Lesson 3 - Economic Business Cycle, Consumer Protection

Question 1

Risks

Answer 1

• Life Insurance – A typical benchmark is 10-16 x gross income, if the client has a life insurance need.
• Health Insurance – A client needs at least a $1 million lifetime cap pre-Affordable Care Act. ACA eliminated per illness or per lifetime caps.
• Disability – If a client is paying premiums with after-tax dollars, then a policy paying about 60-70% of gross income is necessary.
• Property (Both Home and Auto) – A policy that covers both home and auto for fair market value is appropriate.
• Long-Term Care – A policy that provides a daily benefit for nursing home care, home health care or help with activities of daily living (ADLs), with inflation protection is necessary.
• Personal Liability Umbrella Policy – Clients need a PLUP with $1-3M in liability protection

Question 2

Short-Term Savings and Investments

Answer 2

• Emergency Fund – Clients need 3-6 months of non-discretionary expenses in an emergency fund.
• Housing Ratio (28%) – A client’s primary mortgage, which includes principal, interest, taxes and homeowner’s insurance should not exceed 28% of gross income.
• The Housing Ratio Plus All Other Debt Ratio (36%) – A client’s primary mortgage plus all other recurring debt payments should not exceed 36% of gross income.
• Based upon how a client manages their debt, an evaluation can be made whether it is good debt, bad debt or reasonable debt. Good debt is anytime the useful life of the asset far exceeds the term of the debt. Good debt includes a 15-year mortgage or 3-year car loan. Reasonable debt includes a 30-year mortgage or 5-year car loan. Bad debt includes carrying credit card debt each month.

Question 3

Long-Term Savings and Investments

Answer 3

• Education Funding – Depending upon the university, a client should save $3,000, $6,000 or $9,000 per year for 18 years to fund a child’s education. For a public state university, save $3,000 each year for 18 years. For a semi-private university, save about $6,000 per year for 18 years. For a competitive private university, save about $9,000 per year for 18 years.
• Retirement Amount – At age 62-65 an individual should have 16 times the amount of income needed annually saved for retirement. In other words, if an individual needs $100,000 a year in retirement income, the individual needs 16 x $100,000, or $1.6 million in retirement assets.
• Savings Rate – An individual should save 10-12% towards a retirement goal, assuming saving starts at an early age. The education goal is extra.
• Return on Investments – An investor should expect a return on investments of 8-10%, assuming a long-term time horizon.
• Risk – Risk is measured using standard deviation, which is a measure of volatility and variability. The benchmark for the standard deviation of a diversified portfolio is 8-14%.

Question 4

Legacy

Answer 4

• The “Big Three” documents include: - Will. - Durable Power of Attorney for Healthcare. - Advanced Medical Directive.
• All clients should have the “Big Three;” otherwise, it should be considered a weakness.

Question 5

ECONOMIC ENVIRONMENT

Answer 5

• Planners must understand the economic environment in order to forecast the future.
• The planner must be able to anticipate each element’s behavior and any potential effect on a client’s plan. - Elements surround current economic conditions such as interest rates, Gross Domestic Product (GDP), unemployment and inflation.
• Interest Rates – impact on investment returns and purchasing power: - Investment returns are inversely related to changes in interest rates.
• For example, as interest rates increase, stock prices and bond prices decrease in value. - Purchasing power is inversely related to interest rates.
• Taxes – impact on redistribution of wealth: - Redistribution of wealth is directly related to changes in tax rates. As tax rates increase, there is a redistribution of wealth from the higher tax brackets to the lower tax brackets.
• Inflation – impact on cost of goods, services and money: - The cost of goods, services and money is directly related to inflation. As inflation increases, so does the cost of goods, services and money. The cost of money is measured by interest rates.
• Unemployment – impact on wage rates: - Wage rates are inversely related to the unemployment rate. As the unemployment rate decreases, wage rates (wages paid to employees) increases because firms are competing for workers. Alternatively, when the unemployment rate increases, wage rates decrease.
• Monetary and Fiscal Policy – impact on economic expansion/contraction: - Economic expansion/contraction is directly related to monetary and fiscal policy. When monetary and fiscal policy take on a “loosening” policy, that directly leads to an economic expansion. Alternatively, when monetary and fiscal policy take on a “tightening” policy, that directly leads to an economic slowdown.

