Financial Planning

I got holes in my shoes
I got holes in my teeth
I got holes in my socks
I can't get no sleep
I'm trying to make a million

Ain't No Fun (Waiting Round to be a Millionaire), song by AC/DC

Why You Need a Financial Plan

Investing is a tool. While growing wealth as an abstract figure on the bank statement serves no purpose, investments become meaningful when they serve a purpose: reaching specific financial goals. This view also clarifies the objective of any investment. The task at hand is not to maximize our wealth, but to maximize the likelihood of achieving our goals. I will show later, why these two are not synonymous. For now, it is sufficient to note that there can never be a one-size-fits-all investment approach, because the optimal investment strategy is highly dependent on the priority of the various goals, and the gap between the status quo and reaching them.

But how do we assess the status quo, set realistic financial goals for the future, define the roadmap to achieving these goals, and identify any potential gaps in between? This is where financial planning comes in. Besides helping to choose suitable investments, a financial plan is important for the following reasons:

  • Helps navigate your financial future: A financial plan outlines your short- and long-term financial goals and provides a roadmap for achieving them.
  • Improves your financial situation: A financial plan can help you identify areas where you can cut costs, increase income, and manage debt more effectively.
  • Provides peace of mind: A comprehensive financial plan can give you peace of mind by reducing financial stress and providing a sense of security.
  • Helps you prepare for unexpected events: Life is unpredictable, and a financial plan can help you prepare for unexpected events such as job loss, illness, or disability.
  • Supports retirement planning: A financial plan helps you determine the amount of money you need to retire comfortably without outliving your savings and develop a strategy for achieving that goal.
  • Facilitates effective decision making: A financial plan provides a framework for making informed financial decisions that align with your long-term goals.

Overall, your financial plan helps you understand your financial situation and health, the likelihood of achieving your goals, the options to getting there, and the pitfalls to watch out for in-between. Without a good understanding of these aspects, it is impossible to make sound financial decisions. But with a comprehensive financial plan, you can take control of your finances, and provide financial security for you and your loved ones. Therefore, I wholeheartedly recommend everybody creating a comprehensive financial plan.

Main phases in financial planning

Phases of a Financial Plan

I used Envestnet’s MoneyGuide financial planning software for this example and the screenshots. As a free alternative, try the Flexible Retirement Planner.

The goal of financial planning is to model future cash flows with as much detail as possible. This will help us plan for the unforeseen. But our busy life includes hundreds of transactions each month, making this a daunting task. Luckily, we can greatly simplify this process.

First, we can roughly distinguish two phases in our financial plan:

  • Saving for retirement
  • Living off our savings
01 personal info 02 retirement period

At this level, we can already name one of the most important parameters for the whole plan: time. Time is so crucial for the whole plan because our monthly contributions and withdrawals, multiplied with time, define the total amount of money we need to save if we want to confidently fund our goals.

During the savings phase, we focus on only those transactions that go into and out of our savings accounts. In particular, we track the following:

  • Monthly savings
  • Contributions to retirement accounts
  • Expenses paid from savings, e.g., a new car, or a home remodel
  • Out of the ordinary contributions made to savings, e.g., an inheritance or downsizing the primary residence

At the same time, we specifically ignore those expenses, that we pay from our regular cash flow including:

  • Grocery shopping, food, and entertainment
  • Services, including cable TV, or mobile phone
  • Housing and insurance
Cashflows while saving for retirement

It is worth noting that income plays no role in this phase. The underlying assumption is that we will spend all income on day-to-day expenses – unless we commit ourselves to putting it into savings or retirement. However, the delta between our income and savings equates to our living expenses. Knowing this number will be helpful for planning the retirement phase.

What is very relevant though, is the time we will spend in this phase. It is obvious that time is on our side here, and the more time we spend saving, the better off we will be. Starting early makes a huge difference, and thinking about retirement with only ten years left to go is an unfortunate choice.

