A Financial Planning Update

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Just as one’s physical health changes over time, so does financial well-being. Thus, readers have asked how often a well-written financial plan should be updated. Many financial advisors will say that you should have a yearly update to your plan. My response is that updating the plan depends less on the mere passage of time and more on these four factors: (i) your profile or what you might call a history and financial physical, (ii) your goals, (iii) the economic environment, or (iv) the assumptions used in your plan. Changes to any one of these factors may be sufficient to warrant an update of your plan.

Let’s say that you had a financial plan written several years ago; the real question is whether it is still on track to fulfill your long range goals and objectives. A brief comparison of your current financial profile compared to where the plan said you would be could indicate the need for an update. For now, let’s review some of the key elements of a comprehensive plan and ask how these factors might have changed over the past few years. As we near the end of the year, our firm will produce a checklist of items to consider for your financial checkup. If you are not a client of the firm and would like to be added to that distribution list, email casey@dsneal.com, and she will insure that you are added to that list.

Assumptions

Because a financial plan involves a projection into the future, assumptions about how the future will play out are necessary. It is vitally important for you to know what assumptions were used to generate the plan and how close to reality those assumptions have turned out to be. Key assumptions are income, inflation, investment return, tax rates, and spending. Different planners use different assumptions for many of these factors. Some plans assume a rising standard of living while others assume a constant inflation-adjusted standard of living. It is important for you to know which was used and to gauge your performance accordingly.

Goals

The financial planning process begins with a statement of goals. Having written and updated financial plans for the past 30+ years, I have watched with more than a passing interest as client goals have matured and changed over time. The most joyful time for client and planner is when a goal is accomplished and marked off the list. Occasionally however, goals become outdated. As you review your financial plan, it is important to note which of your goals it was trying to address at the time it was written and how those goals might have changed since then. If the goals are no longer valid, it is time to update the plan.

Net Worth

Most financial plans contain a presentation of your current financial net worth on the date of the plan as well as an annual projection of net worth into the future. Recall that net worth is simply assets minus liabilities as of a given date. A review of your current net worth compared to what the plan projected your net worth would be at the end of 2013 should be considered in your present review. The longer the planning horizon, the more significant any present deviation becomes. Prior to retirement, net worth should be growing as you age; therefore, a shortfall between actual and planned net worth is more indicative of the need for a plan update.

Cash Flow

If you know me, you have probably heard me say that there are five things, and only five things, that you can do with each dollar that comes into your life each year. That dollar can be used to (i) pay taxes, (ii) make payments on debts, (iii) be saved, (iv) be given away, or (v) be spent to support living standard. In other words, all dollars of income have to go someplace each and every year. Part of our job as financial planners is to help our clients make an informed decision about the distribution of annual gross income. Since every person has the most control over discretionary cash flow, i.e. what is left over after payment of taxes and debts, focus should be given to how these were projected and how they have actually played out. As you might imagine, consumptive spending can sometimes get away from the best of us as the needs and wants of our families change or as our income grows and contracts. Changes in tax law occur nearly every year and for most readers, tax rates have gone up this year as the result of the fiscal cliff legislation at the beginning of this year.

Investment Returns and Inflation

A key element of most financial plans is the interplay between investment returns and inflation, called the real rate of return. If your plan was based on a long run average return of the stock market (approximately 10 percent) and inflation (three percent), it is possible that your real rate of return was projected to be seven percent per year for the entire planning horizon. If your actual return has been significantly different than the projection, particularly if it has been less, an update is in order. However, I should point out that most planners are fairly conservative when projecting returns so it should not be surprising to find a real rate of return over inflation of four-to-five percent in your financial plan. In deciding whether a plan should be updated, focus should be given to the long run (more than five years) average of your real returns rather than year-by-year assessments. Note however that returns are usually less impactful than spending decisions.

Environment

Needless to say, the past five years have brought on significant changes to our economy. For a long range plan, the key question is whether these changes have been normal, stationary changes or structural, and therefore more impactful in ways that are different than past cycles. We believe that the Great Recession of 2008–09 and the recovery since then has been anything but normal and that structural changes to the economy are playing out right before our eyes. Moreover, this is all happening on the eve of one of the greatest demographic shifts our economy has ever known—the retirement of baby boomers. Being attentive to these changes is key to understanding how existing plans ought to be updated and new plans developed.

Scott Neal is president of D. Scott Neal, Inc. with offices in Lexington and Louisville, Kentucky. Comments and questions are welcome. To learn more, visit www.dsneal.com