Expert Guidance: Creating a personal financial plan With Louise Yamada, Managing Director, Louise Yamada Associates Creating a personal financial plan A financial plan is a personalized strategy for accomplishing your financial goals. While your goals can include short-term objectives — including paying off credit card debt or saving for a vacation — the impetus for making a detailed plan is the challenge of being able to achieve larger, long-term goals, such as buying a home or a second home, paying for your child’s (or grandchild’s) education, and having enough money to retire in the style you’d like.

Your financial plan may be a formal document prepared by someone with professional credentials, describing your financial goals and the specific investment, tax, insurance, and other strategies you may use to achieve them. It might be a letter or memo from the professional you’re working with, summarizing what you hope to accomplish and sketching out a broad strategy for how to approach those goals. Or you might start with a list of objectives and potential actions that you’re considering as a prelude to talking with someone who can help you create a plan.

While people have different opinions about how detailed their plans should be, having your ideas on paper is essential to getting started. And a written plan can be a valuable benchmark to help you and the professionals you work with measure your progress toward your financial goals.
Professional help
If you’ve postponed financial planning, now may be the time to take action. If you have children or elderly dependents, or if you feel you’re just treading water with your investment portfolio, it probably makes sense to seek professional assistance sooner rather than later. It can be an important step in analyzing where you are and how you can get to where you want to be.
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Starting a financial plan When you’re young and don’t have many financial responsibilities, you may be able to live comfortably from paycheck to paycheck without a lot of advance planning. But at some point in your life, the things that you want or need will outdistance what you have in the bank. And if you don’t have a strategy in place for accumulating the assets you need, you may find that you have to postpone or abandon some of the things you were counting on.

A financial plan is about looking ahead, so the money is there when you need it, for as long as you’ll need. While everyone’s specific goals and circumstances may be different, a financial plan should help you: Identifying your goals, selecting the most important ones, and deciding how to achieve them are the crux of your plan. Building an emergency fund will help prevent you from being thrown off track by an unplanned loss of income or unexpected expenses. And practicing good financial habits — such as having a spending plan, investing regularly, and using credit wisely — can help you find yourself where you want to be within the time frame you’ve set.
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Your time frame When you’ve identified the goals that are most important to you, the next step is thinking about the timing.

You might try creating a chart that looks something like this one to help you organize:

  Short term
(2 years or less) 		Mid term
(2 to 10 years)		 Long term
(More than 10 years)
Comfortable retirement     2035
Buying a home 2008    
Child’s education   2015  
Starting a business      

Short-term goals are things you’d like to accomplish within the next year or two, such as buying a home, paying off college debt, or building an emergency fund.

Medium-term goals are plans you’d like to see realized within the next two to ten years, perhaps paying off your mortgage, starting your own business, or sending a teenager to college.

Long-term goals are objectives ten years or more in the future. Some long-term goals might be planning for a newborn’s college education or having enough money to retire comfortably.
From the expert
Louise Yamada discusses how your time frame to meet your goals is individual.

Your time frame also depends on your priorities: For instance, some people want to retire as soon as possible, while others hope to work well into their 70s or beyond.

Remember that no goal is by definition short, medium, or long term. Retiring might be a long-term goal for a 30-year-old, but a short-term goal for a 60-year-old. Similarly, putting away enough money for your child’s college education may be a long-term goal when your child is a toddler, but a short-term goal when he or she is 16.
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Planning for financial goalsOne thing you’ll want to consider is whether the time frame for a specific goal is flexible or has a fairly strict schedule. For instance, if you expect your child to graduate from high school in 2015, you’ll want to make sure you have the money on hand to pay college expenses by that time. On the other hand, some goals — even important ones like retirement — may be a bit more flexible. For instance, you may want to retire by the time you’re 60. But if you had to put your retirement off two or three years — or even five years — your plans would still be more or less on track.

The best way to meet goals that have a specific time frame and a substantial price tag is to start early and invest regularly in accounts specifically designated for that goal. In the case of higher education and retirement planning, you may want to factor the tax-deferred or tax-exempt investment opportunities that are available into your planning.

Another strategy is to invest a portion of the assets you’re allocating to a particular goal to growth investments, such as stocks and stock mutual funds with the potential to increase in value over time, and a portion to a laddered series of fixed-income investments, such as municipal or federal government bonds — perhaps zero-coupon bonds — that are scheduled to mature when you need the money.
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What will your goals cost?An important part of financial planning is putting a price tag on your goals. Like the goals themselves, the costs are likely to change over time, as some things grow increasingly expensive and others become more affordable. But if you don’t have a sense of how much money you’ll need to meet your goals, it will be more difficult to choose a strategy for accumulating it.