Cashflow during retirement

During retirement, this approach changes. Because we are now living off our savings, it is imperative to track all expenses taken out of our accounts, which requires a lot more detail than what we have done so far. In this phase, we specifically track:

  • All income
    • Social security
    • Potential company pensions
    • Potential additional income
  • All expenses
    • In the form of financial goals
    • Prioritized by expense level

What is important to realize is that in this phase time is against us. For once, because our expenses will slowly but steadily deplete our savings, leading to a real possibility of outliving our savings. But further, because we are much less in control of time than we are during the savings phase. While we can, within limits, control when we transition from work and saving into retirement, the length of the retirement phase is beyond our control. It is therefore important to optimistically plan for a long life.

05 investment accounts

Modeling Contributions

During the savings phase of the financial plan, we are setting money aside, so that we can live off these savings later. Typical financial planning software assumes that all income is spent – unless it is specifically contributed to an account.

Our Model family has two main accounts for this. One is John’s 401(k), to which he contributes $19,000 per year. The other account is the couple’s savings account, to which they contribute another $24,000 each year.

In this setup, we assume that the 401(k) is solely used for retirement purposes. The savings account serves a dual purpose though: it is used to fund larger goals on the way, e.g., to replace the cars, or to put the children through college. Any leftover funds can and will, of course, be used during retirement.

wishes wants needs

Setting Financial Goals

For the expenses, there are two main differences to the savings phase. For once, we need to capture all expenses. But also, we should prioritize them, so that we can better scale them back, in case we need to. It is useful to think of these goals in terms of three distinct expense levels:

  • Needs – essentials we cannot do without
    • Living expenses including food, housing, transportation, and basic services
    • Health expenses
  • Wants – optional items with a high priority
    • Support of children
    • Travel
  • Wishes – a bit of extravaganza
    • A yacht
    • Donations
03 goals

Many of these expenses are hard to quantify. For the living expenses, we can go off our current expenses, the delta between our income and the contribution to savings and make assumptions how these might scale back once the children are out of the house. Health expenses are very difficult to predict, especially as we have to leave some room for deteriorating health, increasing costs, and the potential need for additional care.

03 goal timeline

Once we finished entering the goals, we can review all cash flows over time, and easily adjust mistakes. We also get a first idea of how the timing of expenses might influence the outcome. In the example above we can see how in the years between 2020 and 2029, the Models are putting their two children through college – a major expense.

04 social security

Retirement Income

Luckily, not all our spending during retirement comes out of our savings. Instead, there are multiple sources of retirement income:

  • Social security
  • Company pensions
  • Additional income

The first income component stems from Social Security. Unfortunately, Social Security typically covers less than half of the retirement expenses. But truth be told, Social Security was never designed to do so. When the original Social Security Act was signed into law in 1935, many Americans had lost their savings in the Wall Street Crash of 1929. By collecting from the active workforce, and redistributing it to the retirees, it was possible to eliminate the dependency on savings and provide support immediately. In this spirit, we should consider Social Security as insurance, but not the main source of income.

Company pensions, or Defined-Benefit plans, are employer-sponsored retirement plans where employees receive pre-defined benefits, based on length of employment, salary history, and other quantifiable factors. The main difference to Defined-Contribution plans is that with Defined-Benefit plans all investment decisions are with the employer, which implies that the employer also carries the investment risks. Consequently, these plans are a terrific way to diversify. And while most public employees participate in Defined-Benefit plans, only about half of private employees receive such benefits.

Many retirees receive additional income, e.g., from rental properties or part-time work. This income can be a substantial help in making sure we won’t outlive our savings. And because work is often not only a source of income, but can also provide a sense of belonging, esteem and self-actualization, some gainful activity during retirement can be rewarding in many ways. Nonetheless, it is a good idea to be honest and realistic about the level of income that can be achieved, and the number of years one is willing and able to do so.

