Personal Financial Planning Theory and Practice Michael A. Dalton, PhD, JD, CLU®, ChFC®, CFP® James F. Dalton, MBA, MS, CPA/PFS, CFA®, CFP® Randal R. Cangelosi, JD, MBA Randall S. Gutter/, PhD, CLU®, ChFC® Scott A. Wasserman, CPA/PFS, CLU®, ChFC®, CASL®, RFC®, CFP® 7TH EDITION KAPLAN) SCHWESER
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Personal FinancialPlanning Theoryand PracticeMichael A. Dalton, PhD, JD, CLU®, ChFC®, CFP®
James F. Dalton, MBA, MS, CPA/PFS, CFA®, CFP®
Randal R. Cangelosi, JD, MBA
Randall S. Gutter/, PhD, CLU®, ChFC®
Scott A. Wasserman, CPA/PFS, CLU®, ChFC®, CASL®, RFC®, CFP®
7TH EDIT ION
KAPLAN) SCHWESER
About the Authors Hi
Preface xi " - -"
Acknowledgments and Special Thanks xv
Professional Focus xvii
BASDC FDWAWCDAL PLAWWOMG SKILLS 3
1. Introduction to Personal Financial Planning 5
Personal Financial Planning Defined 6
Benefits of Personal Financial Planning 6
Financial Success is a Relative Concept 7
Resource Allocation in Financial Planning 8
Why do People Hire Professional Financial Planners?
9
The Financial Planner's Pyramid of Knowledge 10
Basic Financial Planning Skills 11
Basic Financial Planning Tools 12
Core Topics 12
The Financial Planning Profession 14
2. External Environmental Analysis 17
The External Environment 18
Analyzing the External Environment 20
Why Study the External Environment? 21
The Economic and Legal Environments 21
Importance of the Economic Environment 22
The General Economy 23
Business Cycles 28
Inflation 31
Monetary and Fiscal Policy 34
The Nature of Interest Rates 36
Expansion and Recession 37Forecasting the Economy—Index of LeadingEconomic Indicators 37
Importance of the Legal Environment 39
Torts 39
Property Ownership 41
Consumer Protection 41
Worker Protection (Employer/EmployeeRelations) 45
Financial Institutions 46
FDIC Insurance 48
Negotiable Instruments 51
Investor Protection (The Securities Acts of 1933and 1934) 52
Forms of Business Organizations 53
Importance of the Social Environment 54
Importance of the Technological Environment 55
Importance of the Political Environment 56
Importance of the Taxation Environment 56
Communication and Internal EnvironmentalAnalysis 65
Communication Skills 66
Be Respectful of Your Client 67
Communicate with Your Client 67
Professional Liability 70
Common Law Liability to Clients 70
Common Law Liability to Third Parties 70
Statutory Liability 71
Educate Your Client 71
Understand the Client's Thinking Phase 72
Internal Analysis 75
Life Cycle Positioning 75
Life Cycle Phases and Characteristics 77
Attitudes and Beliefs 80
Special Needs 81
Financial Position 84
Client's Perception of Financial Situation 85
Personal Financial Statements (Preparation andAnalysis) 101
Introduction 102
Decision-Making Uses of Financial Statementsand Financial Statement Analysis 103
xxiv Contents
Rules Regarding Financial Statements 103
Preparation of Financial Statements 104
The Statement of Financial Position 104
Statement of Financial Position Terms andPresentation Order 104
Categories and Classifications of Assets 105
Categories and Classifications of Liabilities106
Valuation of Assets and Liabilities 107 - ..
The Nelson Family Statement of FinancialPosition 108
Valuation of Assets and Liabilities-^-The Nelsons1 1 1 ?
