CFP Curriculum Discussion Questions

Fundamentals Chapter 3 Discussion Questions: “Financial Planning Approaches: Analysis and Recommendations”

Discussion Questions: information relating to the end-of-chapter “Discussion Questions” from the financial planning coursework material through New York University’s CFP® Program (in conjunction with Dalton Education).

Discussion Questions for Chapter 3: “Financial Planning Approaches: Analysis and Recommendations”

  1. List and define the eight approaches to financial planning analysis and recommendations.
    1. Life Cycle approach:
      1. Quick data collection; planner gets a brief overview to facilitate a focused first conversation.
      2. Usually used early in engagement.
      3. Framework based on the idea that client’s age may indicate the life phase:
        1. Asset accumulation phase: usually early 20’s until late 50’s when discretionary CF for investing is low and debt-to-net worth is high.
        2. Conservation (risk management) phase: usually beings late 20’s until early 70’s. CF, assets, and NW have increased and debts somewhat decreased.
        3. Distribution (gifting) phase: usually starts mid 40’s/early 50’s until end of life. High CF, low debt, and higher NW.
    2. Pie Chart approach:
      1. Utilizes visual representation of how client allocates financial resources.
      2. Usually used after prepping financial statements.
      3. Income Statement Pie Chart:
        1. Planner calculates client’s expenses from income statement as a proportion of client’s gross pay.
          1. Expenses can include Taxes, Savings, Insurance, Housing Costs, Discretionary, and Other Living Expenses).
      4. Balance Sheet Pie Chart:
        1. Used to depict B/S items as a percentage of Total Assets; two pie charts used: one for the Asset side and other for Liabilities and NW side.
          1. Asset side = cash & equivalents, investment assets, and personal use assets.
            1. Cash & equivalents percentage is related to the ND cash outflows on IS.
            2. Investment assets percentage related to age of the client and gross pay.
          2. Liabilities side = ST and LT and NW.
            1. If NW is negative, then technically insolvent and pie charts for the B/S might be unreliable.
    3. Financial Statement and Ratio Analysis approach:
      1. Purpose: using financial ratios to help clarify and reveal the true financial situation of a client.
      2. Ratio analysis shines light on strengths, weaknesses, and deficiencies when compared to benchmark metrics.
      3. Four types of ratios: liquidity, debt, financial security goals, and performance.
        1. Liquidity ratios:
          1. Purpose: measure ability to meet ST obligations.
            1. Ratios: Emergency Fund Ratio and Current Ratio.
        2. Debt ratios:
          1. Purpose: how well client is managing debt.
          2. Ratios: Housing Ratio 1, Housing Ratio 2 (Broad), Debt-to-Total Assets Ratio, and Net Worth to Total Assets Ratio:
        3. Financial security goals:
          1. Purpose: Show client progress towards obtaining LT financial security goals.
          2. Ratios: Savings Rate and Investment Assets to Gross Pay
        4. Performance ratios:
          1. Purpose: Adequacy of returns on investments given risks taken.
          2. Ratios: Return on Investments, Return on Assets, and Return on Net Worth.
      4. This approach usually follows Pie chart approach.
    4. Two-step/three-panel approach:
      1. Overview:
        1. A step-by-step approach comparing client to benchmarks.
        2. Relatively thorough approach and a manageable approach.
        3. Emphasizes risk management, avoiding financial dependence, and promotes savings and investing (to obtain financial independence).
      2. Two-step:
        1. Recommends (1) covering risks and (2) savings and investing.
      3. Three-Panel:
        1. A slight refinement of the Two-step approach: it divides saving and investing into short and long-term objectives.
          1. Panel 1: Risk management.
          2. Panel 2: ST Savings and Investments & Debt Management.
          3. Panel 3: LT Savings and Investments.
    5. The Present Value of Goals approach:
      1. Looks at each ST, MT, and LT goal, determines their present values, and adds together as an overall obligation.
      2. Treats this obligation as an annuity compared to current annual savings amount to determine savings adequacy.
    6. The Metrics approach:
      1. Uses quantitative benchmarks as rules of thumb to compare where client’s financial profile should be.
      2. Can use the Three-panel approach to organize the metrics (Risk Management metrics, ST Savings & Investing Goal metrics, and LT Savings and Investment goals metrics.).
