Exam 1 Discussion Questions

Discuss the characteristics of term life insurance

"Pure insurance". The main difference between term life insurance and whole life insurance is that whole life has a savings and investment component, as it lasts your lifetime and has a cash value with a rate of investment return on some of the money (premiums) you pay in to it. Term life is just straight insurance that lasts for the specific amount of time set in the initial contract. The premiums for term life are significantly smaller than those of whole life because of this investment component. Additionally, term life premiums can be fixed throughout the term or annually renewable, usually with an increasing premium.

List the three phases of the life cycle approach

1) Asset Accumulation Phase 2) Conservation (Risk Management) Phase 3) Distribution (Gifting) Phase

List and define the major categories on the assets side of the balance sheet

1) Cash & Cash Equivalents (Current Assets): highly liquid, is cash or can be converted to cash within the next 12 months w/ little to no price variance from their current value (cash, checking accounts, savings accounts, money market accounts, CODs) 2) Investment Assets: appreciating assets or assets being held to accomplish one or more financial goals (401k's, IRAs, education funds, cash value in life insurance, business ownership interests) 3) Personal Use Assets: assets that maintain the client's lifestyle (personal residences, cars, furniture, clothing, boats, collectibles, etc.)

Identify and discuss the 3 general schools of thought for counseling.

1) Cognitive-Behavioral: Human beings are subject to the same learning principles that were established in animal research. Basic principles of classical and operant conditioning are thought to account for an individual's behavior and understandings throughout their lives (advisor spends more time on reinforcing positive results to reinforce client's belief in process, financial behavior, and trust) 2) Developmental: Believes that human development occurs in stages over time. Relationships that are formed early in life become a template for establishing relationships in adulthood. Assumes that all humans develop and progress emotionally in a predictable sequence. (use questions to try to correct previous habits and trends to get back on track) 3) Humanistic: the view that we control, choose, and are responsible for our actions, advisor needs to believe humankind is basically good and people have inherent capability of self-direction and growth under right circumstances. (close, personal relationship with client, view clients as experts on themselves and help bring that out in them, rooted in process and feelings, discovering best goals for self)

Define the process of financial planning

1) Establishing and defining the client relationship (identifying goals and engagement letter) 2) Gathering Client Data (internal & external data) 3) Analyzing and Evaluating Client's Financial Status (preparing data analysis and establishing alternative options for achieving goals) 4) Developing and Presenting Financial Plan Recommendations (selecting one set of recommendations from the alternative options) 5) Implementing Financial Plan Recommendations (defining planner's and client's responsibilities, guiding implementation of plan) 6) Monitoring the Plan (setting schedule for periodic review & adjustment on plan)

List and define the common forms of property ownership

1) Fee simple: when one person has complete and sole ownership of the property, including all rights related to using and selling the property. 2) Tenancy in Common: when two or more people own the same property, and each hold undivided (can be equal or not equal) interest in the property. When one of the owners passes away, his/her interest is divided between his/her children. 3) Joint Tenancy with Right of Survivorship: also when two or more people own the same property, but each person holds undivided and equal interest in the entire property. When one of the owners passes away, their interest is transferred to the other joint tenants.

List the four debt ratios used in the financial statement and ratio analysis approach

1) Housing Ratio 1 2) Housing Ratio 2 3) Debt to Total Assets Ratio 4) Net Worth to Total Assets Ratio

List what should be reflected on forecasted financial statements

1) Implementation of recommendations 2) Inflation adjustment for expenses 3) Inflation adjustment for income 4) Other adjustments (i.e. major changes to income, retiring debt)

Identify and discuss the 4 basic premises for Behavioral Finance

1) Investors are "Normal": not rational, have normal wants and desires, may commit cognitive errors (biases), may be misled by emotions 2) Markets are Not Efficient: does not assume price of stock is equal to fundamental value, can be deviations in price from fundamental value, creates opportunities to buy at discount or sell at premium, or vice versa. 3) The Behavioral Portfolio Theory Governs: investors don't necessarily look at portfolio as a whole, investors segregate their money into various mental accounting layers, compartmentalize to achieve certain goals. 4) Risk Alone Does not Determine Returns: there are many more factors that are evolved in determining returns, considers subjective risk, returns not measured by beta/risk alone

Identify and discuss the 4 basic premises for Traditional Finance

1) Investors are Rational: prefers more wealth and are never confused by the manner or form of wealth, do not care if get wealthy through dividend or selling stock, source of wealth not important 2) Markets are Efficient: a stock's share price in the market incorporates and reflects all relevant info about the stock, stocks traded at fair value on stock exchanges, no "mispricings", riskier investments = higher returns 3) The Mean-Variance Portfolio Theory Governs: investors follow this faithfully and tailor portfolios to comply, do so by viewing and evaluating averages and variance. 4) Returns are Determined by Risk (Beta): risk measured by beta, links return and risk for all assets, measure of an asset's risk in correlation to the market or an alternative benchmark.