Question 6

Shifting Demand Curve

Answer 6

• The demand curve will shift and, thus, create a change in demand due to an increase or decrease in: - Income. - Taxes. - Savings Rate. - Disposable Income

Anything that causes discretionary income to increase will shift the demand curve up and to the right

Example If consumers’ income increases, or the government lowers tax rates, or consumers lower their savings rate, all will lead to consumers spending more and shifting the demand curve up and to the right.

Anything that causes discretionary income to decrease will shift the demand curve down and to the left

Example If consumers’ income decreases, or the government increases tax rates, or consumers increase their savings rate, all will lead to consumers spending less and shifting the demand curve down and to the left

Question 7

Shifting Supply curve

Answer 7

• The supply curve will shift to the left or right because of a change in: - Technology. - Competition. - Anything other than price.

Anything that causes production to improve will shift the supply curve down and to the right.

Example As more firms enter the marketplace, or as technology improves efficiency, or as goods used in the manufacturing process decrease in price, the supply curve will shift down and to the right. Anything that causes an increase in production costs or supply to decrease, the supply curve will shift up and to the left. Example As less firms enter the marketplace, or as goods used in the manufacturing process increase in price, the supply curve will shift up and to the left.

Question 8

Substitutes

Answer 8

• Substitutes are products that serve a similar purpose.
• A price change in one product changes the quantity demanded for another product.

Example If the price for movie tickets suddenly increases, demand for movie rentals may suddenly increase. Movie rentals would be considered a substitute for movie tickets.

Question 9

Compliments

Answer 9

• Complements are products that are consumed jointly.
• A price change in one product changes the quantity demanded for another product.

Example If razors are put on sale, demand for razor blades may increase. Razors and razor blades would be considered complementary products.

Question 10

Elastic Demand

Answer 10

• Quantity demanded responds significantly to changes in price.
• Examples of products that have elastic demand include airline tickets, movie tickets, alcohol, luxury goods.

Exam Tip An elastic demand curve is almost horizontal, sloping down and to the right.

Question 11

Inelastic Demand

Answer 11

• Quantity demanded changes very little to changes in price.
• Life’s necessities respond very little to changes in price. - Examples include milk and gasoline

Exam Tip An inelastic demand curve is almost vertical, sloping down and to the right. Remember the “I” in Inelastic to help remember the shape of the inelastic demand curve

Question 12

Business Life Cycle

Answer 12

Peak Recession Trough Expansion

Inflation Highest Decreasing Lowest Increasing

Interest Rates Highest Decreasing Lowest Increasing

Unemployment Lowest Increasing Highest Decreasing

GDP Highest Descreasing Lowest Increasing

Question 13

Business Life Cycle

Answer 13

Expansion

• The expansion phase is characterized by increasing GDP, inflation and interest rates. The unemployment rate, however, is decreasing.
• Investments should be in short-duration bonds and equities.

Peak

• The peak phase is characterized by GDP being at its highest.
• Inflation and interest rates are peaking, and the unemployment rate is at its lowest level.
• Since interest rates are increasing to cut off inflation; bonds, preferred stock, and other high-duration or fixed income assets should be sold. Equities and hard assets, such as gold and real estate, tend to perform well in this environment.

Contraction/Recession

• The contraction phase is characterized by GDP slowing.
• Inflation and interest rates are also beginning to decline.
• The unemployment rate begins to increase during the contraction phase.
• Equities and hard assets should be sold and reinvested into short-term cash and bonds until the market settles out.

Trough

• A trough is characterized by GDP, inflation and interest rates being at their lowest levels.
• Unemployment is at its highest during a trough.
• High-duration bonds will tend to perform well as bond yields drop and interest rates continue to fall. Stock purchases late in the cycle should be considered if valuations seem appropriate.

Question 14

During a period of recession/contraction, which of the following would be true?

