What is a Financial Plan?
A financial plan is a comprehensive picture of your current finances, your financial goals and any strategies you’ve set to achieve those goals. Good financial planning should include details about your cash flow, savings, debt, investments, insurance and any other elements of your financial life.
A financial plan will also look at any shortfall of funds. Few people, when they first engage a financial planner, will have saved sufficiently. The financial advisor can demonstrate the amount of savings a client needs to achieve their goals as well as the investment risk that will produce a particular rate of return.
Most importantly, an advisor will help clients reconcile whether their risk tolerance can support their dream or if they need a new, more realistic view.
Understanding the Financial Plan
Whether you’re going it alone or with a financial planner, the first step in creating a financial plan is gathering a lot of bits of paper—or, more likely these days, cutting and pasting numbers from various web-based accounts into a document or spreadsheet.
You may complete the following steps as an individual or a couple:
Calculating net worth
To figure out your current net worth, list all of the following:
- Your assets: This may include a home and a car, some cash in the bank, money invested in a 401(k) plan, and anything else of value that you own.
- Your liabilities: These may include credit card debt, student debt, an outstanding mortgage, and a car loan. In some cases, you may have access to a grace period or moratorium.
The formula for your current net worth is your total assets minus your total liabilities.
Determining cash flow
You can’t create a financial plan without knowing where your money is going—and when. Documenting transactions—the flow of cash in and out—will help you determine how much you need every month for necessities, how much might be left for saving and investing, and even where you can cut back a little—or a lot.
One way to get this done is to skim through your checking account and credit card statements. Collectively, they should provide a fairly complete history of your spending.
If your expenses vary a lot seasonally, then it’s best to go through an entire year—counting up all the expenditures in each category and then dividing by 12 to get an average monthly estimate of your spending. This way, you won’t underestimate or overestimate what you spend on utilities, nor will you forget to account for holiday gifts or a vacation.
Document how much you’ve paid over a year in basic housing expenses like rent or mortgage payments, utilities, credit card interest, and even home furnishings. Add categories for food, clothing, transportation, medical insurance, and non-covered medical expenses, then document separately your real spending on entertainment, dining out, and vacation travel.
As you look over your own financial records, your personal spending categories will stand out. You may have an expensive hobby or a pampered pet. Document the costs.
Once you add up all these numbers for a year and then divide by 12, you’ll know exactly what your cash flow has been.
Considering your priorities
The core of a financial plan is a person’s clearly defined goals. These may include funding a college education for the children, buying a larger home, starting a business, retiring on time, or leaving a legacy.
No one can tell you how to prioritize these goals. However, a professional financial planner may be able to help you choose a detailed savings plan and specific investments that will help you tick them off, one by one.
Reasons to Create a Financial Plan
If you are not quite sure if you are ready to allocate personal time to create a financial plan, the following factors should convince you why it is an advantageous idea.
1. Prioritize financial goals
If an individual is saving up for a down payment on a house, mortgage, or car, a financial plan helps organize associated expenses, allowing the individual to plan ahead for a large future purchase.
2. Prioritize personal goals
Personal goals such as a specific savings account balance, portfolio value, or luxury vehicle can be achieved by constructing a financial plan that assigns income effectively to achieve preset goals.
3. Standard of living
The ongoing collection and distribution of finances is a stressful topic for most individuals but can be minimized by the creation of a financial plan. This is because a financial plan is organized, laid out, and provides information on how to reduce debt.
When to Create or Adjust Your Financial Plan
On average, an individual should review and adjust their financial plan every year. However, if you’ve not yet created a financial plan, here are some of the factors that should influence and motivate the idea to begin the process.
1. Change in income
When an individual is granted a change in income, their purchasing power will either increase or decrease. The change will significantly lead to a change in the ability to spend money, invest, and pay off debt.
2. Job change
When an individual lands a new occupation, an assortment of new expenses and costs must be accounted for. For example, a new job may result in an increase in transportation or communication expenses.
3. Change in family dynamics
The creation or adjustment of a financial plan should occur when a change in family dynamics occurs, such as the birth of a child, marriage, or divorce. It is necessary because a number of new expenses will be added, which will affect personal income.
Receiving some sort of inheritance could significantly impact the allocation of income towards expenses and investment, which would warrant an individual to either create or adjust their financial plan.
Beyond the criteria above, it is recommended that every individual who is earning should eventually create a financial plan to ensure comfortability, relief, and success.
Special Considerations of a Financial Plan
Financial plans don’t have a set template. A licensed financial planner will be able to create one that fits you and your expectations. Once complete, it may prompt you to make changes in the short term that will help ensure a smooth transition through life’s financial phases.
The following elements should be addressed and revised as necessary:
- Retirement strategy: No matter what your priorities are, the plan should include a strategy for accumulating the retirement income that you need.
