02 - General Principles of Financial Planning Flashcards
What are the six steps to the financial planning process?
E - Establishing and defining the client-planner relationship
G - Gathering client data including goals
A - Analyzing and evaluating the client’s current financial status
D - Developing and presenting recommendations and/or alternatives
I - Implementing the recommendations
M - Monitoring the recommendations
(Every Good Apple Does Invest Money)
What is the Financial Planning Practice Standard 100-1
100-1: Defining the Scope of the Engagement.
What is intention of the practice standard 100-1: Defining the Scope of the Engagement
The financial planning practitioner and the client shall mutually define the scope of the engagement before any financial planning service is provided
What is the Financial Planning Practice Standard 200-1
200-1: Determining a Client’s Personal and Financial Goals, Needs and Priorities
What is the intention of the practice standard 200-1: Determining a Client’s Personal and Financial Goals, Needs and Priorities
Mutually define client’s personal and financial goals, needs and priorities that are relevant to the scope of the engagement before any recommendation is made
What is the Financial Planning Practice Standard 200-2
200-2: Obtaining Quantitative Information and Documents
What is the intention of the practice standard 200-2
Obtain sufficient quantitative information and documents about a client relevant to the scope of the engagement before any recommendation is made and/or implemented
What is the Financial Planning Practice Standard 300-1
300-1: Analyzing and Evaluating the Client’s Information
What is the intention of the practice standard 300-1
i. Must analyze the information to gain an understanding of the client’s financial situation and then evaluate to what extent the client’s goals, needs, and priorities can be met by the client’s resources and current course of action. You must consider both personal and economic assumptions in this step such as retirement age, life expectancy, income needs, inflation rates, and investment returns
What is the Financial Planning Practice Standard 400-1
400-1: Identifying and Evaluating Financial Planning Alternative(s)
What is the intention of the practice standard 400-1
Consider sufficient and relevant alternatives to the client’s current course of action in an effort to reasonably meet the client’s goals, needs and priorities.
What is the Financial Planning Practice Standard 400-2
400-2: Developing the Financial Planning Recommendation(s)
What is the intention of the practice standard 400-2
Develop the recommendations based on the selected alternatives and the current course of action in an effort to reasonably meet the client’s goals, needs, and priorities.
What is the Financial Planning Practice Standard 400-3
400-3: Presenting the Financial Planning Recommendation(s)
What is the intention of the practice standard 400-3
Communicate recommendations in a way that will assist the client in making an informed decision.
What is the Financial Planning Practice Standard 500-1
500-1: Agreeing on Implementation Responsibilities
What is the intention of the practice standard 500-1
The financial planning practitioner and the client shall mutually agree on the implementation responsibilities consistent with the scope of the engagement.
What is the Financial Planning Practice Standard 500-2
500-2: Selecting Products and Services for Implementation
What is the intention of the practice standard 500-2
i. The financial planning practitioner shall select appropriate products and services that are consistent with the client’s goals, needs, and priorities.
ii. All products selected must be suitable to client’s situation.
iii. The products one CFP professional selects may differ from what other CFP professionals would select.
iv. CFP Board assumes more than one product can reasonably meet goals.
What is the Financial Planning Practice Standard 600-1
600-1: Defining Monitoring Responsibilities
What is the intention of the practice standard 600-1
The CFP professional and client shall mutually define monitoring responsibilities.
In general, how many subject areas are engaged to define a financial planning engagement? Are there any other indications that a financial planning engagement is in place?
It is generally believed that two or more subject areas are warranted to define financial planning, but you must look at the facts. In particular:
a. “U” and “I” “M”ust “C”oordinate “B”etter
i. Understanding and Intent in engaging CFP
ii. Multiple financial planning areas covered
iii. Comprehensiveness of data gathered
iv. Breadth and depth of recommendations
In the financial planning practice, are assets, liabilities, and net worth shown at their current market value, or historical value?
Assets, Liabilities, and net worth are shown at their current market value
On the balance sheet prepared by a financial planner, how many primary categories are shown in the asset section? What are the primary categories?
