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PTMBA III / TRIM VII YEAR 2010-11 Personal Financial Planning (PFP) Mahesh Parikh / JUNE 2010 1 PTMBA III TRIM VII YEAR 2010-11 Personal Financial Planning (PFP) Some like it. Some don’t. But personal financial planning is a reality for every working person. Most young people today think of retirement as a distant reality. However, it is important to plan for your post-retirement life if you wish to retain your financial independence and maintain a comfortable standard of living even when you are no longer earning. This is extremely important, because, unlike developed nations, India does not have a social security net. Financial Planning acquires added importance because of the fact that though longevity has increased, the number of working years haven’t 2 Personal Financial Planning (PFP) People are facing a common problem. They have uncertainty in their financial plans. That personal financial planning is a niche area meant for the affluent class and is for the needy is a general feeling among people. Financial planning does not require heavy bank balances or real estate property. Whether one has enough money or very less, personal financial planning comes handy for everyone. Personal financial planning refers to the proper planning and implementation of well-coordinated plans to achieve financial objectives. If a person has huge cash reserves, he can plan to invest and spend it wisely. Similarly, even for a person who has low or inadequate income, financial planning is the need of the day. Financial planning can help such a person to deploy the scarce available resources in a wise manner. In other words, whether the person is rich or poor, depending on his future goals, savings and investments become essential. The savings and investments made today have to match the future goals. To make sure that this happens, proper projection of the future needs and the evaluation of the future courses of actions becomes necessary. Thus, Personal Financial Planning can be defined “ as taking conscientious and systematic steps towards fulfilling one Financial Goals” 3 Personal Financial Planning (PFP) Rewards of Financial Planning • Improved Standard of Living • Spending Money Wisely • Current Needs • Future Needs • Accumulating Wealth 4 REWARDS OF FINANCIAL PLANNING 1. Personal Financial Planning (PFP) Improved Standard of Living Management of resources and controlling undue expenses. To provide for investment to meet future needs. As income increases, the need for planning also increases. 2. Spending Money Wisely Spend it or save it for the future. Sometimes, it is important for an individual to forgo current needs to save for the future. If money is to be spent, it should be spent wisely. 3. Current Needs Current needs depend on level of basic necessities of life such as food, clothing, shelter etc. and propensity to consume. One can easily be influenced by various attractive schemes for buying expensive consumer durables, large houses, clothes etc. irrespective of income. One has to strike a balance between current expenses and future requirements. This is dependent upon individual attitude of the person. 5 Personal Financial Planning (PFP) REWARDS OF FINANCIAL PLANNING 4. Future Needs Future needs can be taken care of by allocating a part of current income for saving or investment. Lower the income, lesser is saving / investment. But, it is imperative for a person to save for the future. There may be a need to spend a lump-sum which has to be catered to out of saving / investment; saving for such needs may call for sacrificing on current needs. 5. Accumulating Wealth * Accumulation in the form of tangible or intangible assets. * Assets can be Earning Assets & Tangible Assets (Car is tangible but not earning) * Tangible asset have two character - Income Generating (e.g. Rent) - Capital Appreciation (e.g. land / real estate) 6 Objectives 1. Regular Income 2. For predictable events / goals -Education -Marriage -Holidays 3. Funds for Emergency - Hospitalisation / Accident -Family Needs -Un-employed Period 4. Investment Planning -Housing -Car/Vehicle - High Value Entertainment objects like Home-Theatre - Club/Gymkhana Membership / Entrance Fees 5. Wealth Creation 6. Hedge against inflation 7. Retirement Planning / Estate Planning 8. Unfortunate events like - pre-mature or early death - Disability Losses - Unemployment Personal Financial Planning (PFP) 7 Personal Financial Planning (PFP) STEPS IN FINANCIAL PLANNING PROCESS 1. Defining Goals 2. Developing Goals 3. Implementation 4. Monitor & Control 5. Evaluating results of Plans & Budgets 6. Revising & Redefining Goals 8 Personal Financial Planning (PFP) DEFINING FINANCIAL GOALS Goals should be a) b) c) d) SPECIFIC REALISTIC FOR WHOLE FAMILY HAVING TARGET DATES 9 Personal Financial Planning (PFP) Types of Financial Goals 1. Long term Goals May extend beyond 5/6 years. The time-period should not be so long that the goal become unrealistic to achieve. The goals change over a period of time and need to be revised on regular basis. The table below illustrates individual’s long-term goals. Goal Priority Target Date Cost Estimate Take Home Loan Priority 3 Yrs. from now 5,00,000/- own 20,00,000/- own Investment in Land / Farm House Medium 5/7 yrs. from now Take Singapore Holiday Medium 2/3 Yrs. from now 2,00,000/- 10 Personal Financial Planning (PFP) SHORT-TERM GOALS Period one year or less. They are immediate goals in the form of expenses in the current period. The Short-Term goals also provide for the surplus required for savings, which are crucial for long-term goals. The following table illustrates the same. Goal Priority Target Date Cost Estimate School Uniform & accessories for children High Immediate 4500/- Replacement of mobile which has battery problem High Immediate 15000/- Seat-Cover for Car Medium 1 / 2 months from