Modeling Inflation and Investment Returns

Curious readers will have noticed that, so far, we left out two major factors:

  • Inflation and rising costs
  • Return on savings and investments

This is where the software package used for financial planning comes in. Typical packages allow us to specify assumed inflation rates. This significantly streamlines the planning process, as we can now specify all income and expenses in today’s dollars and don’t need to scale them with time.

03 goal expenses

The image shows how the software scales our expenses over time to adjust for inflation. In this example we can see how the Model family’s spending is significantly higher in the years 2021 to 2028 and while they are putting their two children through college. We will review this in more detail later.

07 risk score

The final pieces to the puzzle are returns on our savings and investments. Hopefully, these returns will substantially grow our savings and help us get further. These investment returns not only apply during the savings phase, but thankfully also during the retirement phase.

The way typical financial planning packages model these returns is hinged on individual risk tolerance. The way to adjust this parameter is to think about the losses one can tolerate in a recession, e.g., the Great Recession of 2007. If those losses would make you reconsider your investment strategy, you should select a lower risk score.

This is because de-risking your investment strategy after experiencing drawdowns is almost always a terrible idea. In doing so, investors lock in their losses, and miss out on future rebounds. This results in a double-whammy as they have combined the worst of two worlds: the high drawdown of the risky portfolio with the lower returns of the safer one. When selecting your investment strategy, it is therefore crucial to watch your risk tolerance, and tame your greed for high returns.

I very much subscribe to this risk-centric approach – but it also has its limitations. The risk score is mapped on one of several strategic (buy and hold) portfolios which, most prominently, differ in their exposure to the stock market. The remaining capital is diversified across bonds, REITs, and commodities. We will look at such portfolios in the chapter about strategic investments.

With this model, it is not possible to accurately represent tactical portfolios – the main topic of this book. However, this is not as bad as it initially appears. The goal of any tactical strategy is to beat a buy-and-hold index with similar characteristics. Consequently, if we can make the plan work with a conventional strategic portfolio, chances are high we should do even better with a tactical portfolio.

06 other assets

Other Assets

In addition to our income, savings, and investment returns, there are most likely additional assets we can access. For once, we might at some point receive an inheritance. And while we of course wish our loved ones all the best, I still believe that a realistic financial plan should take this possibility into consideration.

Further, there is our primary residence. Of course we need to have a place to stay, but we should think carefully about where that might be. At some point, it might be a good idea to downsize, and reduce the burden of ownership. Further, it might be possible to turn the primary residence into an additional source of income, e.g., through a reverse mortgage.

08 fund all goals

Evaluating and Improving the Financial Plan

Finally, we can evaluate our plan to determine its feasibility. But because the returns on our savings and investments can and will fluctuate, it is impossible to accurately predict the future. Instead, we do the next best thing: Using Monte Carlo simulations, we can create a range of possible outcomes with statistical properties that match historical data. Based on these outcomes, we can assess the probability of reaching some or all of our financial goals.

Oftentimes, the initial plan does not work out. But we should not be disappointed here. Instead, we should look at the positive in this: we identified a shortcoming in our financial future, which we can now address and improve. Instead of being blindsided, we anticipate the shortfall and can act on this information and improve the outcome. This is exactly what taking control of your finances means.

In the image above, we can immediately spot the issue: the Model family is running out of cash somewhere between 2025 and 2028, while funding the children’s college education. What now? There is no way around it, the couple will need to give something up.

The Monte Carlo chart also shows us something else: in the later phases of retirement, the plan already looks fairly promising. Consequently, we can immediately rule out those options that immediately spring to mind, but won’t affect the near-term future:

  • Retiring later
  • Cutting back on retirement goals

It is curious why these options to fix the financial plan come up first. This is rooted in human psychology that makes it easier to tolerate reduced spending in the future, than give up some amenities here and now. But kicking the can down the road is never a good plan for financial health.

