Financial Planning
Key Points:
• Financial planning is the process whereby an individual establishes a comprehensive pathway to achieving their short- and long-term financial objectives.
• All financial plans are unique, but utilize a few common steps: calculating net worth and cashflow, determining financial priorities, and establishing strategies to have the former serve the latter.
• Individuals with highly complex financial situations and objectives benefit the most from the services of professional financial planners.
• Estate planning, tax optimization, investment strategizing, and retirement planning are common — but not exhaustive — elements of financial plans.
• Financial planning is an ongoing process. Individuals should expect to regularly review and update their financial plans according to changes in their lives.
Financial planning is the process whereby an individual, either alone or with the help of a financial planning professional, establishes a comprehensive pathway to achieving their short- and long-term financial objectives. While certain common considerations underlie all financial plans, each individual plan is highly personalized, designed to fit an individual’s unique needs. Financial plans are developed by considering the individual’s current net worth, cashflow expectations, financial objectives, family dynamics, and more.
All financial planning begins with a thorough audit of the individual’s financial life. Planners source information from a wide variety of documents, accounts, and online profiles, aiming to develop an exhaustive list of the individual’s assets and liabilities. Subtracting liabilities from assets is how planners calculate the individual’s net worth. From there, planners develop cashflow estimates — how much income the individual generates through income and investments; how much outflow the individual generates through expenses. Planners then synthesize this information with the individual’s stated objectives, which can include funding college accounts for children, purchasing a home, and developing seed money for new business ventures. From all of this information, planners recommend various strategies for making current earning/spending habits conducive to stated financial objectives.
Because all people need money in order to achieve even the most elemental goals, all people benefit from some level of financial planning. At its most rudimentary, financial planning can entail tracking income and expenses, and making sure there’s as much — and hopefully more — coming in as there is flowing out. As an individual’s financial circumstances and objectives grow more complex, the services of professional financial planners become more and more relevant. When income and expenses are low, and their sources are few, it’s easy for a person to develop a full picture of their earning and spending on their own. But as earning and spending sources proliferate, family situations grow more complex, tax consequences become greater, and long-term objectives get more difficult to quantify, professional financial planners often become necessary.
Individuals who seek out the services of financial planners should be prepared to make adjustments to their financial habits. These changes range from minor and easy to absorb — opening an investment account, eating in one more day per week — to major and more challenging to absorb — altering a living situation, spending less on hobbies, adjusting workload up or down. Financial planners recommend these or other changes because their tools allow them to see far into the future, extrapolating how current habits would impact individuals’ portfolios across many decades. Most individuals have not performed these calculations, through no fault of their own — career-oriented people typically don’t have time to also become financial planning experts. Recommend changes therefore are not criticisms, but long-term health strategies, on the order of exercise and diet regimens.
While financial planning originates with a defined set of strategies, financial planning is not a one-and-done process. Individuals’ lives are constantly evolving, and their financial plans should therefore evolve as well. For instance, if an individual gets married, their tax situation will likely change, prompting adjustments to their financial plan. The same applies if an individual has children, buys a home, gets a promotion, or inherits money from a deceased relative. Individuals should get in the habit of contacting their financial planner at all significant life milestones.
How Financial Planning Works
As referenced in the introduction, there is a common step-by-step process financial planners follow to develop plans for their clients. While the overarching phases are nearly universal, the results are entirely particular, especially for individuals with highly complex financial circumstances and lofty financial goals.
Step 1: Net Worth Calculation
Many have heard the term “net worth,” and generally know that it refers to a person’s monetary value. This is true, but it’s worth understanding the very basic calculations by which net worth is determined.
Assets. Anything of value that a person owns constitutes an asset. This can include automobiles, homes, artwork, jewelry, cash, stocks, retirement accounts, and more.
Liabilities. Anything that needs to be paid off constitutes a liability. This can include personal debts, credit card debts, rent/mortgage, student loans, and more.