Information Sources 111
Identification of Ownership of Assets andLiabilities 113
Footnotes to the Statement of FinancialPosition 114
The Personal Statement of Cash Flows 114
Statement of Personal Cash Flows Terms andOrder of Their Presentation 115
Information Sources 115
Compromise in Information Reporting 118
The Relationship of the Statement of FinancialPosition to the Personal Statement of CashFlows 118
The Statement of Changes in Net Worth 118
Nelson Example Recap 121
Financial Analysis of Personal,FinancialStatements 121
Ratio Analysis 122 \
Vertical Analysis 134
Growth Analysis 137
Limitations of Financial Statement Analysis137
Sensitivity Analysis 138
Risk Analysis 138
Budgeting 138
Description 138
Nelson Budgeting Plan 139
Saving and Consumption Habits 142
Debt Management 142
Personal Use—Assets and Liabilities 142
Home Mortgages 143
5. Establishing Financial Direction: The FinancialPlanning Process 153
~- The Financial Planning Process 154
Step 1: Establishing and Defining the Client-PlannerRelationship 157
Step 2: Gathering Information Necessary to Fulfillthe Engagement 158
Identifying Relevant Environmental Information158
Establishing Financial Goals 159
Developing Financial Objectives 162
Step 3: Analyzing and Evaluating the Client'sCurrent Financial Status 165
Step 4: Developing and Communicating theRecommendations 167
Selecting the Most Appropriate Strategy 170
Communicating the Recommendations 173
Step 5: Implementing the Recommendations 173
Step 6: Monitoring the Recommendations 174
Chapter 5 Supplement 179
Calculations for Retirement Needs and KeyWest Home for the Nelsons 179
BASIC FINANCIAL PLAWIMOWG TOOLS 1183
6. Time Value of Money 185 :
Understanding Time Value of Money 186
Future Value and The Power of CompoundInterest 187
Basic Tools for Time Value of Money (TVM)Analysis 188
Timelines 188
TVM Tables 189
Financial Calculators 190
Computer Software 191
Accumulation Schedules 191
Future Value of an Ordinary Annuity (FVOA) 192
Future Value of an Annuity Due (FVAD) 192
Present Value of a Dollar (PV) 193
Present Value of an Ordinary Annuity(PVOA) 193
Present Value of an Annuity Due (PVAD) 194
Other TVM Concepts 195
Uneven Cash Flows 195
Contents XXV
Combining Sum Certains with Annuities 196
Net Present Value Analysis 196
Internal Rate of Return (IRR) 197
Yield to Maturity 198
Solving for Term Given the OtherVariables 199
Selecting the Rate of Interest for Accumulatingor Discounting 200
Serial Payments 201 • .. _ -
Perpetuities 202
Other TVM Tools 203
Amortization Tables 2Q3
The Rule of 72 205 '
7. Education Funding 215
Introduction 216
Issues and Goals 217
Information Gathering 218
Determining Financial Need 220
Financial Aid Programs 223
Federal Pell Grants 224
Stafford Loans 224
PLUS Loans 226
Consolidation Loans 226
Campus-Based Student Financial Aid 227
State Governmental Aid 228
Other Financial Aid Sources 228
Tax Advantages From Education Expenses and TaxIssues 230
Qualified Tuition Programs 230
Prepaid Tuition Plans 231
College Savings Plans 231
Coverdell Education Savings Accounts(ESAs) 234
Traditional IRA 235
Roth IRA 235
The American Opportunity Tax Credit 236
The Lifetime Learning Credit 236
Series EE Bonds 237
Uniform Gift to Minors Act 237
Uniform Transfers to Minors Act 238
Interest on Education Loans 238
Employer's Educational AssistanceProgram 238
Equity Lines of Credit 238
Highlights of Benefits for Higher Education . 239
Education Funding/Savings Regimen Example 241
Investment Strategies to Accomplish EducationGoals 244
INSURANCE PLANNING 253
8. An Introduction to Insurance and RiskManagement 255
Introduction 256
Understanding Risk 257
Risk Classification 257
Pure Versus Speculative Risk 257
Dynamic Versus Static Risk 257
Subjective Versus Objective Risk 258
Particular Versus Fundamental Risk 258
Financial Versus Nonfinancial Risk 258
Probability of Loss 259
Law of Large Numbers 259
Responses to Pure Risk 260
Risk Avoidance 260
Risk Reduction' 261
Risk Retention 261
Risk Transfer 261
Insurance as a Risk Management Tool 262Transfer of Losses 262
Sharing Losses with Others 263
Self-Insurance 264
Causes of Insured Losses 265
Perils 265
Hazards 265
Adverse Selection 266
Insurable Losses 266
Insurance Versus Gambling 266
Requisites for an Insurable Risk 267
The Law of Insurance Contracts 268
Elements of a Valid Contract 269
Legal Principles of Insurance Contracts 270
Legal Form 273
Distinguishing Characteristics of InsuranceContracts 273
The Law of Agency . 274
Agents and Brokers 274
Agency Relationships 275
xxvi Contents
9.
