Do you picture yourself owning a new home, starting a business, or retiring comfortably? These are a few of the financial goals that may be important to you, and each comes with a price tag attached. That's where financial planning comes in. Financial planning is a process that can help you reach your goals by evaluating your whole financial picture, then outlining strategies that are tailored to your individual needs and available resources.
WHY IS FINANCIAL PLANNING IMPORTANT?
One of the main benefits of having a financial plan is that it can help you balance competing financial priorities. A financial plan will clearly show you how your financial goals are related, for example, how saving for your children's college education might impact your ability to save for retirement. Then you can use the information you've gleaned to decide how to prioritize your goals, implement specific strategies, and choose suitable products or services. Best of all, you'll have the peace of mind that comes from knowing that your financial life is on track.
THE FINANCIAL PLANNING PROCESS
- Creating and implementing a comprehensive financial plan generally involves working with financial professionals to:
- Develop a clear picture of your current financial situation by reviewing your income, assets, and liabilities, and evaluating your insurance coverage, your investment portfolio, your tax exposure, and your estate plan
- Establish and prioritize financial goals and time frames for achieving these goals
- Implement strategies that address your current financial weaknesses and build on your financial strengths Choose specific products and services that are tailored to meet your financial objectives
- Monitor your plan, making adjustments as your goals, time frames, or circumstances change
SOME MEMBERS OF THE TEAM
- The financial planning process can involve a number of professionals. Financial planners typically play a central role in the process, focusing on your overall financial plan, and often coordinating the activities of other professionals who have expertise in specific areas. Financial Planners also provide advice about investment options and asset allocation, and can help you plan a strategy to manage your investment portfolio.
- Accountants or tax attorneys provide advice on federal and state tax issues.
- Estate planning attorneys help you plan your estate and give advice on transferring and managing your assets before and after your death.
- Insurance professionals evaluate insurance needs and recommend appropriate products and strategies
- The most important member of the team, however, is you. Your needs and objectives drive the team, and once you've carefully considered any recommendations, all decisions lie in your hands
WHY CAN'T I DO IT MYSELF?
You can, if you have enough time and knowledge, but developing a comprehensive financial plan may require expertise in several areas. A financial professional can give you objective information and help you weigh your alternatives, saving you time and ensuring that all angles of your financial picture are covered
STAYING ON TRACK
The financial planning process doesn't end once your initial plan has been created. Your plan should generally be reviewed at least once a year to make sure that it's up-to-date. It's also possible that you'll need to modify your plan due to changes in your personal circumstances or the economy. Here are some of the events that might trigger a review of your financial plan
- Your goals or time horizons change
- You experience a life-changing event such as marriage, the birth of a child, health problems, or a job loss
- You have a specific or immediate financial planning need (e.g., drafting a will, managing a distribution from a retirement account, paying long-term care expenses)
- Your income or expenses substantially increase or decrease
- Your portfolio hasn't performed as expected
- You're affected by changes to the economy or tax laws
COMMON QUESTIONS ABOUT FINANCIAL PLANNING:
What if I'm too busy?
- Don't wait until you're in the midst of a financial crisis before beginning the planning process. The sooner you start, the more options you may have.
Is the financial planning process complicated?
- Each financial plan is tailored to the needs of the individual, so how complicated the process will be depends on your individual circumstances. But no matter what type of help you need, a financial professional will work hard to make the process as easy as possible, and will gladly answer all of your questions.
What if my spouse and I disagree?
- A financial professional is trained to listen to your concerns, identify any underlying issues, and help you find common ground.
Can I still control my own finances
- Financial planning professionals make recommendations, not decisions. You retain control over your finances. Recommendations will be based on your needs, values, goals, and time frames. You decide which recommendations to follow, then work with a financial professional to implement them.
SHOULD YOU PAY OFF YOUR MORTGAGE OR INVEST?