In the first stage, financial planners total all assets and all liabilities, subtracting the latter from the former. The result of that calculation is the individual’s net worth. While indeed subject to change over time, for the purposes of financial planning, net worth is an inert figure that serves as an indicator of an individual’s overall financial health.
Step 2: Cashflow Calculation
Like the term “net worth,” many have probably heard the term “cashflow,” and correctly understand that it refers to income and outflow. But there is a somewhat more nuanced understanding of cashflow that individuals develop via financial planning, outlined hereunder.
Income. Any source of revenue contributes to an individual’s income. This can include wage/salary, dividend payments, investment profit, rental income, and more.
Outflow. Any source of expenditure contributes to an individual’s outflow. This ranges from the most basic (e.g.: personal hygiene products and home furnishings) to the most complex (e.g.: vacation costs, money devoted to hobbies, and tax payments).
By subtracting what flows out from what comes in, financial planners determine the value of an individual’s cashflow. High income does not necessarily indicate a positive cashflow. An individual making $200,000/yr is in the higher reaches of yearly income, but if they spend $215,000/yr, their cashflow is negative, and their net worth will diminish over time. Meanwhile, a person making $70,000/yr but spending $25,000/yr has a positive cashflow, and will steadily increase their net worth over time.
Here, we see that cashflow is the variable figure that impacts the inert net worth figure. Net worth either grows or shrinks according to cashflow. Understanding what a person has (net worth) and how their habits impact it (cashflow) is the most fundamental aspect of financial planning.
Step 3: Defining Objectives
While deciding on a list of objectives depends on a subjective assessment of an individual’s life priorities — whether they want to get married or stay single, own a home or rent, retire early or work into their golden years — once determined, financial planners can develop statistically based plans for realizing the objectives.
For example, in the case of buying a home, financial planners will combine net worth/cashflow figures with the price of homeownership, and develop a timeline for being able to afford a downpayment and subsequent mortgage and home maintenance costs. While, on their own, individuals might be able to develop reasonably accurate estimates of the same, financial planners’ estimates will be exact, and will include ancillary strategies for increasing income, reducing costs, minimizing taxes, and other tactics for realizing the objectives efficiently and sustainably.
Typical Components of a Financial Plan
Many people know that financial planning includes creating an investment portfolio, but incorrectly assume that this constitutes the entirety of financial planning. Particularly when working with financial planners who have received elite certifications, the process is much broader, and encompasses all aspects of an individual’s financial life.
Estate Planning
Financial planners can help an individual set up processes for crucial events like end-of-life-care, asset distribution, and business ownership transfers. Estate planning is a universe unto itself — read our article explaining it here.
Tax Optimization
The Internal Revenue Service (IRS) tax code is a mammoth tome, with which regular individuals cannot be expected to be intimately familiar. Expert financial planners, meanwhile, are expected to have a thorough grasp of its guidelines, and can therefore help their clients minimize their tax payments. Financial planners often also coordinate with outside professionals, like tax accountants and attorneys, who can assist in optimizing this process.
Investment Strategizing
Investment strategizing is the most commonly known component of financial planning. Based on an individual’s risk tolerance and financial needs, financial planners will develop an investment portfolio and allocate funds accordingly. Portfolios intended for long-term growth tend to be more risky, while portfolios intended for immediate income tend to be a bit more conservative.
Retirement Planning
Many individuals plan to retire according to the “traditional” model — that is, working into their sixties, and then living off their savings. Others, millennials especially, want to retire sometime in their forties, and devote the rest of their lives to passion projects. Financial planners can help individuals determine their retirement objectives, and orient their finances accordingly.
While these are some of the most common elements of financial planning, this is by no means an exhaustive list. Financial plans are by nature complex and individualized. Each financial plan will be tailored to its specific individual, and will comprise a unique set of areas. The benefit of working with a professional, certified financial planner is that they are trained in all of these areas, and are capable of acting as a one-stop-shop for all financial needs.