FIN3337-Personal Financial Planning Chapters 1-3

100 Pages·2009·20.89 MB·English

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Lindsay is a student who has accrued a lot of debt over the past year.
She is so overwhelmed she doesn’t know where to begin.
OH MY GOSH...
I just can't seem to
make ends meet! I need to I wonder what
get all of this in order and GJ11 would do...
come up with some kind
of plan.
PART 1 Foundations of
Financial Planning
Chapter 1 Understanding the Financial Planning Process
Chapter 2 Developing Your Financial Statements and Plans
Chapter 3 Preparing Your Taxes
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Understanding the Financial
Planning Process
CHAPTER 1 L E A R N I N G G O A L S
LG1 Identify the benefits of using personal financial planning
techniques to manage your finances. p. 2
LG2 Describe the personal financial planning process
and define your goals. p. 6
LG3 Explain the life cycle of financial plans and their role
in achieving your financial goals. p. 13
LG4 Examine the economic environment’s influence on
personal financial planning. p. 18
LG5 Evaluate the impact of age, education,
and geographic location on personal income. p. 22
LG6 Understand the importance of career choices and their
relationship to personal financial planning. p. 22
LG1 THE REWARDS OF SOUND FINANCIAL PLANNING
What does living “the good life” mean to you? Is it owning a home in a certain part of town,
starting a company, being debt free, driving a particular type of car, taking luxury vacations, or
having a large investment portfolio? Today’s complex, fast-paced world offers a bewildering
array of choices. Add to this a rapidly changing economic, political, technological, and social
environment, and it’s easy to see why developing solid financial strategies, guaranteed to
improve your lifestyle, is increasingly difficult. Today a couple may need two incomes just to
maintain an acceptable standard of living, and they may have to wait longer to buy a home.
Clearly, no matter how you define it, the good life requires sound planning to turn financial
goals into reality.
The best way to achieve financial objectives is through personal financial planning. It
helps us define our financial goals and develop appropriate strategies to reach them. We can
no longer depend on employee or government benefits such as steady salary increases, or
adequate funding from employer-paid pensions or Social Security, to retire comfortably.
Creating flexible plans and regularly revising them is the key to building a sound financial
future. And successful financial planning brings rewards, such as an improved standard of liv-
ing, wise spending habits, and increased wealth. Of course, planning alone does not guaran-
tee success; but having an effective, consistent plan can help you use your resources wisely.
The goal of this book is to remove the mystery from the personal financial planning
process and replace it with the tools you need to take charge of your personal finances
and your life. To organize this process, the text is divided into six parts:
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• Part 1: Foundations of Financial Planning
• Part 2: Managing Basic Assets
FINANCIAL
• Part 3: Managing Credit
ROAD SIGN
• Part 4: Managing Insurance Needs
• Part 5: Managing Investments
EVALUATE YOUR PERSONAL WEALTH
• Part 6: Retirement and Estate Planning
Use these seven steps to assess your cur-
rent wealth and monitor it in the future. Each part explains a different aspect of personal financial planning
1. Calculate your net worth (see Chapter as shown in Exhibit 1.1. This organizational scheme revolves around
2). financial decision making that’s firmly based on an operational set of
2. Compare your net worth with others in financial plans. We believe that through sound financial planning, individ-
your age and income bracket.
3. Compare your earnings with others in uals can make decisions that will produce their desired results. Starting
your field. with Part 1, where we look at personal financial statements, plans, and
4. Compare your investment assets. taxes, we move through the various types of decisions you’ll make
5. Examine your spending habits. when implementing a financial plan.
6. Total up your debt.
7. Review your results and adjust your
financial plan accordingly. Improving Your Standard of Living
With personal financial planning we learn to acquire, use, and control
Source: Adapted from Walter Updegrave, our financial resources more efficiently. It allows us to gain more enjoy-
“How Are You Doing?” Money, July 1999,
pp. 63–73. ment from our income and thus improve our standard of living—the
necessities, comforts, and luxuries we have or desire.