1. The supply of goods and services would be decreasing.
2. Interest rates would be decreasing.
3. Unemployment would be decreasing.
4. Inflation would be decreasing.
   a) 1, 2 and 3.
   b) 1 and 3.
   c) 1, 2, 3, and 4.
   d) 1, 2 and 4.
   e) 1 and 2.

Answer 14

Answer: D

1. The supply of goods and services would be decreasing.
2. Interest rates would be decreasing.
3. Unemployment would be decreasing – would be increasing.
4. Inflation would be decreasing.

Question 15

Gross Domestic Product

Answer 15

• GDP measures the amount of goods and services produced in the US, regardless of ownership.

Example

Mexican beer made in Texas is included; however, a Big Mac made in France is not.

Question 16

Gross National Product

Answer 16

• GNP measures the amount of goods and services produced by a country’s citizens, regardless of where the goods and services are produced.

Example

Ford production in Mexico is included in GNP.

Question 17

Recession

Depression

Answer 17

• A recession consists of six consecutive months (or two quarters) of declining GDP
• A recession becomes a depression if the recession lasts for 18 months or six consecutive quarters.

Question 18

Inflation

Answer 18

• Inflation is defined as an increase in prices.
• A loss of purchasing power is the risk that inflation impacts.

Example
A retired couple, both age 62, receives a pension of $50,000 per year. Their annual living expenses are $45,000 per year. With inflation just 3% per year, their living expenses will increase to $64,000 per year in 12 years. At age 74, their pension income will still be $50,000 per year, but their living expenses will exceed their income by $14,000 per year.

• The formula below is used to measure inflation: Inflation = (Price level (year x) – Price level (year x – 1)) / Price level (year x – 1)

Example
Coffee beans cost $2.20 per pound this year and $2.00 per pound last year. The inflation rate is: (2.20 – 2.00) / 2.00 = 0.10 or 10%

Question 19

MEASURES OF INFLATION

Answer 19

Consumer Price Index

• The Consumer Price Index (CPI) measures the price change in a basket of goods and services at the retail level.
• CPI is applicable to consumer purchases and is historically 2-3%.

Producer Price Index

• The Producer Price Index (PPI) measures price changes in the wholesale and manufacturing sectors.
Economic Indicators

• Leading economic indicators anticipate changes in the economy.
• Coincident indicators change along with changes in the business cycle.
• Lagging indicators summarize or “confirm” past performance.

Leading Indicators
• Initial unemployment claims

• Stock prices
• Money supply (M2)
• New manufacturing orders
• New private housing units
• Consumer sentiment

Coincident Indicators

• Employees on payroll
• Personal income
• Industrial production
• Manufacturing sales

Lagging Indicators

• Avg. duration of unemployment
• Change in the CPI
• Change in labor cost per unit
• Consumer credit to income
• Value of outstanding loans
• Avg. prime rate charged by banks

Question 20

Monetary Policy

Answer 20

• Monetary policy is the policy and means by which the Federal Reserve controls the money supply and influences interest rates.
• The Federal Reserve has three main goals:
• Maintain long-term economic growth.
• Maintain price levels supported by the economy.
• Maintain full employment.

• The Federal Reserve has the ability to:

• Ease Monetary Policy (through increasing money supply and decreasing interest rates.)
• Tighten Monetary Policy (through decreasing money supply and increasing interest rates.)

Question 21

Monetary Policy Continued

Answer 21

• The Federal Reserve has four tools by which it can influence the money supply and interest rates.

1. Reserve Requirement (First Tool).

• The reserve requirement is a percentage of deposits a bank must maintain in cash.
• As the reserve requirement increases, there’s less cash available to lend; therefore, the money supply decreases and interest rates increase.
• As the reserve requirement decreases, there’s more cash available to lend; therefore, the money supply increases and interest rates decrease.

2. Discount Rate (Second Tool).

• The discount rate is the overnight interest rate at which member banks can borrow from the Federal Reserve to meet their reserve requirements.
• As the discount rate increases, short-term interest rates increase.
• As the discount rate decreases, short-term interest rates decrease.