What do the three panels of the three panel approach cover?

1) Panel 1: Risk management of personal, property, and liability risks (evaluate need for personal insurance) 2) Panel 2: Short-term savings and investments & debt management (emergency fund, housing ratios 1 and 2) 3) Panel 3: Long-term savings and investments (goals for retirement, education, large purchases, legacy)

List the common performance ratios used in the financial statement and ratio analysis approach

1) Return on Investments (ROI) 2) Return on Assets (ROA) 3) Return on Net Worth (RONW)

List four responses to managing risk

1) Risk Avoidance 2) Risk Reduction 3) Risk Retention 4) Risk Transfer

List and define the liabilities categories on the balance sheet

1) Short-term (Current) Liabilities: due or expected to be paid within next 12 months (utilities bills, credit card bills, taxes, insurance premiums) 2) Long-term Liabilities: due or expected to be paid beyond the next 12 months (mortgage, student loans, car loans, loans in general)

What are three methods used to determine the amount of life insurance needed?

1) The Human Life Value Method 2) The Financial Needs Method 3) The Capitalization of Earnings Method

List and define the eight approaches to financial planning analysis and recommendations

1) The Life Cycle Approach: used to collect limited, initial data in the beginning of the process with a client. It provides the financial planner with a general idea of the client's financial profile to allow for a more effective initial conversation. 2) The Pie Chart Approach: is useful as a visual representation of the client's relative financial standings after the internal data is collected. It can be useful when compared to market benchmarks to illustrate where the client's money and financial resources are being allocated and how appropriate each is. 3) The Financial Statement and Ratio Analysis Approach: this approach is generally used after the pie chart approach as a tool to briefly illustrate the client's current financial status and their actual financial ratios. It further allows for comparison with benchmark metrics to show areas of strength and weakness in the client's financial resources.

List some of the unique characteristics of an insurance contract

1) Unilateral (only insurer making promise) 2) Aleatory (paid in not necessarily equal paid out) 3) Adhesive (insured cannot negotiate) 4) Utmost good faith (both parties truthful) 5) Based on indemnity (make whole, no more no less, insured cannot make a profit on a claim) 6) Insured must have an insurable interest 7) Coverage conditioned on payment of premiums

What are some of the questions that an income statement pie chart will answer?

1) What percentage of gross pay is the client paying in taxes? 2) percentage saving? 3) percentage going to insurance? 4) percentage spent on basic housing costs? 5) percentage spent on debt repayments? 6) percentage left to live on?

List documents that a client can provide to the financial planner as sources of information to properly prepare financial statements

1) bank statements 2) brokerage statements 3) loan amortization schedules 4) tax returns

Property ownership continued

4) Tenancy by Entirety: for married couples only, in which the husband and wife each own 100% of the property. If one spouse dies, their property ownership is automatically transferred to the surviving spouse. 5) Community Property: also for married couples, and it is when each spouse owns an equal undivided interest in all property that they accumulate over the course of their marriage. Property owned before the marriage is not included and is considered separate property. This type of ownership is only incorporated into civil law in some select states.

Eight approaches continued

4) The Two-Step/Three-Panel Approach: breaks it down step by step to compare the client's actual financial data to benchmark data. This approach dives deeper in the information given to the client; it proposes methods for achieving financial independence. 5) The Present Value of Goals Approach: looks at short-term, intermediate-term, and long-term financial goals to calculate and sum the present value of each goal in order to find the amount (obligation) of current resources to achieve such goals. Using an ordinary annuity, one can figure out the amount that needs to be saved throughout the rest of the client's lifetime. This approach then evaluates current savings to determine if they are adequate to achieve the client's goals. An income tax analysis is also necessary in this approach.

