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Financial Planning Process Goal, Benefits, and Components A financial planner’s goal is simple: to provide sound, organized financial advice to individuals and their families. People can benefit from the services of a financial planner in several ways. Financial planners provide a coordinated strategy for managing the immediate and long-term needs of clients who may be too busy to stay informed on financial issues. Financial planners are able to synthesize the information provided by various financial specialists and determine the best course of action for a particular client. Financial planners can serve as a liaison between clients and other financial professionals. There are five major components of financial planning: insurance, investments, income tax planning, retirement planning, and estate planning. Step One The first step in the financial planning process is to establish a client-planner relationship in which both parties state their expectations. The relationship must be based on a firm trust to be successful. The first part of building such a relationship is identifying what services need to be provided. Then, the financial planner should disclose his or her rate of compensation. Next, both the financial planner and the client should work together to outline the responsibilities that each party will bear in the relationship. After that, the two parties may decide on the duration of the agreement. Finally, the client and financial planner should provide any additional information necessary to adequately define or limit the work to come. Step Two After a solid relationship has been established between the financial planner and his or her client, the financial planner should gather all the data necessary to do the job effectively. This includes determining the client’s goals and expectations. Only by collecting thorough and accurate data will the financial planner be able to create a viable financial strategy. This means collecting both quantitative and qualitative data. Quantitative data assesses the client’s current financial situation and is found using a fact-finding questionnaire. Qualitative data, on the other hand, gives a more subjective picture of the client. Specifically, it tells the financial planner why the client has set his or her goals. Qualitative data is obtained during a goals (broad-based projections) and objectives (specific steps for reaching goals) interview. Step Three After the financial planner has established a solid working relationship and acquired the data necessary to construct a good financial plan, he or she should seek to painstakingly assess the client’s current financial status. This can only be done by rigorously analyzing and evaluating the client’s insurance and risk management, special needs, investments, taxation, employee benefits, retirement, and estate planning. Of course, not all of these subjects will be applicable for each client. The purpose of this assessment should be to identify the strengths and weaknesses of the client’s financial situation. Once this is done, it may be necessary to revise the goals set forth by the client during step two of the financial planning process. Steps Four, Five, and Six Once the financial planner and client have set out achievable, realistic goals based on an accurate assessment of the client's financial status, the financial planner can begin to develop a suitable financial plan. This means creating a set of financial strategies that are suited to the client’s objectives and goals. Once the client has agreed to a plan, the financial planner will move to implement that plan. This may involve motivating the client as well as incorporating the advice and aid of outside experts as required. Once the plan has been fully implemented, the financial planner must constantly monitor it. This includes evaluating performance, reviewing changes in the client’s circumstances (as well as any relevant changes in tax law), and adjusting the plan as necessary. Responsibilities of Financial Planner, Client, and Other Advisers All of the parties involved in the financial planning process have certain responsibilities. The financial planner must evaluate the needs of the client, explain complicated financial concepts, analyze the financial circumstances of the client, prepare financial plans, clarify client goals, and, finally, implement and monitor the financial plan. The client is responsible for making known his or her goals and objectives, for being receptive to creative financial plans, and for working to advance the agreed-upon plan. The other advisers that are brought in to assist in the financial planning process are responsible for fulfilling whatever their particular task may be as designated by the financial planner with the approval of the client.
Balance Sheet (Statement of Financial Position) A balance sheet is basically a freeze-frame of an individual’s wealth at a particular time. There are three categories on a balance sheet: assets, liabilities, and net worth. Net worth is total assets minus total liabilities. Net worth increases due to an appreciation in the value of assets, an increase in assets from retaining income, an increase in assets from gifts or inheritances, or a decrease in liabilities from forgiveness. Net worth is unchanged by the paying off of debt or the purchase of an item with cash. Assets and liabilities are given at fair market value. Assets may be either categorized as cash and cash equivalents (checking or savings account), invested assets (stocks, bonds, mutual funds), or use assets (homes, furniture, cars). Liabilities are either current liabilities (credit card balances, for instance) or long-term liabilities (auto loans, life insurance loans, or real estate mortgages).
