Financial planning practice

This audiovisual presentation looks briefly at current cash flow statements of income and expenditure.

(Each audiovisual opens in a new window)

 

The third step of the ISO six step financial planning process is analysing and evaluating the client's financial status, based on the information gathered and objectives established in Step 2.

Before the analysis, the client and financial planner will consider the life events that will have a major impact on the client’s financial plan, together with their timing. A ‘timeline’ can then be prepared, which creates a visual representation of these milestone future events, events which will then be incorporated into the overall financial plan.

 The timeline will of course be specific to the client and will depend on their particular objectives and personal situation, however among the most common events that appear in client timelines are:

Starting a family

Children starting (and finishing) private school and/or university

Moving house (downsizing or upsizing)

Moving to part-time working hours

Retirement

Cruise/holiday of a lifetime

Death

We will now look at the situation of fictional clients Steven and Audrey and the timeline that...

Shortened demo course. See details at foot of page.

...nd Audrey 9. The schemes are both 1/80ths schemes, with pensions based on the average salary in the last 5 years and a 50% spouse’s benefit on death. There are no funding concerns with either scheme.

Steven and Audrey have always wanted to go on a worldwide cruise and would like to do so as soon as they retire. They would ideally like to leave the family home, the shares in Steven’s father’s business and some cash and/or investments as an inheritance for their children.

Their financial planner prepares the following timeline for them:

Age

Event

34

Wedding

35

Start a family/E stop work

37

Birth of second child

40

Child 1 at Hartwood

42

Child 2 at Hartwood

49

Child 1 at uni

51

Child 2 at uni

60

Retirement and cruise

90

Care fees

99

Mortality

Behind the timeline their financial planner has built in a number of assumptions around the financial impact of each event and these will be accounted for in the lifetime cash flow analysis, which is covered later in this chapter.

The financial planner will analyse a client’s assets and liabilities before drawing up a ‘net worth statement’, which simply represents their assets less liabilities at a specific point in time.

Assets (as well as liabilities) will be broken down into different categories for the summary and analysis. For couples the ownership of each asset and liability should be made clear. Typical categories of assets are as follows:

‘Used’ or ‘Fixed’ Assets – (these are assets that are not available for financial planning today, e.g. main residence, personal effects, vehicles)

Savings

Investments

Pension funds – these would be analysed, but would usually not form part of the net worth statement as they cannot normally be accessed before age 55 (due to rise to 57 in 2028). Specific analysis of the retirement situation is covered in Chapter 3.2

Business interests

A summary of assets should give a more detailed analysis in comparison to the final net worth statement (which is usually a more high level view of assets and liabilities). For example in the assets summary the planner may choose to break down investments by tax wrapper and/or asset class but simply use totals for the net worth statement. The summary below looks at the assets of our fictional clients, Steven and Audrey:

Summary of assets – Steven and Audrey

Asset

Steven

Audrey

Joint

Total

Main Residence*

-

-

£200,000

£200,000

Personal effects

£15,000

£10,000

£10,000

£35,000

Vehicles

£14,000

£12,000

-...

Shortened demo course. See details at foot of page.

... there are factors that could potentially have a significant impact on the overall financial plan.

For savings it might also be useful to record details of interest rates, any fixed terms or regular savings being made. There are a number of different areas to analyse when it comes to investments, such as asset allocation (and how it matches the client’s risk profile), performance and tax wrappers – specific analysis of investments however will be dealt with in detail in chapter 3.2.

Steven has some shares in the family business, Polley Foods, which is now run by his younger brother Daniel. The last valuation of the business was some years ago before the economic downturn and Steven is unsure of their real worth at the moment. The valuation of £40,000 represents a 20% stake in the business, based on the last valuation of £200,000. He doesn’t plan to ever cash these shares in however and will eventually pass them down to his two sons.

As is the case with Steven it can be very difficult to value some business assets, especially unquoted shares. This is particularly true where part of the valuation is made up of goodwill and/or where the owner of the assets has little involvement in the business.

Other issues to consider when analysing assets:

Is ownership of the assets as tax-efficient as it could be? Where one of a couple pays tax at a higher rate than the other, it may be beneficial to transfer ownership of certain assets to reduce any tax due.

Are assets well diversified? Many clients may be overly reliant on their property for example, which may leave them asset-rich but cash-poor in retirement.