It's easiest to anticipate the cost of most short-term goals by checking current prices. If you’re planning to buy a car next year, it's reasonable to assume that the cost won’t be significantly different from what it is this year. But if you’re planning to move to another area of the country, you’ll want to base your down payment or monthly rental estimate on that market rather than on the one where you live now.

Estimating college costs

If you’re saving for college tuition, you can find estimates of future costs on the U.S. Department of Education Web site (www.ed.gov) or request college planning material from your brokerage firm, mutual fund company, bank, or other financial services company you work with. Those estimates are based on average annual increases in the recent past.

Retirement expectations

The rule of thumb with retirement planning is that you’ll need at least 75% to 85% of what you’re currently earning to maintain your lifestyle when you retire. For example, if you earn $70,000 per year, you'll need an income of $56,000 in the first year of retirement to replace 80% of your salary.

So the question is, how much should you have accumulated in a retirement account to make it possible to withdraw what you need? On average, assuming the balance is compounding at an average annual rate of 6%, inflation averages 3%, and you’re planning on a 20-year retirement, at the time you retire you should have about 20 times the amount you expect to need in the first year. That should allow you to withdraw 5% of the total each year. In this example, if you plan to withdraw $56,000 the first year, you should have savings of about $1.12 million.

Of course, if you anticipate a longer retirement, your rate of return averages less than 6% a year, or if inflation averages more than 3%, you’ll either need more savings or you’ll have to withdraw at a lower rate.
From the expert
Louise Yamada shows you what questions to ask to estimate your retirement needs.

The answers to the following questions will help you determine the retirement savings you should accumulate:
The longer your retirement and the more you plan to withdraw from your accounts, the larger your retirement savings should be. For example, if you plan to withdraw $70,000 a year for 20 years, you’d need closer to $1.75 million in retirement savings.
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Investing vs. savingOnce you’ve identified your time frame for achieving a particular financial goal and have estimated what the goal is likely to cost, you can develop a strategy to help ensure that the money is available when you need it. Chances are that saving or investing — or some combination of the two — will be a big part of that strategy.

While saving and investing both involve setting aside some of your income for the future, saving usually means putting money in the bank — in savings, certificates of deposit (CDs), and money market accounts — while investing means buying stocks, bonds, mutual funds, and other assets.

When you save, you’re preserving the money you have for a later time, earning interest on your principal. When you invest, you’re taking some calculated risks that you believe will make it possible for your investment to grow in value over time or provide long-term income, or both.

Saving is an effective way of managing your money to meet short-term needs and to provide a safety net for emergency expenses. That’s because money you put in a bank account or other savings vehicle almost certainly won’t lose much value in the short term — although it probably won’t gain much value either.

Investing can help you achieve your longer-term goals since invested money has the potential to increase substantially in value over the long term or provide more income than insured savings. The risk, of course, is that returns on your investment assets aren’t guaranteed, and your account could lose value, especially in the short term.
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Meeting long-term goalsThe more time you have to reach a financial goal, the more investment risk you can usually afford to take. That means allocating most of the principal you set aside for long-term goals to equities either individually or through exchange-traded funds (ETFs), mutual funds, or managed accounts that invest in stocks.

Although the value of an investment portfolio may fluctuate dramatically over the course of a month or year, over periods of 15 or 20 years or more, stocks as an asset class — usually a fairly volatile type of investment over the short term — have historically increased in value, though there is no assurance that what has happened in the past will happen in the future.

Despite the fact that a return on your investment isn’t guaranteed, it is true that when you invest for the long term, your earnings have the opportunity to compound. Compounding is what happens when your investment earnings are reinvested and in turn generate earnings. The longer you have to invest the more you stand to benefit from the power of compounding.
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InflationInflation is another reason you may want to invest rather than use a savings account to meet your long-term financial goals. Because the rate of return you realize on savings accounts is generally fairly low, you risk falling victim to inflation, or the gradual decline in the purchasing power of the dollar. Inflation has averaged 3% annually since 1926.

For example, if you put $10,000 in a money market account earning 2.5% interest, your account would have $15,676 after 18 years. If inflation averaged 3% per year, your account value would have approximately $8,500 worth of buying power.