Cash Flow Statement A cash flow statement shows where an individual’s financial resources are going. To be accurate, it must indicate the period of coverage, which is usually a calendar year. The first step in constructing a cash flow statement is to estimate the family’s annual income. Then, estimate both fixed and discretionary expenses. Next, determine the excess or shortfall of income during the budget period. The net cash flow is the total income minus the total expenses. Once this is determined, consider ways of increasing income or decreasing expenses. Finally, calculate income and expenses as a percentage of the total to determine a better flow of resources.
Quantitative Analysis Financial planners use modeling and simulation as tools to analyze the possible effects of planned financial decisions. Probability analysis is used to determine the likelihood that a certain event will occur. This is often used to forecast the development of insurance rates and insurance risk. Probability analysis is often combined with modeling and simulation to give financial planners a window into the possible performance of planned investments. Sensitivity analysis is a form of modeling in which financial planners consider how small changes in the market or in investment will affect the client’s portfolio. An independent variable is adjusted to see how much change it will cause in the dependent variable.
Pro Forma Statement A pro forma statement forecasts future balance sheets and cash flow statements. Sometimes, the best way to create a pro forma statement is to consider three scenarios: the worst-case budget, in which income is lowest and expenditures are highest possible; an average-case budget, in which both income and expenditures are at a reasonable level; and a best-case budget, in which income is highest and expenditures are at lowest possible. These three measures typically are enough to create pro forma statements that can serve as a rough guide to the potential cash flow over the coming year.
Personal Income Statement The personal income statement, also known as the statement of cash flows, is a physical representation of a client’s cash flows during a certain period of time. The most common time period for this statement is January 1 through December 31 of a given year. Contained on the income statement are the client’s various forms of income, fixed and variable outflows, and payments of taxes. Fixed outflows include such items as monthly auto loans, home mortgages, and property taxes. Variable outflows cover expenses such as monthly food spending, entertainment spending, and other unpredictable expenses. The most common taxes shown on the income statement are the client’s property taxes, income taxes, self-employment taxes (if any), and FICA taxes. The income statement is useful in helping illustrate to clients whether or not their lifestyle is within their means.
Budgeting Discretionary Versus Nondiscretionary Budget expenses can be either discretionary or nondiscretionary: discretionary expenses can be changed or timed depending on convenience. Nondiscretionary (fixed) expenses can be changed somewhat, but must be paid at some time. A variety of strategies are used to maximize income and minimize expenses. Debt restructuring is the process of consolidating a number of different debts into one low personal line of credit. Asset reallocation is the process of changing underperforming assets to more productive investment assets. Expenditure control is the process of reducing consumption. Incorporating children’s assets is the process of saving for a child in a custodial account in order to avail oneself of the lower tax rate for children. Financing Strategies People can use a number of financing strategies in personal budgeting. One common strategy is to consolidate credit card or student loan debt, so as to lock in a low interest rate. A person may also take a cash-out refinance, in which a first mortgage is renewed and additional cash is disbursed to the mortgager. People also often take out a home equity loan or home equity line of credit. Sometimes, an individual will use the cash value of a life insurance policy for a loan. Another common financing strategy is tapping into a company savings plan. Finally, individuals often use the after-tax money from a Roth IRA; this money can be taken out without any penalty or tax consequences.
Savings Strategies Individuals can use a few common savings strategies when budgeting. One basic strategy is setting goals. The goals that are set should be realistic, and known to all the involved parties. Another common savings strategy is to decide ahead of time to take all of the money that is saved and devote it to some special purchase. Some people use a savings-first approach, in which they save first and pay cash in order to avoid the high interest charges on loans. They may also earn interest by investing their savings. Many people force themselves to save by having money automatically deducted from their paycheck and placed into a savings account. This may include money that is placed directly into mutual funds or money that is contributed to a company retirement plan.
Emergency Fund Planning Most people feel comfortable if they have set aside three to six months of monthly expenses in case of an emergency. If a family has only one income, they may want to set aside enough money to cover expenses for a longer period. The marketability of an asset is the ease with which an asset may be bought or sold, while the liquidity of an asset is the ease with which it can be converted into cash with little loss of principal. Both of these factors should be considered when planning emergency funds. Real estate is considered illiquid because it can often take a long time to sell, but it is considered marketable because it is easy to sell in a moment of desperation. Some liquidity substitutes are checking and savings accounts, money market accounts, CDs, life insurance policies, US Treasury bills, and home equity loans.