There are three primary categories in the asset section of the balance sheet
i. Liquid assets (or current assets or monetary assets)
ii. Investment assets
iii. Personal use assets (or household assets or other assets)
What are examples of “Investment Assets”
Examples of Investment assets include:
i. Future defined benefit pension plan benefits and projected Social Security benefits are not included on the balance sheet but could be included in the notes section of the balance sheet
ii. Retirement assets that have separate accounts, such as a 401(k), should be included
What are examples of “Household Assets”
Examples of Household assets include:
i. Personal use real estate (primary homes and vacation home) is listed in this section; real estate held for investment is reported as an investment asset
ii. Household assets are reported at fair market value (not adjusted basis)
Does the Current Liabilities section of the balance sheet include the current portion of long-term liabilities?
No, do not include the current portion of long-term liabilities in the Current Liabilities section (differs from GAAP)
Should savings be grouped with variable or fixed expenses?
Savings are grouped with variable expenses. Since savings generally is not obligatory, it is also classified as a discretionary expenditure
Should savings for specific goals be listed together under variable expenses for simplicity, or should they be listed separately for detail?
Savings for specific goals should be listed separately within the group so that savings rates can be easily determined
It is useful to categorize expenditures as discretionary and non-discretionary expenses. What ratio is this distinction most helpful?
It is also useful to categorize expenditures as discretionary and non-discretionary expenses. This categorization is very helpful when calculating the emergency fund ratio.
What is the goal of the Current Ratio?
Current ratio - Provides an indication of how easily the household could pay its current liabilities
What is the goal of the Emergency Fund Ratio?
Emergency fund ratio - Indicates how many months non-discretionary living expenses could be paid using current assets
What is the goal of the Retirement Savings Ratio?
Retirement savings ratio - Specifically looks at what percentage of income is being contributed to retirement accounts or for retirement. Includes both the employee’s and employer’s contributions.
What is the goal of the Debt Payments to Income Ratio?
Debt payments to income ratio - Shows what percentage of income is devoted to servicing current debt; indicates the financial flexibility of the household.
What is the goal of the Long-Term Debt Coverage Ratio?
Long-term debt coverage ratio - Like the current ratio, this ratio assesses the household’s ability to pay its long-term debts.
What is the goal of the Debt Ratio?
Debt ratio - Determines what percentage of assets are financed using debt.
What is the formula for the Current Ratio formula?
Current Assets / Current Liabilities
What is the standard benchmark for the Current ratio?
Current Ratio benchmark: Ratio > 1.0 or 100%
What is the formula for the Emergency Fund Ratio?
Current Assets / Monthly non-discretionary living expenses
What is the standard benchmark for the Emergency Fund ratio?
Emergency Fund ratio: Ratio > 3 to 6 months
What is the formula for the Retirement Savings Ratio?
(Household + Employer retirement plan contributions) / Income
What is the standard benchmark for the Retirement Savings ratio?
Retirement Savings ratio: Ratio > 0.12 or 12%
What is the formula for the Debt payments to Income ratio?
Total debt payments / Income
What is the standard benchmark for Debt Payments to Income ratio?
Debt payments to income ratio: Ratio < 0.36 or 36%
What is the formula for the Long-term debt Coverage ratio?
Income / Long-term debt payments
What is the standard benchmark for the Long-term debt coverage ratio?
Long-term debt coverage ratio: Ratio > 2.5
What is the formula for the Debt ratio?
Total Liabilities / Total Assets
What is the standard benchmark for the Debt ratio?
Debt Ratio: Ratio < 0.40 or 40%
In regards to an emergency fund, how many months of non-discretionary cash flow should a one-income and two-income household maintain?
In regards to an emergency fund, for the purposes of the CFP Examination, you should assume
i. One-income household = 6 months of nondiscretionary cash flow
ii. Two-income household = 3 months of nondiscretionary cash flow
Are high-yield savings accounts a safe vehicle for holding emergency funds?
Yes, High-yield savings accounts are a safe vehicle for holding emergency funds
Are CDs and Short-Term bonds appropriate vehicles for holding emergency savings?
Yes, CDs and Short-Term bonds are appropriate vehicles for holding emergency savings, though CDs and Short-term bonds are not as liquid as a savings account
Are Investments, including stock or high-yield bond mutual funds appropriate vehicles for holding emergency savings?
No, Investments, including stock or high-yield bond mutual funds, should not be considered when evaluating a vehicle for holding a client’s emergency fund due to short-term volatility
Is access to a line of credit or funds readily available an acceptable alternative to an emergency fund?
