Personal Financial Management

Personal Financial Management

Semester 2 2008 – 2009

Gareth Myles [email protected]

Paul Collier [email protected]

Lecture Notes

These slides are available at:www.people.ex.ac.uk/gdmyles/GDM.html

Course TextbookG. Callaghan “Personal Finance”

Wiley

Secondary TextbookT. W. McRae “Managing Your Own Finances”

Thomson Learning

PFM Classes

The class teachers are Zhiren Mao and Humaira Asad

There are six groupsEach group meets once every two

weeksGroups/times are displayed on noticesExercises are found on the web page

Reading

Callaghan: Chapter 1McRae: Chapter 1

Why manage?

Increasing self-dependence Student tuition fees and loans

“Tories plan to keep student fees” (Link)

More students declare bankruptcyThree times more students wrote off student loans by declaring themselves bankrupt in 2003 than in 2002. 899 filed for bankruptcy last year, compared with 276 in 2002, 249 in 2001, 97 in 1998 and eight in 1992. A number are thought to have taken advantage of a loophole in government legislation allowing student loan debts to be cancelled out by bankruptcy. (Link)

Why manage?

Increasing self-dependenceHealth care

“Two-tier NHS care for pregnant women ready to pay £4,000” (Link)

Private pensions “New bond threat to pensions” (Link) “Pension reform: what other countries do” (Link)

The State Pension

State Pension as % of Average Earnings

0

5

10

15

20

25

1973 1978 1983 1988 1993 1998 2003 2008

Year

% o

f Ave

rage

Ear

ning

s

Why Manage?

Financial risksProperty prices continue to fall House price inflation in England and Wales dropped sharply in December, according to the Land Registry. Average prices fell by 0.4% in December. The December fall was the first decline recorded by the Land

Registry since August 2005. It said the latest data was "a clear indication of a weakening market". The average house price was £184,469 in December. (Link)

Why Manage?

Increasing financial complexity Range of products

Mortgages (discount, fixed, interest only) Insurance (car, house, life, travel)Pensions (defined contribution, defined benefit)

Exposure to productsStudent loansCredit cardsLegislation: sellers’ packs (Link)Choice: saving for children (Link)

Why Manage?

The current financial crisis has shown The vulnerability of the financial system The extent of risk

The implication is uncertainty about the future When will economic growth return? How will the economy be organized in the future?

Financial planning must take this into account

Lecture Topics

Week 1: IntroductionWeek 2: Risk and ReturnWeek 3: Financial AssetsWeek 4: Personal TaxationWeek 5: Capital Gains and Estate Duty

Lecture Topics

Week 6: InsuranceWeek 7: Interest and Interest RatesWeek 8: Purchasing Real AssetsWeek 9: Pensions and Annuities Week 10: Revision Lecture

Style

Partly practical E.g. What kinds of mortgages are

available? Partly analytical

E.g. How do you calculate the payments? Intention

To allow evaluation, comparison and selection

The Need for Planning

Example 1: Housing A “standard” 1930s three-

bed semi-detached house in Exeter costs £200,000

This is 8 times average earnings (£24908 in 2007: Data)

The Need for Planning

The interest payments on a 100% mortgage would be £10,000 per year

Most mortgage lenders would not lend more that 4 times income

This is only half what is requiredHow can this be affordable?

The Need for Planning

Example 2: Pensions USS, the pension scheme for university

employees, pays a pension of 50% of final salary plus a lump-sum of 150% of final salary.

A professor earning £60,000 would receive a pension of £30,000 (protected against inflation) plus a tax-free lump-sum of £90,000.

How much would you need to save to obtain this with a private pension?

Assume inflation/length of life cancel out Assume a 5% interest rate. Then £30,000 per

year requires savings of £600,000. With the lump-sum, total required is £690,000

With a 4% interest rate, £840,000 is required Even with 7%, the sum is £520,000 Can this be accumulated?

The Need for Planning

The Need for Planning

Example 3: Life-Cycle Earnings Most career paths have earnings that

increase over timeThe typical earnings profile is shown in

Figure 1The typical pattern of savings is shown

in Figure 2

Age

Income

Enterwork

Retire

Figure 1: Income

The Need for Planning

Age

Saving

Enterwork Retire

Figure 2: Saving = Income - Expenditure

The Need for Planning

Earnings Profiles

Year 1 3 4 8 11 15 17

Salary 28010 28849 29716 34448 37642 42367 45166

University Lecturer

House

Officer

Senior House Officer

Registrar Qualified Consultant

19703 24587-34477 27483-41733 28845-72882 67113-90838

NHS Hospital Medical Staff

Year 1 3 5 7 9 11 13 15

Salary 18264 21645 22992 24501 25848 26688 27669 28905

Police Officer

The need for planning is to produce a smooth flow of consumption

This requires borrowing early in life, saving in mid-life and planned dis-saving in retirement

This process should be planned and managed

The Need for Planning

Example 3: Costs and Rewards Consider the annual cost of a maintaining a

typical standard of living for a family of four Mortgage 15,000 Food 7,000 Utilities 4,000 Holidays

5,000 Cars 3,000 Other Items 5,000 TOTAL 39,000

To support this expenditure requires a pre-tax income of about £60,000

The Need for Planning

For some additional items Education 15,000 Leisure

5,000 The required pre-tax

income is now £90,000 And this does not include

pension contributions How does this compare

with salaries?

The Need for Planning

Salaries in the UK

Teacher £30,000 General Manager £30,000 Junior Civil Servant £35,000 Accountant (non-partner) £40,000 Solicitor £40,000 Professor £50,000 + MP £60,000 Accountant (partner) £65,000 + Doctor (GP) £80,000 + Doctor (Consultant) £80,000 + Judge/Senior Civil Servant £120,000

Observe

How few achieve the required £60,000And very few £90,000Conclusion

To meet such aspirations requires planning:career choiceexpenditure investment

Financial Plan

Short-termExample 1: To provide finance for university

Aim: to graduate with only student loan outstandingExpenditures: fees, accommodation, books, leisureIncome: loan, work, savingsOptions: summer work, reduce leisure costs

Financial Plan

Medium Term

Example 2: To provide finance for house purchase

Aim: To purchase in fifth year of employmentExpenditures: Rent, food, car, utilities Income: WorkOptions: Reduce holidays, sell car

2007 2008 2009 2010 2011

Income

Salary 25000 26000 27000 30000 31000

After Tax 17500 18200 18900 21000 21700

Expenditure

Rent 7000 7200 7400 8500

Mortgage 10000

Food 4000 4050 4100 4150 4200

Car 1500 1700 1800 1800 1900

Utilities 800 840 900 940 1000

Clothes 500 550 600 600 600

Holidays 2000 2100 2200 2300 3250

Sundries 500 500 500 500 500

Total 16300 16940 17500 18790 21450

Savings 1200 1260 1400 2210 250

Total Saving 1200 2460 3860 6070 320

House Deposit 6000

Long-Term PlanObjectives: To enjoy at least two holidays a

year, detached house, run two cars (<3), finance children through university

Requirements: Evaluation of costs, borrowing possibilities

Choices: Career options to make this achievable

Financial Plan

Very Long-Term PlanObjective: To retire at 55Requirements: Sufficient savings

Pension rightsPotential lifespan

Choices: Career options, investment choices

Financial Plan