Americans view standards of living and what constitutes necessities
and luxuries differently depending on their level of affluence. For example, 45 percent of
Americans consider a second or vacation home the ultimate symbol of affluence, while
others see taking two or more annual vacations or living in an exclusive neighborhood as
an indicator of wealth.
So our quality of life is closely tied to our standard of living. Although other factors—
geographic location, public facilities, local cost of living, pollution, traffic, and population
density—also affect quality of life, wealth is commonly viewed as its primary determinant.
The presence or absence of material items such as a house, car, and clothing, and having
money available for healthcare, education, art, music, travel, and entertainment, contribute
to our quality of life. Of course, many so-called wealthy people live “plain” lives, choosing
to save or invest or support philanthropic organizations with their money, rather than
standard of living The indulge themselves with luxuries.
necessities, comforts, and
luxuries enjoyed or desired One trend with a profound effect on our standard of living is the two-income family.
by an individual or family. What was relatively rare in the early 1970s has become commonplace today, and the
EXHIBIT 1.1 Organizational Planning Model
This text emphasizes making financial decisions regarding assets, credit, insurance, investments, and retirement
and estates.
Financial Actions
Financial Basic asset decisions Financial
Plans Credit decisions Results
Insurance decisions
Investment decisions
Retirement and estate decisions
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HOW AMERICANS FEEL meeting their bills. Their top financial Gender differences also affect the
priority was getting out of debt (71 way Americans think about money.
ABOUT MONEY
percent). Owning a home free and Most married adults share all their
Since World War II, inflation-adjusted clear (52 percent) and taking one lux- money, but 28 percent of women and
income has nearly tripled and the ury vacation every year (33 percent) 20 percent of men maintain separate
size of new homes has more than were two other important goals. accounts. Women tend to be more
doubled. Yet polls show that the The rich are not so different from conservative and less confident than
wealthiest Americans aren’t any hap- the average American. They want big- male investors, but 80 percent of
pier than those with less money. At ger financial cushions (85 percent) and women say they’re more knowledge-
an annual income of about $50,000, have significant debt loads (42 percent able about investing than they were 5
the happiness curve flattens out. are spending less so they can pay off years ago. Historically most women
However, a sense of control over bills). Their most pressing financial weren’t involved in their families’
finances does correlate with happi- concerns were retirement planning (34 financial planning, but their role is
ness. To feel secure (and happy), percent), wealth accumulation (19 per- evolving as more (63 percent) partici-
Americans need to have enough cent), and supporting their families (18 pate in investment decisions.
money to retire, buy things they percent). Most of the rich consider
want, and cope with a financial set- themselves middle class, not wealthy. Critical Thinking Questions
back. These and other poll findings They say they need $2.5 million to feel 1. What, if any, is the correlation
offer insights into our attitudes wealthy and the best ways to increase between income and happiness?
toward money matters. wealth are to invest in real estate (19 2. What are some common finan-
According to a recent survey on percent), get a professional degree (15 cial concerns of Americans today?
Americans and their money, 54 per- percent), inherit money (14 percent), 3. What role does gender play in
cent of adults said one of their biggest invest in stock (12 percent), or start a how Americans think about
money pressures right now is just business (12 percent). money?
Sources: Marion Asnes with Andy Borinstein and Douglas King, “The Changing Face of Affluence,” Money, September 27, 2002, p. 42; Gini Kopecky Wallace,
“Can Money Buy Happiness?” Family Circle, April 15, 2003, pp. 64–68; Jean Sherman Chatzky, “Women & Money,” Money, June 1, 2002, p. 150; Jean Sherman
Chatzky, “The 10 Commandments of Financial Happiness,” Money, October 1, 2003, p. 113.
incomes of millions of families have risen sharply as a result. Seventy-five percent of mar-
ried adults say they and their mate share all their money, while some partners admit to
having a secret stash of cash. Two incomes buy more but also require greater responsibil-
ity to manage the money wisely and coordinate the partners’ financial and career goals.