Yes, having access to a line of credit or funds that are readily available can be an alternative to an emergency fund.
If a proper emergency fund is in place, what are ways to reduce expenses (and increase discretionary cash flow)?
- If a proper emergency fund is in place, one way to reduce expenses is to increase the deductible on an insurance policy.
- Another way to increase cash flow is to focus on paying off the highest-interest debt first.
- One obvious way to increase cash flow is to earn more income through a second job, overtime, etc.
Is refinancing debt an acceptable way to increase cash flow?
Yes, Increasing the term will lower the monthly payments, or a lower-interest rate can also decrease expenses.
Is a HELOC (home equity line of credit) an acceptable way to increase discretionary cash flow?
Debt can also be refinanced into a HELOC (home equity line of credit), but only if the client is financially stable. HELOC’s are secured loans, and non-payment can cause the client to lose their property.
When would a Cash-Out Refinancing be beneficial to a client?
Cash-Out Refinancing could be beneficial if the reduction of higher-interest loans or rates of return are greater than the additional future amounts borrowed
Is an adjustable rate mortgage acceptable to increase discretionary cash flow?
Refinancing into an Adjustable rate mortgage if interest rates are expected to decrease in the future or the client expects to move in 3 to 7 years
What are some benefits of debt, or leveraging?
i. Convenience in purchasing and consumer protections (credit cards)
ii. Acquisition of a home
iii. Acquisition of an automobile
iv. Development of human capital (e.g. education and training)
v. Creation of financial capital (investing)
vi. Starting or growing a business
In what situations would a predatory loan or car title loan be acceptable?
Predatory loans such as car title loans and payday loans are to be avoided in all cases for the exam (due to extremely high interest rates)
If a client is financially stable, what type of debt should they concentrate on paying off first?
Financially stable = prioritize paying high-interest debt
If a client is financially unstable, what type of debt should they prioritize paying off first?
Financially unstable = prioritize paying secured over unsecured debt
What is the general percentage of Principal, interest, taxes and insurance (PITI) / Monthly Income to qualify for a mortgage or refinance?
PITI (Principal, interest, taxes and insurance) / Monthly income <= 28%
What is the general percentage of [Principal, interest, taxes and insurance (PITI) + All other recurring debt] / Monthly Income to qualify for a mortgage or refinance?
(PITI + All other recurring debt) / Monthly income <= 36%
Why should a client consider refinancing?
i. To lower the interest rate (with same term reducing payment amount)
ii. To extend the loan term (even with the same rate), thereby reducing payment and freeing up cash flow
iii. To gain a faster buildup of equity in the property from lower rates
What is No-Cost Refinancing?
i. The lender covers the closing costs but charges a higher interest rate
ii. Refinancing fees are included in the loan. They become part of the principal
What are some techniques to use your home as financing strategy?
Home Equity as Financing Strategy
i. Cash-out refinance
ii. HELOC (Home equity line of credit)
iii. Home equity loan
What are the requirements to qualify for a reverse mortgage?
To qualify for a reverse mortgage: must qualify through a number of tests, such as being over the age of 62, occupying the property as a principal residence, and own outright or paid down a significant part of the mortgage
What factors may change the supply of a good or service in the marketplace?
Changes in factors such as more competition, increased efficiencies through technology, etc. may change the amount of a good or service a produce may supply at any given price, and shift the supply curve
What factors can lead to a shift in the demand curve?
Shifts in the demand curve reflect changes other than price in consumer’s willingness to consume at a certain price. Examples may be the gov’t lowering taxes, consumers’ decreasing their savings rate, or increasing incomes.
What are reasons why, when the price of goods or services increases, consumers will tend to buy less?
Substitution effect - Occurs when consumers are faced with rising prices and choose to purchase a similar, but lower-priced product or service instead
Income effect - A result of prices rising at a greater rate than incomes
Are necessities price elastic or inelastic? Luxuries?
i. Necessities are considered inelastic. Demand for necessities is relatively unresponsive to changes in price – Food and medicine
ii. Luxuries are elastic and respond to changes in price.
What is the Gross Domestic Product?
The GDP is the total value of all goods and services produced within the US (Apple iPhones are not part of GDP, but Toyota automobiles are part of GDP)
What is the Gross National Product?
