MG105 – Personal FinanceChapter 1-Understanding the Financial Planning Process

Professor’s Message:

I would like to welcome you to our first chapter of Personal Finance and I encourage you to read the Chapter outline, then view the PowerPoint presentation, read the Chapter in the book, and finally complete assignments and take quizzes as posted.

Learning Objectives and Lecture Notes

After reading this chapter, you should be able to:

 Identify the benefits of using personal financial planning techniques to manage your finances Describe the personal financial planning process and define your goals Explain the life cycle of financial plans, the role they play in achieving your financial goals, how to deal

with special planning concerns, and the use of professional financial planners Examine the economic environment’s influence on personal financial planning Evaluate the impact of age, education, and geographic location on personal income Explain the importance of career choices and their relationship to personal financial planning

This chapter discusses the basics of personal finance and it introduces the concept of financial planning. While this may seem simple enough for a person to figure out on his own, financial planning requires more than creating a list of revenue and expense sources. Additionally, the impact of financial planning could be felt for a long period of time and it has a direct correlation to an individual’s standard of living.

CHAPTER OUTLINE

Why Is This Chapter Important for you?

Financial planning is an integral part of everyone’s life; however, not many people take the time needed to properly manage and plan their finances. This chapter along with the remaining chapters in this book could change your life significantly. Your standard of living, the satisfaction you get out of life and your financial freedom could be changed dramatically as you apply what you learn in this class to your personal life. I encourage you to treat this class as if it were the manual for the rest of your financial life.

Lecture Notes

Personal financial planning provides major benefits that help us to more effectively marshal and control our financial resources and thus gain an improved standard of living. Because the emphasis in this text is on planning—looking at the future—we must examine many areas to set and implement plans aimed at achieving

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financial goals. These areas are introduced in this chapter and examined in detail in later chapters. The major topics covered in this chapter include:

1. The benefits of personal financial planning techniques in managing finances, improving one’s standard of living, controlling consumption, and accumulating wealth.

2. Defining financial goals and understanding the personal financial planning process necessary to achieve them.

3. Financial planning as a lifetime activity that includes asset acquisition plans, liability and insurance plans, savings and investment plans, employee benefit plans, tax plans, and retirement and estate plans.

4. Special financial planning concerns with an emphasis on the economic environment’s influence, including managing two incomes, planning employee benefits, and adapting to other major life changes.

5. The use of professional financial planners in the financial planning process, the various types of financial planners, and choosing a financial planner.

6. The influence of government, business, and consumer actions and changing economic conditions on personal financial planning.

7. Age, marital status, education, geographic location, and career as important determinants of personal income levels.

8. The important relationship between career planning and personal financial planning.

Key Concepts

To begin developing a personal financial plan, one must understand basic financial planning terminology, principles, and environmental factors. The following phrases/terms represent the key concepts stressed in the chapter.

1. Standard of living2. Consumption patterns3. Wealth accumulation4. The personal financial planning process5. Financial goals6. The role of money7. The psychology of money8. Money and relationships9. Types of financial goals10. The life cycle of financial plans11. Plans to achieve financial goals 12. Technology in financial planning13. The planning environment—players, economy, and price levels14. Special planning concerns15. Financial planners16. Determinants of personal income17. Career planning18. Average propensity to consume19. Financial assets, Tangible assets, and Liquid assets20. Utility21. Liability22. Flexible benefit (cafeteria) plans23. Commission-based versus fee-only planners

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24. Factors of production25. Fiscal policy26. Monetary policy27. Economic cycles (business cycles)28. Expansion versus Contraction29. Peak versus Trough30. Inflation31. Consumer price index and Purchasing power

Standard of living, which varies from person to person, represents the necessities, comforts, and luxuries enjoyed by a person. It is reflected in the material items a person owns, as well as the costs and types of expenditures normally made for goods and services.

Although many factors such as geographic location, public facilities, local costs of living, pollution, traffic, and population density affect one's quality of life, the main determinant of quality of life is believed to be wealth.

Generally, consumption patterns are related to quality of life, which depends on a person's socioeconomic strata. This implies that wealthy persons, who are likely to consume non-necessity items, quite often live higher quality lives than persons whose wealth permits only consumption of necessities.

The average propensity to consume is the percentage of each dollar of a person's income that is spent (rather than saved), on average, for current needs rather than savings. Yes, it is quite possible to find two persons with significantly different incomes with the same average propensity to consume. Many people will increase their level of consumption as their incomes rise, i.e., buy a nicer home or a newer car. Thus, even though they may have more money, they may still consume the same percentage (or more) of their incomes as before.

