Topic 1 - Personal Financial Planning Flashcards
What was the worldwide impact of the global financial crisis?
- some financial institutions were forced to close
- some, such as the Lehman Brothers, were bailed out by the government at a very high cost
- several financial institutions became wary of dealing with other institutions because of heightened credit risk
- countries were forced to guarantee bank liabilities and to stimulate their economies to avoid recession
Name the three different perspectives finance can be studied from.
- From an individual or personal perspective.
- From the corporate perspective.
- From the government or public perspective.
Differentiate between short-term, medium-term and long-term financial planning goals.
Short-term
- those that must be achieved within a year or within 12 months from the start of planning
- includes buying a car or paying for a holiday
Medium-term
- between 2 and 5 years
- includes paying to attend an educational program that will increase income in the long-term
Long-term
- extend from 6 to 40 (or more) years
- includes planning the purchase, or even the sale of a house
The Superannuation Guarantee is one reason why personal financial planning has increased in importance in recent years.
(b) Will you make your decision about setting an investment portfolio choice in an accumulation fund or will you leave it to a default choice where the fund manager nominates one portfolio selection such as ‘conservative’ for all members who do not nominate their own selection?
Write your opinion about making a choice of investments for your own superannuation fund.
Most people need a level of education and knowledge to understand portfolio differences and related risks and rewards.
People need an understanding of the long-term volatility and return to assist them in their own selection choice.
Indirect property investment occurs when the owner
Select one:
a. owns a company that manages the property portfolio
b. owns a trust that can invest in property
c. is a company or trust through which the investor participates in the cash flows from the property
d. rents the property before owning it
c. is a company or trust through which the investor participates in the cash flows from the property
The global financial crisis:
Select one:
a. was brought about by US investment banks disguising the true risk characteristics of the collateralised debt obligations they were selling
b. was made worse by the uncertainty within global markets as to the level of credit risk posed by financial institutions leading to governments having to guarantee bank deposits
c. resulted in Governments offering stimulus packages to attempt to prevent economies from slipping into recession
d. all of the above
d. all of the above
All of the issues raised above were relevant to the recent global financial crisis.
(Learning objective 1.7 ~ outline the origin of the global financial crisis and describe its impact on Australia)
In recent years, what changes have the government made to the pension age and why?
What incentives are the government providing?
- to reduce the pressure of taking care of a large number of retirees, the government has increased the pension age from about 60 years to 65 years for women, to match that of men
- an increase in the retirement age above 65 years has also been proposed for men
- the government is also providing incentives, such as the work bonus scheme, to encourage people to stay at work longer and to defer taking the pension
A close reading of chapter 1 provides which of the following lessons for investors:
Select one:
a. be aware of market cycles
b. do not diversify unless there are no other options available
c. both a and b
d. none of the above
a. be aware of market cycles
Being aware of market cycles is one of the lessons in chapter 1. The chapter also advocates the benefits arising from diversification as a sound investment principle.
(Learning objective 1.1 ~ describe the concept of personal financial planning)
The term personal financial planning generally implies:
Select one:
a. the achievement of a financial outcome within a specified time period
b. successfully gaining a job promotion
c. winning the lottery within a specified time period
d. both a and b
a. the achievement of a financial outcome within a specified time period
Personal financial planning generally implies the achievement of a financial outcome within a specified time period. The other factors listed, although personal in nature, would not be expected to form part of the personal financial planning process.
(Learning objective 1.1 ~ describe the concept of personal financial planning)
What is finance?
Finance deals with how we manage our money.
It includes activities such as:
- investing,
- borrowing,
- lending
- and planning.
Suppose you had a friend who lost their job and was unable to pay the electricity account when it was due and the electricity was disconnected.
How could a financial counsellor assist your friend?
A financial counsellor could assist your friend by:
- Negotiating on your friend’s behalf with the electricity supply company. This could enable immediate re-connection of the electricity supply as well as establishing an on-going payment plan to cover the arrears.