Calculation Buying an Automobile There are certain considerations that a consumer can make when deciding to buy rather than lease an automobile. First, if a taxpayer is purchasing a car for business use, he or she may use the standard mileage rate at first and then switch to the actual expense method later on should it become more favorable. It may also be a good idea to buy rather than lease if the consumer intends to keep the car for more than four years, or if the consumer has cash available to make a down payment. Finally, it will make more sense to buy an automobile if it will be driven more than 15,000 miles a year, since most lease agreements will charge the consumer extra for miles driven over this limit. Leasing an Automobile In some situations, it may make more sense for a consumer to lease rather than buy an automobile. For instance, some leases will offer lower monthly payments with a very small down payment. A lease may also be preferable for those individuals who plan on acquiring a new car every three or four years, or for those who would have to borrow money in order to pay for a new car. For such individuals, the trade-in value will be less than the loan value, which would result in a loss. The advantages offered by a lease are service, convenience, and flexibility. The tax advantages of leasing increase as the quality of the car rises, so individuals in need of a nice car for business may be better off leasing. When a vehicle is bought for business, interest is not deductible; if a vehicle is leased, the cost of interest is included in the payment, which is entirely deductible. Buying or Leasing a House There are a few factors consumers should consider before deciding whether to buy or lease a home. Most of the time, people will lease (or rent) when they do not have the requisite funds to make a down payment. Purchasing a home creates a number of tax advantages for the buyer. In addition, creditors tend to give better treatment to homeowners. A purchased home may become an appreciating asset for the owner. Also, in most cases a monthly payment made on a purchased home is more stable than the cost of renting, which is more commonly affected by changes in the market. Still, it often makes more sense to rent a home if the consumer knows that his or her stay in that home will be brief.
Adjustable and Fixed Rate Loans Fixed rate loans may be preferable for clients that are less able to take financial risks because they have a set interest rate that remains constant for the duration of the loan. On the other hand, some clients may prefer an adjustable rate loan in which there are provisions for changing the interest rate periodically. An adjustable rate mortgage (ARM) on a home is preferable if the home is only going to be owned for a brief time, as the initial interest rates will tend to be lower. When an ARM is said to have a 2/6 cap, this means that there is a 2 percent maximum interest rate increase every year, and 6 percent over the life of the loan. A fixed rate loan is best in a low or increasing interest rate environment, and a variable rate loan is better in a high or decreasing interest rate environment.
Purchased, Leased, or Rented Assets Effects on Balance Sheet and Cash Flow Statement Leased and rented assets are not entered on the balance sheet unless a sum of money was taken from one of the listed assets in order to pay for the leased asset. This initial payment will create a decrease in cash and a decrease in net worth. Assets purchased entirely with cash will not cause any change in net worth, since the reduction in cash will be balanced by an increase in the form of the asset itself. Assets purchased with a loan will cause a reduction in cash or whatever other liquid asset was used for the purchase or down payment. If a loan was secured in order to purchase the asset, the loan will be entered as a liability and there will be no change in net worth. As for the cash flow statement, any purchase of an asset or lease payment will be shown as an outflow of cash.
Divorce Settlement, Career Assets, Family Business, and House A divorce settlement is supposed to be equitable, which means not that it will be equal but that it will be fair. Many times, one spouse will have a significant amount of assets invested in his or her career. These assets may include life, health, disability, and long-term care insurance; vacation and sick pay; Social Security payment; stock options; pensions; and retirement plans. In divorce settlements, it is assumed that both spouses jointly own career assets. There are three available options when dividing a business and/or house: one spouse may keep the house or business by buying out the other’s interest; both spouses may continue to own the business/home; or the business/home may be sold and the proceeds divided. Retirement Plans, Alimony, and Child Support There are two ways to divide a retirement plan during a divorce settlement. In the buy-out (or cash-out) method, the nonemployee spouse receives a lump-sum settlement in return for the employee’s right to keep the retirement plan. In the deferred division (or future value) method, each spouse will receive an equal share of the benefits when they are paid. Alimony may be arranged as a series of payments from one spouse to another, or to a third party on behalf of the receiving spouse. The taxable income goes to the recipient, and usually the tax-deductible expense goes to the payer. Child support payments will be set by the court and based on the ratio of each parent’s income. Child support cannot be deductible by the payer and cannot be included in the income by the recipient.