now 3000/- Buy Crockery Set Low 1 / 2 months from now 3000/11 Personal Financial Planning (PFP) INTERMEDIATE GOALS They fill up the gap between the short term & long term goals. They are spread over 2 to 5 years. Goal Priority Target Date Cost Estimates Re-payment High of Educational Loans 1 year from now 1,00,000/- Take OneMonth holiday 6 Months from now 1,00,000/- Medium Advisable to prioritize goals on the basis of urgency to fulfill them. This would help individual to concentrate on some goals & defer some. 12 Personal Financial Planning (PFP) PLANNING FOR A LIFE-TIME Financial Planning is a dynamic process. Goals & Targets change with changing environment and situations. They have to be updated at the right time. Contingencies such as unemployment, illness, disability etc. have impact on Financial Planning. To start with, one depends upon parents. Then Career starts for the self. The income increases as years pass by and stabilize at one stage. One takes responsibilities for children and requisite standard of life. Also, one has to plan retirement needs. Financial plan give a picture of what financial plans can be adopted in various stages of life. 13 Personal Financial Planning (PFP) 14 Personal Financial Planning (PFP) Asset Acquisition Planning Asset planning is the first form of financial planning. The assets acquired may range from liquid assets to real estate property to personal assets. Cash held and balances in savings accounts are examples of liquid assets, while assets such as automobiles, household furniture, appliances and jewellery are personal assets. Land and structures fixed to it, like houses, etc., constitute real assets. Liability and Insurance Planning A person may have to manage his/her debt like education / car loan etc. in the same way as managing his / her assets. Apart from managing one’s debt, one also has to provide for his or her insurance. There is the risk that a critical illness may wipe out the entire earnings of a person or that an accident wipes out the savings accumulated through years of hard work. Thus, it is essential to have an adequate insurance cushion for a smooth living. Too much of insurance, too, is not desirable. 15 Personal Financial Planning (PFP) Savings and Investment Planning As a person’s income increases, the importance of savings and investment will also increase. People generally start savings for meeting unexpected situations. At a later stage, it is essential to start investing in investment instruments such as bonds, saving schemes, personal property to accumulate wealth. Tax Planning Tax planning assumes importance for an individual, once he or she falls in the tax bracket. There are various exemptions and deductions available, under different sections of the Income Tax Act for different purposes and based different criteria. Not considering the tax benefits available when planning the investments, can result in loss of a substantial portion of the return to taxes. Hence, tax planning and financial planning go hand in hand. 16 Personal Financial Planning (PFP) Employee benefit Planning Generally, large firms provide employee benefits in the form of life and health insurance, disability insurance, reimbursement plans for education or it may be in the form of pension or retirement plans. Apart from these traditional plans, firms now-a-days also give benefits in the form of stock options, health and child care expenses, vacation leave, sick leave, etc. An individual should try to integrate his/her own personal plans with the benefit plans provided by the organization should also be duly supplemented by personal policies. In today’s uncertain employment conditions, one should be prepared for eventualities like a loss of job – either through layoffs or dismissal – and having no run the family without a job for some time. 17 Personal Financial Planning (PFP) Retirement and Estate Planning One of the main long-term goals of financial planning is to make proper retirement plans. Apart from maintaining one’s standard of living and meeting all necessities in life, one has to take care of his/her retirement days. Old age brings with itself increased medical expenses and other requirements. Thus, investment in a retirement plan is of utmost importance for a person who is approaching middle age. It is always advisable to start planning for retirement well in advance , rather than after one is into the late 40s or the 50s. This is because, investments made early in life multiply with accrual in interest and the final sum available will be much more. Apart from retirement plans, estate planning should also be done carefully for passing on the wealth to legal heirs. Estate planning is a complicated topic that calls for an understanding of wills, trusts, and their legal aspects. It will be covered in detail later. 18 Personal Financial Planning (PFP) The planning Environment Financial and economic environment need to be properly understood by an individual before starting his/her financial plan. The economic environment of a country influences the individual financial decisions made by a person. Economic variables such as inflation, interest rates, retirement plans available by the government agencies, etc., influence the planning decisions. 