Financial Planner | Know the financial planning delivery process.

Financial planning requires financial advisors to follow a process that enables acquiring client data and working with the client to arrive at appropriate financial decisions and plans, within the context of the defined relationship between the planner and the client. The following is the six-step process that is used in the practice of financial planning.

 a. Establish and define the client-planner relationship: The planning process begins when the client engages a financial planner and describes the scope of work to be done and the terms on which it would be done.

 b. Gather client data, including goals: The future needs of a client require clear definition in terms of how much money will be needed and when. This is the process of defining a financial goal.

 c. Analyse and evaluate financial status: The current financial position of a client needs to be understood to make an assessment of income, expenses, assets and liabilities. The ability to save for a goal and choose appropriate investment vehicles depends on the current financial status.

 d. Develop and present financial planning recommendations: The planner makes an assessment of what is already there, and what is needed in the future and recommends a plan of action. This may include augmenting income, controlling expenses, reallocating assets, managing liabilities and following a saving and investment plan for the future.

 e. Implement the financial planning recommendations: This involves executing the plan and completing the necessary procedure and paperwork for implementing the decisions taken with the client.

 f. Monitor the financial planning recommendations: The financial situation of a client can change over time and the performance of the chosen investments may require review. A planner monitors the plan to ensure it remains aligned to the goals and is working as planned and makes revisions as may be required.

 Defining the Client-Planner Relationship 

The terms of engagement between the client and the financial planner describes the scope of services that a planner would offer, the fees that would be paid, and the rights and obligations of both parties. The terms are usually spelt out in a legal agreement that is signed by both parties.

It is important for the agreement to be compliant with the prevalent regulations. The SEBI(Investment Advisers) Regulations 2013 require that the advisers disclose a defined list of information about themselves, including their background, their track record in grievance redressal and the services they would offer. Documentation of client information, risk profiling, suitability tests of products being offered are all mandatory under the regulation. The terms of engagement has to comply with these Regulations.

 Understanding Client’s Financial Situation 

Financial Planning is the exercise of ensuring that a household has adequate income or resources to meet current and future expenses and needs. The income is primarily derived from two sources:

1. Income from profession or business or employment undertaken.
2. Income and earnings from assets or investments such as rent from property, interest from bank deposits, dividends from shares and mutual funds, interest earned on debentures.

Income from business or profession will be the primary source of income in the period when the individual is capable of being gainfully employed and generating an income. When this period is over, the dependence for income from the assets and investments will increase. 

Assets and investments as a source of income are typically built over a period of time from surplus income after meeting expenses. 

Current income is first assigned to meet current expenses. Surplus income available after meeting expenses is called savings and it is used to create assets that will provide future income or meet future expenses. Large ticket size assets, such as real estate, or, purchases that are not amenable to being met out of regular income, such as buying a car, may require surplus income to be accumulated over a period of time. Typically such assets are acquired with a combination of own funds and loans. Loans result in a liability that has to be met out of current and future income.

• Income is used to meet current expenses and create assets to meet future income needs and expenses.
• Expenses have to be controlled to fit into available income and to be able to generate savings.
• Savings are used to create assets that will generate income for the future needs.
• Borrowings or loans may be combined with savings to acquire assets of a large value or meet expenses.
• Borrowings impose a liability to be met out of income to pay the cost and repay the loan. 

Financial planning helps in understanding the relationship between the four elements of the personal finance situation of an individual: income, expenses, assets and liabilities so that all the current and future needs are met in the best way possible.

 Identifying Financial Goals 

Financial goal is the term used to describe the future needs of an individual that require funding. It specifies the sum of money required in order to meet the needs and when it is required. Identifying financial goals help put in place a spending and saving plan so that current and future demands on income are met efficiently.

Goals described in terms of the money required to meet it at a point of time in future, is called a financial goal. For example, Rs. 3 lakhs required after five years for the college admission for a child is a financial goal. Converting a goal into a financial goal requires the definition of the amount of money required and when it will be required. Other examples of financial goals are:

• Rs. 2 lakhs required each month after 10 years to meet household expenses in retirement.
• Rs. 3 lakhs required after 5 years for a foreign holiday.
• Rs. 7 lakhs required after three years as down payment for a house.
• Rs. 1 lakh required after 6 months to buy a car.