Owning a home outright is a dream that many Americans share. Having a mortgage can be a huge burden, and paying it off may be the first item on your financial to-do list. But competing with the desire to own your home free and clear is your need to invest for retirement, your child's college education, or some other goal. Putting extra cash toward one of these goals may mean sacrificing another. So how do you choose?
EVALUATING THE OPPORTUNITY COST:
Deciding between prepaying your mortgage and investing your extra cash isn't easy, because each option has advantages and disadvantages. But you can start by weighing what you'll gain financially by choosing one option against what you'll give up. In economic terms, this is known as evaluating the opportunity cost.
Here's an example. Let's assume that you have a $300,000 balance and 20 years remaining on your 30-year mortgage, and you're paying 6.25% interest. If you were to put an extra $400 toward your mortgage each month, you would save approximately $62,000 in interest, and pay off your loan almost 6 years early.
By making extra payments and saving all of that interest, you'll clearly be gaining a lot of financial ground. But before you opt to prepay your mortgage, you still have to consider what you might be giving up by doing so--the opportunity to potentially profit even more from investing.
To determine if you would come out ahead if you invested your extra cash, start by looking at the after-tax rate of return you can expect from prepaying your mortgage. This is generally less than the interest rate you're paying on your mortgage, once you take into account any tax deduction you receive for mortgage interest. Once you've calculated that figure, compare it to the after-tax return you could receive by investing your extra cash.
For example, the after-tax cost of a 6.25% mortgage would be approximately 4.5% if you were in the 28% tax bracket and were able to deduct mortgage interest on your federal income tax return (the after-tax cost might be even lower if you were also able to deduct mortgage interest on your state income tax return). Could you receive a higher after-tax rate of return if you invested your money instead of prepaying your mortgage?
Keep in mind that the rate of return you'll receive is directly related to the investments you choose. Investments with the potential for higher returns may expose you to more risk, so take this into account when making your decision.
OTHER POINTS TO CONSIDER:
While evaluating the opportunity cost is important, you'll also need to weigh many other factors. The following list of questions may help you decide which option is best for you:
- What's your mortgage interest rate? The lower the rate on your mortgage, the greater the potential to receive a better return through investing.
- Does your mortgage have a prepayment penalty? Most mortgages don't, but check before making extra payments.
- How long do you plan to stay in your home? The main benefit of prepaying your mortgage is the amount of interest you save over the long term; if you plan to move soon, there's less value in putting more money toward your mortgage.
- Will you have the discipline to invest your extra cash rather than spend it? If not, you might be better off making extra mortgage payments.
- · Do you have an emergency account to cover unexpected expenses? It doesn't make sense to make extra mortgage payments now if you'll be forced to borrow money at a higher interest rate later. And keep in mind that if your financial circumstances change, if you lose your job or suffer a disability, for example, you may have more trouble borrowing against your home equity.
- How comfortable are you with debt? If you worry endlessly about it, give the emotional benefits of paying off your mortgage extra consideration.
- Are you saddled with high balances on credit cards or personal loans? If so, it's often better to pay off those debts first. The interest rate on consumer debt isn't tax deductible, and is often far higher than either your mortgage interest rate or the rate of return you're likely to receive on your investments.
- Are you currently paying mortgage insurance? If you are, putting extra toward your mortgage until you've gained at least 20% equity in your home may make sense.
- How will prepaying your mortgage affect your overall tax situation? For example, prepaying your mortgage (thus reducing your mortgage interest) could affect your ability to itemize deductions (this is especially true in the early years of your mortgage, when you're likely to be paying more in interest).
- Have you saved enough for retirement? If you haven't, consider contributing the maximum allowable each year to tax-advantaged retirement accounts before prepaying your mortgage. This is especially important if you are receiving a generous employer match. For example, if you save 6% of your income, an employer match of 50% of what you contribute (i.e., 3% of your income) could potentially add thousands of extra dollars to your retirement account each year. Prepaying your mortgage may not be the savviest financial move if it means forgoing that match or shortchanging your retirement fund.