Spending Money Wisely
Using money wisely is a major benefit of financial planning. Whatever your income, you
can either spend it now or save some of it for the future. Determining your current and
future spending patterns is an important part of personal money management. The goal,
of course, is to spend your money so that you get the most satisfaction from each dollar.
Current Needs
Your current spending level is based on the necessities of life and your average propensity
to consume. A minimum level of spending would allow you to obtain only the necessities
of life: food, clothing, and shelter. Although the quantity and type of food, clothing, and
shelter purchased may differ among individuals depending on their wealth, we all need
these items to survive.
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Average propensity to consume refers to the percentage of
each dollar of income, on average, that is spent for current needs
FINANCIAL
rather than savings. Some people with high average propensities to
ROAD SIGN
consume earn low incomes and spend a large portion of it for basic
necessities. On the other hand, many “ultraconsumers” choose to
SAVING 101
splurge on a few items and scrimp elsewhere. These people also
1. Do have an emergency account big exhibit high average propensities to consume. Conversely, individuals
enough to cover your core expenses for earning large amounts quite often have low average propensities to
3-6 months.
2. Don’t buy in response to unsolicited consume, because the cost of necessities represents only a small
sales pitches. part of their income.
3. Do use your own bank’s ATM. Still, it’s not unusual to find two people with significantly different
4. Don’t put off paying your credit card incomes but the same average propensity to consume due to differ-
bills! Late fees account for almost one- ences in their standard of living. The person making more money may
third of credit card issuers’ profits.
5. Do save for retirement through auto- believe it is essential to buy better-quality items or more items and will
matic payroll deductions—and add half thus, on average, spend the same percentage of each dollar of income
of every bonus or raise to your savings. as the person making far less. The Money in Action box on page 4
6. Don’t make impulse purchases. reveals some of our attitudes toward getting and keeping wealth.
7. Do opt out of preapproved credit offers at
http://www.optoutprescreen.com or Future Needs
by calling the Credit Reporting Industry at In any carefully developed financial plan, you should set aside a por-
1-888-567-8688. The more credit you tion of current income for deferred, or future, spending. Placing
have, the more you’ll be tempted to use.
these funds in various savings and investment vehicles allows you to
Source: Adapted from Lynn Brenner, “A Budget generate a return on your funds until you need them. For example,
You Can Live With,” Parade, January 19, 2003. you may want to build up a retirement fund to maintain a desirable
standard of living in your later years. Instead of spending the money
now, you defer actual spending until the future when you retire.
Thirty-four percent of Americans say retirement planning is their most pressing financial
concern. Other examples of deferred spending include saving for a child’s education, a
primary residence or vacation home, a major acquisition (such as a car or home enter-
tainment center), or even a vacation.
The portion of current income we commit to future needs is a function of how much
we earn and our average propensity to consume. Forty-five percent of affluent Americans
say they need at least $2.5 million to feel rich. The more we earn and the less we devote
to current spending, the more we can commit to meeting future needs. In any case, some
portion of current income should be set aside regularly for future use. This practice cre-
ates good saving habits.
average propensity to
consume The percentage
of each dollar of income,
on average, that a person Accumulating Wealth
spends for current needs In addition to using current income to pay the everyday expenses of living, we spend it to
rather than savings.
acquire assets such as cars, a home, or stocks and bonds. Our assets largely determine
wealth The total value of how wealthy we are. Personal financial planning plays a critical role in the accumulation of
all items owned by an indi-
vidual, such as savings wealth by helping to direct our financial resources to the most productive areas.