- Comprehensive risk management plan: This includes a review of life and disability insurance, personal liability coverage, property and casualty coverage, and catastrophic coverage.
- Long-term investment plan: A customized plan based on specific investment objectives and a personal risk tolerance profile.
- Tax reduction strategy: A strategy for minimizing taxes on personal income to the extent allowed by the tax code.
- Estate plan: Arrangements for the benefit and protection of your heirs.
How to Personalize a Financial Plan
Many advisors use behavioral analytics to understand the subtle power of the financial plan and help their clients reach their goals. You can follow these steps to create a personalized financial plan:
- Understand perspective: Clients come to the table with their culture and family dynamics. A client’s culture may expect children to take care of their parents as they age and that factors into their financial planning. Asking questions and learning about customs and norms can be especially impactful in our multicultural society.
- Understand past experience: Clients may have attempted to save for long-term goals with varying results. Discerning what has previously transpired without judgment can energize them to create a better current plan.
- Understand motivation: Clients often show up with an incomplete idea of what they want to accomplish. They have read that they are “supposed to” be worried about long-term goals, but have never truly taken the time to understand what that means to them. Making the plan about the clients themselves can uncover thought processes that might otherwise derail them from implementing your recommendations.
- Use a fact-finder: The best information can be found in the space between the questions. A fact-finder gives you permission to ask sensitive questions that would otherwise seem too personal. For example, a fact-finder will ask names and ages of a spouse or children. Armed with that information, an astute advisor can then ask about potential goals involving 529 plans for college saving or spousal lifetime access trusts. Client answers are often candid and extremely insightful when approached this way.
- Explain the importance of each component: When you ask for a list of documents from clients, they may balk at the effort needed to collect them. However, when clients understand why detailed information is important for the overall picture, they are more willing to gather and share these critical details.
- Build a picture: As the plan comes together, you can relay to your clients how each piece plays a crucial role in the total picture. This will help them appreciate the analytical pages, but also see how they are individually reflected in the total plan. As you explain each section, continue to tie it back to the goals you fleshed out and how it matches with their risk tolerance. Document your work for both future reviews and compliance purposes.
- Create actionable steps: When the plan truly reflects their needs, clients love to be able to take immediate action and see definitive results. Generating actionable items, you can empower your clients to take positive steps toward the desired results.
This creates both client satisfaction and, ultimately, better retention. The latter is equally important for raising your firm’s valuation and assets under management, or AUM.
Steps to Build a Financial Plan
When it comes to actually constructing a financial plan, several elements should be considered and eventually included in the individual’s design. Numbered below are the steps needed to be taken when creating such a plan.
- Calculate net worth: Before diving into finances, it is recommended that an individual is to calculate their net worth by summing their assets and comparing them to their liabilities.
- Determine cash flow: Inflows and outflows of an individual’s income must be determined in order to organize funds and locate current and potential debt.
- Set financial goals: Setting financial goals will create the baseline for the entire plan and will motivate the individual. For example, a financial goal would be to save $10,000 by 2021.
- Start an emergency fund: Prepare for unexpected events by allocating a certain amount of money to the fund and set it aside.
- Debt strategy: Start looking at all of the debt that contributes to the reduction of your income and determine the best way to pay off that debt. In such a case, it is most beneficial to design a strategy that pays off the most demanding debt first.
- Investment strategy: Create an investment strategy that does not rely heavily on risky investments and will bring forth a close to “guaranteed” return.
- Insurance: Start allocating a portion of income towards health, auto, disability, life, and home insurance to establish security.
- Retirement plan: To ensure that there is a sufficient amount of money left over once an individual decides to retire, there must be some sort of plan in effect that allocates a portion of income into RRSPs, 401(k)s, IRAs, or other forms of retirement plans.
- Tax strategy: Not planning for taxes can result in a negative financial impact during tax season. To reduce the impact, allocate a fixed amount of income towards it.
- Stay on track: It is easy to deviate from the original financial plan that is created. However, if the plan is constructed prudently and effectively, it is unlikely that an individual’s goals are not reached if they decide to stay on track with the plan.
Creating a financial plan is one of the most instrumental things that an individual can do with their income. Once a plan is implemented, the achievement of personal goals and financial freedom now become one step closer.
What Are the Key Components of a Financial Plan?
Financial plans don’t have a set format, although the good ones do tend to focus more or less on the same things. After calculating your net worth and spending habits, you’ll explore your financial goals and figure out ways to make them achievable.
Usually, this involves some form of budgeting and creating a means to put money away each month. To ensure that you live comfortably for the rest of your life, it’s generally advisable to devise a retirement, risk management, and long-term investment strategy and keep tax expenses to a minimum.