3. Open Market Operations (Third Tool).

• As the Federal Reserve buys or sells government securities, the money supply is influenced and places pressure on interest rates.
• As the Federal Reserve buys Treasuries, money supply increases and interest rates decrease.
• As the Federal Reserve sells Treasuries, money supply decreases and interest rates increase.

4. Excess Reserves (Fourth Tool)

• Excess reserves are monies that a bank holds at the Federal Reserve (or central bank) in excess of the required reserve amount.
• In 2008, under the Economic Stabilization Act, the Federal Reserve began paying interest on excess reserves.

Question 22

Monetary Policy #3

Answer 22

Exam Tip
Interest rates represent the cost of “buying” or borrowing money. As money becomes scarce (or the money supply decreases) it becomes more expensive in the form of interest rates to “buy” or borrow money. Be sure to understand the relationship between the money supply and interest rates.

Exam Tip
Do not be tricked on the Exam. The Federal Reserve does not control the prime lending rate. The discount rate is the rate that member banks will borrow from the Federal Reserve. The Fed Funds Rate is the overnight borrowing rate between member banks

Example
Unemployment is low, GDP is high relative to historic levels and the Federal Reserve is con-cerned about high inflation. Therefore, the Federal Reserve implements a tightening economic policy. Through open market operations, the Federal Reserve would sell government securities. By selling government securities, the Fed is putting treasury securities on the market and receiv-ing cash in return. This decreases the money supply and increases interest rates.
Alternatively, if the Fed wanted to maintain a loosening economic policy, it would buy govern-ment securities. It would put cash into the market and take treasuries off the market. This increases the money supply and decreases interest rates.

Question 23

Fiscal Policy

Answer 23

• Fiscal policy is the policy and means by which Congress controls spending and taxation, which influences the money supply and interest rates.
• Congress has three goals related to fiscal policy:
• Maintain economic growth.
• Maintain price stability.
• Maintain full employment.

Question 24

Fiscal Policy Continued

Answer 24

• Congress has three tools by which they can influence fiscal policy:

1. Taxation (First Tool).

• Increasing tax rates will reduce money available for spending, thereby increasing interest rates.
• Decreasing tax rates will increase money available for spending, thereby decreasing interest rates.

2. Spending (Second Tool).

• Through government spending, Congress can increase the money supply, thereby decreasing interest rates. Alternatively, Congress can cut spending, thereby increasing interest rates.

3. Debt Management (Third Tool).

• Deficit spending is when Congress spends more than tax revenues that are collected.
• Because of deficit spending, Congress must borrow to continue spending. As Congress borrows more, the amount of dollars available to be lent decreases, and it places increasing pressure on interest rates.

Question 25

Which of the following is a fiscal policy used by the Congress that influences the money supply and interest rates? a) Prime Lending Rate. b) Open Market Operations. c) Discount Rate. d) Debt Managemen

Answer 25

Answer: D Choices B and C are examples of monetary policy which is controlled by the Federal Reserve. Prime lending rate is not part of monetary or fiscal policy.

Question 26

Yield Curve

Answer 26

• The yield curve is a diagram that plots the current interest rates against the term to maturity for similar securities, such as Treasuries.
• The normal yield curve is concave, sloping upward to the right.
• The inverted yield curve is convex, sloping downward to the right
• The fiscal or monetary policy in effect will help to determine the shape of the yield curve.
• Expansionary policy from both fiscal and monetary typically results in a normal yield curve.
• Contractionary policy from both fiscal and monetary typically results in an inverted yield curve.

Question 27

LEGAL ENVIRONMENT

• A planner should have a high level of understanding of the legal environment so that clients can attain financial goals, while avoiding legal risks and protecting their rights.
• The legal environment includes consumer protection laws, worker protection laws and investor protection laws.

Answer 27

Consumer Protection Laws

• Consumer protection laws protect so-called weak consumers from powerful corporations.
• In addition, consumer protection laws help protect honest businesses from less-than-honest businesses.

• The Federal Trade Commission protects both consumers and businesses.
Fair Credit Reporting Act

• If a consumer is refused credit or employment based upon information contained in a credit report, the consumer must be provided with the information in the report.
• The three main credit bureaus are Equifax, Experian, and Transunion.