When summarising liabilities it will be useful to include details of the term, interest rate, monthly repayments and amount outstanding, as well as details of what the borrowing is secured on (where applicable). The most common liabilities clients tend to have are:

Mortgage(s)

Loans

Credit Cards

Car Finance

Tax liabilities

The table below shows a summary of Steven and Audrey’s liabilities:

Summary of liabilities - Steven and Audrey

Liability

Amount Outstanding

Secured on

Remaining Term (yrs)

Interest Rate (APR)

Monthly repayment

Steven

Personal Loan

£2,000

n/a

2

9%

£150

£500

n/a

n/a

15%

(min) £25

£10,000

Car

5

6%

£200

Audrey

Store Cards

£1,500

n/a

n/a

19%

(min) £25

Credit Cards

£800

n/a

n/a

15%

(min) £25

Car Loan

£8,000

Car

4

10%

£220

Joint

Mortgage

£110,000

Home

20

5%

£750

Home Improvements Loan

£11,000

n/a

6

7%

£250

Total

£143,800

£1,595

Planners should also check whether clients have any informal debts, such as loans from family members and also whether they are acting as guarantor on anyone’s behalf.

When analysing liabilities, planners will look closely a...

Shortened demo course. See details at foot of page.

...he debt each month or clearing it altogether. Where this is not possible, she could investigate transferring the balance to a cheaper alternative. Their other unsecured borrowings all have fairly reasonable interest rates and will be paid off reasonably quickly.

Of special concern will be where clients hold ‘payday loans’ – these can have outrageous four figure rates of interest and clients should be advised to clear these as quick as possible. The planner may also be able to assist the client(s) in obtaining cheaper borrowing, particularly where payday loans are concerned.

Business Liabilities

Some clients will also have business liabilities which the planner will need to factor in. The level of personal liability which the client has in relation to these will depend on the type of business in question:

Sole Traders: Sole traders have unlimited personal liability for any debts or claims against the business.

Partnerships: Partners have unlimited personal liability for both their own and their partner’s share of any business debts or claims.

Limited Companies or Limited Liability Partnerships (LLPS): Individuals are not personally liable for the debts of the business, which will be limited to the assets of the limited company or LLP. These types of company offer the greatest level of protection for personal assets (unless a personal guarantee has been provided).

The net worth statement brings together the main details from the summaries of assets and liabilities to provide an overall net worth figure. As mentioned before this is usually a more high level view, compared to the specific asset and liability summaries, and focuses mainly on ownership and the main asset types. Below is a net worth statement for Steven and Audrey, at the current point in time, based on the assets and liabilities detailed earlier:

Current net worth statement - Steven and Audrey

ASSETS

Steven

Audrey

Joint

Total

Main Residence

-

-

£200,000

£200,000

Personal effects

£15,000

£10,000

£10,000

£35,000

Vehicles

£14,000

£12,000

-

£26,000

Total Used Assets

£261,000

Cash Deposits

£45,000

£60,000

-

£105,000

Investments

£35,000

£15,000

£70,000

£120,000

Total Savings and Investments

£225,000

Shareholding in Polley Foods

£40,000

-

-

£40,000

Total Business Interests

£40,000

TOTAL ASSETS

£149,000

£97,000

£280,000

£526,000

LIABILITIES

Mortgages

-

-

£110,000

£110,000

Secured Loans

£10,000

£8,000

-

£18,000

Unsecured Loans

£2,000

-

£11,000

£13,000

Credit/Store Cards

£500

£2,300

-

£2,800

TOTAL LIABILITIES

£12,500

£10,300

£121,000

£143,800

NET WORTH

£136,500

£86,700

£159,000

£382,200

Analysis

Steven and Audrey are reasonably well-diversified in terms of assets and have investible capital of £225,000 at the moment, spread across a number of different holdings.

With Audrey being a basic rate taxpayer and Steven a higher rate taxpayer, they should consider switching Steven’s bank deposits and investments to Audrey’s name to reduce the potential tax liabilities, as well as the joint holdings.

The shareholding in Polley Foods is likely to be highly illiquid and could be over or undervalued

At the moment borrowings represent around 27% of total assets, which is not too high a level of gearing to cause concern.