As can be seen from the above examples, each financial goal contains two important

components: (a) goal value and (b) time to goal.

 a. Goal Value 

The goal value that is relevant to a financial plan is not the current cost of the goal but the amount of money required for the goal at the time when it has to be met. The current cost of the goal has to be converted to the value in future. The amount of money required is a function of:

• Current value of the goal or expense
• Time period after which the goal will be achieved
• Rate of inflation at which the cost of the expense is expected to increase.

The current cost of a college admission may be Rs. Two lakhs. But after 5 years, the cost would typically be higher. This increase in the cost of goods and services is called inflation. While saving for a goal, therefore, it is important to estimate the future value of the goal because that is the amount that has to be accumulated.

 The future value of a goal = Current Value x (1+ Rate of Inflation) ^ (Years to Goal) 

In the above example, if the rate at which the cost increases is taken at 10% then the cost of the college admission after 5 years would be:

 Rs.200000 x (1+10%) ^ 5= Rs.322102. 

This is the value of the goal which needs to be achieved by saving and investment.

 b. Time to Goal or Investment Horizon 

Financial goals may be short-term, medium-term or long-term. The term to goal refers to the time remaining for the funds to be made available to meet the goals. The investment horizon will determine the type of investment that will be selected for investing funds for the goal. If the goal is short-term, low risk investments will be preferred even though the returns will be low since the investor would not like to take a chance of losing the principle and return on the amount invested. As the time available for the investment increases, the investor will be able to take higher risks for better returns.

Farida (aged 35) is setting aside money to create an emergency fund and is also saving for her retirement. She has the option of investing in a short-term debt fund or in an equity fund. What will be the consequence of her decision?

A short-term debt fund may be ideal for her to hold her emergency fund since it has the twin features of relatively safe returns and ability to draw the funds out whenever she requires. But her retirement goal may see inadequacy of funds because the returns from

short-term debt funds are low and the amount she is investing may not be earning as well as it could.

If Farida invested in an equity fund, she may find that the value of her emergency fund has gone down when she needs the money since the returns from equity will be volatile. This is a risk she will be unwilling to take. On the other hand, her retirement corpus will benefit from the higher returns from equity since she requires the funds only after a long period during which the volatility in returns will be ironed out.

The appropriate investment for a goal will be one that aligns the risk and return preferences of the investor to the investment horizon.

The term to the goal will keep reducing and the investments made for the goal has to align to the new situation.

In the above example, as Farida’s retirement comes closer she will need to move her investments from equity to lower risk products.

 Funding the goal 

Once the financial goals have been identified, the next step is to evaluate the available income to determine how the goals will be met. Funding goals will depend upon the existing investments and assets that are available to meet future goals and the ability to save which will depend upon the current level of income and expenses of the household, and the liabilities of the individual which are the obligations that have to be met out of their available income. The ability to take loans to acquire assets or meet expenses will depend upon existing liabilities and the adequacy of the available income to meet the additional obligations.

The questions that help assess the ability to fund goals are:

• What is the current income available to meet expenses?
• What is the level of expenses?
• What is the amount of income that can be saved?
• What are the assets available that can be used to meet goals?
• What are the liabilities existing that also have a claim on income?

The current financial position will determine which of the financial goals are achievable and which may have to be postponed or given up till such time the savings improve.

Once the savings and investments available to meet the financial goals have been ascertained, the next step is to assign the existing savings and assets to the goals, so that the shortfall in funds required can be accumulated over time. It may not be possible to save and meet all the goals. Prioritizing, or identifying the goals that are more important and urgent, and saving for them first will be necessary. The amount of savings that will be assigned to a goal will depend upon the value to be accumulated, the time available to reach it and the type of investment selected to invest the savings. If the time to the goal is longer and the investor is willing to invest in investments with higher risk for better returns, then the amount of savings that needs to be set aside will be lower.

• Higher the return earned on investments, lower will be the current savings needed since the higher returns earned will lead to the savings grow to a larger amount.
• Longer the period available to accumulate the saving, lower will be the savings needed since the savings have a longer time to earn returns and reach the required value.