- In addition, the counsellor may also be able to identify and assist your friend in avoiding other potential crises relating to their acute unemployment and a current cash shortfall.
- The counsellor may also be able to assist in drawing up a new personal budget for your friend to help them manage their current situation as well as to optimise the benefits of saving once they gain new employment
Why do you need a budget of expenses when planning for retirement?
- a budget of expenses is needed to help you work out how much money you require for retirement
- it is estimated that a single person will need about $43,000 to live a comfortable lifestyle in retirement
- a couple will need close to $60,000 for a similar lifestyle
- if you want to spend money on holidays, as well as eating out during retirement, you will need to increase your allowance for leisure
Given an understanding of interest-rate risk, an existing fixed-interest investor in bonds would be affected in which of the following way(s) if the market interest rates on bonds were to rise from 8% to 10%?
Select one:
a. interest receipts from the bonds would fall and the market price of the bond would also fall
b. interest receipts from the bonds would rise and the market price of the bond would also rise
c. interest receipts from the bonds would be unaffected and the market price of the bond would fall
d. interest receipts from the bonds would be unaffected and the market price of the bond would rise
c. interest receipts from the bonds would be unaffected and the market price of the bond would fall
A market which processes news instantaneously and correctly is
Select one:
a. perfect
b. efficient
c. risk free
d. inconceivable
b. efficient
List the various types of risk and explain why they are worth knowing about.
- there are various types of risk worth knowing about because they affect the returns and capital values of investments
- knowing about the risk factors will help in choosing appropriate assets for risk profiles:
The currency risk effects from holding an investment valued in an overseas currency will result in:
Select one:
a. a rise in the Australian dollar value of the investment if the Australian dollar falls relative to the overseas currency
b. a rise in the Australian dollar value of the investment if the Australian dollar rises relative to the overseas currency
c. a fall in the Australian dollar value of the investment if the Australian dollar rises relative to the overseas currency
d. both a and c
d. both a and c
A rise/fall in the Australian dollar value of the investment will result if the Australian dollar falls/rises relative to the overseas currency – this is the basis of currency risk
(Learning objective 1.5 ~ define various types of risk)
Market volatility as a component of interest-rate risk:
Select one:
a. affects the amount of interest payments received on a fixed-interest investment
b. affects the value of a fixed-interest investment at its maturity date
c. affects the value of a fixed-interest investment sold before its maturity date
d. both a and b
c. affects the value of a fixed-interest investment sold before its maturity date
Market volatility affects the value of a fixed-interest investment sold before its maturity date. Any increase in market interest rates will have an inverse relationship on the value of the fixed-interest investment resulting in a decrease in its relative value.
(Learning objective 1.5 ~ define various types of risk)
What are the main objectives of the Financial Services Reform Act?
- to reduce systematic risk and provide fair and effective clearing and settling facilities!!
- to encourage confidence and informed decision-making about financial products and services among customers
- to provide the guidelines for fair, honest and professional dealings between customers and their financial planners
- has led to a number of licencing regimes, including the Australian Financial Services Licence (AFSL)
Explain why the defined benefit scheme was replaced by the defined accumulation fund.
- due to the combined effect of increased longevity and increased numbers nearing retirement (including their surviving spouses), employers were worried about their future exposure to paying pensions for longer than initially calculated
- moving to the defined accumulation fund means employees receive a superannuation benefit which is the accumulation of the fund after the employer has made the compulsory contributions
These crises are interspersed with periods of economic boom, resulting in four stages of the business cycle:
1) Boom or expansion
- characterised by high employment, high economic growth and an increase in inflationary pressure
2) Contraction
- marked by slow economic growth, decline in sales and a rise in the unemployment rate, extending into a recession
3) Recession
- unemployment becomes high and economic growth declines to very low levels
4) Recovery
- unemployment begins to fall and economic growth starts to rise
Define the time value of money.