accounts, stocks, bonds, As a rule, a person’s wealth is a function of the total value of all the items he or
home, and automobiles. she owns. Wealth consists of financial and tangible assets. Financial assets are
financial assets intangible, paper assets, such as savings accounts and securities (stocks, bonds,
Intangible assets, such as mutual funds, and so forth). They are earning assets that are held for the returns they
savings accounts and securi-
ties, that are acquired for promise. Tangible assets, in contrast, are physical assets, such as real estate and
some promised future automobiles, that can be held for either consumption (like your home, car, artwork, or
return. jewelry) or investment purposes (like the duplex you bought for rental purposes). In
tangible assets Physical general, the goal of most people is to accumulate as much wealth as possible while
assets, such as real estate maintaining current consumption at a level that provides a desired standard of living.
and automobiles, that can
be held for either consump- To see how you compare with the typical American in financial terms, check out the
tion or investment purposes. statistics in Exhibit 1.2.
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EXHIBIT 1.2 The Average American, Financially Speaking
This financial snapshot of the “average American” gives you an idea of where you stand in terms of income, net
worth, and other measures. It should help you set some goals for the future.
Income and Assets
What Do We Earn? (average)
All familes $ 70,700
Self-employed 141,500
Retired 43,200
What Are We Worth? (average)
All familes $ 448,200
Self-employed 1,423,200
Retired 469,000
Home Ownership (average)
Value of primary residence $246,800
Equity in primary residence 61,200
Mortgage on primary residence 185,600
How Much Savings Do We Have? (average)
Mutual funds $14,700
Individual stocks 17,600
Bank accounts 13,200
Retirement accounts 32,000
Source: Adapted from Brian K. Buck, Arthur B. Kennickell, and Kevin B. Moore, “Recent Changes in U.S. Family Finances: Evidence from the 2001 and
2004 Survey of Consumer Finances,” Federal Reserve Bulletin, Board of Governors of the Federal Reserve System, Washington, D.C., February 2006,
http://www.federalreserve.gov/pubs/oss/oss2/2004/bullo206.pdf.
Concept Check
E P T C H E C K • C O N C E P T C H E C K • C O N C E P T C H E C K • C O N C E P T C H E C K • C O N C E P T C H E C K • C O N C E P T C H E C K • C O N C E P T C H E C
1-1 What is a standard of living? What factors affect the quality of life?
1-2 Are consumption patterns related to quality of life? Explain.
1-3 What is average propensity to consume? Is it possible for two people with very
different incomes to have the same average propensity to consume? Why?
1-4 Discuss the various forms in which wealth can be accumulated.
LG2 THE PERSONAL FINANCIAL PLANNING PROCESS
Many people erroneously assume that personal financial planning is only for the wealthy
when nothing could be further from the truth. Whether you have a lot of money or not
enough, you still need personal financial planning. If you have enough money, planning can
help you spend and invest it wisely. If your income seems inadequate, taking steps to plan
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your financial activities will lead to an improved lifestyle. This is what personal financial
planning is: a systematic process that considers the important elements of an individual’s
financial affairs and is aimed at fulfilling his or her financial goals.
Everyone needs to develop a personal financial plan—including recent college gradu-
ates, single professionals, young married couples, single parents, mid-career married
breadwinners, and senior corporate executives. Knowing what you need to accomplish
financially, and how you intend to do it, gives you an edge over someone who merely
reacts to financial events as they unfold.
For example, purchasing a new car immediately after graduation may be an important
goal for you. But buying a car is a major expenditure involving a large initial cash outlay and
additional consumer debt that must be repaid over time. Therefore it warrants careful plan-
ning. Evaluating, and possibly even arranging, financing before your shopping trip, as
opposed to simply accepting the financing arrangements offered by an auto dealer, might
save you a considerable amount of money. Moreover, some dealers advertise low-interest
loans but charge higher prices for their cars, so knowing all your costs in advance can help
you identify the best deal. Using personal financial planning concepts to reach all your
financial goals will bring similar positive benefits.
