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PERSONAL
FINANCE FOR
ENGINEERS
CS 007: SESSION 8
FINANCIAL
PLANNING &
GOALS
CS 007
PLANNING
how to set financial goals and meet them
WHAT IS A FINANCIAL PLAN?
• Comprehensive evaluation of current & future
financial state.
• “The process of determining whether and how
an individual can meet life goals through the
proper management of financial resources”
— CFP Board
• Cash flow, assets, withdrawals.
• Key components
• Net Worth
• Cash Flow Analysis
• Retirement Strategy
• Risks / Insurance
• Investment Strategy
• Tax Strategy
• Estate Plan
WHY IS FINANCIAL PLANNING NEEDED?
• People tend to spend more than
they need to, if they lack
sufficient motivation for saving.
• Short term rewards vs. Long term
payoff. Need time to build assets.
• Making a financial plan explicit
increases likelihood of success
• Extremely important when more
than one person involved
(couples / families)
WHAT ARE FINANCIAL ADVISORS?
• Term can be used by anyone. Be extremely wary.
• Two accreditations are well respected:
CFP & CFA.
• Most have a very high variable cost (1%+) and high
minimums ($1M+)
• There is evidence that financial planners
significantly help people avoid behavioral errors.
Vanguard estimates that value at 150 bps! *
• Communication about money is often dysfunctional
for couples. Financial advisors force transparency
& joint planning, which is essential.
• Industry is rife with conflict of interest & high
commissions.
• Will likely be disrupted by personalized, data-
driven automated solutions over the next 10 years.
* Quantifying Vanguard Advisor’s Alpha
https://www.vanguard.com/pdf/ISGQVAA.pdf
WHY DO FINANCIAL ADVISORS CHARGE SO MUCH?
• A financial advisor has a very small client
base, typically between 50 - 75 clients.
• A financial advisor has to cover high fixed
costs (expensive office) and high variable
costs (their salary & support team)
• If an advisor wants to make $100,000, and
their business has overhead of $100,000,
they need $4,000 per client per year, just to
break even.
• The higher quality the advisor, the larger
that problem becomes.
• Solution: high minimums, high fees, hidden
product placement kickbacks / commissions.
TYPES OF GOALS
e.g. build an emergency fund, retire
WHAT ARE FINANCIAL GOALS?
• Any goal with significant financial
requirements (assets / income)
• Time frame matters.
Short-term, medium-term, long-term,
indeterminate & conditional goals.
• Examples
• Emergency Fund
• Get out of Debt
• Buy a car
• Buy a house
• Start a business
• College
• Retirement
* http://brokegirlrich.com/doin-it-by-the-decade-the-wealthy-barber-review/
HOW TO PROJECT SAVINGS GOING FORWARD?
• Cash accounts, assume FDIC rates for
the appropriate time frame.
• For diversified portfolio, use historical
rates of return, adjusted for inflation.
• Inflation can be estimated from the
difference from US Treasuries to TIPS.
(about 1.9%)
• Simple method: assume annual rate,
divide by 12 for monthly, build out
projection month by month.
• More sophisticated: Monte Carlo uses
statistical projection to estimate a
huge number of potential outcomes,
and assign probabilities.
SIMPLE GOAL: EMERGENCY FUND
• One of the most important short
term goals.
• Priority: Liquidity & Safety
• Typical target: 3-6 months of
expenses, in an FDIC-insured bank
account.
• Simple projection: monthly savings x
number of months.
• Example: $12,000 emergency fund
might require $1,000 in savings per
month for a year.
MORE COMPLEX GOAL: HOUSE
• US Census: 63.9% homeownership rate
(as of Q3 2017)
• Two key components: down payment & income
requirement (cash flow)
• Down payment typically 20%. For $1M house, that’s
$200K. Plus closing costs.
• Common debt / income ratio for banks is 36% (pre-
tax). In high cost areas, might stretch to 40% or more.
• Do you have flexible timeline? If so, you likely can
afford some level of market risk. If not, stick to cash.
• Houses dramatically lower liquidity (hard to get $ out)
and mobility (relocation for work)
• Long term track record for real estate is positive:
combination of beating inflation & leveraged
investment.
MORE COMPLEX GOAL: COLLEGE
• Very expensive goal. Wealthfront estimates
that sending my son to Stanford in 2027
will cost $358,942. Inflation adjusted!
• College costs have increased faster than
inflation (Wealthfront uses 1.1% faster than
inflation as the long term trend)
• Limited time frame. You have 40-50 years
for retirement. 18 years is not a lot of time
for compounding to become significant.
• 529 College Savings Plans have significant
tax advantages, at the cost of liquidity.
• Layered planning for multiple children
rewards over-saving early.
COMPLEX: RETIREMENT
• Extremely complicated goal.
• Four interrelated problems
• Projecting income for 40+ years
• Replacing income for 30+ years
• Tax efficiency
• Planning for multiple people
• Long term asset allocation
(diversified portfolio)
• Asset location
(where to put which investments)
• Tax-deferred accounts
401(k), IRA, Roth IRA, etc.