19 Personal Financial Planning (PFP) The Planning Environment Government There are two main tools applied by the government, which impose restrictions – they are taxation policies and government regulations. Taxation The government levies taxes on the income of the individual, sales, real estate and personal property. Taxes form one of the main sources of revenue for the government. By changing the taxation rates, the government can decide the amount of disposable income in the hands of the consumers and affect their financial planning. Regulations Governments impose various regulations to safeguard interests of the consumers, investors and general public as a whole. The government may impose restrictions on the undesirable activities of the sellers, producers, financial institutions, etc. 20 Personal Financial Planning (PFP) The Planning Environment Business Business enterprises produce goods and services by employing labor and utilizing land, capital and technology. Business firms need to pay wages, interest, and rent for the use of the factors of production and in turn earn profits. Thus, business enterprises facilitate the circular flow of income in the economy. Enterprises not only create healthy competition in the economy but also facilitate greater array of goods and services available to the customers. Consumers Consumer is the ‘king’ in today’s dynamic environment. Consumer’s tastes and preferences determine the strategies of the business enterprises. In case the economy is depressed with low economic activity, the general public may cut its expenditure and vise-versa. 21 Personal Financial Planning (PFP) 22 Personal Financial Planning (PFP) Other Factors Affecting Financial Planning Economy The economy is the result of interaction among various groups such as the government, business and the consumers. The government is the most important player in the economy, maintaining the economic stability and high employment levels. The government through its monetary and fiscal policy is able to determine the requisite level of economic activity by influencing the interest rates, inflation and money supply. The government, by reducing and increasing taxes and interest rates, is able to regulate the fundamentals of the economy. Taxes and interest rates are generally lowered when the economy needs a stimulus and they are increased when the economy is getting overheated, during a boom. 23 Personal Financial Planning (PFP) Other Factors Affecting Financial Planning Economic Cycles The level of economic activity changes constantly giving rise to various economic cycles also known as business cycles. An economic cycle goes through the following stages: Expansion Expansion in the economy occurs when the economy goes through high levels of employment and production. Recession Recession results, when the economic activity declines for a period of more than six months (often mentioned as two consecutive quarters). Depression Depression in the economy is said to occur, when the economic activity comes to a standstill. Economic Recovery The recovery stage in the company occurs when the production and employment levels start rising indicating a revival in the economic activity. Percentage changes in the Gross Domestic Product (GDP) are commonly used to measure the growth of an economy. An increase in the GDP means that the economy is growing and a fall in GDP indicates poor economic conditions. Unemployment rate is also used frequently to measure the health of an economy. 24 Personal Financial Planning (PFP) Other Factors Affecting Financial Planning Inflation, Level of Prices and Interest Rates Every economy is based on the exchange of goods and services among business and their customers. This exchange is facilitated by ‘Money’ and the price of the product or service. Inflation occurs when the level of prices increases. In this situation, the economy is said to be going through inflation. The level of inflation influences financial planning, as the disposable income in the hands of the individual may reduce. Inflation also affects interest rates – high rates of inflation increase the cost of borrowing, as the lenders demand a higher compensation as a price for parting with their money. Inflation also affects stock and debt market. Apart from all this, high level of inflation affects the retirement plans drastically. Thus, the economic scenario should be completely understood before formulation of any long-term financial plan by an individual. 25 Personal Financial Planning (PFP) DETERMINANTS OF PERSONAL INCOME Persona1 income of an individual depends on various factors such as age, marital status, IeveI of education; place of residence and last but not the least, the choice of career. Earning money is not difficult, but it is influenced by the above mentioned variabIes associated with the individual. Age The age group in which an individual falls determines his/her earning capacity. Marital Status Where both the spouses are working, it is easier to plan financially for the future and also maintain the requisite lifestyle of the family. 26 Personal Financial Planning (PFP) Determinants of Personal Income Education Although it is not necessary that the education of a person is the sole determinant of an individual's income but high education makes a difference in the long run for thefinancial stability of a person. Place of Residence Number of opportunities available in a bigger city or town gives a better exposure for finding a better job or changing a job than a smaller city for an individual. Choice of Career Earning capacity of a person depends on the type of career he or she chooses. The career chosen by a person is again dependent on the education, standard of living, skills and interests of a person, his / her preferences and personal values. 27 Personal Financial Planning (PFP) Determinants of Personal Income Career Plan There is a close relationship between career and financial planning. Decisions made in one area affect the other. Career planning is similar to financial planning, as short and intermediate goals determine long-term goals of an individual. Proper career planning helps in determining the financial goals of an individual. The foIlowing points will help in proper financial planning for an individual: 1. Identify skills, interests, values, etc. 2. Identify long-term and short-term career goals. 3. Develop a career plan and implement it to achieve the targets set. 4. Keep reviewing the plan to adjust to the changing situations. 28