Special Situations Disability, Terminal Illness, and Nontraditional Families Many people do not know that they are more likely to become disabled before retirement than to die. For this reason, it is always a good idea to purchase a disability income policy that carries full protection. Work-related injuries should be covered by a worker’s compensation plan. In the case of terminal illness, long-term care insurance will fund nursing and hospice treatment not covered by Medicare, while viatical agreements are arrangements in which a terminally ill person sells his or her life insurance policy to a company in order to help finance present care. Nontraditional families should be sure to carefully plan estates through wills and trust, as there is no unlimited marital deduction if a couple is not married. Single parents also need to plan carefully and should probably carry more insurance. Job Change, Job Loss, and Dependents with Special Needs Most people should maintain an emergency fund with enough to cover between three and six months of expenses in case of job loss. Although there are state unemployment insurance programs that will help individuals who want to work but cannot, these funds are limited and subject to many restrictions. State unemployment income is taxable. When a client has a dependent with special needs, he or she will need to set aside extra emergency funds to cover unforeseen expenses. An individual with special needs is one who has serious physical, emotional, and/or cognitive problems. Some people elect to create special-needs trusts, which will help preserve state-provided benefits that may otherwise be unreasonably expensive.
Supply and Demand Demand Curve According to the law of demand, higher prices will reduce the demand for an item and lower prices will increase demand. As the price of a product increases, consumers will find more substitutes, products that fill a similar role, and consumers will be more responsive to price when more viable substitutions are available. A demand curve, then, will slope down and to the right. Price elasticity exists when a small change in price results in a large change in sales. When perfect elasticity exists, the demand curve is exactly horizontal. Price inelasticity, on the other hand, exists when a large price change produces only a small change in sales. A vertical demand curve indicates perfect price inelasticity. Supply Curve and Income Elasticity The law of supply states that a higher price will increase the supply of a good. A supply curve is elastic when a price change leads to a great change in the quantity supplied; the curve is inelastic when a price change produces only a small change in supply. The change in quantity supplied is simply movement along the supply curve. Factors that can cause movement along the supply curve include changes in resource prices, changes in technology, natural disasters, or other disruptive events. Income elasticity is the sensitivity of demand to changes in consumer income. An inferior good will have negative income elasticity, meaning that as income increases, the quantity demanded will decrease. The relation will be opposite for a normal good, which is said to have positive income elasticity.
Fiscal Policy Fiscal policy is the action taken by the government to influence the economy by raising or lowering government spending and taxes. For instance, if the government wants to stimulate economic activity, it can do so by implementing expansionary fiscal policy. Specifically, it does so by increasing spending or reducing taxes. Usually, expansionary policy creates an increased gross domestic product and higher price levels. Conversely, the government may want to use restrictive fiscal policy in an effort to slow the economy. Restrictive fiscal policy generally consists of decreasing spending or increasing taxes, which usually causes the gross domestic product to decrease and price levels to drop.
Monetary Policy The Federal Reserve System, or Fed, uses monetary policy to influence the money supply. The Fed has three tools at its disposal when creating monetary policy. The first is to adjust the required reserve ratio, which is the minimum amount that a bank is allowed to have in its reserves. When this ratio is lowered, the money supply tends to increase. The Fed’s most powerful tool is its open market operations, in which it buys and sells government securities, depending on whether it wants to remove or add money to circulation. The Fed can also manipulate the money supply by adjusting the discount rate, the rate charged to member banks when they borrow money from the Fed. A favorable discount rate will encourage banks to borrow more money and put it into circulation.
Supply of Money In the short-run, an unanticipated increase in the money supply tends to increase aggregate demand. If the increase is anticipated, however, there will be negligible impact on aggregate demand or interest rates. There are a few definitions for the money supply. M-1 is the simplest definition, and includes currency in circulation, checkable deposits, and traveler’s checks. M-2 is a bit broader; it includes everything in M-1 along with savings deposits, time deposits less than $100,000, and money market mutual fund shares. When money leaves the system, interest rates will rise, which will tend to drive down the value of stock (since the required rate of return will increase and the firm’s earnings will likely decrease).