- money owned today is worth more than money to be acquired in the future
- anything can happen to future money: due to inflation, it can diminish in value and buy fewer goods than it could today
- money available today can be invested to earn future interest, but there is a risk in receiving money in the future, rather than today
- however, there is enough information about the risk factors to allow us to value and account for dealings in the future through:
discount and interest rates
Generally accepted finance principles would support which of the following statements?
Select one:
a. ‘high return generally equals high risk’
b. ‘high return generally equals low risk’
c. ‘high risk is generally inversely related to high return’
d. none of the above
a. ‘high return generally equals high risk’
The risk-return trade-off is positive with a higher investment return generally only being possible when the investor is (financially) exposed to relatively higher risk levels.
(Learning objective 1.1 ~ describe the concept of personal financial planning)
Describe the role of the financial planner.
- the financial planner, on the other hand, provides services for fees, including advice on investing and superannuation issues
- work with people who have savings and are looking to maximise income from their investments
Define assets, liabilities and equity.
Assets
- refers to something valuable that we own
- includes our car, computer, books, clothing and debts owed to us from debtors
Liabilities
- what we owe to others
- although both can be used to make payments, banknotes and coins are assets, while credit cards are liabilities
- include bank loans and overdrafts
- amounts owed to others and are yet to be paid
- to be recognised as liabilities they must be legally enforceable
- a purchased house is an asset, but the mortgage on the house is a liability
- when the mortgage owed on the house is taken out of the value on the house, the difference is equity
Equity
- the value left of the asset after subtracting the outstanding liability
Why is it so important to have a dedicated savings plan to meet retirement needs?
- during retirement, our consumption is reduced because we have fewer expenses
- for example, we may finally own our home and therefore do not have further mortgage payments
- in reality, however, people are very unlikely to have sufficient money to cover their retirement
- few people have a dedicated savings plan to meet their retirement needs
- in contrast, most people tend to accumulate debt or use credit cards, rather than to save during their working lives
- most retirees do not have enough money to cover the lifestyle they want during retirement
The main measure of a share’s value on a stock exchange is the
Select one:
a. dividend yield
b. Sharpe ratio
c. the net present value of expected future earnings
d. price-earnings ratio
d. price-earnings ratio
What does it mean to say that the goals you set must be realistic?
- this means that they must be specific:
- they must have value (must be quantifiable)
- the time period over which goals are to occur must be stated
- e.g. a short-term goal is to:
- buy a car in 6 months-time (statement of time-frame)
- for not more than $50,000 (statement of value)
A client aged 50 years says to you, a junior financial planner, ‘I would like to retire with a comfortable level of income. Can you help me do that?’
How would you restate the client’s request in more definite terms?
A more definite goal would be: ‘I would like to retire in 15 years time with an after-tax income of $60 000 in today’s dollars’.
That is an objective that contains a defined time frame and a specific dollar amount.
Tanya is 19 years old and has been working as a retail assistant for 2 years. She earns $33 800 per year in salary after tax. Because her family lives in a country town, Tanya had to leave home to find employment and learn to look after herself and her finances.
She shares a flat with two friends. Her weekly payments on average are rent $150; public transport fares $50; food $140; utility bills $50; mobile/internet phone $30; clothing $50; and entertainment $60. She also makes sure that she is saving some of her income and for the past 2 years has arranged for automatic debit of $400 per month from her bank account into a managed fund. The amount accumulated in the fund comprises the original $2 000 she was given for her seventeenth birthday to start the fund when she left home and contributions and earnings of $8 000, making a total sum of about $10 000. The managed fund is a balanced fund. Any money left over after expenses and investment is kept in her bank account, which totals $1 000.
Tanya’s main goal is to buy a car in the next 6 months if she can afford it. She will use some money in her managed fund if she has to, but hopes to buy a car valued at about $13 000 plus insurance of $750 p.a.