Steps in the Financial Planning Process
Take a closer look at financial planning, and you’ll see that the process translates personal
financial goals into specific financial plans and then helps you implement those plans through
financial strategies. The financial planning process involves the six steps shown in Exhibit 1.3.
personal financial plan- In effect, the financial planning process runs full circle. You start with financial goals,
ning A systematic process formulate and implement financial plans and strategies to reach them, monitor and control
that considers important progress toward goals through budgets, and use financial statements to evaluate the plan
elements of an individual’s
financial affairs in order to and budget results. This leads you back to redefining your goals to better meet your cur-
fulfill financial goals. rent needs, and to revising your financial plans and strategies accordingly.
EXHIBIT 1.3 The Six-Step Financial Planning Process
The financial planning process translates personal financial goals into specific financial plans and strategies, implements
them, and then uses budgets and financial statements to monitor, evaluate, and revise plans and strategies as needed.
This process typically involves the six steps shown in sequence here.
1. Define financial goals.
H E C
2. Develop financial plans and strategies to achieve goals.
3. Implement financial plans and strategies.
4. Periodically develop and implement budgets to monitor and control progress toward goals.
5. Use financial statements to evaluate results of plans and budgets, taking corrective action as required.
6. Redefine goals and revise plans and strategies as personal circumstances change.
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Let’s now look at how goal setting fits into the planning process. In Chapters 2 and 3,
we’ll consider other information essential to creating your financial plans: personal financial
statements, budgets, and taxes.
Defining Your Financial Goals
Financial goals are results that an individual wants to attain, such as buying a home,
building a college fund, or achieving financial independence. What are your financial goals?
Have you spelled them out? Without financial goals, it’s impossible to effectively manage
your financial resources. We need to know where we are going, in a financial sense, to
effectively direct the major financial events in our lives. Perhaps achieving financial inde-
pendence at a relatively early age is important to you. If so, then activities such as saving,
investing, and retirement planning will be an important part of your finan-
cial life. Your financial goals or preferences must be stated in monetary
FINANCIAL terms because money, and the utility (defined later) it buys, is an integral
ROAD SIGN part of financial planning.
The Role of Money
GETTING YOUR FINANCIAL ACT
TOGETHER About 80 percent of Americans believe that money is power, and about
75 percent say that it is freedom. Money is the medium of exchange
Will this be the year you finally straighten
used as a measure of value in financial transactions. Without the stan-
out your finances? Here are five important
things you can do to get your financial act dard unit of exchange provided by the dollar, it would be difficult to set
together: specific personal financial goals and measure progress toward achieving
1. Start keeping good financial records. them. Money, as we know it today, is the key consideration in establish-
2. Put together a realistic budget you can ing financial goals, yet it’s not money as such that most people want. We
live with.
want the utility, the amount of satisfaction received from buying certain
3. Save for a specific goal by paying your-
self first. types or quantities of goods and services, that money makes possible.
4. Begin saving seriously for retirement. People may choose one item over another because of a special feature
5. Set up an emergency fund. that provides additional utility. For example, many people will pay more
for a car with satellite radio than one with only a CD player. The added
utility may result from the actual usefulness of the special feature, or
from the “status” it’s expected to provide, or both. Regardless, people receive varying lev-
els of satisfaction from similar items, and their satisfaction isn’t necessarily related to the
cost of the items. When evaluating alternative qualities of life, spending patterns, and
Is getting the lowest forms of wealth accumulation, we need to consider utility along with cost.
price important to you?