But if you’d invested the money in a portfolio of stocks with an average annual return of 8% for 18 years — a realistic historical long-term return for stocks, though not a guaranteed rate — you’d have $40,000. After accounting for 3% inflation that would produce more than $21,500 worth of buying power.
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Meeting short-term goalsBecause you plan to use the money you set aside for the short term relatively quickly, you’ll probably want to put most of it in savings accounts and investments that are liquid. Liquidity means that you can sell the investment easily with little or no loss of value if you need the money.

For example, say you bought a home and have been putting away money to renovate the kitchen. If you invested it in stock funds and the market took a tumble the week before you signed a construction contract, you might have to sell the fund shares for less than you’d expected.

In that case you might have to scale back your plans or take a loan to complete the project. But if you’d put that money into a highly liquid money market or savings account, you’d be able to withdraw it at its full value. And since you plan to spend your short-term savings in the near future, inflation won’t have much of an impact on its buying power.
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Short-term strategiesHowever, a savings account isn’t the only way to save for short-term goals: The best strategy depends on your time frame. For instance, if you know you’ll need the money on a specific date — say two years from now — you may decide to invest the money in a 24-month certificate of deposit (CD). That way, the money is out of reach while it earns more interest than it probably would in a regular savings account.

And if some of your goals are still a few years off, you can invest a percentage of your savings — say 25% — in a lower-volatility balanced fund, short-term bond fund, or even a blue-chip stock fund, so that your savings have the opportunity to grow without as much risk to your principal as some other investment opportunities. As the date you need the money approaches, you can gradually shift more of your money into a savings account.
From the expert
Louise Yamada shows you how flexible spending accounts and other benefits programs can help you save.

One way to increase the amount you have to spend on short-term goals is to make sure you’re taking full advantage of benefits at your own or your partner’s job that could lower your expenses. Some companies offer flexible spending accounts that allow you to pay for healthcare and other qualifying expenses with pretax income. Or you may be able to participate in a commuter program that will reduce your transportation costs. If you allocate what you save with these benefits to your savings accounts, you should be in a stronger financial position.
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Meeting mid-term goalsWhen you’re trying to meet financial goals that are two to ten years away, you’ll want to strike a balance between protecting your assets and achieving the total return that will help you afford your goal. Total return is calculated by adding any income the investment provides to the change in value, whether a gain or a loss.

By keeping a close eye on your portfolio, you can manage some of the risk that’s often associated with investments that have the potential to increase in value but could also lose ground. Among the things you might consider:

In addition, as your goal nears, you can start shifting some of your assets into less volatile savings and investment vehicles.
From the expert
Louise Yamada discusses how your circumstances informs your risk tolerance.

Everyone handles risk differently. That’s because some people can live with — or can afford to take — more risk than others. For instance, if you have children who will be going to college in the next few years, aging parents who depend on you for financial support, or if you’re taking the risk of building your own business, you might invest differently than someone of the same age and same general income who has fewer family responsibilities.
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Building emergency fundsBuilding an emergency fund is essential to your financial well being, since you’re rarely given advance notice of job cutbacks or an accident that keeps you out of work for an extended period. The likely alternative to an emergency fund — charging everything on your credit card and paying back the debt later at a high interest rate — could set you back significantly in your overall financial plan, even if your credit lines were large enough to cover all the bills.

You’ll want a substantial part of your emergency fund to be low risk and extremely liquid, meaning you can access your cash easily and quickly. By putting the money in a low-risk account, you won’t have to worry that your investments will have lost value if you need money right away. And if some of your assets are in a savings or money market account, you’ll be able to get money from an ATM or just write a check if you’re in a pinch.

You might want to put the rest of your emergency funds in short-term U.S. Treasury bills and certificates of deposit (CDs), since your need for back-up cash may extend for several months. And you can always sell T-bills or cash in CDs early if you need to. You could lose some interest, but if an emergency doesn’t materialize, you are likely to earn more than with regular savings.
From the expert
According to Louise Yamada, building an emergency fund should be a financial priority.

If you’re just getting started creating a financial plan, building an emergency fund should probably be one of your primary financial goals — especially if you don’t already have funds in the bank to cover unanticipated expenses. The one thing that might take precedence is paying off any high interest rate debt.
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Emergency assets: How much?The size of your emergency fund will depend on your personal situation. Many people keep three to six months’ salary in reserve, but that’s a ballpark range. You’ll have to decide on an appropriate amount based on whom you support other than yourself and what your monthly expenses are.

For example, if you’re single with no dependents, and can readily move in with friends or relatives in a pinch, you might not need as substantial a cushion as someone that pays nursing home costs for both parents and has a young family to support. Deciding on a comfortable amount is something you can discuss with your professional consultant or planner.

