ¬Ã¢â€ž ¢s present portfolio and the projected inflation, it seems that at present he is able to maintain a good lifestyle. However, this may not be sufficient if he desires a similar lifestyle after retirement. The rule of thumb with retirement planning is that Dr. Taylor will need at least 75% to 85% of what he is currently earning to maintain his lifestyle when he retires. Thus, if he earns  £100,000 (including bonus) today, he will need an income of  £75,000 in the first year of retirement. Dr. Taylor should have accumulated sufficient amount in a retirement account to make it possible to withdraw what he needs when he retires. On an average, assuming the balance is compounding at an average annual rate of 6%, inflation averages 3% (assumed), and Dr. Taylor is planning on a 17-year retirement, at the time he retires he should have about 17 times the amount he expects to need in the first year. That should allow him to withdraw 5% of the total each year. Thus, if he plans to withdraw  £75,000 in the first year, he should have savings of about  £1.27 million. ( £75,000 * 17). This amount can be reduced as the assumption for the financial plan is that when Dr. Taylor retires, his expenses will come down by 20%. (Source: Yamanda Louisa ) Davidà ¢Ã¢â€š ¬Ã¢â€ž ¢s Education Needs College costs for David can be estimated on the basis of average annual increases in the recent past. In the UK education costs seem to increase in line with the inflation. Dr Taylor may take insurance to cover the education costs of David. Alternatively he may invest money in an Education Saving Plan each year. The current cost for four years of university education, including books and additional fee, is approximately  £25000. Davidà ¢Ã¢â€š ¬Ã¢â€ž ¢s college education will begin in 2014. On the basis of the annual increases (in line with an inflation rate of 3%), his requirement each year beginning 2014 can be calculated by providing for the inflation. (Refer appendix A ). However, as David is currently going to a grammar school and Dr. Taylor is affording a fee of  £14,000 per annum and also at the time of Davidà ¢Ã¢â€š ¬Ã¢â€ž ¢s college, Dr. Taylor would not have retired, Davidà ¢Ã¢â€š ¬Ã¢â€ž ¢s education costs seem to be sufficiently covered. Emergency Fund In addition to the estimates based on the current requirements, an emergency fund too may be build up that will help prevent Dr. Taylor from being thrown off track by an unplanned loss of income or unexpected expenses. Dr. Taylor should keep around 6 months salary as emergency fund. Risk / Return Profile of Dr. Taylor Dr. Taylor seems to be a conservative investor. He has put money in a Building Society account which has a low risk. He has a portfolio of shares but these shares have been inherited and not invested by Dr. Taylor. Re-looking at Asset Allocation There is a need to re-look at his asset allocation. Dr. Taylor needs a strategy to help ensure that the money is available when he needs it. We recommend saving or investing or some combination of the two to ensure this. Saving vs. Investing While saving and investing both involve setting aside some of Dr. Taylorà ¢Ã¢â€š ¬Ã¢â€ž ¢s income, saving will help Dr. Taylor preserve the money he has for a later time while earning interest on the principal. However, if he invests, he takes some calculated risks that he believes will make it possible for his investment to grow in value over time or provide long-term income, or both. Saving may prove to be an effective way of managing money to meet short-term needs. However, Dr. Taylor needs investments to achieve his longer-term goals. Invested money has the potential to increase substantially in value over the long term or provide more income than insured savings. The risk, of course, is that returns on investment assets are not guaranteed. Dr. Taylor has 17 years before he retires. ( Source: Jeffrey H Rattiner (2005)) He may benefit by setting aside some sum for long-term goals to equities either individually or through exchange-traded funds (ETFs), mutual funds, or managed accounts that invest in stocks. (Refer Appendix B for