Earned Income

The main source of pre-retirement income for most clients will be earned income and the planner should take into account the following when considering earned income:

Basic Salary/Self-employed income - for self-employed earnings the planner may want to use an average of the last three year's net profit

Bonuses/Commission - what are they based on? How much are they likely to fluctuate from year to year?

Employer Benefits - such as a company car, private medical insurance, income protection or life cover. Many benefits in kind are taxable and some will need to be replaced if the client retires, moves jobs or becomes unemployed. The level of employer sick pay also needs to be considered

Tax Position - how much tax and National Insurance is being paid?

Job Security- how safe is their job?

Investment Income

Income from investments can often be more variable than earned income, for example dividends received from equities or variable rate cash deposits. Planners will generally use the most recent income received for the cash flow statement unless they anticipate a change. 

The planner also needs to decide whether investment income is included or not – if dividends from collectives are reinvested (or arise from accumulation units or sh...

Shortened demo course. See details at foot of page.

...g to a cheaper mortgage, reducing the cost of their borrowing or getting a better deal on their utilities. Any savings made can be put towards meeting some of their financial goals or paying off debts. Tax and National Insurance liabilities will often be included under expenditure; however some planners prefer to use net figures (as in our example in the audiovisual presentation). Steven and Audrey’s expenditure is detailed in their current cash flow statement in section 3.1.8.

Summary

Clients with steady, predictable incomes will have different needs to those with more volatile levels of earnings. The latter may require more flexible arrangements, such as a flexible mortgage where payments can be varied or flexible banking and overdraft facilities. They are also likely to require higher cash reserves to see them through any periods where earnings are significantly lower than usual.

Those with worries around job security or future self-employed profits would be advised to be more cautious, particularly when considering any borrowing, and should also seek to build up cash reserves as a precaution. Self-employed clients or employed clients with little or no employer benefits may have shortfalls in areas such as income protection, which the planner will bring to their attention.

The current cash flow statement brings together all of the information gathered on income and expenditure and produces a net cash flow figure (either a surplus net income or shortfall). The statement will summarise income and expenditure under several main categories, although these categories can vary from client to client. The net cash flow figure, if in surplus, can then be used to help fund planning for the client's goals, together with any savings that can be made from discretionary expenditure.  Expenditure can be split between fixed and discretionary in the statement or the planner can simply record how much of the overall expenditure is discretionary as a separate item.

Cash flow statements are typically produced for an annual period, however those clients with more variable income and/or expenditure may require more frequent statements. For analysis purposes some planners calculate how much each category represents as a percentage of total income/expenditure, as in our audiovisual presentation.

Example cash flow statement (not including savings income):

  

£ (per annum)

Salary - Steven

73,895

Salary - Audrey

25,067

Total income

98,962

Income tax on salary (Steven)

17,060

National Insurance on salary (Steven)

5,851

Income tax on salary (Audrey)

2,527

National Insurance on salary (Audrey)

1,743

Mortgage

9,000

Council tax/rates

2,500

Home insurance

500

Utilities

3,000

Other household expenditure

1,800

Food

9,000

Car loans

5,040

Other Car (tax, petrol, insurance, servicing etc)

5,000

Pet costs (food, insurance, grooming)

750

Mobile phones

1,500

Unsecured debt repayments

5,100

Clothing

6,000

Holidays

5,000

Insurance (excl home & car insurance)

2,000

Eating out

3,600

Gym memberships

1,200

Other leisure

3,200

Christmas/birthday presents

2,800

Domestic help

2,400

Total expenditure

96,571*

Net cash flow

+2,391

*of this figure £10,000 has been determined as discretionary expenditure

Analysis

Steven and Audrey currently spend nearly all of their income, leaving very little available to put towards trying to achieve any financial planning goals

When Jacob and Matthew start private school in 2 years time there will certainly not be enough income to fund this and Steven and Audrey will have to start calling on their available capital. The lifetime cash flow statement can be used to demonstrate the effect of this to the clients

They are prepared, however, to look at reducing their discretionary expenditure  by cutting down on eating out, holidays, other leisure (satellite TV and magazine subscriptions) and gym membership

Their planner doesn’t believe that any significant savings can be made on their borrowings

The current cash flow statement can then form the basis for the lifetime cash flow statement and various ‘what if' scenarios.