In thinking about an emergency fund, you might also want to analyze how difficult it might be for you to find a new job at your current salary if you were suddenly in the market for employment. Or, if you have a two-income household, you might want to weigh the contribution of both parties in calculating how much you should keep available for a rainy day.
It might be helpful to keep your emergency fund in a separate account, so that you don’t spend it if you simply run over your budget at a certain point.
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Protecting assets: Life insuranceMaking a financial plan includes arranging to have enough insurance to protect the wealth you have accumulated, ensure your dependents’ financial security, and perhaps provide a legacy.

Life insurance is designed to replace the income and investable assets you would have provided had you continued to live. At the least, it can help your family or friends cover your final expenses. And if you have adequate coverage, the death benefit can cover your dependents’ day-to-day needs and be invested to pay for bigger costs, including college educations for your children. In addition, life insurance can provide the liquidity your heirs may need to pay potential estate taxes.

One question you need to answer is how much insurance to buy. A life insurance calculator can help you estimate the amount. But it won’t take your individual needs into account, which is one reason to seek professional help. Together you can calculate your loved ones’ needs, identify other sources of income they can count on, and determine the size of the policy you need.

You also need to find a balance between the ideal and the practical. If insurance costs more than you can afford, you’re more likely to let the policy lapse. That wipes out the potential protection. But if the policy is too small, your beneficiaries may have to use investment assets earmarked for future goals to pay living expenses.
Term or permanent protection?
Term life insurance covers you for a specific period and permanent insurance covers you for your lifetime if you continue to pay the premiums. Term is generally less expensive but offers only a death benefit. Permanent allows you to accumulate a tax-deferred cash balance against which you can borrow if you need to.
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Disability insuranceDisability insurance replaces part of your income if you are unable to work because you are ill or have been injured. Most policies pay a percentage of your salary — often 50% to 70% — up to a predetermined limit, such as $10,000 a month.

While the premiums tend to be expensive and most policies use fairly strict definitions of what it means to be disabled, this type of insurance can make a major difference to your financial security should the unexpected happen. In this vein, you’ll want to discuss the advantages of a type of disability insurance called own-occupation, or own-occ, with a knowledgeable professional. Own-occ policies pay benefits if your disability prevents you from doing the skilled work for which you are trained. Other policies often won’t pay benefits if you can do any type of work at all, even work that pays much less than you formerly earned.

In addition to the income it can replace, disability insurance can also help you pay medical bills, which may increase as a result of the same problem that limits your ability to work.
From the expert
Louise Yamada discusses another benefit of being insured.

From a financial planning perspective, another benefit of adequate insurance is that it prevents you from having to use up the assets you have been accumulating to meet your long-term goals — goals that are likely to continue to be important to you and your dependents.
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Net WorthYour net worth is a snapshot of where you stand financially at a given time. When you calculate your net worth, by adding up all of your assets and subtracting all of your liabilities, you figure out how much progress you’ve made toward achieving your goals. Calculating your net worth is usually straightforward enough, but it can take a bit of time. You’ll need to gather your financial records — bank statements, credit card bills, and other documents — to create your balance sheet. If a lot of your assets are owned jointly, but you want to figure out your individual net worth, you can divide the value of those assets in half. The same is true of assets you hold in common, such as property you own with siblings. And it’s also important to include your share of the liabilities as well.

Keep it handy

When you’ve finished your calculation, keep your net worth statement on file. This will make it easier to update — something you’ll probably want to do once a year as part of evaluating your progress toward your financial goals.

Calculating net worth

You’ll want to include all of your assets and liabilities when you calculate your net worth. Here’s a checklist:

What you own
What you owe

Fair market value
One tip for calculating assets is to use the fair market value, which is the price a knowledgeable buyer would pay on the open market for something you are willing to sell. Fair market value assumes that neither the buyer nor the seller is under any pressure to buy or sell.
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Purpose of a financial plan
Because the purpose of a financial plan is defining your goals and finding ways to achieve them, you’ll need to decide what’s important to you. Many people include buying a home, paying for their children’s education, or building an investment account among their goals. Others want to start a new business, go back to school, or retire comfortably as soon as possible. Depending on your personal situation at this point in your life, all or just a few of these may be goals on your list. And you may decide that while some of your goals would be nice to achieve, others are essential.

The good news is that developing a plan to reach your goals may be easier than you think. You’ll want to start by evaluating where you are now and what you hope to achieve. If you find the prospect of developing a plan on your own or with your partner daunting, there’s no substitute for seeking trusted professional assistance. Whatever route you decide to take, a promising financial future begins with a sound financial plan.
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