An individual's wealth is the accumulated value of all items he or she owns. People accumulate wealth as either financial assets or tangible assets. Financial assets are intangible assets such as savings accounts or securities, such as stocks, bonds and mutual funds. Financial assets are expected to provide the investor with interest, dividends, or appreciated value. Tangible assets are physical items, such as real estate, automobiles, artwork, and jewelry. Such items can be held for either consumption or investment purposes or both.

Money is the exchange medium used as the measure of value in our economy. Money provides the standard unit of exchange (in the case of the U.S., the dollar) by which specific personal financial plans—and progress with respect to these plans—can be measured. Money is therefore the key consideration in establishing financial plans. Utility refers to the amount of satisfaction derived from purchasing certain types or quantities of goods and services. Since money is used to purchase these goods and services, it is generally believed that greater wealth (money) permits the purchase of more and better goods and services that in turn result in greater utility (satisfaction).

Money is not only an economic concept; it is also a psychological one that is linked through emotion and personality. Each person has a unique personality and emotional makeup that determines the importance and role of money in his or her life, as well as one’s particular money management style. Personal values also affect one's attitudes to money. Money is a primary motivator of personal behavior and has a strong impact on self-image. To some, money is of primary importance, and accumulation of wealth is a dominant goal. For others, money may be less important than lifestyle considerations. Therefore, every financial plan must be developed with a view towards the wants, needs, and financial resources of the individual and must also realistically consider his or her personality, values, and money emotions.

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Money is frequently a source of conflict in relationships, often because the persons involved aren't comfortable discussing this emotion-laden topic. Each person may have different financial goals and personal values, leading to different opinions on how to spend/save/invest the family's money. To avoid arguments and resolve conflicts, it is essential to first become aware of each person's attitude toward money and his or her money management style, keep the lines of communication open, and be willing to listen and to compromise. It is possible to accommodate various money management styles within a relationship or family by establishing personal financial plans that take individual needs into account. Some families are able to avoid conflict by establishing separate accounts, such as yours, mine and household, with a set amount allocated to each account each pay period. This way, no one feels deprived, and enough has been set aside to pay the bills and to meet common financial goals.

Realistic goals are set with a specific focus and a reasonable time frame to achieve results. It is important to set realistically attainable financial goals because they form the basis upon which our financial plans are established. If goals are little more than "pipe dreams," then the integrity of the financial plans would be suspect as well

Your description of the steps to achieve a specific goal will, of course, vary. They should follow the general guidelines in the chapter: define financial goals, develop financial plans and strategies to achieve goals, implement financial plans and strategies, periodically develop and implement budgets to monitor and control progress toward goals, use financial statements to evaluate results of plans and budgets, and redefine goals and revise plans as personal circumstances change.

Individual time horizons can vary, but in general individuals would expect to achieve their short-term financial goals in a year or less, intermediate-term goals in the next 2-5 years, and long-term financial goals in more than five years. Refer to Worksheet 1.1 on p. 10 of the text for examples of financial goals.

In making personal financial goals, individuals must first carefully consider their current financial situation and then give themselves a pathway to reach their future goals. People in the early stages of their financial planning life cycle may need more time to accomplish long-term goals than those who are already established in their careers and may also need to give themselves more flexibility with their goal dates.Personal needs and goals change as you move through different stages of your life. So, too, do financial goals and plans, because they are directly influenced by personal needs. When your personal circumstances change, your goals must reflect the new situation. Factors such as job changes, a car accident, marriage, divorce, birth of children or the need to care for elderly relatives must be considered in revising financial plans.

The loss of two percentage points on investment returns is anything but inconsequential, particularly if the loss occurs annually over a period of several years. For example, if Chris had invested $1,000 at an 8% return and subsequently had invested all earnings from the initial investment at 8%, in 40 years he would have accumulated $21,725 from the initial $1,000 investment. If, on the other hand, he had earned a 10 %return on the same investment, he would have accumulated $45,259 in 40 years—more than double his return at 8%! Clearly, two percentage points over time can make a significant difference! Calculate various rates of return on a $1,000 investment to see that for every 2 %increase in return, your investment results will more than double over a 40-year period.

By carefully considering his investment and banking choices, it is likely that Chris would be able to get a 2% greater rate of return without taking on additional risk. This can be done both by choosing investments and bank accounts that hold down expenses, as well as by finding investments of the same type that have performed better.

