A financial plan is a written document which lists your household financial priorities or goals and lays out the steps you must take over time to achieve them. You can formulate the plan yourself, in collaboration with a spouse or partner, or you can turn to a professional known as a “financial planner.”
Financial planners should function as fiduciaries and charge by the hour or an agreed upon flat fee for providing the plan. This arrangement avoids potential conflicts of interest inherent in other compensation mechanisms. We’ll get into conflicts and fees in a later chapter.
You can easily find sample financial plans online. Such plans typically contain the following sections, which I’ve labelled as steps A to K, below:
A. A high-level summary of your household’s circumstances, including the ages of all family members, their states of health and status as students, dependents, wage-earners, etc.
B. Household priorities and goals, such as:
-Cover our children’s college education
-Retire at age 60
-Protect family against the death of a breadwinner
-Take care of an elderly parent
-Maintain current standard of living in retirement
-Set aside a sufficient emergency or rainy-day fund
C. An assessment of household Net Worth. Net Worth is a formal term for your nest egg. It is calculated by subtracting all your debts from the total assets owned by your household.
D. A recent annual budget quantifying all income and expenses. The budget shows whether your household is living within its means or overspending. It also approximates how much excess cash you generate annually to fund additional investments or pay down debt.
E. An assessment of your investing time horizon and tolerance for risk-taking. These two factors are typically measured using a questionnaire. The questionnaire results direct you to investments deemed appropriate to your comfort level with, and ability to withstand, risk.
F. A specific asset allocation recommendation consistent with your risk tolerance preferences. If you have high risk tolerance you’ll be directed to form a riskier portfolio. If your tolerance for risk is low you’ll be directed to a low-risk portfolio.
G. A retirement planning forecast of your expected total nest egg as a retiree, and an assessment of the income you can realistically expect to receive each year in retirement from that nest egg. The forecast highlights gaps between your currently anticipated vs. desired outcomes, and provides guidance on how to get from the former to the latter.
H. Summary of existing insurance policies and recommended amendments to address any coverage gaps. The objective is to properly protect the household (people and property) in the event of death or disability of a wage-earner, an accident causing damage to property, or liability for injury to a person.
I. Analysis of children’s college education funding needs and recommendations for contributions to education savings accounts such as 529 College Savings Plans.
J. Estate planning recommendations including a Will stating how your assets are to be distributed upon your death, and any other directives governing your medical care and financial decisions in the event you are incapacitated.
K. A list of specific recommended actions aimed at closing any gaps identified during the analysis to put you on a successful financial path.
In subsequent chapters we’ll cover each and every one of these financial planning components. You will also find chapters on dealing with financial advisors, decision making biases, and negotiating employment contracts.
What are the Pillars of Wealth?
Pillars of Wealth is a metaphor I find useful as a pedagogical tool. The Pillars are the various financial assets we accumulate over our lifetime. These assets are akin to pillars that support our household financial needs and ultimately our retirement. They are also repositories for any wealth we wish to pass to our heirs or charitable organizations. In the Pillars of Wealth context, a debt is a “negative” pillar, or visually, a hole in the ground. We can’t successfully build up our nest egg until we fill in those holes. Extending the metaphor, insurance policies are domes or moats that surround and protect our pillars, and financial advisors are the masons who help us build pillars. Unfortunately, sometimes they take large chunks of our pillars for themselves.
Before we delve into the individual components of financial planning, let’s review several fundamental axioms or truths which should help guide our financial decisions.