Eight approaches continued

6) The Metrics Approach: uses numerical benchmark criteria to compare to the client's financial status to tell where they are and where they should be. The end goal of this approach is dollar and percentage objectives that are measurable compared to ratio analysis for the client to achieve. 7) The Cash Flow Approach: looks at recommendations using the three-panel approach and a pro forma approach. It is meant to mitigate discretionary cash flows and identify positive cash flows to fund the recommendations. 8) The Strategic Approach: utilizes the client's mission, goals, and objectives in consideration of the internal and external data. Can also be used with other approaches.

Define a personal automobile policy (PAP)

A PAP is a package policy that protects against loss for damage to the owned automobile, to the property of others, and bodily injury to the insured, family members, and to others. Organized into 6 parts: 1) Part A: liability coverage 2) Part B: medical payments coverage 3) Part C: uninsured motorist coverage 4) Part D: coverage for insured automobile, comprehensive 5) Part E: duties of the insured 6) Part F: general provisions **Automobile liability insurance required in every state

What is the job and economic outlook for the financial planning profession?

A PFP helps guide, advise, and plan. They help their client's in achieving their financial goals and wisely investing and saving their money. They make $75,000-100,000 per year, and there is unlimited growth in this profession. Also has a lot of flexibility in hours.

What are some of the benefits a client receives from choosing to use a professional financial planner?

A client who chooses to use a professional financial planner will receive experienced knowledge and advice, security in their financial decisions, objectivity, and a comprehensive financial plan for their future.

What should you do as a financial advisor if you believe that a client's heuristic is clouding his/her judgement?

As a financial advisor, I would try to discuss other perspectives with my client to get them to see past the heuristic clouding his/her judgment. By pointing out other viewpoints or ideas, I would hope to broaden their perspective and get them thinking. If this was not effective, I would encourage my client to do some research on their own in order to cultivate an educated conversation so that we could reach a conclusion together.

Discuss how assets and liability values are reflected on the balance sheet

Assets are reflected at their fair market value (not the price you bought them for) and liabilities are stated at their current outstanding principal balance as of the date of the balance sheet

Why is the present value approach easy to understand at the completion of the analysis?

At the completion of analysis, you have the specific requirements for each goal of the client in present and future dollar terms, as well as the corresponding savings required to achieve those goals. This allows the client to see how realistic their combined goals are, if they are attainable, or if they need to pick and choose which ones to pursue. Gives a dollar amount to their goals to make more realistic.

Discuss the average savings rate for retirement funding and the average retirement withdrawal rate

Avg savings rate: 10-13% for 25-35 year olds, increases if you start saving later Avg withdrawal rate: 4%, and increases as you get older in retirement because want to use up all the money, and adjust for inflation

List some important elements of a financial planning engagement letter

Description of the mutually agreed upon services, time horizon for the work to be completed, description of fees and costs, obligation and responsibilities of each party (in financial planning process)

Define the difference between own occupation and any occupation disability definitions and the associated coverage

Disability coverage determined by... Own: whether or not the insured can carry out each and every one of the duties of his employment; if cannot, will qualify for disability benefits; can be until retirement or for a term of years. Any: if insured cannot work in any occupation for which they are qualified for by education, training, or experience. If can do a similar job to what they had, benefits may be discounted.

Define the expense category of the income statement and give examples of variable and fixed expenses

Expense category represents those items that are paid regularly by the client during the time period being presented. Variable: entertainment, vacation, travel, charitable contributions (more discretionary) Fixed: mortgage payment, car payment, student loans, property taxes, insurance premiums, federal and state income taxes, social security (less discretionary)

Define the two-step approach to financial planning

Focuses on risk management and appropriate saving and investing (considers personal risk as possible catastrophic loss or dependence on someone else for financial well being / savings and investments as path to financial independence)

What is the usefulness of the cash flow approach to financial planning?

Forecasts what cash flows would be after implementing all of the planning recommendation. Works on suggested recommendations for different financial areas for client. Aims to drive down discretionary cash flows and focus on priorities. If cash flow impact is positive, all is good, but if negative (usually the case) planner needs to look for the money to fund the recommendations.

Discuss the benefits and drawbacks to the "why" question of a client?

Good because gives client option to formulate own answer and understand their reasoning more, but bad because can make them feel like they have to justify themselves and might not tell whole truth because afraid of looking stupid

Define the three main types of a hazard

Hazard increases probability of a peril occurring. 1) Physical: tangible condition, such as slippery roads. 2) Moral: involves dishonesty by an individual that increases the chance for a loss, such as fraud in health insurance claims. 3) Morale: when a person becomes indifferent to loss because they are covered by insurance. This attitude can cause individuals to be more careless and more prone to perils, such as not locking your car because the contents in it are insured.