- What are the main three investment risks that Tanya faces given her short-term goal?
The three investment risks that Tanya faces given her short-term goal are:
- Mismatch risk – the fact that Tanya will have to liquidate a long-term investment asset (managed fund) to pay for a short-term, depreciating asset (new car)
- Market risk – the price of the car and/or the cost of insurance may increase over the next six months
- Interest rate risk – the rate of return on Tanya’s investment fund increases which means that she pays a higher opportunity cost on the money she withdraws from the fund to pay for her new car and insurance
Define money.
- a medium of exchange (payment) and an indication of the value of an asset
- everyone accepts money in exchange for other assets or things they are selling
- includes:
coins, notes, amounts held in chequing and savings accounts, and credit cards
What does personal financial planning mean?
How does it differ from business planning?
How are goals set regarding time-frames?
- it means the steps taken to plan your finances for the future
- it is different from planning for a business because the business accounts are separate from your personal finances
- personal financial planning starts with setting goals for the short term, medium-term and long term
What major economic events does the textbook cover?
- the major global and national economic events since the 1987 share market crash to the dot.com crash at the beginning of the current century
- the World Trade Centre attack to the Global Financial Crisis and the more recent European Debt Crisis
Sketch the four stages of the business cycle.
Why is it now so important that employees have a good understanding of defined accumulation funds?
- moving from a defined benefit fund to a defined accumulation fund means that the risk of investment has now been transferred from the employer to the employee
- the employee now bears the risk of the investment choice and the resulting performance of the fund
- employees, therefore, need a good understanding of the complexity of the legislation, products and decisions associated with managing their super investments
Why is the Financial Services Reform Act of 2001 central to the profession of financial planning?
- forms the basis of several changes to the business of financial planning
- it is the main regulatory framework covering:
- financial products and services
- financial markets
- the clearing and settling of facilities
- administered by the Australian Security and Investment Commission (ASIC)
Describe the earlier defined benefit fund.
- before, employees would receive a retirement benefit based on a formula comprising the length of service and final average salary (last 2-3 years of service)
- the employee was not involved in the investment decisions of the superannuation fund
- it was the employer’s responsibility to place sufficient contributions into the fund to meet the expected retirement payments
- the benefit was mostly in the form of a pension which was payable for life
Why has the government introduced the compulsory superannuation scheme?
What are the current and future contribution rates?
- since the pension is not enough to allow for a decent lifestyle during retirement, the government has introduced the compulsory superannuation scheme
- the scheme currently requires employees to contribute 9.5% of employee’s wages to their superannuation savings
- it is expected that this contribution will increase to 12% in 2025
A number of lessons can be drawn from the issues covered in the topic.
Discuss why we need to plan early.
- it is necessary to plan very early in order to obtain sufficient income for retirement
- this means understanding the sources of income and the various assets in which income can be invested to grow
Why is personal financial planning gaining importance?
What does it require the estimation of and why?
- because it allows people to set personal goals and arrange the financial means to achieve them
- these goals include planning for retirement
- eventually, we all have to retire, but people are now retiring at a much older age and without sufficient superannuation to maintain the lifestyle they want
- personal financial planning, therefore, requires estimating how long we expect to live in order to:
- calculate how much it will cost to maintain the lifestyle that we want during retirement
- and how much we need to save now in order to reach our retirement target
What was the initial impact of the Collateralised Debt Obligations (CDOs) being sold?
- the CDOs were sold worldwide, although luckily, they were not extensively offered within Australia compared to within other countries
- the rating agencies helped the process by rating securities higher than they were worth, even though the performance of the securities appeared suspicious
- the economic contraction saw house prices fall so that the value of houses was less than the loans
- led to a severe and unexpected shock in the US real estate market, spreading to a number of large financial institutions in various countries
A number of lessons can be drawn from the issues covered in the topic.
Discuss the risk of investment.