Example

Madhur is saving for a car and requires Rs.7 lakhs at the end of five years. He has the option of investing the savings in equity which is expected to give him 15% return or a bank deposit that will give him 8% return.

If he decides to invest in equity, he will require Rs.7902 to invest each month to be able to accumulate the funds. If he chooses to invest in a bank deposit, he will have to invest

Rs.9526 each month since the returns are lower.

If he increases the time available to 7 years, he will need Rs.4757 only to invest each month in equity and Rs.6243 if he chooses a bank deposit. This is because there is a longer time available to contribute to the goal and for the savings to appreciate to the required sum. However, the assumption made here is that the value of the goal remains the same Rs.7 lakh after 7 years. This may not necessarily be true.

The selection of the right type of investment in which to park the savings will depend upon the time available before the goal has to be met and the ability of the investor to take risks. If the investment period is long enough then the investor can consider products such as equity. This is because the returns from investments such as equity are high but volatile in the short-term and require a longer investment horizon to smoothen out.

A risk-averse investor may not be willing to invest in a risky investment even if it is suitable given the time horizon available. For example, an investor may choose to park their savings for long-term goals in bank deposits which they see as an investment with low risk. But they run the risk of not being able to accumulate the funds required in the time available. To catch up with their goal value, they will either have to increase the amount they are contributing for the goal, or increase the time available for reaching the goal.

The existing investments of the individual will also be assigned to the different goals by matching the need of the goal to the features of the investment. If the investor has investments in bank deposits, then it can be used for goals that are near-term or may require periodic fixed payout, such as education fees and expenses of children. 

Assigning existing investments to a goal will bring down the savings to be set aside for the goal, since these investments will also contribute to the targeted value of the goal. 

In the above example, if Madhur had Rs.100000 in equity mutual funds today which he assigns to this goal, then the value that he is saving for will come down to the extent that this Rs.100000 will gain in value over 5 years, assuming the same return of 15%.

 Value of the goal:                                          Rs.700000 

 Value of Rs.100000 after 5 years:                 Rs.201000 (Rs.100000 x (1+15%) ^ 5(approx.) 

 Value to be met from additional savings:      Rs.700000- Rs.201000=Rs.499000(approx.) 

Monthly saving to be invested for this goal: Rs.5634 as against Rs.7902 if no existing

investment was assigned to the goal.

Note: The ‘PMT’ function in excel can be used to calculate the periodic investments required. The inputs required for the function are

Rate: the rate of return expected to be earned. This is divided by 12 if the investment is

expected to be made monthly.

Nper: the number of periods (months/years) over which the investment will be made.

Future value: the amount that has to be accumulated.

 Risk Profiling 

Clients' financial risk tolerance - attitudes, values, motivations, preferences and experiences, is measured with a risk profile. The risk profile questionnaire helps in understanding the risk tolerance levels of a client. Risk tolerance is the assumed level of risk that a client is willing to accept.

Financial risk tolerance can be split into two parts:

 Risk capacity: the ability to take risk 

This relates to the client’s financial circumstances and their investment goals. Generally speaking, a client with a higher level of wealth and income (relative to any liabilities they have) and a longer investment term will be able to take more risk, giving them a higher risk capacity.

 Risk attitude: the willingness to take risk 

Risk attitude has more to do with the individual's psychology than with their financial circumstances. Some clients will find the prospect of volatility in their investments and the chance of losses distressing to think about. Others will be more relaxed about those issues.

Risk tolerance is typically measured using questionnaires that estimate the ability and willingness to take risks. The responses of investors are converted into a score that may classify them under categories that characterize their risk preferences. Consider the following classification:

 I. Conservative Investors 

• Do not like to take risk with their investments. Typically new to risky instruments.
• Prefer to keep their money in the bank or in safe income yielding instruments.
• May be willing to invest a small portion in risky assets if it is likely to be better for the longer term.

 II. Moderate Investors 

• May have some experience of investment, including investing in risky assets such as equities.
• Understand that they have to take investment risk in order to meet their long-term goals.
• Are likely to be willing to take risk with a part of their available assets.