Financial planners use lifetime cash flow statements to project income and expenditure for the remainder of a client's (expected) lifetime, year by year. The lifetime cash flow will also factor in available capital (i.e. savings and investments) and, where there is an income shortfall in a given year, the cash flow will use any capital available to plug it. Similarly where there is a surplus income this can be added to the capital balance, unless the likelihood is that it will just be spent by the client.

The lifetime cash flow enables the planner to look ahead and try to predict any future shortfalls – most commonly this is used to ascertain whether or not the clients’ standard of living can be maintained in retirement. This would be particularly useful for clients planning to use drawdown from their pension to fund their retirement, which will likely become much more common given recent changes in pension legislation. Often shortfalls arise where the client wishes to retire on a certain income which is fairly high in relation to the size of the pension fund. In these cases the lifetime cash flow will often show that the income will run out altogether at some point during their retirement and so the alternatives will be to revise desired income levels in retirement, defer retirement age or save more towards retirement.

It is important to bear in mind that lifetime cash flows are not appropriate for all clients and should only be used if they add some value to the overall planning. They are also likely to require frequent revision as they are based on a large number of assumptions, which are very difficult (if not impossible) to accurately predict. In addition client circumstances and potentially their objectives will also change with time. Typically these revisions will be made at the annual review stage but other events may trigger revisions as well.

The main assumptions to be made will be around:

Life expectancy

Future income and expenditure streams

Future investment returns

Inflation

Capital and asset values

Timing of major life events (see earlier Timeline section)

Cash from other sources - as well as income, cash may arise from other sources such as an inheritance or the sale of a house or business.   

Nowadays many financial planners prefer to use specialist software to generate their lifetime cash flow statements, particularly where they are looking for a more impressive graphical output. Statements can however be prepared using a simple spreadsheet, with very good results.

We will now look at a lifetime cash flow for Steven and Audrey to determine whether or not they are likely to enjoy their desired standard of living in retirement, or whether they are more likely to run out of ...

Shortened demo course. See details at foot of page.

...e. by the time Jacob’s university costs start they will have a value of £13,095 and £14,763 when they end 4 years later

For convenience we have assumed that all other items of expenditure, as noted in the current cash flow statement, remain the same throughout Steven and Audrey’s lifetime (with the exception of debt repayments, which will be repaid as per the timescale indicated in the liabilities section).

Steven and Audrey’s lifetime cash flow statement

The table below shows the figures year by year for analysis, with a graphical display of the cash flow following afterwards (which is more presentable to clients). Please note that investment capital refers to their liquid assets (investments and savings).

 

Analysis

Steven and Audrey would run out of capital at age 75, based on the current projections and assumptions, so have a serious issue to address  assuming they live to 90

There would be no means of funding the deficit from age 75 onwards for the rest of their lives and they would have to consider downsizing the family home (which they want to pass on to the children), amongst other measures

Steven and Audrey could look at reducing their discretionary expenditure, which is reasonably high. The savings could then be redirected into a pension arrangement in order to increase income at retirement

Various ‘what if’ scenarios can be modelled for Steven and Audrey, based on the original lifetime cash flow, showing what would happen if they reduced expenditure by £x and increased saving for retirement by £y

This table takes no account of the State pension – with an aging population, it would be optimistic to assume the State pension will survive in its current form

In addition to the ‘main’ lifetime cash flow, alternate lifetime cash flows may be run for clients using assumptions on both the higher and lower side to demonstrate the effects on the overall financial plan.

Contingent cash flow analyses

A contingent cash flow or ‘what if' analysis can be produced by altering the inputs from the lifetime cash flow to project the effects of various scenarios, such as the client or their spouse/partner suffering a serious illness, unemployment or passing away.

These analyses will help the planner identify any shortfalls in these areas and determine whether or not additional provision is needed. Recommendations to address these shortfalls will then follow at the next stage of the process (Step 4)

The chart below shows one way that financial planners might display lifetime cash flows for their clients, based on Steven and Audrey’s statement, although there are many different formats used:

 

 

In this chapter we have looked at how financial planners analyse assets, liabilities, income and expenditu...

Shortened demo course. See details at foot of page.

... detail, looking at financial protection, investments, retirement provision and the client’s estate.

This revision test (opens in a new window) ...

Shortened demo course. See details at foot of page.

...test will be added to your CPD certificate.