Chapter 3

Investment Asset to Gross Pay Benchmarks to Achieve Retirement Goal (chart)

25 - 0.2:1 30 - 0.6-0.8:1 35 - 1.6-1.8:1 45 - 3-4:1 55 - 8-10:1 65 - 16-20:1

Robin met with you recently to make some changes to her insurance needs. You have made several recommendations. Which of these recommendations will have a positive cash flow impact from an insurance perspective? A)Cancel an insurance policy. B)Change the name of the beneficiary on her life insurance policy. C)Increase coverage on an existing insurance policy. D)Lower the deductible on her auto insurance.

A. Canceling an insurance policy will result in $0 premiums due, which positively impacts cash flow. Changing the beneficiary of a life insurance policy will not impact the premium or cash flow. Increasing the amount of coverage will increase the premium and negatively impact the cash flow. Lowering deductibles will increase premium payments thus having a negative impact on cash flow.

CJ bought the following assets this year. Which of these purchases would be considered "bad debt?" A)He purchased a slightly used car from a pre-owned dealer. The car has an estimated useful life of 3 years. He put down 5% and financed the balance over 72 months. B)He bought a new living room set that cost $5,000. He used his credit card that has a 23% APR. He paid the balance off within one month. C)He purchased a home for $500,000. He made a down payment of 20% and financed the remainder over 15 years. D)He took a CFP® Certification education program in order to meet the education requirement to take the CFP® Certification Examination. He paid $5,000 for the program utilizing a student loan.

A. The car debt is not good because the term of the debt exceeds the useful life. The credit card purchase is okay because he paid it off within the month. The home loan is fine because the residence presumably has a greater than 15 year estimated useful life. The student loan debt is okay because this education should provide increased future income.

Natalie and Brian visited your office today. They are both in their early 30s and have two children with one on the way. During your meeting they provide you with the following financial information: • Gross Income per Year - $150,000 • Housing Costs per Year (P & I and T & I) - $24,000 • Other Debt Payments per Year - $50,000 • Total Assets - $300,000 • Total Debt - $200,000 Which of the following is true? A)The housing ratio 1 (basic) is within the normal range. B)The housing ratio 2 (broad) is within the normal range. C)The debt to total assets ratio is 25%. D)There are not enough facts to determine the net worth to total assets ratio.

A. The housing ratio 1 (basic) is 16% ($24,000 ÷ $150,000) which is within the normal range of 0 - 28%. The housing ratio 2 (broad) is 49% [($24,000 + $50,000) ÷ $150,000] which is above the normal range of 0 - 36%. The debt to total assets ratio is 67% ($200,000 ÷ $300,000). The net worth to total assets ratio is 33% [($300,000 - $200,000) ÷ $300,000]. Remember that net worth is equal to assets minus liabilities.

During your work with your new client, Brian, you created several visual representations of how your client spends his money. Which approach to financial planning are you utilizing? A)Pie Chart Approach. B)Cash Flow Approach. C)Financial Statement Approach. D)Metrics Approach.

A. The pie chart approach provides a visual representation of how the client spends his money. The cash flow approach takes an income statement approach to recommendations. The financial statement approach helps establish where the client is today and uses ratio analysis to determine the client's weaknesses and strengths. The metrics approach utilizes qualitative benchmarks to determine where a client should be.

You currently manage Cody's investment portfolio. He provided you with the following information for the beginning and the end of the year: • Investment Balance (beginning of the year) - $105,000 • Investment Balance (end of the year) - $115,000 • IRA Balance (beginning of the year) - $75,000 • IRA Balance (end of the year) - $82,000 • Net Worth (beginning of the year) - $1,000,000 • Net Worth (end of the year) - $970,000 • Annual Savings to IRA - $5,000 Which of the following statements is correct? A)The return on investments ratio is within the normal range. B)The return on the IRA ratio is 10%. C)The return on net worth ratio is 3.5%. D)The return on investments, return on IRA, and return on net worth ratios are all within the normal range.

A. The return on investments ratio is 9.5% (($115,000 - ($105,000 + $0)) / $105,000). This is within the normal range of 8 - 10%. The return on the IRA ratio is 2.67% (($82,000 - ($75,000 + $5,000)) ÷ $75,000). This is within the normal range of 2 - 4%. The return on net worth ratio is -3.5% (($970,000 - ($1,000,000 + $5,000)) ÷ $1,000,000). This is negative and therefore not within the normal range.