• Consumers have the right to one free credit report once a year from each of the three bureaus.
Fair Debt Collection Act

• Collection telephone calls are limited to 8:00am – 9:00pm. • Collectors must contact your attorney if you have an attorney.

• Collection calls are not permitted at work if your employer forbids such calls.
Fair Credit Billing Act

• Gives a creditor 30 days to acknowledge receipt of a billing dispute and explain or correct the error within 90 days.
• A consumer’s liability for a lost or stolen credit card is limited to $50 (if notice is given to the credit card company) or the actual amount charged on the card, whichever is less.
Truth in Lending Act

• Lenders must disclose the total cost of financing, including the cost of any credit life insurance.
• Interest must be stated in terms of Annual Percentage Rate (APR).
• Truth in Lending Act is administered by the Federal Reserve.

Credit Card Accountability Responsibility and Disclosure Act of 2009 (Credit CARD Act)

• Card companies must give cardholders 45 days’ notice of any interest rate increases.
• Card companies cannot charge interest on debt that is paid on time during the grace period.
• A credit card cannot be issued to someone under age 21 unless they have a co-signer who is 21 or over.
• Late fees are generally limited to $25 ($35 if a payment was missed in the last 6 months).

Question 28

FDIC INSURANCE

Answer 28

• Each depositor has a total of $250,000 of insurance per type of account ownership. • Four types of ownership: - Individual accounts. - Joint accounts. - Trust accounts (per owner, per beneficiary) - Self-directed retirement accounts.
• Accounts at different banks are insured separately; therefore, a depositor could deposit $250,000 in accounts at two different banks and still be insured for a total of $500,000.
• The amount of insurance for an IRA (and other retirement plans, e.g. SEPs) is up to $250,000 as long as the IRA is invested in bank deposits such as CDs. FDIC insurance does not cover mutual funds, stocks, bonds or annuities.
• Each person is deemed to own 50% of a joint account for FDIC insurance purposes. • Any deposit payable in the US IS covered. • Any deposit only payable outside of the US is NOT covered. • Money held in a money market mutual fund is NOT covered. • Stocks, bonds and mutual funds are NOT covered.

Question 29

BANKRUPTCY LAWS

Answer 29

• Chapter 7 – Provides relief through liquidation.

• Below are examples of debts that are not discharged through Chapter 7:
• Students and Government loans.
• 3 years of back taxes.
• Alimony and Child support.
• Monies owed due to malicious acts, drunk driving, criminal fines and penalties, or embezzlement.
• Exempt property: homestead, life insurance, qualified plans - Debts related to fraud are not discharged but debts associated with negligence are discharged.
• Contributory Traditional and Roth IRAs are exempt assets, up to $1 million as indexed every three years. Filings between April 1, 2019 and March 31, 2022 with have $1,362,800 in protection.

• IRAs Inherited by a non-spousal beneficiary will have no bankruptcy protection (unless a trust is named).

• Qualified plans along with converted IRAs have an unlimited exemption. Converted IRAs (aka rollover) must be clearly marked rollover and have no other contributions commingled.
• Bankruptcy filing may remain on the credit report for up to 10 years.
• Means testing began in October 2005 to determine if a debtor would be permitted to file for Chapter 7 Bankruptcy protection.
• If the debtor’s average monthly income for their region is in excess of the threshold they cannot file for Chapter 7.
• Chapter 11 – Provides relief through reorganization for businesses or the self-employed.
• Chapter 13 – Provides relief through adjusting debts

Question 30

Workers Compensation

Answer 30

• Workers compensation is an absolute form of liability.
• Regardless of fault if injured at work the employee will collect benefits.

Example
Holly owns an ice cream store that has a tile floor that becomes slippery when wet. While mopping the floor, two employees decide to have a food fight and begin throwing chocolate chips at each other. One of the employees falls, cuts her head and needs stitches. The employee is entitled to collect workers compensation benefits, under absolute liability, even though the employees were acting inappropriately by having a food fight at work.