Discuss the coverage available under a homeowners insurance policy

Homeowners insurance coverage is a package policy covering dwelling, dwelling extensions (garage), personal property, loss of use, medical payments for others, and liability. For dwelling, can have policies of 18 perils (broad) or open perils (all). For personal property, can have policies of actual cash value (ACV) or replacement value. Can mix and match. Suggested: open perils and replacement value. Typically covers fires, tornadoes (wind), trees falling, theft, and loss of use. Usually does not cover floods, earthquakes, mold, war, neglect, etc. Must schedule personal property items specifically (i.e. collectibles)

Define housing ratios 1 and 2

Housing ratio 1: determines if the amount of income and housing debt are appropriate and affordable Housing ratio 2: essentially housing ratio 1 plus all other debt. Determines if the total amount of debt is appropriate for a given level of income (to qualify for a loan)

Define and explain the purpose of financial statement analysis

In this, the planner is measuring a client's progress towards attaining financial goals, assessing their ability to meet short-term obligations, and overall debt management. Accomplished by conducting vertical, horizontal, and ratio analysis. Overall, helps planner see if client is moving in the right direction and on track with goals.

Define net discretionary cash flow

Income - Savings - Expenses - Taxes = Net Discretionary Cash Flow Represents the amount of cash flow available after all savings, expenses, and taxes have been paid. Want to be positive so that income is greater than savings, expenses, and taxes

Discuss the difference between income and savings contribution categories listed on the income statement

Income is incoming money that is generated and can be spent on current consumption. Savings contributions is money being put away for a later date/goal. Examples of income are salary, interest, dividend, pension, retirement account withdrawal, business income. Examples of savings contributions are 401k plan, IRA, education savings, any other type of savings account, reinvested dividends, interest, or capital gains.

What are examples of internal data items collected from the client as part of the "gather client data" part of the financial planning process?

Internal Data: Qualitative: goals, attitudes, personal preferences Quantitative: bank reports, insurance policies, financial statements, retirement account (Roth IRA and 401K)

What is an advantage to using the pie chart approach with clients?

It focuses the client on the relative size of financial variables, helps to visualize where their money is going, analytical and illustrative, provides representations of income statement and balance sheet, clear and concise

Describe the personal risk management process

It is a systematic process of identifying, evaluating, and managing pure risk exposures faced by an individual. Steps: 1) determining the objectives of the risk management program 2) Identifying risk exposures 3) Evaluating the identified risks 4) Determining and selecting the best risk management alternatives 5) Implementing a risk management plan based on the selected alternatives 6) Periodically evaluating and reviewing the individual risk management program

Define the emergency fund ratio

Measures how many months of non-discretionary expenses the client has in the form of cash and cash equivalents or current assets.

Define the savings rate

Measures the amount a client is saving towards a retirement goal

Define performance ratios

Measures the return a client is generating on assets, net worth, and investments

Define and discuss the net worth category listed on the balance sheet

Net worth = Assets - Liabilities Represents the amount of total equity a client has accumulated. Important b/c represents an absolute dollar amount reflective of a client's financial position (can be positive or negative number)

Discuss whether capital gains, dividends, interest, and other portfolio income should be part of the savings ratio.

No, because it would be double-counting if you included these in the savings ratio (they are already part of your savings) . They should be included in the investment return.

Differentiate between noncancellable and guaranteed renewable

Noncancellable: ensures that the insurance will not be cancelled and that the premiums will remain fixed for the term of the policy (more expensive premiums b/c of low risk) Guaranteed Renewable: obligates the insurer to continue coverage as long as premiums are paid on the policy. While renewal is guaranteed, premiums can increase if they are increased on the entire group (less expensive premiums than noncancellable)

What are your options if you sense a client is saying one thing but believes another?

Paraphrase for better understanding, ask questions to offer different perspectives, come back to the question later on

Discuss why there is a need for personal liability insurance

Personal liability insurance is necessary nowadays because lawsuits are increasingly more common, and accidents causing harm to others can happen almost anywhere. Having personal liability coverage for yourself and your family can save you millions of dollars if such a peril/lawsuit were to happen. A personal liability umbrella policy (PLUP) provides excess liability coverage and legal defense for claims that go beyond one's homeowners or auto insurance. It is fairly inexpensive and is usually sold with your auto or homeowners insurance.