Economic Indicators Investors whose livelihoods depend on knowing the relationship between security prices and economic activity will want to be able to guess the direction of economic activity. The ten leading economic indicators (as compiled by the National Bureau of Economic Research) are: stock prices; average weekly work hours; average unemployment claims; manufacturer’s new consumer goods orders; manufacturers’ new orders for nondefense capital goods; vendor performance; new building permits; the difference in interest rates for ten-year Treasury bonds and the federal funds rate); inflation-adjusted M-2; and consumer expectations as measured by the University of Michigan Research Center.
Methods of Measuring Inflation The behavior of investors is determined in large part by their perception of inflation, which is the general rise in prices. There are two common indices for evaluating inflation. The Consumer Price Index is calculated using statistics from the Bureau of Labor. This index, commonly known as the CPI, measures the cost of a basket of goods and services over a set time period. The Producer Price Index, known as the PPI, is calculated by the United States Department of Labor. It takes a slightly different look at the price of goods by measuring the wholesale cost of a certain set of goods over a determined period of time.
Business Cycles A business cycle is a pattern of changing economic output and growth. The peak of a business cycle is generally accompanied by an increased rate of inflation; when this occurs, unemployment rises and national output declines, creating a recession. A recession is defined as a period in which real GDP declines for two or more consecutive quarters; a depression is simply a severe recession. The most common means of measuring economic activity is gross domestic product, which is the total value of all final goods and services newly produced within a country by domestic factors of production. Most of the time, economists will use real GDP (GDP adjusted to exclude the impact of inflation) and the unemployment rate to determine the phase of the business cycle.
Inflation and Deflation When inflation occurs, investors will try to avoid interest-sensitive securities and long-term debt instruments that pay fixed amounts of interest. Often, investors will seek to acquire short-term instruments whose yields will increase with the rate of inflation. In an inflationary environment, investors should expect to benefit from stocks whose asset bases will be enhanced by increased asset values. In a period of deflation, however, investors should try to secure assets whose values will not fall. The safest strategy in a deflationary period is to acquire short-term liquid assets, like bank deposits, since deflation will increase the purchasing power of money. Long-term debt is not so bad in a deflationary period, as the value of the payments will decrease. Only bonds of excellent quality should be purchased in a deflationary period, as many firms may go out of business.
Recession and Economic Stagnation Typically, the Fed will try to jolt the economy out of a recession by putting more money in circulation and expanding the supply of credit. Meanwhile, the federal government will implement expansionary fiscal policy, lowering taxes and increasing government expenditures. Investors will then attempt to move out of short-term money market instruments and into the stocks of firms that will benefit from expansionary monetary and fiscal policy. An individual investor may want to pursue a conservative strategy, purchasing a number of convertible securities and common stocks of firms with low beta coefficients. On the other hand, a more aggressive investor may want to increase the potential for capital gains by purchasing common stocks from firms that have low payout ratios if these firms are using the earnings to finance expansion.
Yield Curve A yield curve is a graph that shows the relationship between term to maturity and yield to maturity. A yield curve will show the relationship between interest rates and time, typically as relating to government Treasury securities. This graph is helpful for investors because rates do not usually change by the same amount as basis points across maturities. Yield curve risk is the risk that yields for different maturities may not change by the same amount of basis points across maturities. This risk can be measured with the help of duration, which is a measure of bond price sensitivity to interest rates. In general, short- and intermediate-term rates are lower in an upward-sloping yield curve.
Present Value and Future Value Present value is determined by taking the future value of an amount of money and then calculating, using a discount rate, what it will be worth today. The formula for present value is: The higher the discount rate, the smaller the present value will be as compared to the future value. Future value, on the other hand, is the future amount of a sum invested today if it grows over time through compounding interest.