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Employee benefits, such as insurance (life, health, and disability) and pension and other types of retirement plans, will affect your personal financial planning. You must evaluate these benefits so that you have the necessary insurance protection and retirement funds. If your employer's benefits fall short of your needs, you must supplement them. Therefore, employee benefits must be coordinated with and integrated into other insurance and retirement plans.

Tax planning involves looking at an individual's current and projected earnings and developing strategies that will defer and/or minimize taxes. For income tax purposes, income may be classified as active income, passive income, or portfolio income. While most income is currently subject to income taxes, some may be tax free or tax deferred. Tax planning considers all these dimensions and more. Tax planning is an important element of financial planning because it guides the selection of investment vehicles and the form in which returns are to be received. This means that it is closely tied to investment plans and often dictates certain investment strategies.

This statement reflects a very short-sighted and too often expressed point of view. Due to the inconsistencies and unexpected changes of our economic system—and of life itself—the goals of and plans for retirement should be established early in life. If retirement goals are incorporated into an individual's financial planning objectives, short- and long-term financial plans can be coordinated. Thus, financial plans can guide present actions not only to maximize current wealth and/or utility, but also to provide for the successful fulfillment of retirement goals. Furthermore, if retirement is desired earlier than anticipated, the plans may still permit the fulfillment of retirement goals.

Government, businesses, and consumers are the three major participants in the economic system. Government provides the structure within which businesses and consumers function. In addition, it provides a number of essential services that generally improve the quality of the society in which we live. To create this structure, various regulations are set forth, and to support its activities and provision of essential services, taxes are levied. These activities tend to constrain businesses and consumers.

Businesses provide goods and services for consumers and receive money payments in return. They also employ certain inputs in producing and selling goods and services. In exchange they pay wages, rents, interest, and profit. Businesses are a key component in the circular flow of income that sustains our economy. They create the competitive environment in which consumers select from many different types of goods and services. By understanding the role and actions of businesses on the cost and availability of goods and services, consumers can better function in the economic environment and, in turn, implement more efficient personal wealth maximizing financial plans.

Consumers are the focal point of the personal finance environment. Their choices ultimately determine the kinds of goods and services that businesses will provide. Also, consumer spending and saving decisions directly affect the present and future circular flows of income. Consumers must; however, operate in the financial environment created by the actions of government and business. Consumers may affect change in this environment through their elected officials, purchasing decisions and/or advocacy groups. Yet, basically, change occurs slowly and tediously, often with less than favorable results. Thus, consumers should attempt to optimize their financial plans within the existing financial environment.

The stages of the economic cycles are expansion, peak, contraction, and trough. The stronger the economy, the higher the levels of real GDP and employment. During an expansion, real GDP increases until it hits a peak, which usually signals the end of the expansion and the beginning of a contraction. During a contraction (recession), real GDP falls to a trough, which is the end of a contraction and the beginning of an expansion. An understanding of these four basic stages, coupled with knowledge of the stage in which the economy is presently operating, should permit individuals to adjust and implement financial actions in order to efficiently and successfully achieve their personal financial goals.

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Inflation is a state of the economy in which the general price level is rising. It is important in financial planning because it affects what we pay for goods and services; it impacts how much we earn on our jobs; it directly affects interest rates and, therefore, it affects such things as mortgage and car loan payments. The most common measure of inflation is the consumer price index, which is based on the changes in the cost of a typical "market basket" of consumer goods and services. This can be used to compare changes in the cost of living over time for the typical family. Inflation is measured by the percentage change in the consumer price index from one time period to another, so that as the CPI rises, the cost of living also increases.

Disagree. Although higher levels of education may result in higher levels of income, this does not mean that everyone with a given level of education will achieve a specified level of income. Factors such as age, marital status, geographical location, and career choice also impact a person's level of income. A number of other factors, such as the degree of personal motivation and the methods by which one utilizes his or her formal education, can also affect one's income level.

Career planning is a critical part of the life cycle of the personal financial planning process. The choice of a career affects the amount you earn. By setting both short- and long-term career goals, you can incorporate them into your financial plans. For example, if you need additional education and/or other training for a particular job, you may include a savings plan to obtain the needed funds. You should reevaluate your career decision periodically to see if it still meets your personal and financial goals. Other important considerations with regard to a specific job (and company) include the earnings potential, advancement opportunities, and benefits, plus how well the job fits your lifestyle and values. In today's rapidly changing job environment, you should expect to change careers several times. It is important to keep up with developments in your industry, acquire a broad base of experience, and continue to learn new skills, both general and technical.

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