3 : 3 - Financial Planning Assumptions

Question 1

Give examples of assumptions that may need to be made when performing calculations:

(9)

Answer 1

• future inflation rates
• future expenditure patterns
• rate of earnings increases
• investment and asset growth rates
• school and university fee increases
• annuity and/or pension drawdown rates
• future tax rates
• life expectancy
• future social security benefits

Question 2

How should assumptions be justified?

Answer 2

By showing why the assumption is reasoned, reasonable and relevant to the client’s financial plan.

Question 3

What is Simple interest?

Answer 3

It assumes that interest credited to the investment
does not earn further interest.

(In reality, when an investment or a deposit in an account grows, the principal as well as earned interest both earn further interest.)

Question 4

What is the name of the original sum invested?

Answer 4

The principal sum OR the present value

Question 5

EG:

Suppose you were to invest £1,000 for five years at an interest rate of 10%. If simple interest is calculated,
the total amount of interest earned will be as follows:

Answer 5

£1,000 × 0.10 × 5 = £500

The total value of the investment at the end of the five years (its future value) will therefore be £5,500
on this basis.

Question 6

What is the Compound interest formula?

Answer 6

FV = PV x (1 + r)^n

FV = Future Value
PV = Present Value
r = periodic interest rate
n = number of periods

Question 7

What is Discounting?

Answer 7

The name for calculating the Present Value of a future lump sum

Question 8

What is the Discounting formula?

Answer 8

This is done by simply rearranging the compounding formula to make PV the subject as below:

PV = FV ÷ (1 + r)n

(eg: PV = £30k ÷ (1.025)^22 = £17,425.94)

Question 9

Calculating other variables: rearrange the equation to solve for ‘r’

Answer 9

r = √(FV/PV) – 1

Question 10

Calculating other variables: rearrange the equation to solve for ‘n’

Answer 10

n = (log FV/PV) ÷ log(1 + r)

Question 11

EG: Solving for r

Noah wishes to have £30,000 in place to pay university fees for Mason in 16 years’ time. If Noah currently
has £18,500 to invest, what rate of interest must an investment offer in order for his future financial goal
to be met?

Answer 11

r = 16 √(£30k/£18.5k) – 1

= 0.0306

(equivalent to 3.06%)

Question 12

What is the definition of an Annuity?

Answer 12

An annuity is a series of equal sequential cashflows that will arise for a specified period of time.

Question 13

What is the annuity formula?

Answer 13

PV = £Annuity x [ 1 - (1 = r)^-n ] ÷ [ r ]

• the exam calculator might actually be able to do this, look into this at some point (on page 209)

Question 14

EG: Annuity formula

Mrs Adeboli wishes to have an annual income after retirement of £25,000. She anticipates that she may
live for a further 20 years after she retires. How much will she need at retirement in order to purchase a
suitable annuity. Use an interest rate of 3% for your calculations and assume that cashflows arise at the
end of each year.

Answer 14

PV = £25k x [ 1 - 1.03^-20 ] ÷ [ 0.03 ]

= £25k x 14.8775

= £371,937

Question 15

** Calculator Guidance **

Answer 15

Check pages 209 - 212 for a guide on using the exam calculator to do these equations.

GET FAMILIAR WITH THESE.

Question 16

What is the issue with a client having too much capital?

Answer 16

This creates an IHT issue

Question 17

What does it mean when the client ‘zeroes out’?

Answer 17

And IFA wants to make sure that the money does not run out before life does.

Perfection is when the client ‘zeroes out’, and the cheque to the undertaker bounces.

Question 18

What is the Nominal rate of return?

Answer 18

A nominal rate of return (sometimes referred to as a money rate) includes the effects of inflation

Question 19

What is the real rate of return?

Answer 19

Inflation has been stripped away or removed

Question 20

EG:

As an approximation, if the nominal rate is 10% and inflation is 3%, the real rate can be estimated as what?

Answer 20

7%

Question 21

Why is this not one hundred percent accurate?

Answer 21

As the connection between real rates and nominal rates is not additive but multiplicative; the rates are not arithmetically linked but geometrically linked

Question 22

How is this calculated?

Answer 22

(1 + nominal) = (1 + real) (1 + inflation)

eg:

real = [ (1 + nominal) ÷ (1 + inflation) ] – 1
= [ 1.10 ÷ 1.03 ] – 1
= 0.06796 (this is equivalent to 6.796%)

Question 23

What is Combination funding?

Answer 23

When working towards achieving a particular goal, a planner should not limit themselves to using only income or only capital as a combination of several options may be more appropriate.