For a single cash flow, the formula for finding future value is:
Ordinary Annuity, Annuity Due, and Net Present Value An annuity is a succession of equal cash flows that occur at regular intervals over a period of time. For instance, if an individual were to receive $5,000 at the end of every year for ten years, that would be considered an annuity. Ordinary annuities are those in which the cash flows begin at the end of the year, and annuities due are those in which the cash flow begins on the same date as the initial investment. Net present value, meanwhile, is the amount of cash flow, expressed in terms of present value, that a project will generate after repaying invested capital and the required rate of return on that capital. When NPV is positive, shareholder wealth increases. NPV is considered to be a better measure than IRR because it measures profitability in dollars added to shareholder value. NPV assumes that the reinvestment rate of cash flows is the cost of capital.
Internal Rate of Return (IRR) and Irregular Cash Flow The internal rate of return (IRR) is the rate of return at which the present value of a series of cash inflows will equal the present value of the cost of a project. It can also be described as the rate of return at which the net present value for a project is zero, assuming that all cash flows are reinvested in the internal rate of return. IRR will be equal to the yield to maturity, the geometric average return, and the compounded average rate of return. If the IRR is less than the cost of the capital, a project should be rejected. The stream of cash flows may change from year to year from certain investments. In order to determine the future and present values of an irregular cash flow, you will need to find the future and present values for each cash flow and then add them up.
Inflation-Adjusted Earnings Rate and Serial Payments
Investors will require the following nominal rate of return: nominal risk-free rate = (1+ real risk-free rate) x (1+ inflation rate) – 1. The real risk-free rate can be calculated: real risk-free rate = [(1+ nominal risk-free rate) / (1 + inflation rate)] – 1. Serial payments are those that increase at a constant rate on an annual basis. The constant rate for a serial payment scheme is often the rate of inflation. Typically, then, the last serial payment will have the same purchasing power as the first. Unlike annuities, serial payments are not fixed payments. The first of the serial payments will be less than the annuity payment, but the last serial payment will be more than the annuity payment.
Client Attitudes and Behavioral Characteristics Cultural When we refer to the cultural characteristics of a client, we mean the values and beliefs that are common to the group of which the client is a member. The aspects of a client’s culture that are relevant to financial planning may be obvious, as in the cases of language or race, or less obvious, as in the cases of obscure customs or beliefs. Acquiring a more complete understanding of a client’s culture will make it easier to provide that client with superior service. One way that many financial planners seek to do this is by establishing relationships with many different people in a particular community so that a variety of perspectives from the same group can be considered. Family A financial planner’s clients will no doubt have many goals and objectives that relate to their family. For instance, many clients will want to save money to put their children through college or in case of some emergency relating to their children. Also, clients with families are likely to want to set aside funds to protect against financial disaster. Moreover, a client’s willingness to assume a financial risk will often depend on his or her family situation. Clients who have small children are generally less likely to pursue risky financial ventures, as they realize that there may be some unexpected and large financial costs in the future. Emotional The emotional characteristics of a client will often influence their financial plan. In many cases, individuals will let their emotions drive their financial decisions; one of the important roles of a financial planner is to guide clients towards reasonable and prudent financial decisions. Also, investors are too often influenced by sensational stories in the media, and so a financial adviser must encourage calm here as well. Investors may be averse to admitting their mistakes, and a financial planner should help them to acknowledge unsuccessful strategies and make positive changes. One way to keep emotions from guiding investment decisions is to diversify investments so that no one investment carries too much emotional emphasis. Life Cycle and Age (Accumulation and Consolidation Phases) A financial planner should acknowledge four main phases in the life cycle. The accumulation phase is typically the client’s first forty years, during which he or she wants to earn funds to help his or her family avert financial disaster; save money for homes, automobiles, and college; and develop some assets for long-term security. Individuals in the accumulation phase usually are willing to accept some high-risk investments if there is the promise of above-average return. In the consolidation phase, individuals are usually less willing to accept high-risk ventures, but will attempt some moderate-risk investment. In the consolidation phase, individuals will have paid off all of their loans and funded the education of their children, but will need to keep saving for retirement. Individuals are usually in the consolidation phase between the ages of 40 and 60. Life Cycle and Age (Spending and Gifting Phases) When an individual reaches the spending phase of his or her life cycle, he or she will begin to seek investments that offer security and the preservation of capital. Although individuals in this phase will want to stick with low-risk investments, it is a good idea for them to maintain some more adventurous investments as a partial protection against inflation. The spending phase typically begins at retirement. The gifting phase can occur at the same time as the spending phase. In this phase of the life cycle, the individual seeks to disburse his or her capital to loved ones and preferred institutions. In this phase, a financial planner will mostly be helping with estate planning. The gifting phase is basically an individual’s preparations for death. Level of Knowledge, Experience, Expertise, and Risk Tolerance As a client develops his or her knowledge and experience in investment, he or she is likely to be more tolerant of risk. However, clients who are approaching retirement will probably be less willing to make risky investments. It is essential for a financial planner to identify his or her client’s level of knowledge so that he or she can be careful not to encourage too much investment in instruments that the client does not understand. As for measuring the general risk tolerance of an investor, this has less to do with assessing knowledge than with assessing the emotional and financial ability of the investor to withstand a loss. Most financial planners try to classify clients by the level of risk they're willing to take on: high, medium, or low.