      3. Also, can use risk tolerance metrics for asset allocation for the investment portfolio.
    7. Cash Flow approach:
      1. An income statement approach utilizing the three-panel approach and as if client was purchasing the recommendations.
      2. Drives down discretionary cash flow and looks at ways (positive CF’s or asset sales) to finance the recommendations.
    8. Strategic approach:
      1. Uses a “mission, goal, and objective approach” looking at internal and external environment.
      2. Can be used with other approaches.
  2. List the three phases of the life cycle approach.
    1. Asset Accumulation, Conservation, and Distribution.
  3. What are some of the questions that an Income Statement pie chart will answer?
    1. “The questions that the pie chart approach address are:
      1. What percentage of gross pay is the client paying in taxes (income and Social Security)?
      2. What percentage of the client’s gross pay are they saving?
      3. What percentage of the client’s gross pay goes to protection (insurance)?
      4. What percentage of the client’s gross pay is spent on basic housing costs (principal, interest, tax, and insurance or rent plus insurance)?
      5. What percentage of the client’s gross pay is spent on debt repayments both excluding housing costs and including housing costs?
      6. What percentage of the client’s gross pay is left to live on?”
  4. What are some of the questions that a Balance Sheet pie chart will answer?
    1. “The questions that the balance sheet pie chart approach addresses include, what percentage of total assets are in the form of:
      1. Cash and cash equivalents?
      2. Investment assets?
      3. Personal use assets?
      4. Current liabilities?
      5. Long-term liabilities?
      6. Net worth?”
  5. What is an advantage to using the pie chart approach with clients?
    1. “A pie chart focuses the client on the relative size of financial variables. People can only spend 100 percent of what they have and visualizing where the money goes is often a sobering, but helpful exercise. The pie chart is an effective analytical and illustrative tool for financial planning clients.
  6. What are the liquidity ratios used in the financial statement and ratio analysis approach?
    1. Purpose: measure ability to meet ST obligations.
    2. Ratios: Emergency Fund Ratio and Current Ratio.
      1. Emergency Fund Ratio = (Cash & CE) / Monthly ND CF’s.
      2. Current Ratio = (Cash & CE) / Current Liabilities
  1. Discuss the difference between discretionary and non-discretionary cash flows?
    1. “Discretionary cash flows are those cash flows that can be avoided in the event of loss of income, whereas non-discretionary cash flows are generally fixed monthly obligations and expenses that are required to be met regardless of the loss of income.”
      1. Common discretionary cash flows include Entertainment, vacations, and Satellite or Cable TV. Common cash flows that may be either include charitable contributions, church donations, lawn service, and child care.
  2. List the four debt ratios used in the financial statement and ratio analysis approach.
    1. Debt ratios: how well client is managing debt.
      1. Housing Ratio 1 = Housing Costs / Gross Pay <= 28%
        1. Housing Costs = principal pmt’s on mortgage (or rent), interest, homeowners insurance, property taxes, and any association dues.
      2. Housing Ratio 2 (Broad):
        1. Housing Ratio 2 = All Monthly Debt Payments / Gross Pay
          1. Housing Ratio 2 combines basic housing cost (HR1) with ALL other monthly DEBT payments (auto loans, student loans, bank loans, revolving consumer loans, credit card pymt’s, and any other recrurring debt payments).
        2. Benchmark is <= 36% of gross pay.
      3. Debt-to-Total Assets Ratio:
        1. Debt-to-Total Assets Ratio = Total Debt / Total Assets
        2. Purpose: shows what percentage of assets owned are financed by creditors.
        3. Benchmarks: commonly as high as 80% for young people and as low as 10% or less for people near retirement age.
      4. Net Worth to Total Assets Ratio:
        1. Net Worth to Total Assets Ratio = Net Worth / Total Assets.
        2. Purpose: shows percentage of total assets owned or paid for by client. (flip-side to Debt to Total Assets ratio).
  3. Discuss the average savings rate for retirement funding and the average retirement withdrawal rate.
    1. “The savings rate benchmark depends on the number of long-term goals of the client. If the only goal of the client is financial security (retirement) the benchmark savings rate should be 10 to 13 percent of gross pay. The persistent savings rate needed for a 25-year old with retirement as his only goal should be 10 to 13 percent, excluding Social Security contributions.