Adriana is an analyst at High Tech Hedge (HTH) where she earns $150,000 base salary with a bonus of $50,000. HTH sponsors a profit-sharing plan with a 401(k) feature and provides for a dollar-for-dollar match up to 3% of compensation. Her account had $10,000 of capital gains this year and dividends of $5,000. She defers $15,000 into the 401(k) plan. The employer made no additional contribution to the profit sharing plan. What is her savings rate this year? A)10.5%. B)14%. C)18%. D)31%.

A. The savings rate equals the savings to her 401(k) plan and the employer match, divided by her compensation. Calculation = ($15,000 + $6,000) ÷ $200,000.The savings rate includes the match, which equals $6,000. The match is dollar-for-dollar up to 3% of compensation (3% of $200,000 = $6,000). The total saved is therefore, $21,000, which is then divided by the compensation of $200,000. This calculation equals 10.5%.

Rachel is 30 years old and single. She is healthy, has no children or pets. Rachel works as a human resources coordinator and earns approximately $40,000 per year. Due to her outstanding student loans, she has a fairly low net worth. She rents an apartment but does own her car outright. All of the following are likely insurance coverage needs, except? A)Life Insurance. B)Health Insurance. C)Disability Insurance. D)Liability Insurance.

A. Because Rachel is single with no dependents she is not likely to need life insurance. However, health, disability, and liability insurances are definitely needed. The health insurance is needed to cover current health risks. The disability insurance is needed to cover any loss of income from disability. She also needs liability insurance to protect future income from any liability claims.

Ronnie visited your office today. He is 55 years of age. He is divorced and has two children. One child recently graduated from college and the other child is just entering into high school. Ronnie earns $350,000 a year as the operator of a very specific type of medical equipment. There are only two of these particular machines in existence. He has provided you the following financial information. • Cash and Cash Equivalents - $100,000 • Annual Non-Discretionary Expenses - $300,000 Which of the following is true? A)Given all the facts and circumstances, Ronnie probably does not have an adequate emergency fund. B)Ronnie has an emergency fund ratio of 3 months. C)All individuals should have an emergency fund equal to 3 - 6 months. D)Disability insurance is irrelevant in determining whether the emergency fund ratio is appropriate.

A. Ronnie probably does not have an adequate emergency fund. His emergency fund is 4 months ($100,000 ÷ ($300,000 ÷ 12)). This is within the normal range of 3 - 6 months, however, since he is older and has a very specialized job, 4 months is not likely to be an adequate amount of time for him to get another job paying the amount of money he is currently making. A slightly longer emergency fund ratio would be better for this particular client. Disability insurance is relevant in determining whether the emergency fund ratio is appropriate because some job losses are a result of disability. The elimination period incorporated in the disability policy should be considered.

Return on Assets (ROA)

A1 - (A0 + Savings) / A0

Your new client, Kerri, age 35, came into your office today. She provided you with the following information for the year: • Income - $100,000 • Taxes - $18,000 • Rent - $14,000 • Living Expenses - $40,000 • Credit Card Debt - $12,000 • Savings - $5,000 • Student Loan Payments - $5,000 • Car Payment - $6,000 After receiving this information you created a pie chart to visually depict where her income was spent. Utilizing targeted benchmarks which of the following statements are you most likely to make during you next meeting? A)"You are spending too much on housing." B)"Your current living expenses are within the normal range." C)"Your mortgage and debt payments are within the normal range." D)"Your savings is low but still appropriate for your age."

B. The current living expenses are at 40% which is within the normal range of 40% - 60%. The rent is at 14% which is within the normal range of 0 - 28%. The housing and debt percentage is 37% (rent of $14,000 + credit card debt of $12,000 + student loan payments of $5,000 and car payment of $6,000) which is above the normal range of 0 - 36%. The savings of 5% is too low for her age group. She should be within the 10% - 18% range.

Paul and Lucy Martin are married and both are 65 years of age. Paul is retired from the military and receives a military pension as well as disability benefits from an injury he sustained during the Vietnam War. Lucy is a retired nurse. Lucy is fairly healthy, although she is borderline diabetic. Paul is diabetic and had a triple bypass several years ago. He also has extensive hearing loss in one ear that he sustained during his military service. Both have a family history of Alzheimer's disease. Their home is paid for and they just purchased a new car with financing. They have three self sufficient adult children and two grandchildren. The Martins have a life insurance policy on each of their adult children they purchased when the children were young with a death benefit of $10,000. All three policies have a cash value of $3,000 each. They also have policies on each other with a death benefit of $100,000. The Martins live comfortably with their pensions but do not have a lavish lifestyle or high net worth. Which of the following is their most important need/goal? A)They should immediately begin a gifting plan giving $13,000 to each child each year. B)They should investigate long-term care insurance. C)They should purchase additional life insurance immediately. D)They should purchase a disability policy on Paul.

