The purpose of personal financial planning

The purpose of personal financial planning


The “big picture”: Matching your lifetime financial assets and liabilities

Most people don’t really grasp what we regard as the primary purpose of personal financial planning. As a result, they often fail to identify some long term issues that should significantly influence their current decision making.

Personal financial planning is often viewed as having three increasing levels of complexity or sophistication. They are:

  • Financial planning as investment advice – those without experience of financial planning usually associate it primarily with providing advice on investments. Some planners, while paying lip service to the more sophisticated levels of financial planning, also see their key role as advising on and managing investments;
  • Financial planning as technical advice – while also providing investment advice, planners provide advice of a more technical nature in areas such as superannuation, taxation, insurance and estate planning; and
  • Financial planning as strategic advice – more generally known as comprehensive or lifestyle planning, detailed long term cash flow analysis examines the consistency of a client’s lifestyle objectives with their current and projected financial resources. Relevant investment and technical advice is also provided to increase the chances that any gap between the client’s current and desired position is closed with no more investment risk than is necessary.

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Australian households have never been wealthier

170517.Household wealth Picture

High level aggregate data suggest household balance sheets are in good shape …

 

In both actual dollar terms and relative to household incomes, Australian households have never been wealthier. The chart below (or a variant of it) is often used to demonstrate that despite the potentially worrying levels of debt being taken on by households, net wealth as a percentage of income has completely recovered from GFC lows and now exceeds the previous pre-GFC, September 2007, high.

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At last, a “good news” financial planning story

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Our clients respond to an online “Client experience” survey

In late February-early March 2017, a representative group of our clients was asked to participate in a confidential on-line “Client Experience” survey. The survey aimed to help us, among other things, better understand:

• what our clients look for in their relationship with us;
• how they measure the value of our service;
• their greatest personal finance fears; and
• how they felt we were doing.

We were pleased with the 70% response rate we received and thank those clients who participated.

The same survey was simultaneously offered to clients of other financial advisers that choose to use the services of global fund manager, Dimensional Funds Advisors, both in Australia and internationally. The results provide us with the opportunity to compare our clients’ feedback with that of almost 19,000 other respondents.

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The trade-offs for financial independence

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There are three levers of financial independence

To increase the chances of achieving financial independence (i.e. having sufficient investment wealth to fund your desired lifestyle indefinitely, without the need to work), you have essentially three options or levers available to you. They are listed below in order of capacity to directly control:

  1. Reduce cash outflows, including lifestyle spending, taxes and investment costs;

 

  1. Increase cash inflows, primarily from increased employment or business income; and/or

 

  1. Increase net (i.e. after costs) investment returns.

Most families have significant discretion regarding the amount of their cash outflows and, within a fairly broad range, are able to decide (above a base level of living) how much they want to spend.

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How should I rebalance my growth portfolio?

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The key decision is your defensive versus growth allocation

It is a key element of our approach to investment risk management that you should select a target asset allocation that is consistent with your attitude to risk (i.e. a level of investment risk that will enable you to “sleep well”, regardless of what investment markets are doing). The target is to be met at or before your desired retirement date and/or by the time you wish to be financially independent (i.e. have sufficient investment wealth to support your desired lifestyle, without the need to work).

The target asset allocation is primarily focused on your mix of defensive assets (i.e. cash, fixed interest) and growth assets (i.e. primarily, Australian and international shares, and property). If the current defensive/growth allocation varies from target, we work with clients to develop and implement a strategy to transition over time from where they are now to that target.

We also agree with clients how they allocate the growth component of their investment portfolio between the primary growth asset classes i.e. Australian shares, international shares and property. While this allocation decision is both part art and part science, most investors (both in Australia and around the world) tend to have a strong “home company bias” i.e. Australian investors tend to heavily overweight Australian shares and property, despite our markets only being a small percentage of global share and property markets.

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The “retirement spending smile”

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Retirement spending shown to decrease with age

We have written a lot about the pattern of retirement spending, with “Will spending remain constant in retirement?”, from 2013, and “How much do I need to retire, revisited?”, of only three months ago, being particularly relevant. The underlying theme of these articles is that we don’t believe our “Rule of 25”, the suggestion that you need investment wealth of at least 25 times your expected annual retirement spending to be highly confident of financing a 30 year retirement, is conservative or an unrealistic “rule of thumb response” to the “How much do I need to retire” question.

