fter setting financial goals and gathering data, the next step in the financial planning process is analyzing the information. This is done to determine the steps that need to be taken to move the client from where he or she is now to where he or she would like to be, as defined by the client’s goals.
This is the part of the process where the plan begins to take form. During the analysis of the information, the planner identifies the strengths and weaknesses in a client’s plan. It is in this phase that the importance of good data gathering becomes obvious.
Reading this chapter will enable you to:
1–4 Recommend assets appropriate for use in an emergency fund.
All financial plans need a base. That base is often the simplest form of savings—
i.e., liquid savings and money that can be accessed without delay, penalty, or incurring debt. These funds are generally the basis of the emergency fund.
The Emergency Fund
How Much
It is recommended that individuals retain a sufficient amount of liquid assets at all times to handle emergencies so they will not have to borrow money or liquidate investments at a potentially inopportune time. However, because investments with the greatest liquidity tend to have the lowest earnings, it is important that the amount that is held out for an emergency fund is not excessive. A good rule of thumb is that the client should have the equivalent of three to six months of fixed and variable expenses in liquid accounts for emergencies. This would exclude the expense of income-related taxes and contributions to savings and investments.
A
Where did this rule of thumb come from? From a theoretical point of view, the worst emergency is one where a client loses his or her income due to the loss of a job or a disability. If the individual is not earning an income, income taxes won’t be paid (with the exception of taxes on investment income). Likewise, if there is no income, the client will not be adding to savings and investments; rather, he or she will be drawing on savings and investments. This rule of thumb came about prior to pre-tax medical premiums, flexible spending plans, and a host of other important benefits that are not incorporated into this calculation.
If a client has child care costs of $5,000 per year, medical insurance they have to pay on an after-tax cost of $8,000 per year, and are using the flex plan to pay medical expenses of $2,500, these numbers should be factored into the emergency reserve calculation. Most test questions will not incorporate this information, but for your client’s sake, you need to examine emergency fund needs with these in mind. Other emergencies can also take large chunks of money. Lawsuits, serious illnesses, major dental work, a child’s illness requiring a parent to take time off, etc. can constitute a need for cash in a short amount of time. When adequate disability income insurance is in place, some practitioners recommend that the emergency fund be sufficient to cover the waiting period before benefits become payable (which typically is from three to six months).
Which investments?
In essence, the appropriate vehicles for an emergency fund are cash and/or cash equivalents, as defined in Chapter 2 of this module. Vehicles included are checking accounts (excluding funds to be utilized for normal expenses, which from a practical standpoint means that you should reserve an amount equal to one month’s expenses, and can use any remaining checking amounts for an
emergency fund), savings accounts, and money market accounts or funds, which all can be converted to cash quickly, if needed. When determining amounts to be used for emergency funds, you do not need to “make up the difference” between what is in checking and the amount of monthly expenses. For example, if monthly expenses are $5,000, but there is only $4,000 in checking, you do not
need to hold back $1,000 from savings when considering how much is available for the emergency fund. In this example, you simply would not use any money from checking, but all of the savings account would be available for use.
A certificate of deposit may be appropriate if it matures in the near term;
however, generally speaking, CDs with maturity dates of more than 90 days are not appropriate for emergency use because of the early withdrawal penalties frequently assessed. Life insurance cash values are another potential source of emergency funds, although students should note that life insurance policies contain delay clauses that enable an insurance company to delay payment of cash values for up to six months. Additionally, all of the cash value may not be available. These clauses usually affect payment only during periods of extreme economic distress; however, since emergencies may happen at any time, it is important that clients be prepared to handle them, whenever they might occur.
Life insurance cash values normally should be used as a source of emergency funds only as a last resort, which means that, for this course, unless you are given a compelling reason to use life insurance cash values for an emergency fund, do not do so. Some clients will argue that they have lines of credit and do not need as much in reserves. If an income source is disrupted, banks can pull lines of credit, including second mortgages. Relying on credit adds serious risk.
Table 2: Overview of Emergency Fund Assets
Appropriate: Inappropriate:
Cash/Cash Equivalents Money Market
Short-term CDs (< 90 days) Savings
Checking: but must reserve an amount equal to one month’s expenses
Equities
Debt/Debt Instruments Life Insurance Cash Value
Anything that creates a debt or liability
A further discussion of life insurance cash values is in order here. While insurance policies have a provision that allows the insurance company to delay distributions on policy loans for up to six months, it is rarely used, and most companies have never used it. The type of emergency experienced is the primary factor in determining the appropriateness of using life insurance cash values. If a car needs major repairs or a leaky pipe causes expensive water damage, the use of cash values may be appropriate. In the case of a disability or the loss of a job, cash values may not be a good source of emergency funds. The use of cash values results in either an increase in debt or a loss of needed life insurance.