Communications with the Public
Communications with the public (FINRA Rule 2210) - a qualified registered principal must approve all retail communication before its use or filing with FINRA, unless another member has already filed it and it has been approved and the member has not altered it. For institutional communications, members are to establish written procedures for review by a qualified registered principal of institutional communications. The procedures are to be designed to ensure that institutional communications company with the standards. All communications, retail and institutional, are to be retained according to requirements, and must include: - A copy of the communication · The name of any registered principal approving of the communication · If not approved by a registered principal prior to first use, the name of the person who prepared it · Information about the source of information used in graphic illustrations · If approval is not required for retail communication, the name of the member that filed it with FINRA, as well as the letter from FINRA
Written Communication Written communication - written communication that is a road show is not required to be filed. A road show written communication does have to be filed if the offering is for common equity or convertible equities under an issuer that is not at the time required to file reports with the SEC, unless there is a bona fide electronic version of the road show made available. Bona fide electronic road show - a written communication regarding the offering of a security transmitted graphically and that involves a presentation of members of management.
Telemarketing
The types of communications covered under FINRA Rule 3230 include: - Outbound calls from a member or associated person of a member to a non-broker dealer, including to wireless telephone numbers. · Outbound calls that have been outsourced to a third party. · Abandoned calls, which are those not answered by someone at the member within two seconds of the person’s completed greeting. · Prerecorded messages. For purposes of this rule, the term telemarketing is defined as consisting of or relating to a plan, program, or campaign involving at least one outbound telephone call, for example cold-calling. The term does not include the solicitation of sales through the mailing of written marketing materials, when the person making the solicitation does not solicit customers by telephone but only receives calls initiated by customers in response to the marketing materials and during those calls takes orders only without further solicitation.
Electronic Communication Network An electronic communication network, or ECN, is a system by which securities orders are matched to bypass the need for a third party. The matching is performed electronically and allows buyers and sellers of securities to communicate directly without the need for a third party to facilitate their trading. ECNs must register with the Securities and Exchange Commission (SEC) as a broker/dealer, and collect a fee for their services. ECNs facilitate trading by displaying the optimal bid/ask prices for the same securities, and then automatically execute the transaction on behalf of the buyers and sellers. ECNs greatly reduce the time it takes to match orders for buyers and sellers. In addition to serving retail investors, ECNs also facilitate trading for institutional investors.
Options Communications The standards that must be followed in communications regarding options include: - Options communications must only provide general descriptions, including the registered clearing agency, the way in which the exchange on which the options trade operates, and a basic description of how options are priced - Options communications must provide the ways in which a copy of the options disclosure document may be obtained - Options communications may not provide statements regarding performance (past or future), rates of return, or the names of any specific options · Options communications must include any statements so dictated by state laws · Options communications may include marketing designs (logos, pictures, graphics, etc.) so long as they are not misleading
Credit and Debt Management Ratios A client should always have enough liquid assets for an emergency fund. Consumer debt should never be greater than 20% of income. The monthly payments on a home should be no more than 28% of the owner’s gross income. The total monthly payment on all debts should never be more than 38% of gross monthly income. A renter’s expenses should always be less than or equal to 30% of his or her gross monthly income. It is always preferable to have more than one source of income. When an individual only has one source of income, he or she needs to do more planning. It is a good rule of thumb to have at least 5-10% of gross income going into savings and investments, not including reinvested dividends and income.