    2. If the client has multiple LT goals, the savings rate must be greater than the 10 to 13 percent to achieve those goals.”
  4. List the common performance ratios used in the financial statement and ratio analysis approach.
    1. Return on Investments (ROI):
      1. Measures: rate of return on investment assets during the year.
      2. Calculation: ROI = [I1 – (I0 + Savings)] / I0
      3. Assumptions: Savings are made in equal monthly deposits.
      4. This is an arithmetic return. Okay for 1-year periods. Geometric average is better over long term and more informationally useful to planner than arithmetic.
      5. Financial statements needed: balance sheets from 1-year ago and current.
      6. Benchmark: compare against same asset class. 8 to 10%.
    2. Return on Assets (ROA):
      1. Measures: a blended growth rate of all assets.
      2. Calculation: ROA = [A1 – (A0 + Savings)] / A0
      3. Considerations:
        1. Use cautiously when client adding assets that are from debt. In this case, consider adding the net equity to year-end assets (A sub-1) to calculate.
      4. Benchmark: 2 to 4%.
    3. Return on Net Worth (RONW):
      1. Measures: growth rate of Net Worth.
      2. Calculation: RONW = [NW1 – (NW0 + Savings)] / NW0
      3. Benchmark: higher-the-better. Likely to become smaller as net worth increases.
  5. Define the two-step approach to financial planning.
    1. “The two-step approach to financial planning recommends covering the risks and savings and investing.”
  6. What do the three panels of the three panel approach cover?
    1. Panel 1 = risk management of personal, property, and liability risks.
    2. Panel 2 = short-term savings and investments & debt management.
      1. Emergency fund adequacy.
      2. Proportion of income spent on housing.
      3. Proportion of income spent on debt other than housing debt repayments.
    3. Panel 3 = long-term savings and investments. Evaluate the adequacy of progress toward:
      1. Retirement goal savings rate and investment assets.
      2. Education funding goal.
      3. Any large purchase goal.
      4. Legacy goals (documents and financial goals).
  1. Why is the present value approach easy to understand at the completion of the analysis?
    1. “Presuming annual savings are not adequate, it is relatively easy to see the cost of each goal in terms of annual required savings and consider priorities.”
  2. Discuss the usefulness of the metrics approach.
    1. “The metrics approach provides quantitative example benchmarks for the financial planner and client to use as guidance for necessary comprehensive financial goals and objectives…the metrics can be applied to establish financial planning recommendations.”
  3. What is the usefulness of the cash flow approach to financial planning?
    1. “The cash flow approach takes the annual current income statement and adjusts the cash flows by forecasting what they would be after implementing all of the planning recommendations.” This approach begins with the discretionary cash flows at the bottom of the income statement and accounts for each of the recommendations in the order of priority. The annual cost of each recommendation is charged against the discretionary cash flows regardless of any negative cash flow impact.”
    2. “A lack of funding availability will limit the ability to immediately implement recommendations. However, since the recommendations are already prioritized, the planner can simply cut off implementing recommendations at the point where there is no additional funding remaining and later fund the remainder of the recommendations.”
  4. Define the strategic approach to financial planning.
    1. This approach uses a mission, goal, and objective approach considering the internal and external environment and may be used with other approaches.”
      1. Mission = enduring long-term statement
      2. Goals = broadly conceived, needs-driven goals.
      3. Objectives = narrow, measurable objectives.
      1. “…the strategic approach takes into consideration needs versus wants.”
  5. Discuss whether capital gains, dividends, interest and other portfolio income should be part of the savings ratio.
    1. “Note: dividends, interest, capital gains, and other types of portfolio income are not counted or included as part of savings since this type of income is already considered as part of the overall portfolio rate of return. If they were included in both, then they would be double counted. If they were included as part of savings, then the portfolio rate of return would have to be reduced to reflect that treatment.” – page 82.

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