When a person is not earning an income due to a job loss or disability, increasing debt is not a good choice. The need to maintain existing life insurance is
increased, especially in the case of disability. Jeopardizing the existence of that insurance would simply be bad planning.
Please note that this position may conflict with the position taken by some experts. The decision to use cash values is a matter of perspective (however, for the exam, you should take the perspective that life insurance cash values should not be used).
Just as life insurance cash values are generally inappropriate for emergency funds, credit cards are a bad choice for funding emergencies. The use of credit cards increases the debt load and can easily make financial problems worse.
Another controversial emergency fund vehicle is Roth IRAs invested in money markets. The advantage is that one can access contributions without tax at any time while still having some creditor protection. The disadvantage is that the accounts may be more highly leveraged using growth investments for retirement.
Additionally, the earnings cannot be accessed without tax or penalty except under certain circumstances.
Flexibility
A recommendation that the client hold funds somewhere between three to six months’ expenses should be based on the client’s individual situation. The most conservative approach, obviously, is to retain at least six months’ expenses, but some situations may warrant less. For instance, if the client has several sources of income, or if the sources of income are particularly stable, three months’
expenses may be sufficient. For example, a family where both clients are working, have rental income from several properties and ongoing distributions from a trust. The gap of losing one salary may be very minimal. On the other hand, a sole support of a family with no other sources of income that owns a own business or is based solely on commissions with a large number of children may need an amount greater than six months. The financial planner uses the statement of financial position and cash flow statement to ascertain what cash/cash
equivalents are currently in place and whether the client’s emergency reserve is adequately funded.
A different category of emergency fund may be set aside for all unplanned, large expenses that the individual cannot reasonably meet out of income. These may include medical and dental expenses that are not covered by insurance, home or automobile repairs that must be made to ensure safety and well-being, and emergency travel. It also is available to replace short-term losses of income resulting from unemployment, disability, or death of a breadwinner. It is important that clients recognize that money drawn for emergencies from established emergency funds must be replaced as soon as possible to manage future emergencies. Amounts for this category of emergency fund should be determined based on client objectives, available resources (including sources of income), insurance coverage and deductibles, the age of equipment (e.g., a new furnace is not likely to break down, but one that is 40 years old may not last much longer), and the like.
Opportunity Funds
Some financial planners also recommend that clients set up “opportunity funds,”
which are liquid or semi-liquid accounts available for large purchases of a nonemergency nature that the client may wish to make, such as cars, jewelry, furniture, or travel. Such funds would prevent the client from having to borrow to attain these items. Some planners use opportunity funds for investing purposes, ensuring that clients have liquid funds available to take advantage of investment opportunities that may arise.
Debt Management
Debt can be an important tool for clients in obtaining what they want and
managing outflows, or it can be a drain on their resources. In general, debt is best used for large purchases, especially those that normally create equity, such as a mortgage for home ownership, where it would be difficult for clients to obtain the item for cash. However, entering into debt requires (1) the payment of interest, which increases the cost of obtaining the item, and (2) periodic
repayment of principal, which limits funds available for other consumption and savings. Therefore, consumer debt (credit cards, automobile loans) should be avoided as much as possible. This is particularly true for individuals who are unable to control spending when consumer debt is readily available. In addition, while mortgage interest is deductible for income tax purposes, interest on consumer debt is not.
Therefore, any financial benefit of carrying balances on credit cards or financing other purchases, such as automobiles, is reduced. Although some situations will require the use of consumer credit for the individual to obtain a needed item or service, consumer credit generally should be used for convenience only—i.e., to consolidate bills into one payment and to delay payment for an item until the billing date. One benchmark sometimes used by financial planners is that payments on consumer debt should not exceed 20% of net income (gross income minus taxes).
Some loan officers use this and the following rules of thumb in assessing whether a home mortgage will be offered to a prospective borrower.
Monthly housing costs (including principal, interest, taxes, fees, and insurance) should be no more than 28% of the prospective borrower’s gross income.
Total monthly payment on all debts should be no more than 36% of gross monthly income. According to the underwriting guidelines for Fannie Mae, this includes:
monthly housing expense (including taxes and interest)
monthly required payments on installment/revolving credit monthly mortgage payments on non-income-producing property
monthly alimony, child support, or maintenance payments
While the purpose of these benchmarks is to assess an applicant’s ability to assume additional debt, they also may be useful for financial planners in assessing whether current debt appears to be excessive, given the client’s resources. Notice that housing costs include items that are not debt. Taxes, insurance, and association fees are part of housing costs. However, even though they are expenses rather than debt, they are included in the “total debt” benchmark. Further, these benchmarks are all mutually exclusive. If any one of the benchmark percentages is surpassed, the client’s situation must be evaluated to try to bring the debt under control. Each client’s circumstances will be different. A client with a given level of debt and
$1,600 of property taxes is in a much different situation than a client with the same level of debt and $7,500 of property taxes.