However, a recent article in “Forbes” magazine, titled “What is the ‘Retirement Spending Smile’?”, by Professor Wade Pfau, a prominent US academic specialising in the financial planning field, provides another potential challenge to the robustness of the “Rule of 25”. It examines US research on retirement spending, by David Blanchett [1], that suggests spending tends to decrease both at and during retirement at a real rate of about 1% p.a.

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Will share returns remain low?

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Share and cash investment returns are unexciting

It feels like the Australian share market has been going up and down in about the same spot for the past six or seven years. Many are becoming disillusioned with shares as an investment class and are looking to “juice returns” with the various hybrid structures and private equity “opportunities” on offer to take advantage of the discontent.

Cash, in the form of term deposits, has also lost its lustre, with yields at record lows. It’s not surprising that in this environment the perennial favourite, direct investment into residential property, has become even more popular. The house price rises experienced over the past three or four years, particularly in Sydney and Melbourne, make the share market appear a pretty dull alternative.

This article examines some of the historical facts that underpin current feelings. While we don’t know what will happen in the future, the past suggests that current investment returns are not inconsistent with what investment theory would expect and may not be a good guide to future investment returns.

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How much do I need to retire, revisited?

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The “Rule of 25” sets a daunting target, for many

When we talk to prospective clients who are at or close to retirement, one of their inevitable questions is “Have I saved enough to retire?”. We explain that while we need to understand their situation in greater detail, our rule of thumb is that they should aim for at least 25 years of expected annual spending i.e. our “Rule of 25”.

So, if they expect to spend $100,000 p.a. in retirement, a reasonable guide is that they need more than $2.5 million in net investment wealth, assuming they wish to stay in their current home and have no other lifestyle assets or expected inheritances to draw on.

Unfortunately, too often, our prospective client has saved nowhere near this amount, with little prospect of doing so between now and retirement. Typically, they may have saved about 15-16 years of their expected annual spending i.e. $1.5 – $1.6 million in the above example.

It isn’t unusual for them to comment that that they are sure that many of their friends are far less prepared, financially, for retirement than they are and to ask how will such people cope. They also ask or, we suspect, think, are we too conservative?

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Should parents assist adult children to buy their first home?

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Our Prime Minister and RBA Governor suggest parental support is required

In November 2014, we published a Blog article titled “How do you give financial help to your adult children?”. Its focus was to match any assistance provided with the objective of developing children’s financial maturity. The views expressed were not influenced by what was actually happening at the time i.e. they were meant to be as timeless as possible.

However, since then, housing prices have continued to rise, particularly in Sydney. Young adults are finding it increasingly difficult to purchase a first home to meet their current living requirements. For most, housing that is also consistent with raising a future desired family is out of the question.

This has prompted a number of commentators, including both the Prime Minister, Malcolm Turnbull, and the retiring Governor of the Reserve Bank, Glenn Stevens, to suggest that the only way many young adults will be able to purchase their first home is with significant parental support i.e. the “Bank of Mum and Dad”. There is often an inference that “good parents” should provide such support.

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The power of compounding and deferred gratification

160816.The power of compounding

“Compound interest is the eighth wonder of the world”

The following quotation is often, most likely incorrectly, attributed to Albert Einstein:

“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t …pays it.”

“Compound interest” refers to the practice of continually reinvesting earnings received on investments over long periods of time (e.g. 40 years), as a mechanism to accumulate wealth. Regardless of who was responsible for the hyperbolic statement above, it’s a reality that the considerable power of compounding is not well understood by most and, even if understood, requires an ability to defer gratification that seems to be beyond many.

Like the achievement of a lot of generally desired things in life (e.g. becoming physically fit, losing weight, competence at a selected sport, hobby or musical instrument), accumulating wealth through compounding takes long term commitment and discipline. Early in the process, there may be little apparent reward for considerable sacrifice, making it difficult to resist the temptation to spend now rather than save and/or to think that there are few consequences for deferral of saving to later in life.

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