features on recommended products) Although the value of an investment portfolio may fluctuate dramatically over periods over 15 or 20 years the earnings have the opportunity to compound. Inflation is another reason Dr. Taylor may want to invest rather than use a savings account to meet his long-term financial goals. This is because the rate of return on savings accounts is generally fairly low, and he may risk falling victim to inflation. à ¢Ã¢â€š ¬Ã‚ For example, if he puts  £10,000 in a money market account earning 2.5% interest, his account would have  £15,676 after 18 years. If inflation averaged 3% per year, his account value would have approximately  £8,500 worth of buying power. Alternatively, if he invests the money in a portfolio of stocks with an average annual return of 8% for 18 years, though not a guaranteed, he could have  £40,000. After accounting for 3% inflation he still would have more than  £21,500 worth of buying power. By keeping a close eye on your portfolio, Dr. Taylor can manage some of the risk that is often associated with investments. He should determine when to sell an investment, either to lock in a profit or prevent a loss.à ¢Ã¢â€š ¬Ã‚ (Source: Yamanda Louisa ) Thus, we would recommend an asset allocation to Dr. Taylor that maximizes return on his portfolio while minimising the risk. Dr. Taylor should move from his current asset allocation as given below to a more balanced allocation and have a diversified portfolio. His portfolio should include investment in equity for growth, building society account for income and balanced returns through balanced stocks and bonds. We would propose an asset allocation as given below: Insurable Risk In addition to all the recommended investments for retirement planning, Dr. Taylor should also invest in life Insurance and disability insurance. Dr. Taylorà ¢Ã¢â€š ¬Ã¢â€ž ¢s family faces some risks which are insurable. These include the following: Dr. Taylor and / or his wife may die or become disabled Risk to the house and its contents, failure to pay mortgage Taxes may be outstanding Childà ¢Ã¢â€š ¬Ã¢â€ž ¢s Education costs need to be met Some of these risks are already covered for Dr. Taylor. For instance, Dr. Taylorà ¢Ã¢â€š ¬Ã¢â€ž ¢s house is insured for  £500,000 and its contents for  £100,000. Besides, Dr. Taylor has a term assurance policy for  £200,000 to cover repayment of the mortgage on his or Julieà ¢Ã¢â€š ¬Ã¢â€ž ¢s death. However, Dr. Taylor requires adequate life insurance, disability insurance, outstanding debt and taxes insurance and maybe insurance for Davidà ¢Ã¢â€š ¬Ã¢â€ž ¢s education. In fact, if Dr. Taylor takes a permanent life insurance, he will also be covered for his childà ¢Ã¢â€š ¬Ã¢â€ž ¢s education, outstanding debt and taxes etc. If Dr. Taylor dies, life insurance will provide an income for survivors, coverage of funeral expenses, capital gains taxes on investments, real estate at death etc. However, Dr. Taylor should only take up the insurance in accordance to his affordability as if he defaults in payment of premium, it will merely wipe out the potential protection. Also the policy has to be adequate as if the policy is too small, his beneficiaries may have to use investment assets earmarked for future goals to pay living expenses. (Source: Hallman et al (2003)) Besides life insurance, Dr. Taylor should also take disability insurance. Disability insurance will offer protection against the possibility of being unable to meet the requirements of the family if Dr. Taylor is rendered disabled due to accident or illness. Most disability policies pay a percentage of salary (50% to 70%) if the insured is rendered disabled. In fact, disability insurance can make a major difference to Dr. Taylorà ¢Ã¢â€š ¬Ã¢â€ž ¢s financial security should the unexpected happen. (Source: Hallman et al (2003)) Adequacy of Pension Based on the 15-year contributions made by Dr. Taylor, the pension balance stands at  £195000 (Refer Annexure A). By the time Dr. Taylor retires, another 17-years contribution would have been made. The impact of inflation on Pension fund has already been provided for and