Go to http://www The Psychology of Money
.thomsonedu.com/ Money and its utility are not only economic concepts; they’re also closely linked to the psy-
finance/gitman for Web chological concepts of values, emotion, and personality. Your personal value system—the
sites where you can ideals and beliefs you hold important and use to guide your life—will also shape your attitude
search for the best toward money and wealth accumulation. If status and image are important to you, you may
prices, both online
and off. spend a high proportion of your current income to acquire luxuries. If you place a high value
on family life, you may choose a career that offers regular hours and less stress, or an
employer who offers flextime rather than a higher-paying position requiring travel and lots of
overtime. You may have plenty of money but choose to live frugally and do things yourself
financial goals Results that rather than hire someone to do them for you. Clearly then, financial goals and decisions are
an individual wants to attain, consistent with your personal values. By identifying your values, you can formulate financial
such as buying a home, plans that provide the greatest personal satisfaction and quality of life.
building a college fund,
or achieving financial Money is a primary motivator of personal behavior because it has a strong effect on
independence. self-image. Each person’s unique personality and emotional makeup determine the impor-
money The medium of tance and role of money in his or her life. Depending on timing and circumstances, emo-
exchange used as a measure tional responses to money may be positive—such as love, happiness, and security—or
of value in financial negative—such as fear, greed, and insecurity. For example, some people feel satisfaction
transactions.
in their work when they receive a paycheck. Others feel relief in knowing that they can
utility The amount of pay past-due bills. Still others worry over what to do with the money. Some young people
satisfaction received from
purchasing certain types have a negative attitude toward money. You should become aware of your own attitudes
or quantities of goods toward money because they are the basis of your “money personality” and money man-
and services. agement style. Exhibit 1.4 explores American attitudes toward money.
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EXHIBIT 1.4 Does Money Equal Happiness?
Money. Would life be sweeter if we had more of it? The answer is . . . maybe.
• 77 percent of adults believe that America is the land of financial opportunity.
• 85 percent agree that the rich get richer and the poor get poorer.
• 94 percent believe that corporate greed is out of control.
• 76 percent of Americans believe that money can’t buy happiness.
• 84 percent of adults believe that Americans worship money.
• 70 percent say the love of money is the root of all evil.
• 29 percent chose being healthy over being rich.
• 70 percent of adults say it’s as easy to love a rich person as a poor one.
• 69 percent say they are doing better than their parents did.
• 40 percent of seniors say they feel financially secure.
Source: Reprinted with permission of FAMILY CIRCLE magazine.
Some questions to ask yourself are: How important is money to you? Why? What types
of spending give you satisfaction? Are you a risk taker? Do you need large financial reserves
to feel secure? Knowing the answers to these questions is a prerequisite to developing real-
istic and effective financial goals and plans. For example, if you prefer immediate satisfac-
tion, you will find it more difficult to achieve long-term net worth or savings goals than if you
are highly disciplined and primarily concerned with achieving a comfortable retirement at an
early age. Clearly, trade-offs between current and future benefits are strongly affected by val-
ues, emotions, and personality. Effective financial plans are both economically and psycho-
logically sound. They must not only consider your wants, needs, and financial resources but
also realistically reflect your personality and emotional reactions to money.
Money and Relationships
The average couple spends between 250 and 700 hours planning their wedding, and they
spend an average of about $20,000 on the big day. But with all the hoopla surrounding the
wedding day, many couples overlook one of the most important aspects of marriage—
financial compatibility. Money can be one of the most emo-
tional issues in any relationship, whether with a partner, your
parents, or children. Most people are uncomfortable talking
about money matters and avoid such discussions, even with
their partners. However, differing opinions of how to spend
money may threaten the stability of a marriage or cause
arguments between parents and children. Learning to com-
municate with your partner about money is a critical step in
developing effective financial plans.
Your parents will play an important role in your financial
planning. As they age, you may have to assume greater
responsibility for their care. Do you know what healthcare
coverage and financial plans they have in place? Where do
they keep important financial and legal documents? What
preferences do they have for healthcare should they become
incapacitated? Asking these questions may be difficult, but
having the answers will save you many headaches.
As we noted earlier, there are many distinct money personality types. One person may
be analytical and see money as a means of control, another may use it to express affec-
tion, and yet another may use it to boost self-esteem. When couples have very different
attitudes toward money—for example, if one person likes to prepare detailed budgets but
the other is an impulse shopper—conflicts are bound to arise.
