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The Six Steps of the Personal Financial Planning Process
The financial planning process can be thought of as a science, where a logical step by step process is taken to assist you in achieving your financial goals. Generally there are six specific steps to the financial planning process. These six steps may vary slightly from one source to another, however they are generally as follows.
- Establish and define the relationship with your advisor
- Assess your current financial situation and determine your goals and objectives
- Analyze and evaluate your financial status
- Present recommendations
- Implementation of recommendations
- Periodic review
Note that some of these steps may be worked on at the same time as these steps are generally interrelated.
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Step 1 - Establish and define the relationship with your advisor
When establishing a new relationship with an advisor it is important that you clearly understand what financial planning services are to be provided to you. It is also important that you understand what services cannot be provided to you by your advisor and must be provided instead by outside professionals.
Additional issues that should be discussed and mutually agreed upon are:
- Fees that will be charged for the financial planning services;
- Who will be responsible for fees charged for services rendered by external professionals;
- Expected time frame in which the various services will be completed;
- Frequency of annual plan reviews and any costs associated with these plan reviews and any required plan amendments.
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Step 2 - Assess your current financial situation and determine goals and objectives
At this stage, both quantitative and qualitative information should be gathered and goals and objectives set.
Examples of the quantitative information that should be gathered would include:
- Personal and family information (i.e. names, birth dates, etc);
- Net Worth statement (i.e. summary of all assets and liabilities and their current value);
- Cash Flow statement (i.e. summary of current income and expenses);
- Recent income tax returns;
- Most recent Notice of Assessment from the Canada Customs and Revenue Agency (CCRA);
- Most recent employee pay-slip if applicable.
The Net Worth and Cash Flow statement are cornerstones of the financial planning process and any financial projections prepared.
Gathering qualitative information is also very crucial in the financial planning process and this type of information will allow the most suitable financial planning recommendations to be made. Qualitative information can include the following:
- Risk tolerance - risk tolerance is the foundation for an appropriate investment solution;
- Family relationships and obligations - knowing which people are important and what current family obligations are (i.e. children from first marriage, plan to send daughter to Ivy League school, caring for elderly parents, disabled child, etc) can assist formulating specific recommendations;
- Familiarity with financial products - your level of sophistication and knowledge level is important for not only investment planning purposes but also other areas of financial planning such as tax planning and estate planning;
- Lifestyle and health - information on your current and future lifestyle (i.e. winters in Arizona during retirement, longevity in the family, high medical expenses, etc) can assist in formulating specific recommendations.
Gathering certain qualitative information will require you to "open up" and provide personal information to your advisor, so you should be comfortable providing this information and understand the benefit of doing so. Personal information disclosed to the advisor would be kept strictly confidential.
By identifying your goals and objectives, a target is established that you can plan towards as well as providing a means of measuring progress along the way. Goals should be attainable and measurable. Some common examples of goals and objectives are as follows:
- Retirement from employment/self-employment at age 55;
- Have enough savings and income to produce annual after-tax retirement income of $50,000;
- Save over the next five years for a downpayment of $50,000 to purchase a cottage worth $200,000;
- Meeting future education expenses for children currently aged 5 and 3;
- Eliminate all debt by age 50;
- Reducing current and future income taxes;
- Increasing investment returns to beat the index by 1%;
- Maintaining an emergency fund of three months of gross income;
- Provide 80% of current income for beneficiaries after death.
Although reasonable financial goals should be established, dream a little and push yourself when establishing targets; the process of goal setting should be fun and can be a catalyst for someone to achieve incredible success! Although, there is nothing wrong with setting lofty goals, you should be aware of the potential discipline and sacrifices that you may have to make to achieve your goals. For example, if you are adamant about buying a cottage in three years instead of five years it may mean that you have to take on a part-time job on the weekends and cut your dining out to once a month instead of four times a month. No one said that the financial planning process was going to be easy!
Once goals are established, you should consider ranking goals from most important to least important and also set reasonable time horizons for when goals should be completed.
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Step 3 - Analyze and evaluate your financial status
All the quantitative and qualitative information gathered in Step 2 should be assimilated and its time to start the process of determining if you can meet your stated financial goals and objectives. If you are unable to meet your goals then current problem areas should be identified that are hindering you in meeting these goals. Common financial problems could include:
- Unrealistic retirement age or retirement income expectations;
- Current expenditures in excess of disposable income;
- Too much or too little life insurance;
- Not taking advantage of potential income splitting opportunities;
- Investments are over or under diversified;
- Investments are too risky or too conservative based on risk tolerance and financial goals and objectives in Step 2;
- Little or no estate planning done;
- Too much high interest debt;
- No emergency fund.
One of the best methods to determine if goals are attainable is to perform financial projections using financial planning software. However, when doing any financial analysis and projections it is important that realistic assumptions are used for inflation, investment returns and tax rates. Also it's generally prudent to use conservative assumptions in the analysis. However, overly conservative assumptions can be dangerous as it could create incorrect conclusions and recommendations.
After the financial analysis, it's now time to develop strategies and specific recommendations. The recommendations should be attainable and measurable based on your circumstances.
Recommendations will of course differ from person to person based on their individual circumstances but examples of recommendations are as follows:
- Maximize RSP contribution and save $500 per month in a non-registered investment to meet retirement income need;
- Change asset allocation of investments to be in line with stated risk tolerance;
- Delay retirement by 12 months and/or decrease retirement income expectations by $3,000 per year;
- Stop making regular RSP contributions and start making spousal RSP contributions;
- Create a Power of Attorney document;
- Create a provision in Will to establish a testamentary spousal trust;
- Set up a prescribed rate loan strategy with spouse to reduce future income tax on investment income;
- Increase emergency fund assets to $15,000 of which $10,000 can be in the form of a line of credit;
- Receive Canada Pension Plan at age 60 rather than waiting until age 65;
- Reduce current discretionary expenditures by $300 per month;
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Step 4 - Present recommendations
This step simply involves meeting with your advisor to discuss the analysis and recommendations.
You should ensure that you understand and are comfortable with the recommendations presented. That is, you should feel that you would have the ability and discipline to execute the recommendations on a current and on going basis if required.
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Step 5 - Implementation of recommendations
Step 5 is absolutely crucial to ensure that the recommendations in Step 4 are put into action so you can commence your journey to achieving financial independence. If the recommendations are not executed properly then the entire process up to this point is wasted. You will likely require the assistance of several other professionals (i.e. accountant, estate lawyer, banker, licensed insurance agent, etc) to implement certain recommendations.
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Step 6 - Periodic review
This is one of the key steps that many people fail miserably to accomplish.
During the review, you should ensure that you are implementing the specific recommendations and these actions are still allowing you to reach your stated objectives. However, during this periodic review you also need to ensure that your previously stated goals and objectives in Step 2 are still valid. Life changes. People change. The economy changes. If your goals and objectives have changed then the recommendations in Step 4 may have to be revised.
Even if there has not been dramatic changes in your personal life, goals or economic assumptions, it's still prudent for you to assess your progress and ensure that you are on track to meeting your goals. Financial planning is an on-going life process.
It is generally recommended that you sit down with your advisor for this progress review at least once per year.
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