- the income from assets are subject to various levels of risk depending on the assets and the cycles within the economy
- reducing risk requires diversifying the investment portfolio so that assets within the portfolio have different levels of risk and comprise assets with risk levels moving in opposite directions
- the portfolio of investments will need to be reviewed from time to time to make changes that maximise returns from investment
- we also need to be aware of scams that promise high returns at low risk
- in general, high returns are accompanied by high risk
How have recent regulatory changes helped shape the personal financial planning profession between the 1980s and the year 2001?
- events in the 1980s and 1990s led to the Financial Services Reform Act, which was put into place in 2001 and has changed the way financial services are provided
What is the role of financial counsellor?
- different from that of the financial planner
- provide free, independent and confidential services to people facing financial hardship
- play a role in educating the public on various financial matters
- help individuals to prepare budgets, restructure their debts and advocate financial issues on behalf of their clients, especially regarding issues relating to debt
- can help their clients to work out repayments with their creditors and improve their expenditure through budgeting
How did the global financial crisis begin?
- began with poor lending standards by US banking and financial institutions
- they lent money to people with very poor credit ratings in the hope that if they defaulted, the financial institutions could recover their money by selling the mortgage properties
- various credit ratings were parcelled into what became known as Collateralised Debt Obligations (CDOs) in the hope that by diversifying these obligations, the bad loans would be hidden among the good ones
What are the challenges and incentives of retirement funds for the self-employed?
- people who are self-employed are allowed a tax deduction for contributions that they make to their superannuation funds
- this is to encourage the self-employed to save for retirement
- however, it is NOT compulsory for the self-employed to contribute to superannuation and some may not have any retirement savings
How did the global financial crisis impact on Australia?
- Australia fared better than most other countries because of the limited exposure to the Collateralised Debt Obligations
- extensive measures were also made to stimulate the economy
What is the role of ASIC regarding the Australian Financial Services Reform Act of 2001?
- the Act is administered by the Australian Securities and Investment Commission (ASIC)
- ASIC provides a legal framework that protects customers and corporate markets that deal with financial products and services
- it ensures Australian financial markets are fair and transparent so that investors and customers can confidently make informed decisions
- ASIC monitors disclosures of the remuneration of licensees or those who represent them
- ASIC can revoke or suspend a licence or even ban a person from providing financial services
A number of lessons can be drawn from the issues covered in the topic.
Why do we need to abide by established rules of conduct and regulations?
- a number of reforms to superannuation now place the responsibility of saving for retirement in the employee’s hands
- this has occurred concurrently with education programs and counselling to help employees make effective financial decisions
- for the rules to work, they must be complied with when making financial decisions and when saving for superannuation
What is the long-term aim of personal financial planning?
- to build sufficient income over our working lives to meet our current consumption and to provide for our retirement during which period we earn little or no income
What are the challenges involved with an aging population?
- like many developed countries, Australia’s population is aging
- more women are working > reduced the birthrate
- people are living longer because of:
- improvements in the health system/lifestyles
- better diet
- good exercise regime
- there is now pressure on the healthcare system to care for older people
- a larger working population is required to meet the needs of those not in the labour force, including retirees
- although immigration may be the way to address this imbalance, it is not without problems
- the expectation is that, by 2050, there will only be about 2.7 workers for each retiree
- this ratio is not enough to maintain the population that is not in the labour force
What is the relationship between personal financial planning and the life cycle theory?
- there is a close association between your personal financial planning and the life cycle theory of consumption and saving
- the theory deals with how much income a person earns over their lifetime and how they spend the income
- consumption patterns tend to be relatively stable, while a person’s income tends to fluctuate wildly over their lifetime
- this is because a person might not always have a job or they may leave work to raise children, leaving significant gaps in their earnings capacity
What can we learn from the major historical events of investment markets?
- trends in the economic environment affect the values of assets and the incomes generated from them and the risks they pose
- recognising cycles in the economic environment can help us to effectively manage our personal finances