 III. Aggressive Investors 

• Are experienced investors, who have used a range of investment products in the past, and who may take an active approach to managing their investments?
• Willing to take on investment risk and understand that this is crucial to generating long term return.
• Willing to take risk with a significant portion of their assets.

The risk preferences of the investor are taken into account while constructing an investment portfolio.

 Portfolio Construction 

An individual creates a portfolio of investments to meet their various goals. The investments selected have to balance the required return with an appropriate level of risk. Assets and investments differ on their features of risk, return, liquidity and others.

An investor will have multiple, differing requirements from their portfolio depending upon the goals they are saving for. They may need growth for long-term goals, liquidity for immediate needs and regular payouts to meet recurring expense. No one investment can meet all the requirements for growth, liquidity, regular income, capital protection and adequate return. The investor will have to create a portfolio of securities that has exposure to different assets which will cater to these diverse needs.

Consider the impact of the following investment decisions:

• Jayesh invests only in real estate. He has an urgent need for funds but finds that he is not able sell or take a loan quickly enough.
• Kamal leaves all his money in his savings bank account which earns a very low interest. He finds that he is not able to accumulate enough money required to meet his future expenses.
• Latika invests all her money in equities. She finds that the value of her investment keeps fluctuating and she is not sure if she will have the required funds when she needs it.
• Harmeet has most of her money in gold jewellery. She finds that she is not able to generate the income from her investments to meet her regular monthly expenses.
• Gayatri has invested her money in bank fixed deposits. She is not able to manage her expenses from the interest she receives because the interest is fixed but her expenses keep on increasing.

The risk to the investors in the cases described above comes from the concentration of their portfolio in one category of investment. When equity markets go down, Latika will find that her entire investment portfolio has gone down in value. If the real estate markets crash, Jayesh’s investment value will decline, as will Harmeet’s investments when the price of gold falls. Instead if they were holding some portion of the portfolio in different assets, a fall in one will be cushioned by a rise in another since not all asset values rise or fall together. This process of dividing the portfolio among different assets so that the overall portfolio’s return is protected from the effect of a fall in one or few assets is called asset allocation. Each asset comes with its own focus feature, such as growth, income generation or liquidity, and together the assets in the portfolio will cater to the different needs of the investor.

The asset allocation that is suitable for a person will depend upon their specific situation. For example, a person close to retirement will have a higher allocation to safer investments such as debt and lower allocation to equity. On the other hand, an individual in the high income period whose goals are far away will prefer to earn higher returns with assets such as equity rather than lower risk assets with lower returns. The suitable asset allocation is a function of the investment period available to the investor and their ability to take risk.

Asset allocation leads to different asset categories being included in a portfolio. This brings diversification to the portfolio. Diversification means having a combination of investments in a portfolio in such a way that a fall in the value on one or few will be made up by other investments that are doing well. The benefit of diversification will be available to a portfolio only if the selection of investments is done with care so that they do not rise and fall together.

Asset allocation and diversification reduces the risk of loss in a portfolio and stabilizes the returns that the portfolio generates.

 Review and Rebalancing 

The investments made for the goals will require to be reviewed periodically. The review is necessary to answer the following questions:

• Are all the goals still relevant?
• Are the goals on target for achievement in the required time frame?
• Are the investments performing as expected?
• Do the investments need to be changed if it is no longer suitable for the goal?

A periodic review will help identify problem areas and enable early corrective action. For example, if an investment has not generated returns as expected, the goal may remain under-funded. The investor can take the call to save more for the goal or to divert funds from some other less important goal, if required. These decisions can be made at the right time only when a review throws up the problem.

Rebalancing the portfolio involves modifying the exposure to different asset classes in an investor’s portfolio. Ideally, a portfolio should be rebalanced so that it is aligned to the risk and return requirements of the investor and reflects any change in their needs and situation, and not to benefit from short-term movements in asset prices. For example, Jayant has been saving for the education of his children for the last 8 years by investing in equity. The goal has to be met after 4 years now. Jayant would not want to leave the funds that have been accumulated in equity any more since there is a risk that the fluctuation in equity values will affect the amount that he has accumulated so far. Jayant would be ready to move the funds to less riskier investments at this stage.

Review of the portfolio of investments has to be done at least once a year as part of the financial planning process.

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