Also, investors often feel the urge to invest more aggressively when confronted with financial shortfalls. Again, this rarely improves the situation. Quite to the contrary, most often the probabilities of success will decline when taking on more investment risk. Later in this book, we will learn why that is, and how to analyze the suitability of an investment for reaching our goals.

Instead, and after some consideration, John and Mary Model come up with the following adjustments:

  • Their son Bob is a great football player and is likely to receive a generous scholarship. This will bring down his college tuition to approximately $30,000 per year.
  • While money is tight, the family decides to cut back on travel expenses. Until their children finish college, John and Mary will spend only $2,000 per year on travel.
  • The plan includes a second car for $25,000. The Model family decides to go with a car for $20,000, just like their first car.
  • And finally, the couple decides to save another $100 per month
10 fund levels

What a great achievement! With these relatively painless changes, John and Mary now have options:

  • They can be almost certain to cover their basic retirement needs
  • There is a good chance they can fund their wants as well
  • However, they might not be able to fund all of their wishes

Even though these measures bring the Model family close to reaching their financial goals, these might not be the choices you would have made. Financial planning is not a boilerplate process but highly individual. For instance, you might prefer a different approach:

  • Reducing college costs by sending the children to an in-state public college.
  • Mary decides to work part-time while the children are in school.
  • John gets a promotion with a significant salary increase.
  • Mary expects an inheritance from her family that will likely fill the gap.
  • The couple replaces their cars not every six but every eight years.
  • The family bridges the financial gap with a college loan.

The main takeaway here is that a financial plan has immediate benefits. Knowing about potential financial gaps is important, and oftentimes it requires only moderate changes to significantly improve the likelihood of success. An experienced financial planner will work with you to find suitable solutions and raise the confidence level where you feel you need it to be.

Planning for Crises

Financial planning does not stop here. There are still many risk factors that might keep you awake at night. It is worth looking into these factors to make sure the financial plan is robust, even when things don’t go the way we hoped they would. Here are just a few scenarios:

  • Higher inflation
  • Unexpectedly high recession losses
  • Social security cuts
  • Lower investment returns
  • Longer life
  • Increased health-care costs

With financial planning it is possible to analyze each of these scenarios, and estimate the likelihood of success separately for the various expense levels. Evaluating these scenarios and familiarizing oneself with the range of outcomes helps on multiple levels. For once, it makes the future less scary. But more importantly, the confidence that everything will be ok helps stay the course and avoid second guessing the financial plan. After all, the financial plan is only useful if we follow it.

Where to Go from Here?

This brings us to the end of our financial planning session with the Model family. In this simple example, we have seen how the financial plan is an essential document, detailing your finances and bringing a little more certainty into an unpredictable future by estimating the prospects of you reaching your financial goals.

Even for this simple example, it is clear that creating a comprehensive financial plan requires a dedicated software package. Unfortunately, these packages are mostly geared toward financial professionals and prohibitively expensive for individuals. Therefore, financial planning is an activity that is best performed with an advisor. In a later chapter I will discuss the options for getting professional help.

It is important to note that a financial plan is a living document. As life progresses, the plan needs to be adjusted to the new circumstances. As such, investors should review their financial plan once per year, see how they are tracking the plan, and if the underlying assumptions are still valid.

But for the purpose of this book, it is more important how the financial plan ties into successful wealth management. From the plan, we learn the following:

  • The nearest goal we need to hit
  • The urgency of that goal
  • How likely we will reach that goal

Going back to the Model family’s example, we find the following:

  • The next goal, putting their children through college, is only about five years out
  • Hitting this goal is imperative, as it is the most critical part of the financial plan
  • After making some adjustments, there are good chances of hitting that goal
  • Until the children finish college, money is tight, leaving no room for extras

In the next chapter, I will introduce three major investment scenarios. Based on the findings from the financial plan you will be able to identify the scenario that best reflects your situation. And with that, which criteria to seek when selecting investments.

Next Chapter: Investment Scenarios