Question 31

Unemployment Compensation

Answer 31

• Unemployment compensation provides moderate income replacement, for a specified period of time, if an employee loses his job.
• Unemployment compensation insurance premiums are funded by a tax on employers.
• Maximum number of weeks to receive unemployment is 39 with regular benefits lasting up to 26 weeks. The additional 13 weeks is for periods of high unemployment.

Question 32

Social Security

Answer 32

• Provides old age, survivor and disability benefits (OASDI).
• Social Security is a form of “public” insurance funded by payroll taxes on wages earned and self-employment incom

Question 33

Erisa

Answer 33

protects retirement plans of employees

Question 34

INVESTOR PROTECTION LAWS

Answer 34

• Securities Act of 1933 (covered in more detail in investments). - Regulates new issues of securities in the primary market. - The primary market is the securities market where new issues are sold to the public for the first time. - New issues constitute initial public offerings.
• Securities Act of 1934 (covered in more detail in investments). - Regulates secondary markets. - Secondary markets constitute the buying and selling of securities that were previously sold in the primary market.
- Established the SEC, whose primary function is to regulate the securities market.
• Securities Investor Protection Act of 1970 (covered in more detail in investments) - Created Securities Investor Protection Corporation (SIPC) - Provides coverage if a broker-dealer becomes insolvent or if there is unauthorized trading in an investor’s account.

Question 35

DEBT MANAGEMENT

Answer 35

• FICO (Fair Isaac Corporation) commonly used by lenders to assess a potential borrower’s credit risk. - Scores range from 350 - 850, and the higher the better. The goal for FICO is 760 or higher. - Five factors that affect credit scores:
• Payment history (largest factor)
• Amount of debt
• Length of credit history
• New credit
• Type of credit
• Buy vs. Lease/Rent - The decision to buy or lease property (home or vehicle) requires consideration of all cash outflows and inflows over the planning period.
• Outflows from leasing a home include security deposit, rent payments, personal property insurance, and utilities.
• Outflows from owning a home include down payment, closing costs, principal and interest payments, property taxes, all insurance costs, and maintenance expense.
• Inflows from leasing a home include the return of the security deposit and possibly earnings on savings if the lease payment is low.

• Inflows from owning a home include tax savings due to deductibility of interest, points, and property taxes
- Issues to consider in deciding whether to buy or lease assets:

• Will the asset likely appreciate in value? If yes, buying is preferable.
• Are there tax advantages to either ownership or leasing? All else being equal, choose the tax advantage.
• Will the item be obsolete shortly? If yes, leasing is probably favorable.
• Will purchaser be adding improvements at their expense? If yes, ownership is more favorable.

Question 36

Efficient Debt Repayment Plans

Answer 36

Debt can be a tool to reach goals such as home ownership, purchasing a vehicle, or going to college. Debt can also be
misused which increases financing costs and then limits cash flow available for goals. • Watch for burdensome debt and address ways the client can unburden themselves such as refinancing or moving to a longer repayment schedule to make the payments more manageable.
• Help order debt repayment; higher interest rate debts should be paid down first. • Allocate debt savings towards financial goals. • Proforma cash flow statements are a useful tool for illustrating long-term impact of debt management. • Help the client set up a workable budget, which may mean making some lifestyle adjustments; ie: eating out less, updating wardrobe less, etc.

Question 37

If the Federal Reserve wants to increase interest rates, which of the following actions might it take? a) Buy government securities. b) Sell government securities. c) Decrease the reserve requirement. d) Decrease the prime lending rate.

Answer 37

Answer: B For interest rates to increase, the money supply must decrease. If the Federal Reserve SELLS government securities, they are putting notes on the market and taking cash off the market. As cash comes off the market, the money supply decreases and interest rates increase.

Question 38

If the price of movie tickets decreases by a small amount, but there is a significantly large increase in demand, what can be said about the demand?

a) Elastic.
b) Inelastic.
c) Shift in the demand curve.
d) Inverted demand.

Answer 38

Answer: A If demand is inelastic, then demand does not change much for changes in price. Draw inelastic demand as almost a vertical line. If demand responds significantly to small changes in price, then it is elastic demand