Personal Financial Planning

# Unit 1: Basics of Personal Financial Planning

## 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: (a) your finances, i.e., your income, assets, and liabilities, (b) your goals, i.e., your current and future financial needs and (c) 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.

## 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.

## 1.4 Process of Financial Planning

### 1.4.1 Old Personal Financial Planning

**“Old Planning” Process**

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:

1. The person or the client has to reveal his financial soundness to all the financial advisors

2. 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

3. 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.

We all make hundreds of decisions each day. Most of these decisions are quite simple and have few consequences. Some are complex and have long-term effects on our personal and financial situations.

The personal financial planning process is according to ISO 22222:2005 six-step processes which are as follows:

(1) Determining your current financial situation
(2) Developing financial goals
(3) Identifying alternative courses of action
(4) Evaluating alternatives
(5) Creating and implementing a financial action plan, and
(6) Reevaluating and revising the plan.

**Step 1: Determine Your Current Financial Situation**

In this first step of the financial planning process, you will determine your current financial situation with regard to income, savings, living expenses, and debts. Preparing a list of current asset and debt balances and amounts spent for various items gives you a foundation for financial planning activities.

**Step 2: Develop Financial Goals**

You should periodically analyze your financial values and goals. This involves identifying how you feel about money and why you feel that way. The purpose of this analysis is to differentiate your needs from your wants.

Specific financial goals are vital to financial planning. Others can suggest financial goals for you; however, you must decide which goals to pursue. Your financial goals can range from spending all of your current income to developing an extensive savings and investment program for your future financial security. Such objectives may include short term goals including savings for a deposit on a house or car, or savings for a holiday, and may be for periods of up to three to four years. Longer term goals of beyond four years include mortgage reduction, superannuation savings for retirement and general wealth accumulation.

**Step 3: Identify Alternative Courses of Action**

Developing alternatives is crucial for making good decisions. Although many factors will influence the available alternatives, possible courses of action usually fall into these categories:

- Continue the same course of action.
- Expand the current situation.
- Change the current situation.
- Take a new course of action.

Not all of these categories will apply to every decision situation; however, they do represent possible courses of action.

Creativity in decision making is vital to effective choices. Considering all of the possible alternatives will help you make more effective and satisfying decisions.

**Step 4: Evaluate Alternatives**

- You need to evaluate possible courses of action, taking into consideration your life situation, personal values, and current economic conditions.
- Consequences of Choices. Every decision closes off alternatives. For example, a decision to invest in stock may mean you cannot take a vacation. A decision to go to school full time may mean you cannot work full time. Opportunity cost is what you give up by making a choice. This cost, commonly referred to as the trade-off of a decision, cannot always be measured in dollars.
- Decision making will be an ongoing part of your personal and financial situation. Thus, you will need to consider the lost opportunities that will result from your decisions.
- Evaluating Risk
- Uncertainty is a part of every decision. Selecting a college major and choosing a career field involve risk. What if you don’t like working in this field or cannot obtain employment in it?
- Other decisions involve a very low degree of risk, such as putting money in a savings account or purchasing items that cost only a few dollars. Your chances of losing something of great value are low in these situations.
- In many financial decisions, identifying and evaluating risk is difficult. The best way to consider risk is to gather information based on your experience and the experiences of others and to use financial planning information sources.

**Financial Planning Information Sources**

Relevant information is required at each stage of the decision-making process. Changing personal, social, and economic conditions will require that you continually supplement and update your knowledge.

**Step 5: Create and Implement a Financial Action Plan**

In this step of the financial planning process, you develop an action plan. This requires choosing ways to achieve your goals. As you achieve your immediate or short-term goals, the goals next in priority will come into focus.

To implement your financial action plan, you may need assistance from others. For example, you may use the services of an insurance agent to purchase property insurance or the services of an investment broker to purchase stocks, bonds, or mutual funds.

**Step 6: Re-evaluate and Revise Your Plan**

Financial planning is a dynamic process that does not end when you take a particular action. You need to regularly assess your financial decisions. Changing personal, social, and economic factors may require more frequent assessments.

When life events affect your financial needs, this financial planning process will provide a vehicle for adapting to those changes. Regularly reviewing this decision-making process will help you make priority adjustments that will bring your financial goals and activities in line with your current life situation.

### 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.

1.7 Summary
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. A comprehensive financial plan can enhance the quality of your life and increase your satisfaction by reducing uncertainty about your future needs and resources.

The personal financial planning process is according to ISO 22222:2005 six-step processes which are as follows:
(1) Determining your current financial situation
(2) Developing financial goals
(3) Identifying alternative courses of action
(4) Evaluating alternatives
(5) Creating and implementing a financial action plan, and
(6) Reevaluating and revising the plan.

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).

1.8 Keywords
Financial Planner: A financial planner or personal financial planner is a practicing professional who helps people deal with various personal financial management issues.

Financial Planning: Financial planning is the process of meeting your life goals through the proper management of your finances.

Personal Financial Planning: Personal financial planning is broadly defined as “a process of determining an individual’s financial goals, purposes in life and life’s priorities, and after considering his resources, risk profile and current lifestyle, to detail a balanced and realistic plan to meet those goals.”

1.9 Review Questions
What is Personal Financial Planning?

Why should everyone do personal financial planning?

Discuss the benefits of personal financial planning.

List down the major advantages of personal financial planning.

What are the various steps involved in personal financial planning?

Define "Financial Planner". What are the functions of a financial planner?

What is a Financial Plan? Who can formulate a financial plan?

What are the inputs and output of a financial planning process?

"It is always better to hire a financial planner or advisor for managing your finances." Discuss.

What are the objectives behind hiring a financial planner?

What are the characteristics of good financial plan?

1.10 Further Readings
Books
Chandra, P. Financial Management - Theory and Practice, New Delhi, Tata McGraw-Hill Publishing Company Ltd., 2002, p. 3.

Sudhindra Bhat, Financial Management, New Delhi, Excel Books, 2008

Van Horne, J.C. and Wachowicz, Jr, J.M., Fundamentals of Financial Management, New Delhi, Prentice Hall of India Pvt. Ltd., 1996. p. 2.

Online link http://www.fei.org/