One of the most common questions I am asked by financial planning clients is: “When should I begin the financial planning process?”
The simple answer is: It’s never too early to start planning!
As we traverse the various stages of life, our financial needs and goals change. In general, earlier in life we are trying to grow our incomes, save to purchase our first home, and for those with children, we are saving for educational expenses. As time passes, and we make progress with these initial goals, we begin to focus more on building wealth and saving for retirement. Late in life, we begin to focus on legacy issues and planning for the dispersal of our assets at death. During each phase, there are specific planning needs that should be focused upon, to have the best opportunity of achieving our goals.
According to a study sponsored by the Retirement Income Industry Association, over 10 years, the bottom line for families with investable assets of at least $100,000 who always receive professional advice from a financial planner or other expert, is $106,000 greater (on average in inflation-adjusted dollars), compared to $29,000 for families who navigate their own finances without help.
Many financial planners break the progression clients follow through life into five phases. For each of these phases, there are critical steps clients should take to plan properly.
The first phase typically begins when the client gets his or her first real job. For college graduates, this is usually their first career-specific job just after graduating. These clients face many challenges, but the most difficult is a lack of net cash flow after expenses. Many clients are burdened with student loans, credit-card debt and other bills. Most must purchase a car, cover moving expenses, purchase a professional wardrobe, buy furniture, and possibly purchase equipment to establish a practice or new business office.
With all of these cash flow needs, it is very difficult for individuals to also save for retirement, save to buy a home, etc. At the same time, this is the best time to begin saving, since savers in their 20s have the most time for their savings to grow — to compound over time. Probably the most impactful way to address this challenge is to focus on maximizing 401(k) and other retirement savings plans offered by employers. Deductions are made pre-tax and are automatic, once participation has been elected, making saving through these plans much less painful. Many employers offer matching programs through which they contribute significantly to the retirement savings for the employee. Finally, savings in these plans grow tax-deferred, which can greatly enhance the compounding effect over time, especially for savers who get started early.
Getting married these days can be extremely expensive, and that can be challenging, especially for those living in places with a high cost of living, like Santa Barbara. Many young couples who are already struggling just to pay the rent face overwhelming expenses when planning their weddings. These costs can often result in additional debts that can take many years to overcome.
Once married, couples often get serious about buying their first home, and therefore must balance saving for retirement with their shorter term goal of buying their first home. For local couples who don’t have family assistance, just saving their down payment can be a multiyear endeavor. Some will never reach this goal and will need to relocate to be able to afford a home. Others may have to sacrifice saving for longer term goals such as retirement to secure home ownership.
The adjustment from single life, dating and an early career development lifestyle filled with multiple nights out socializing each week can be difficult for newlyweds. However, this transition does offer opportunities to reduce or eliminate spending on those late nights of partying. An adjustment to spending patterns can increase net cash flow, which can be saved for the house down payment.
Married with Children
Often as newlyweds begin planning their futures, children are at the top of the list of major goals. The costs associated with having kids these days can be overwhelming, especially for locals. Even those with good health insurance (if there is such a thing these days) can still face significant costs associated with the birth of their children. Ongoing costs for health care, food, clothing, education, etc., for most will be one of the most challenging expense categories they will face throughout their lives.
Probably the most important aspect of planning for child-related expenses is educational costs. As with retirement, the earlier one begins saving for educational expenses, the better. Educational expenses are expected to grow at an average rate of 7 percent per year, which is more than twice the rate of inflation. The current cost of one year at UCLA for a California resident living on campus is about $32,000. For a child born today, and assuming the 7 percent per year increase, one year at UCLA will cost about $108,000. Out of state, private school and living off campus will all require substantially more money.
As discussed above, retirement planning should start as early as possible. Because compounding — earning a return on returns previously earned — is so powerful, the earlier money is set aside for retirement, the more likely retirement goals will be reached. For most, the 40s, 50s and 60s are the most significant earning years, and offer the best opportunity to set aside money for retirement. However, as one nears retirement age, the amount of risk that is taken with investments must be reduced to avoid possible sizable losses. As risk is reduced, opportunity for gains is also reduced — risk and potential return go hand in hand. This means that although the individual will likely earn more in the years leading up to retirement, their chance of growing their assets during those years will decrease substantially. Proper planning and investment strategy during the earlier years, especially in the late 40s and 50s when more risk-taking is appropriate, will provide the individual with the best chance of meeting retirement goals.
Once retirement has been reached and ongoing retirement needs have been secured, the planning process shifts to legacy issues and the distribution of assets to beneficiaries. For charitably minded individuals, asset transfers to charities can provide significant tax benefits. There are also a variety of trust structures available to wealthy individuals that allow for transferring assets with favorable tax benefits. The post retirement stage of planning is probably the most complex of all. Those with significant assets will benefit from the advice of professionals with specific expertise in estate planning, tax planning, trusts and wealth transfer.
Although each person may reach the various phases of life at different ages, and some may have additional phases or steps within each phase, virtually everyone can benefit from visualizing their life using this general framework. Working with a professional financial planner, each person should formulate a comprehensive financial plan as early in life as possible. Financial plans should also be updated periodically, especially when a major phase of life has ended and another has begun, or any time a major change occurs, such as a change in career, relocation, divorce, etc. By approaching financial goals in a systematic, structured way, individuals will have the best opportunity for success, which can make life a lot more fulfilling.
— Craig Allen, CFA, CFP, CIMA, is president of Montecito Private Asset Management LLC and founder of Dump Your Debt. He has been managing assets for foundations, corporations and high-net worth individuals for more than 20 years and is a Chartered Financial Analyst (CFA charter holder), a Certified Financial Planner (CFP) and holds the Certified Investment Management Analyst (CIMA) certification. He blogs at Finance With Craig Allen and can be contacted at email@example.com or 805.898.1400. Click here to read previous columns or follow him on Twitter: @MPAMCraig. The opinions expressed are his own.