Table 3: Debt Management Rules of Thumb Type of Debt Rule of Thumb
Consumer debt 20% or less of net monthly income Housing costs 28% or less of gross monthly income Total debt 36% or less of gross monthly income
Two Primary Forms of Debt-to-Income Ratios
1. There is a debt-to income ratio known as the front-end ratio that indicates the percentage of income that goes toward housing costs, which for homeowners includes PITI (principal, interest, taxes, and insurance premiums) and also homeowners’ association dues when applicable. This ratio varies depending on which set of guidelines used, but for purposes of this course, housing should not exceed 28% of gross monthly income. This gross income includes dividends and interest, even if they are being reinvested.
2. The second debt-to income ratio is known as the back-end ratio. This ratio identifies the percentage of income that goes toward paying all recurring debt payments, including those covered by the front-end ratio, and other debts such as credit card payments, car loan payments, student loan payments, child support payments, alimony payments, and legal judgments. In computing this, it is important to use the minimum required debt payment versus the amount the client is paying. For example, if a client is putting
$500 to the credit card debt but the minimum payment is $150, the $150 would be counted toward the debt. The reason is that the client chooses a higher payment but would not be required to maintain that payment. For this course, the maximum measure for back-end ratio for all debt is 36%, as illustrated previously.
Nonmortgage Debt-to-Income Ratio
There is one more measure of debt, the nonmortgage debt-to-income ratio, and much like the debt-to-income ratio, this ratio compares the annual payments to service debt. However, this measure excludes the mortgage and uses a person’s annual take-home pay (or net income). The ratio simply provides insight into what amount of after-tax income is going toward nonmortgage debt. A ratio of 15% or lower is healthy, and a ratio of 20% or higher is considered a warning sign that nonmortgage debt is excessive. The nonmortgage debt-to-income ratio is calculated as follows:
income
Gross Income versus Net Income
For mortgage lending purposes, the debt-to-income calculation is always based on gross income. Gross income is a before-tax calculation. The reason for the use of gross income in both front-end and back-end ratios is the tax-favored status afforded mortgage interest payments. Because consumer debt is afforded no such tax-favored status, this calculation is done on a net income, or after-tax basis.
Net-Investment-Assets-to-Net-Worth Ratio
The net-investment-assets-to-net-worth ratio compares the value of investment assets (excluding equity in a home) with net worth. It is useful in showing how well an individual is advancing toward capital accumulation goals. An individual should have a ratio of at least 50%, and the percentage should get higher as retirement approaches. Younger individuals will most likely have a ratio of 20%
or less because they have not had the time to build an investment portfolio. A family with a statement of financial position showing that they have a ratio of only 18% indicates that they are not progressing well in their goal of
accumulating capital. This information should be used to help guide the client in developing his or her financial plan. The ratio is calculated as follows:
worth
An individual or family that has several sources of income frequently is in a more secure financial position than one where all income comes from only one source.
While having only one source of income is not necessarily a weakness, it does require greater planning to ensure that if the income were to become unavailable, the family or individual would have some means of surviving financially. On the
other hand, when an individual or family has many sources of income, the loss of any one source does not create as great a financial problem for the family, and fewer resources may need to be allocated to contingency planning. Sources may include salaries or wages, investment income, trust income, alimony, child support, commissions, residuals, payments from judgments, gifts, etc. Sources of income are identified on the cash flow statement.
It is the sources of income, combined with their relative amounts, which drive the decision as to what multiple of expenses is adequate as an emergency fund.
Savings and Spending Patterns
An established habit of saving and investing is beneficial and usually necessary to achieve goals. Many financial planners recommend that clients allocate at least 10% to 15% of gross income to savings and investments. However, some clients will need to save far in excess of this amount to achieve the goals they have set.
The financial planner can ascertain whether the client has been allocating this amount to savings by reviewing the client’s cash flow statement. Employer contributions to qualified plans count toward this savings ratio, so it isn’t quite as daunting as it seems at first glance.
The cash flow statement also will show whether clients are living within their means. If the clients are able to save a reasonable amount on a regular basis, do not borrow heavily for regular expenses, and/or have not been required to liquidate investments to meet regular living expenses, they probably are living within their means. The absence of one of these points does not necessarily prove that the clients are not living within their means, but does indicate an area that the planner may need to watch in the future or about which further information should be requested. If the clients are having problems in this regard, they probably would be good candidates for budgeting.
Another factor that may point to the need for budgeting are large miscellaneous expenses (i.e., expenses that cannot be accounted for) on the cash flow statement.
By understanding the nature of the clients’ expenses, the financial planner is better able to assess how dollars should be allocated to achieve goals.