B. The most likely need/goal for Paul and Lucy is a long-term care insurance policy. In this case, both have some medical issues that may require long-term care. The policy may be cost prohibitive, so costs should be investigated. There is no indication that the Martins have a substantial net worth therefore a gifting program is not necessary. There is no indication that they need additional life insurance. They do not indicate that they have an income stream that needs to be replaced and there does not appear to be an estate tax consequence that will require insurance to provide liquidity. A disability policy is not necessary because Paul does not have an income stream that needs to be protected (plus, he is unlikely to qualify anyway).

You have been working with your client, Brenda, for 3 months now. You developed a mission statement, goals, and objectives with the client. You are now constructing a plan that is led by the client's mission statement. Which approach to financial planning are you utilizing? A)Life Cycle Approach. B)Strategic Approach. C)Metrics Approach. D)Three Panel Approach.

B. The strategic approach is led by the client's mission statement. The life cycle approach utilizes quick and simple data collection in a nonthreatening way permitting the financial planner to quickly focus on expected needs. The metrics approach utilizes qualitative benchmarks to determine where a client should be. The three panel approach compares the client's actual financial situation with benchmark criteria.

Janice earns $85,000 working as an administrative assistant in a public company based in New York. The company provides a matching contribution in the 401(k) plan of 50% of her contribution, up to a maximum matching contribution of 4% of compensation. Her 401(k) plan account had $20,000 in it at the beginning of the year. She contributed $5,000 to the plan this year and the employer made the matching contribution before year end. The ending balance of the account is $30,000. What is her return on her investments this year for the 401(k) account? A)8.8%. B)9.9%. C)12.5%. D)25.0%.

C. The ROI equals the net increase in the account attributable to earnings divided by the beginning balance. Reduce the ending balance of $30,000 by her contribution and the match, which totals to $7,500. Take the difference of $2,500 divided by $20,000 to yield 12.5%. The match is 50%, up to a limit of 4% of compensation (4% x $85,000 = $3,400). Since 50% of her contribution (50% x $5,000 = $2,500) is less than the maximum of $3,400, the company match will be $2,500. The total saved is $5,000 + $2,500 = $7,500. This amount is subtracted from the ending balance to determine the net increase attributable to the investment earnings.

Darrin and Kathi are both 44 years of age. They came to your office today and provided the following financial information: • Cash and Cash Equivalents - $333,333 • Investment Assets - $333,333 • Personal Use Assets - $333,333 • Current Liabilities - $100,000 • Long-Term Liabilities - $250,000 After meeting with them you created a pie chart to visually depict their current balance sheet. Utilizing targeted benchmarks, which of the following statements are you most likely to make during you next meeting? A)"You are within all normal ranges for your age group." B)"Your net worth is too low." C)"Compared to the other assets, the investment asset holdings are appropriate." D)"Your long-term liabilities are excessive."

C. The cash and cash equivalents is high at 33%. It should be between 5% - 20%. Although the investment assets and the personal use assets are within the normal range - they are really too low when compared to the significant holdings in cash and cash equivalents. The liabilities and the net worth are within the normal range. Note that the net worth is equal to the assets minus the liabilities ($1,000,000 - $350,000 = $650,000).

Curtis is 60 years old. He plans to retire in five years. He has amassed a net worth of $1,500,000 which he expects will sustain him during retirement. He is divorced with two adult independent children. Which phase of the life cycle is Curtis most likely in? A)Conservation Phase. B)Asset Accumulation Phase. C)Distribution Phase. D)Income Phase.

Curtis is likely in the conservation phase. The conservation phase runs from the late 20s to early 70s and is where the individual begins to cover risks and have increased net worth. He has likely ended or neared the end of the asset accumulation phase and has probably not yet entered or just barely entered the gifting phase. The income phase is a fictitious phrase.

Utilizing investment assets to gross pay benchmarks, which of the following individuals is likely on target with their investment assets? A)Jimmy, age 55, earns $150,000 a year and has invested assets of $900,000. B)Sarah, age 35, earns $30,000 a year and has invested assets of $15,000. C)Terry, age 45, earns $60,000 a year and has invested assets of $150,000. D)Casey, age 25, earns $40,000 a year and has invested assets of $9,000.

D. Jimmy needs invested assets of 8 - 10 times his salary. At a minimum he needs $1,200,000 ($150,000 x 8). Sarah needs invested assets of 1.6 - 1.8 times her salary. At a minimum she needs $48,000 ($30,000 x 1.6). Terry needs invested assets of 3 - 4 times his salary. At a minimum he needs $180,000 ($60,000 x 3). Casey needs invested assets of 0.20 times his salary. At a minimum he needs $8,000 ($40,000 x 0.20).