therefore the decline in the value of cash received at a later date is taken care of. It is assumed that when Dr. Taylor retires, there will be a 20% reduction in the expenses. However, it is also given that if something happens to Dr. Taylor, his wife will only be entitled to 50% of the pension. Therefore, Dr. Taylor should increase the amount of pension so that his family is adequately covered even if he dies. This can be done supplementing pension in two ways: Through personal pension Through stakeholders pension on behalf of David There is no maximum amount prescribed for such pension schemes. Personal Pension A personal pension scheme will provide Dr. Taylorà ¢Ã¢â€š ¬Ã¢â€ž ¢s family a pension and a tax-free lump sum, payable if he dies before retirement. Dr. Taylor may get a tax-free lump sum on retirement of up to 25% of the pension fund which has been built up from his contributions and interest and/or bonuses paid by the pension provider. (Refer Appendix B for more details) Stakeholders Pension Dr. Taylor can start contributions to this pension from as little as  £20, and pay weekly, monthly or at less regular intervals. He will get tax relief on contributions of up to 100 per cent of your earnings each year, subject to anannual allowance ( £225,000 for the 2007-2008 tax year). (Refer Appendix B for more details) Recommendations As indicated earlier, Dr. Taylor needs to re-look at the asset allocation and balance his current portfolio. Dr. Taylor is using his cash earnings to meet his current requirements. However, cash earnings will not keep pace with the rate of inflation. Over time, as inflation and taxes erode what Dr. Taylor earns may not be sufficient to maintain his lifestyle. However, one cannot ignore Dr. Taylorà ¢Ã¢â€š ¬Ã¢â€ž ¢s gross estate that form a part of the inheritance and legacy he leaves behind to his wife and child. Thus, He needs to have adequate amount to ensure adequate finances when he retires as well as meet his goals of providing security to his family and education to his son. Dr. Taylor will require at least 17 times his present earnings at the time of retirement. However, if he anticipates a longer retirement period, his rate of return may average less than 6% a year. Similarly, if inflation averages more than 3%, he will either need more savings or will have to withdraw at a lower rate. Dr. Taylor needs to invest in the following in the same order of priority: Equities either individually or through exchange-traded funds (ETFs), mutual funds, or managed accounts that invest in stocks. Life insurance and disability insurance Emergency fund Education Saving Plan Total Words Excluding Appendices = 2362 APPENDICES APPENDIX A Dr. Mark Taylorà ¢Ã¢â€š ¬Ã¢â€ž ¢s Present Position Dr. Taylorà ¢Ã¢â€š ¬Ã¢â€ž ¢s family Member Age Self 48 Remaining work life 17 years Julie 40 Does not work David 7 Major expense in the future will be on education Personal Income and Expense Statement based on Current Requirements Income Annual Amount ( £) Pre-tax salary income including bonus ( average) 100,000 Family Other Income (Yield @2.5% on shares)* 1,875 Income Taxes (Assuming a 40% tax slab)** 40,750 Total Family Income (After Taxes) 61,125 Own Contribution towards Pension*** 4,000 Net Available Income 57,125 Expenses Annual Amount ( £) Mortgage**** 11,400 Food / Clothing (@1200 per month) 14,400 Healthcare (@ 500 per month) 6,000 Utilities @500 per month 6,000 Childà ¢Ã¢â€š ¬Ã¢â€ž ¢s Education 14,000 Entertainment (@200 per month) 2,400 Miscellaneous 800 Total Expenses 55,000 Net Savings 2,125 Contribution to Building Society 2,125 *Refer Working Note 1 below for calculation of yield on shares ** Tax slab on an average is assumed to be 40% for Dr. Taylor *** Refer Working Note 2 below for calculation of contribution towards pension ****Mortgage is assumed to be at a rate of 5% currently (Refer working note 3 below for calculation of mortgage amount) Note: All the expenses stated above are mere estimates. Familyà ¢Ã¢â€š ¬Ã¢â€ž ¢s Present Assets Assets Present Value House bought in 1997 for  £350,000  £500,000 The house is partly financed with a  £200,000 25-year variable interest repayment mortgage from the Northern Rock Equity Shares  £75,000 Joint Building Society Account Deposit  £50,000 Mrs. Taylorà ¢Ã¢â€š ¬Ã¢â€ž ¢s building society account deposit  £15,000 Pension ( Current Value)  £195,000 (Refer Working Note 2 in Appendix B) Risk Coverage Coverage State Post Retirement Pension will be uplifted each year by a maximum of 4% to allow for inflation. Death If Dr. Taylor dies during employment, a lump sum of 2.5 time final salary will be paid to the family No life insurance or long-term disability policies. If Dr. Taylor should die, his wife would be paid half the pension that would have been paid to Dr. Taylor. No additional pension is paid for the children. Childà ¢Ã¢â€š ¬Ã¢â€ž ¢s Education Not covered Working Notes: Calculation of Yield on Shares Yield on shares = 2.5% of  £75,000 Calculation of Pension Contribution to Pension = Own contribution + Employerà ¢Ã¢â€š ¬Ã¢â€ž ¢s contribution = 5% of  £80,000 + 10% of  £80,000=  £13000 15 year contribution =  £13000 x 15 =  £195000 Calculation of present annual repayment mortgage amount Total amount on mortgage in 1997  £200,000 Mortgage Period 25 years Remaining Period left in 2007, 25 years à ¢Ã¢â€š ¬Ã¢â‚¬Å" 10 years (from 1997 to 2007) = 15 years Assumed variable rate of interest =5 % per annum Principal amount due =  £8,000 Total amount due per annum = £11,400 Calculation of Davidà ¢Ã¢â€š ¬Ã¢â€ž ¢s Fee in 2014 Fee required after 7-8 years = 25000 (1+0.03)8 Note: Due to unavailability f data, some calculations use hypothetical data APPENDIX B Recommended Financial Products Equity Investment Equity investment generally involves buying and holding of shares of stock on a stock market. Returns are in the form of income from dividends and capital gain as the value of the stock rises. Exchange Traded Funds Exchange-traded funds are open ended mutual funds that can be traded at any time throughout the course of the day. ETFs try to replicate a stock market index such as the SP 50 Life Insurance Life insurance provides for a payment of a sum of money upon the death of the insured. In addition, life insurance can be used as a means of investment or saving. It is one of the most important investments to provide financial security to the family. Life insurance benefits payable to a designated beneficiary are non-taxable and are not subject to probate fees. Disability Insurance Disability insurance offers protection against the possibility that one may not be able to meet his / her financial obligations due to accident or illness. Long-term disability insurance is provided with coverage equal to about sixty percent (60%) of the gross salary when combined with social security and other benefits. Personal pension Scheme It is a UK tax-privileged individual savings plan, designed to build a capital sum exclusively to provide retirement benefits. The capital sum must be used to provide benefits between age 50 and 75. On vesting a tax-free lump sum of up to 25% of the fund can be taken but the remainder must be used to provide an income either through a drawdown arrangement or through the purchase of an annuity. Stakeholderà ¢Ã¢â€š ¬Ã¢â€ž ¢s Pension Scheme They are a new form of private pension and form an integral part of the governmentà ¢Ã¢â€š ¬Ã¢â€ž ¢s overall pension policy. One gets a tax relief on contributions of up to 100 per cent of your earnings each year, subject to anannual allowance ( £225,000 for the 2007-2008 tax year). If you are a higher rate taxpayer you can claim the extra tax back. Savings above the annual allowance will be subject to a tax charge. References: G. Victor Hallman, Jerry S. Rosenbloom (2003) Personal Financial Planning McGraw-Hill Jeffrey H Rattiner (2005) Financial Planning Answer Book, CCH Publishers Robert J. Garner, Charles L. Ratner, Barbara J. Raasch, Martin Nissenbaum, Robert B. Coplan (1999) 3rd Edition, Ernst and Youngs Personal Financial Planning Guide, John Wiley Sons Yamanda Louisa, Creating a personal Financial Plan, accessed from https://www.pathtoinvesting.org/experts/finanplan/exp_pm_finanplan_071.htm Page 1 of 10