- How much time do you have before you reach retirement or until your children go off to college? The longer your time frame, the more time you have to potentially grow your money by investing. Alternatively, if paying off your mortgage before reaching a financial goal will make you feel much more secure, factor that into your decision
THE MIDDLE GROUND
If you need to invest for an important goal, but you also want the satisfaction of paying down your mortgage, there's no reason you can't do both. It's as simple as allocating part of your available cash toward one goal, and putting the rest toward the other. Even small adjustments can make a difference. For example, you could potentially shave years off your mortgage by consistently making biweekly, instead of monthly, mortgage payments, or by putting any year-end bonuses or tax refunds toward your mortgage principal.
And remember, no matter what you decide now, you can always re-prioritize your goals later to keep up with changes to your circumstances, market conditions, and interest rates.
HOW MUCH ANNUAL INCOME CAN YOUR RETIREMENT PORTFOLIO PROVIDE?
Your retirement lifestyle will depend not only on your assets and investment choices, but also on how quickly you draw down your retirement portfolio. The annual percentage that you take out of your portfolio, whether from returns or the principal itself, is known as your withdrawal rate. Figuring out an appropriate initial withdrawal rate is a key issue in retirement planning and presents many challenges.
WHY IS YOUR WITHDRAWAL RATE IMPORTANT?
TAKE OUT TOO MUCH TOO SOON, AND YOU MIGHT RUN OUT OF MONEY IN YOUR LATER YEARS. TAKE OUT TOO LITTLE, AND YOU MIGHT NOT ENJOY YOUR RETIREMENT YEARS AS MUCH AS YOU COULD. YOUR WITHDRAWAL RATE IS ESPECIALLY IMPORTANT IN THE EARLY YEARS OF YOUR RETIREMENT; HOW YOUR PORTFOLIO IS STRUCTURED THEN AND HOW MUCH YOU TAKE OUT CAN HAVE A SIGNIFICANT IMPACT ON HOW LONG YOUR SAVINGS WILL LAST.
Gains in life expectancy have been dramatic. According to the National Center for Health Statistics, people today can expect to live more than 30 years longer than they did a century ago. Individuals who reached age 65 in 1950 could anticipate living an average of 14 years more, to age 79; now a 65-year-old might expect to live for roughly an additional 19 years. Assuming rising inflation, your projected annual income in retirement will need to factor in those cost-of-living increases. That means you'll need to think carefully about how to structure your portfolio to provide an appropriate withdrawal rate, especially in the early years of retirement.
SO WHAT WITHDRAWAL RATE SHOULD YOU EXPECT FROM YOUR RETIREMENT SAVINGS? THE ANSWER: IT ALL DEPENDS. A SEMINAL STUDY ON WITHDRAWAL RATES FOR TAX-DEFERRED RETIREMENT ACCOUNTS (WILLIAM P. BENGEN, "DETERMINING WITHDRAWAL RATES USING HISTORICAL DATA," JOURNAL OF FINANCIAL PLANNING, OCTOBER 1994) LOOKED AT THE ANNUAL PERFORMANCE OF HYPOTHETICAL PORTFOLIOS THAT ARE CONTINUALLY REBALANCED TO ACHIEVE A 50-50 MIX OF LARGE-CAP (S&P 500 INDEX) COMMON STOCKS AND INTERMEDIATE-TERM TREASURY NOTES. THE STUDY TOOK INTO ACCOUNT THE POTENTIAL IMPACT OF MAJOR FINANCIAL EVENTS SUCH AS THE EARLY DEPRESSION YEARS, THE STOCK DECLINE OF 1937-1941, AND THE 1973-1974 RECESSION. IT FOUND THAT A WITHDRAWAL RATE OF SLIGHTLY MORE THAN 4% WOULD HAVE PROVIDED INFLATION-ADJUSTED INCOME FOR AT LEAST 30 YEARS. MORE RECENTLY, BENGEN USED SIMILAR ASSUMPTIONS TO
show that a higher initial withdrawal rate--closer to 5%--might be possible during the early, active years of retirement if withdrawals in later years grow more slowly than inflation.