Utilizing the three panel approach, which of the following would be evaluated in Panel 1 - Risk Management? A)Emergency Fund. B)Education Fund. C)Retirement Fund. D)Life Insurance.

D. Life insurance would be evaluated as part of Panel 1 - Risk Management. The emergency fund would be evaluated as part of Panel 2 - Short Term Savings and Investment. The education and retirement funds would be evaluated as part of the Panel 3 - Long Term Savings.

Which of the following is true? A)Debt ratios measure the ability to meet short-term obligations. B)Liquidity ratios indicate how well a client manages debt. C)Ratios for financial security determine the progress that the client is making toward achieving short-term financial security goals. D)Performance ratios determine the adequacy of returns on investments given the risks taken.

D. Liquidity ratios measure the ability to meet short term obligations. Debt ratios indicate how well a client manages debt. Ratios for financial security determine the progress that the client is making toward achieving long term financial security goals. Performance ratios determine the adequacy of returns on investments given the risks taken.

David, 33 years of age, and Kristina, 34 years of age, are married with no children. They anticipate having children within the next five years. David and Kristina both have a graduate degree and student loans. They both have good jobs and earn about $110,000 together. They have mortgage debt of $190,000 on their home that is valued at $210,000. They have one car that they share that is not yet paid for and they anticipate buying a second car in the next year. They have no credit card debt. Which of the following is a likely current goal of the couple? A)Education Funding. B)Gifting. C)Charitable Gifting. D)Retirement Funding.

D. Retirement funding is the most likely current goal for this couple because they are young and should utilize the time value of money to maximize their savings. There is no indication that charitable gifting is one of their goals as this is not a common goal among people (while retirement funding should be a common goal among all working individuals). They are too young to be gifting and there is no indication of excessive net worth. They do not have a child yet, so there is no need for education funding at this time.

Identify the difference between discretionary and non-discretionary cash flows.

Discretionary = cash flows that can be avoided in the even of loss of income Non-Discretionary = are fixed obligations and expenses that are required to be met no matter what

The life cycle approach utilizes liquidity ratios to analyze the client's financial situation. T/F

False:

The metrics approach provides finite benchmarks for the financial planner to use as comparison of client actual to client goal. T/F

False:

Common performance ratios include net worth to total assets, ROI, and ROA. T/F

False: net worth to total assets is a debt ratio

What information is provided by housing ratio 1 and housing ratio 2 and what are the benchmarks for both ratios?

HR1 = % of gross pay that is devoted to basic housing, 28% benchmark HR2 = % of gross pay that combines HR1 with all other monthly debt payments, 36% benchmark

Housing Ratio 1 (HR1)

HR1 = housing costs / gross pay <= 28%

Housing Ratio 2 (HR2)

HR2 = housing costs + other debt payments / gross pay <=36%

Define the strategic approach.

Mission, goals, vision statement

Return on Net Worth (RONW)

NW1 - (NW0 + Savings) / NW0

How is the savings rate calculated and what are the typical benchmarks for this ratio?

Savings Rate = (savings + employer math) / gross pay = 10-13%, but depends on age

Identify the purpose of the example benchmarks used in the metrics approach.

This approach provides quantitative example benchmarks for the financial planner and client to use as guidance for necessary comprehensive financial goals and objectives.

Debt ratios utilized in financial analysis include HR1, HR2, debt-assets, net worth-assets. T/F

True

The 2 step approach considers savings and investments as part of the financial plan leading to financial security. T/F

True

The 3 panel approach provides a plan for risk management of personal , property, and liability risks, along with both ST and LT savings. T/F

True

The pie chart approach provides a pictorial representation of the balance sheet and the statement of income and expense. T/F

True

The savings rate benchmark is client goal oriented, while the investment assets to gross pay benchmark is client age. T/ F

True

The savings rate is measured to help clients achieve long-term goals (retirement, edu, lump sum expenses, legacy plans) T/F

True

Current Ratio

cash and cash equivalents / current liabilities >= 1

Emergency Fund Ratio

cash and cash equivalents / monthly non-discretionary cash flows; benchmark = 3-6 months

Net worth to total assets ratio

net worth / total assets = benchmark depends on age

List the two focuses of the 2-step approach and the financial categories analyzed by the 3-panel approach.

risk management and appropriate savings and investing

debt to total assets ratio

total debt / total assets = benchmark depends on age