Consumer Debt Consumer debt is the most widely known form of debt that a financial planner will need to address. There are three main varieties of consumer debt: thirty-day or regular charge accounts; revolving and optional charge accounts; and installment purchases or time-payment plans. These last can occur either when an individual buys on time from the seller or borrows money from a credit institution, generally in the form of a credit card. The most common sources of consumer credit are commercial banks, consumer finance companies, credit unions, savings and loan associations, life insurance companies, brokerage companies, and auto dealers.
Home Equity Loans, Home Equity Line of Credit, and Secured and Unsecured Debt
A home equity loan is any cash that is given up front at a fixed rate. A home equity credit line, on the other hand, gives the individual the chance to use the money only when it is needed, but at a variable rate that is usually tied to the prime rate. Oftentimes, individuals will keep the current first mortgage and get a second loan for the necessary cash amount. If the current mortgage rates are more than the rates for the existing first mortgage, a home equity loan gives the borrower the opportunity to maintain the lower first mortgage rate. According to the 2017 Tax Cuts and Jobs Act, the interest on a home equity loan is tax-deductible within certain limits (so long as it’s used to buy, build, or substantially improve a home). A secured loan is one in which collateral is used to keep the debtor from defaulting; an unsecured loan will have higher interest rates to the borrower because no collateral is used.
Bankruptcy Code Chapter 7 Bankruptcy Congress established the Bankruptcy Code in 1978 in accordance with Article I, Section 8 of the Constitution. Title 11 of the United States Code governs bankruptcy proceedings. There is a bankruptcy court for each judicial district in the country. Chapter 7 bankruptcy has to do with liquidation; in order to qualify for this form of bankruptcy, the debtor must be an individual, partnership, or corporation. The debtor is allowed to retain certain property, but a trustee liquidates all other assets. The discharge of Chapter 7 bankruptcy will extinguish the debtor’s responsibility for dischargeable debts. Such a discharge is available to individual debtors only and not to partnerships or corporations. Chapter 11 and Chapter 13 Bankruptcy In Chapter 11 bankruptcy, the person, firm, or corporation is allowed to reorganize in order to meet the obligations of debt. After this is done, the court will either confirm or reject the plan of reorganization. Typically, the debtor will remain in possession of his or her assets and will continue to operate the business, though these operations may be subject to the oversight of the court. In Chapter 13 bankruptcy, an individual is allowed to set up a repayment plan. The debtor is allowed to hold on to his or her property as long as he or she makes regular payments. Debtors will often file for Chapter 13 bankruptcy if they are threatened with foreclosure. Many of the debts that cannot be discharged through Chapter 7 can be discharged through Chapter 13. Estate, Qualified Retirement Plans, Tax-Advantaged Savings Plan, and Exemptions In a bankruptcy settlement, the property of the estate is all the property that is not exempt from being divided. Typically, the trustee sells the property of the estate and creditors are paid from the proceeds.
The Supreme Court has ruled that creditors cannot seek to take funds from the retirement plans of a debtor. This includes almost all pensions and 401(k) plans. If retirement savings are a part of the estate, they may be exempted under the available exemption statutes. Exemptions are the forms of property that, according to state law, are beyond the reach of creditors. In sixteen states, debtors have the ability to choose whether they would like to honor the state or federal set of exemptions; in all other states, the state exemptions must be selected. Dischargeable and Nondischargeable, and Alternatives If a debt is discharged, the debtor is freed from any personal liability and the creditor may not take any actions to collect the debt. Most unsecured debt is dischargeable. Secured debt, on the other hand, will survive bankruptcy as a charge on the property to which it attaches unless a court order modifies the lien.
There are a few types of debt that cannot be discharged in either Chapter 7 or 13 bankruptcy. These include debts that were not listed in the bankruptcy papers, child support, alimony, debts for personal injury or death caused by driving while intoxicated, student loans, fines incurred by breaking the law, recent income tax debts, and some long-term obligations like home mortgages. Instead of declaring bankruptcy, a debtor may elect to consolidate debt, negotiate debt, take out a home equity loan, or start a line of credit.
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