The GNP is the total value of goods and services produced by U.S. residents’ labor and property, regardless of where the goods are produced (Apple iPhones produced in China are part of GNP)
What are the four phases of the business cycle?
i. Expansion phase – Increasing GDP
ii. Peak Phase – GDP at or near highest points
iii. Contraction or Recession phase – GDP slowing or decreasing
iv. Trough Phase – GDP at or near low point
What is the definition of a recession?
Recession = GDP declining for 6 consecutive months
What is the definition of a depression?
Depression = GDP declining for 18 consecutive months
Who conducts monetary policy?
The Federal Reserve conducts monetary policy
What are the primary tools the Fed uses to meet monetary policy goals?
The Fed uses three primary tools to meet monetary policy goals
- Raising or lowering the reserve requirement that banks must hold
- Raising or lowering the discount rate (interest rate charged to banks for loans received from the Fed)
- Engaging in open market operations, which include the Fed buying and selling government securities
Who conducts fiscal policy?
Fiscal policy is conducted by Congress
What are the primary tools Congress uses to exercise fiscal policy?
Congress has two tools to exercise fiscal policy
- The power to tax
- The power to spend
What is inflation?
Inflation is the increasing cost of money, goods, and services. Deflation refers to prices falling.
In general, do the prices of bonds and equities increase or decrease when interest rates rise?
In general, the prices of bonds and equities DECREASE when interest rates rise
What is an annuity due?
If the payments are taking place at the beginning of each period, the type of annuity we have is an annuity due.
What is an ordinary annuity?
If the payments are taking place at the end of each period, the type of annuity we have is an ordinary annuity.
What are serial payments (in relation to an annuity)?
Serial payments (as opposed to fixed payments), increase each year at the rate of inflation. The result is that the first serial payment is typically less than the respective fixed payments and the last serial payment is greater than the respective fixed payments.
Calculating Needs Analysis - What does the capital utilization method assume?
The capital utilization method, which assumes all, or virtually all, accumulated funds will be depleted by the end of the period under consideration
Calculating Needs Analysis - What does the capital preservation method assume?
The capital preservation method, which assumes periodic payments made are interest only and the capital accumulated will be preserved
Capital Needs Analysis - What method, capital utilization or capital preservation will need to accumulate more money to meet the client’s goals?
Of the two methods, the capital preservation method means more money will have to be accumulated since the client will be distributing only interest earned.
What re the steps to calculate a client’s capital needs?
- Determine the income need for the first year of retirement
- Determine how much will be needed to fund each year’s income need throughout the entire retirement period
- Determine the required savings (yearly or monthly) to accumulate the necessary nest egg
How do you calculate Net Present Value?
Net Present Value is calculated by discounting each projected cash flow, at our investor’s required rate of return, and subtracting the initial investment
What is Internal Rate of Return?
Internal Rate of Return (IRR) is the discount rate that results in the equaling of the net cash inflows and net cash outflows. In other words, it is the discount rate that makes the NPV of all cash flows equal to zero.
What are the primary sources of information?
There are two primary sources of information:
i. Content = what is actually stated (and sometimes unstated); here the planner clarifies and ensures that he or she is hearing exactly what the client is saying and expressing.
ii. Process = nonverbal data, including how information was expressed and conveyed through body language, tone, facial expressions, eye movements, and so on.
For a client with high income and high job security, paying off what type of debt should be prioritized?
Most CFP Exam questions will be based on determining the financially optimal recommendation for a client who has a high income and high job security. In this case, you will always prioritize paying the highest interest-rate debt with any extra available cash flow.
If a client’s future income is questionable and the client is currently insolvent, what type of debt should be prioritized? Why?
If a client’s future income is questionable and the client currently is insolvent, then prioritize secured over unsecured debt.
The reason for this is that nonpayment for secured debt can lead to repossession and unsecured debt may be forgiven when a bankruptcy is filed.
What is the majority of a credit score based on?
The majority of a credit score (65%) is based on making payments on time and managing credit card utilization ratio, as a low ratio increases the credit score.
Is Chapter 7 bankruptcy considered liquidation or income-based bankruptcy?
Chapter 7 is considered liquidation bankruptcy
Is Chapter 11 bankruptcy considered liquidation or income-based bankruptcy?
Chapter 11 is considered income-based bankruptcy