The best way to resolve money disputes is to be aware of your partner’s financial
style, keep the lines of communication open, and be willing to compromise. It’s highly
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unlikely that you can change your partner’s style—or your own, for that
matter—but you can work out your differences. Financial planning is an
FINANCIAL
especially important part of the conflict resolution process.
ROAD SIGN
To gain a better understanding of your differences, work together to
establish a set of financial goals that takes into account each person’s
PLANNING TO REPAY STUDENT DEBT
needs and values. For instance, you may be a risk taker who likes to
The level of student debt continues to grow speculate in the stock market, while your more cautious partner wants to
in response to increases in college tuition. put all your money into a savings account in case one of you loses your
According to the 2003–2004 National
Postsecondary Student Aid Study: job. If you can agree on the amount of money you should have readily
available in low-risk investments and savings accounts, you can then allo-
• Two-thirds (65.6 percent) of undergradu- cate a specific portion of your funds to riskier investments.
ate students graduate with some debt.
• The average federal student loan debt
among graduating seniors is $19,202. Types of Financial Goals
• One-quarter of undergraduate students
borrow $24,936 or more. Financial goals cover a wide range of financial desires—from controlling living
• One-tenth of undergraduate students expenses to meeting retirement needs, from setting up a savings and invest-
borrow $35,193 or more. ment program to minimizing your taxes. Other important financial goals
• The additional debt for a graduate include having enough money to live as well as possible now, being finan-
degree ranges from $27,000 to cially independent, sending children to college, and providing for retirement.
$114,000.
Financial goals should be defined as specifically as possible. Saying
Financial planning can play an important that you want to save money next year is not a specific goal. How much
role in reducing the high and increasing do you want to save, and for what purpose? A goal such as “save 10 per-
levels of debt that students have at
graduation. cent of my take-home pay each month to start an investment program”
states clearly what you want to do and why.
Because they’re the basis of your financial plans, your goals should be
realistic and attainable. If you set your savings goals too high—for example, 25 percent of your
take-home pay when your basic living expenses already account for 85 percent of your take-
home pay—your goal is unattainable and there’s no way to meet it. But if savings goals are set
too low, you may not accumulate enough for a meaningful investment program. If your goals
are pipe dreams, they’ll put the basic integrity of your financial plan at risk and be a source of
EXHIBIT 1.5 Financial Planning Reality Check
How realistic are your assumptions about your financial future? Take this reality check and see.
Assumption 1: You need only 75 percent of your preretirement income to maintain a comfortable lifestyle
after you retire.
Reality: That figure is more likely to be 100 percent, because health costs are increasing, outpacing
any savings gained by eliminating work-related expenses.
Assumption 2: You’ll cover 50 percent or more of your living expenses with your pension and Social Security.
Reality: Social Security and company pension plan payments are decreasing, so anticipate using your
401(k) and other retirement savings for living expenses.
Assumption 3: You can retire at 60.
Reality: You’ll need more savings than you think to stretch your retirement nest egg over your life
expectancy. If you can’t save more, you’ll need to retire later or work part-time after retirement.
Assumption 4: It takes a few thousand dollars a year to accumulate enough to finance your child’s college
education.
Reality: College costs are climbing faster than inflation. You’ll need to save at least $260,000 to fund
your newborn’s private college education. Investigate state-sponsored 529 college savings
plans or expect to use loans.
Assumption 5: A 3-month emergency fund provides enough financial cushion.
Reality: Six months is the minimum, and a year is better, especially if your industry is prone to layoffs.
It takes more than 4 months on average to find a new job.
Source: Adapted from Janice Revell, “Your Financial Reality Checkup,” Fortune, June 16, 2003, pp. 90–96.
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Understanding the Financial Planning Process
Cengage Learning