Discuss the usefulness of the metrics approach

Provides quantitative example benchmarks to use as guidance for financial goals and objectives. The metrics can be applied to establish financial planning recommendations.

Identify and describe some differences between a rational investor and a normal one

Rational: never confused by the manner or form of wealth, source of wealth not important, do not take emotions or biases into account Normal: not rational, have normal wants and desires, may commit cognitive errors (biases), may be misled by emotions

Discuss the difference between discretionary and non-discretionary cash flows

Discretionary cash flows are monthly financial obligations that are not vital to the client and can be eliminated in the event of a loss of income. Non-discretionary cash flows are not optional and cannot be eliminated if there is a loss of income, they are relatively permanent. Non-discretionary cash flows are payments like loan payments, insurance payments, taxes, food, utilities, etc. Discretionary cash flows could be vacations, cable TV, subscriptions to various entertainment platforms. There can be cash flows that are specific to the client and can be discretionary or non-discretionary for different people. For example, church donations, lawn service, or child care. These monthly payments could be vital to one client and optional to another. It is very important to look at and establish the client's monthly discretionary and non-discretionary cash flows to get a sense of what you are working with and how to plan for a possible loss of income. When discussing these types of cash flows with a client, it is important to ask open-ended questions and let them direct the conversation.

What are the liquidity ratios used in the financial statement and ratio analysis approach?

Emergency Fund Ratio and Current Ratio

Discuss the difference between evaluating a portfolio as a whole vs evaluating a portfolio in mental layers

Evaluating as whole: consider covariances between assets as they construct their portfolios. Care only about the expected returns and variance of the overall portfolio, not its individual assets. Have consistent attitudes towards risk, they are always averse to risk. Evaluating in mental layers: build portfolios as pyramids of assets, layer by layer, where layers are associated with particular goals and particular attitudes towards risk. Contrary to the prescriptions of mean-variance theory, covariances among securities are often overlooked.

Discuss what you believe are the reasons how someone can buy a lottery ticket and insurance at the same time

Someone can buy a lottery ticket and insurance at the same time because people, by human nature, weigh losses more heavily than gains. This means that people view insurance as a safety net, thus limiting the potential loss of the cost of a lottery ticket. People feel safer with insurance, therefore limiting their losses in other areas.

What are examples of external data items required as part of the "gather client data" part of the financial planning process?

Stock market, housing market, interest rates, inflation rates, job market, business cycle

Define ratio analysis

The process of calculating key financial ratios for a client, comparing those metrics to industry benchmarks and then making an evaluation regarding any deficiencies.

What is personal financial planning?

The process of formulating, implementing, and monitoring financial decisions into an integrated plan that guides an individual or a family to achieve their financial goals.

Define a peril

The proximate (via chain reaction) or actual (direct) cause of a loss, can have open-perils policies (all risk except) or named-perils policies (specifically stated)

What is a financial planner's purpose in creating a client's budget?

To evaluate the client's spending and savings behavior, and to establish a spending and savings plan to assist the client in achieving their financial goals.

What is the purpose of the statement of net worth?

To explain changes in net worth between two balance sheets by reporting financial transactions that are not reported on the income statement or other financial statements (stuff other than cash). Formula: beginning balance of net worth + additions (appreciation of assets, receiving gift/inheritance) - subtractions (giving gifts other than cash) = ending balance of net worth

What is the purpose of the cash flow statement?

To explain how cash and cash equivalents were used or generated between the period of two balance sheets. Includes nonrecurring cash transactions from investing activities (like buying or selling personal use assets or contributing to a retirement or education fund) and financing activities (like reducing loans or getting new loans).

Define the strategic approach to financial planning

Uses the client's mission, goals, and objectives while considering the internal and external environment data (may be used alongside other approaches). Focuses on needs-driven vs wants-driven priorities to create a plan for short and long term directed and created for the client.

Define vertical and horizontal analysis as comparative financial statement tools

Vertical: lists each line item on income statement as a % of total income and presents each line item on the balance sheet as a % of total assets. The restated % is known as a common size income statement or balance sheet (within one period comparing items in it) Horizontal: lists each financial statement item as a percentage of a base year and creates a trend over time (looks from year to year in chronological order)

What are some of the questions that a balance sheet pie chart will answer?

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