Important Features of Insurance Contracts 276
Exclusions 276
Riders and Endorsements 277
Valuation of Insured Losses 277
Deductibles and Co-Payments 278
Coinsurance 278
Individual Loss Exposures and Insurance Coverages279
Perils That Can Reduce and/or Eliminate theAbility to Earn Income 279
Perils That Can Destroy or Deplete ExistingAssets 280
Characteristics of Insurance Companies' 281
Types of Ownership 281
Insurance Underwriting 281
Reinsurance 282
Insurance Regulation 282
National Association of InsuranceCommissioners (NAIC) 282
Selecting an Insurance Company 283
Rating Agencies 284
Additional Considerations 285
The Risk Management Process 285
Determining the Objectives of the RiskManagement Program 286
Identifying the Risk Exposure 286
Evaluating the Identified Risks 286
Determining and Selecting the Best RiskManagement Alternative 287
Implementing a Risk Management Plan Basedon the Selected Alternatives 288
Periodically Evaluating and Reviewing the RiskManagement Program 288
Managing Life, Health, and Disability Risks 293
Introduction 295
Identifying Risks Associated with Premature Death295
Premature Death 295
Inadequate Financial Resources 295
Estate Preservation 296
Measuring Needs Related to PrematureDeath 297
Human Life Value Approach 298
Financial Needs Approach 299
Capital Retention Approach 303
Measuring Disability Income and Long-Term CareNeeds 305
Disability Income Needs 305
Long-Term Care Needs 307
Individual Life Insurance Policies 307
Term Life Insurance 308
Whole Life Insurance 312
Universal Life Insurance 318
Modified Endowment Contracts (MECs) 323
Group Life Insurance 325
Life Insurance Policy Selection 326
Life Insurance Policy Illustrations 327
Life Insurance Policy Replacement 328
Life Insurance Policy Provisions 329
Grace Period 329
Incontestability 329
Entire Contract Clause 330
Misstatement of Age or Gender 330
Assignment 330
Suicide 330
Reinstatement 331
Policy Loan Provision 331
Automatic Premium Loan 331
Beneficiary Designations '331
Aviation Exclusion 332
War Exclusion 332
Survivorship Clause 332
Simultaneous Death Provision 332
Life Insurance Settlement Options 333
Interest Only 333
Fixed Amount 333
Fixed Period 333
Life Income 333
Life Income with Period Certain 333
Life Income with Refund 334
Joint and Last Survivor 334
Annuity Contracts 334Types of Annuities 334
Annuitization 336
Taxation of Life Insurance and Annuities 337
Tax Treatment of Life Insurance 337
Taxation of Lifetime Benefits 337
Taxation of Benefits Received after Death340
Contents xxvii
Viatical Agreements 340
Annuities 341
Individual Health Insurance 341
Purpose 342
Cost Concerns 342
Eligibility 342
Major Medical Insurance 342
2010 Health Care Reform Legislation 343
Medical Expense Insurance 345
Health Savings Accounts (HSAs) 346
Eligibility 346
Long-Term Care Insurance 349
Disability Income Insurance 353Overview 353
Characteristics 354
Health and Disability Insurance PolicyProvisions 357
Rights of Renewability 358
Group Health Insurance 359
Eligibility 359
Characteristics 359
Group Disability Income Insurance 361
Business Uses of Life Insurance and Other EmployeeBenefits 366