Other studies have shown that broader portfolio diversification and re-balancing strategies also can have a significant impact on initial withdrawal rates. In an October 2004 study ("Decision Rules and Portfolio Management for Retirees: Is the 'Safe' Initial Withdrawal Rate Too Safe?," Journal of Financial Planning) Jonathan Guyton found that adding asset classes such as international stocks and real estate helped increase portfolio longevity (although these may entail special risks). Another strategy that Guyton used in modeling initial withdrawal rates was to freeze the withdrawal amount during years of poor portfolio performance. By applying so-called decision rules that take into account portfolio performance from year to year, Guyton found it was possible to have "safe" initial withdrawal rates above 5%.
A still more flexible approach to withdrawal rates builds on Guyton's methodology ("Using Decision Rules to Create Retirement Withdrawal Profiles Journal of Financial Planning, August 2007). William J. Klinger suggests that a withdrawal rate can be fine-tuned from year to year, using Guyton's methods but basing the initial rate on one of three retirement profiles. For example, one person might withdraw uniform inflation-adjusted amounts throughout his or her retirement. Another might choose to spend more money early in retirement and less later; still another might plan to increase withdrawals as he or she ages. This model also requires estimating the odds that the portfolio will last throughout retirement. One retiree might be comfortable with a 95% chance that his or her strategy will permit the portfolio to last throughout retirement; another might need assurance that the portfolio has a 99% chance of lifetime success. The study suggests that this more complex model might permit a higher initial withdrawal rate, but also means the annual income provided is likely to vary more over the years.
Don't forget that all these studies were based on historical data about the performance of various types of investments. Given market performance in recent years, many experts are suggesting being more conservative in estimating future returns.
Note: Past results don't guarantee future performance.
INFLATION IS A MAJOR CONSIDERATION
For many people, even a 5% withdrawal rate seems low. To better understand why suggested initial withdrawal rates aren't higher, it's essential to think about how inflation can affect your retirement income.
Here's a hypothetical illustration; to keep it simple, it does not account for the impact of any taxes. If a $1 million portfolio is invested in an account that yields 5%, it provides $50,000 of annual income. But if annual inflation pushes prices up by 3%, more income--$51,500--would be needed next year to preserve purchasing power. Since the account provides only $50,000 income, an additional $1,500 must be withdrawn from the principal to meet expenses. That principal reduction, in turn, reduces the portfolio's ability to produce income the following year. In a straight linear model, principal reductions accelerate, ultimately resulting in a zero portfolio balance after 25 to 27 years, depending on the timing of the withdrawals.
VOLATILITY AND PORTFOLIO LONGEVITY
When setting an initial withdrawal rate, it's important to take a portfolio's ups and downs into account—and the need for a relatively predictable income stream in retirement isn't the only reason. According to several studies in the late 1990s by Philip L. Cooley, Carl M. Hubbard, and Daniel T. Walz, the more dramatic a portfolio's fluctuations, the greater the odds that the portfolio might not last as long as needed. If it becomes necessary during market downturns to sell some securities in order to continue to meet a fixed withdrawal rate, selling at an inopportune time could affect a portfolio's ability to generate future income.
Making your portfolio either more aggressive or more conservative will affect its lifespan. A more aggressive portfolio may produce higher returns but might also be subject to a higher degree of loss. A more conservative portfolio might produce steadier returns at a lower rate, but could lose purchasing power to inflation.
CALCULATING AN APPROPRIATE WITHDRAWAL RATE
Your withdrawal rate needs to take into account many factors, including (but not limited to) your asset allocation, projected inflation rate, expected rate of return, annual income targets, investment horizon, and comfort with uncertainty. The higher your withdrawal rate, the more you'll have to consider whether it is sustainable over the long term.
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