• Beware of the life insurance charlatans
COMPLEX: RETIREMENT
• Projecting Income
Can use wage inflation as a proxy
• Replacing Income
Can use the “4% rule” as a first
approximation
• Tax Efficiency
Leverage tax-deferred accounts, like 401(k)
plans. Roth accounts have significant
advantages for some high income savers.
• Family Planning
Ensure you know the retirement plans of
each partner, and have estimated timing for
major expenses for children. Look at total
household income & assets collectively.
COUPLES
how financial planning changes with a partner
PLANNING FOR TWO (OR MORE)
• Financial planning is difficult.
Requires projecting the future &
prioritizing choices
• Exponentially harder with couples,
because of different timelines,
priorities & possibilities.
• Key issues include communication,
transparency, relationship & values.
• Money & related issues are some
of the most common reasons
relationships fail.
COUPLES: BUDGETS & SPENDING
• How to manage budgeting / spending with
two people?
• One account approach: one joint account, fully
shared.
• Two account approach: separate accounts,
coordination on bill paying.
• Three account approach: two personal
accounts & one joint account.
• None of these tactics solve the core problem:
communication & values.
• “magic” number for size of expense to discuss
• Warning: Joint liability for credit is a serious
commitment. Not to be taken lightly.
JOINT ACCOUNTPERSONAL 1 PERSONAL 2
PERSONAL
SPENDING
PERSONAL
SPENDING
COMMON
BILL
JOINT
SAVINGS
JOINT
INVESTMENTS
COMMON
BILL
COMMON
BILL
COMMON
BILL
401K / IRA 401K / IRA
COUPLES: SAVING & INVESTING
• Retirement accounts (401k & IRA) are
individual.
• Brokerage accounts can be individual or
joint. Equity compensation is individual.
• Social security can be individual or joint,
depends on how you claim.
• Varying incomes, careers, time lines and
complicate savings rates.
• Quality of benefits at different companies
can vary significantly (e.g. Google 401(k) vs.
a startup 401(k))
• Likely needs to be revisited as situations
adapt / change.
JOINT ACCOUNTPERSONAL 1 PERSONAL 2
PERSONAL
SPENDING
PERSONAL
SPENDING
COMMON
BILL
JOINT
SAVINGS
JOINT
INVESTMENTS
COMMON
BILL
COMMON
BILL
COMMON
BILL
401K / IRA 401K / IRA
LIFE INSURANCE
how does it work? when does it make sense?
LIFE INSURANCE: WHY DOES IT EXIST?
• Death Insurance
• There are costs associated with death.
• People with dependents need a way to provide
for them after death.
• Retirement plans often take decades to
execute. Life insurance can replace income that
was never received due to death.
• There is a fundamental economic benefit to
pooling risk around uncertainty. When a person
will die is the original actuarial case for adding
value this way.
• Life insurance has several tax benefits. The
owner is not taxed on the potential benefit size,
and the beneficiary is not taxes on receipt.
LIFE INSURANCE: WHAT TYPES ARE THERE?
• Term Life Insurance is the plain vanilla variety. You pay
monthly for a time period to ensure payment to a
beneficiary if you die. Payout can be level or decreasing.
• Whole Life Insurance provides a death benefit no matter
how old you are. AKA “permanent” life insurance.
• Universal Life Insurance is similar to whole, but with
greater flexibility to change death benefit & cash value.
• Variable Life Insurance has fixed premiums and death
benefit can increase based on rate of return of the cash
value.
• Every combination you can imagine has been tried. This
is a $2 Trillion industry in the US.
• High expenses & fees, with punitive clauses for exiting
agreements makes life insurance a poor financial product
choice for long term investment. Stick with term life
insurance.
LIFE
INSURANCE
TERM PERMANENT
LEVEL VARIABLEUNIVERSALWHOLEDECREASING
LIFE INSURANCE: HOW MUCH DO YOU NEED?
• Think of costs associated with death.
• Think of dependents and expenses that
require your income for funding.
House. College. Retirement.
• Think about the time frame before you will
have accumulated the assets to pay those
costs out of pockets.
• Costs are non-linear because probability of
dying increases with age. 30 year policy is
not just 3x a 10 year policy.
• Very inexpensive for young people.
• Typically purchased at marriage or during
planning for a child.
*
QUESTIONS
CS 007

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Stanford CS 007-08 (2019): Personal Finance for Engineers / Financial Planning & Goals

  • 3. PLANNING how to set financial goals and meet them
  • 4. WHAT IS A FINANCIAL PLAN? • Comprehensive evaluation of current & future financial state. • “The process of determining whether and how an individual can meet life goals through the proper management of financial resources” — CFP Board • Cash flow, assets, withdrawals. • Key components • Net Worth • Cash Flow Analysis • Retirement Strategy • Risks / Insurance • Investment Strategy • Tax Strategy • Estate Plan
  • 5. WHY IS FINANCIAL PLANNING NEEDED? • People tend to spend more than they need to, if they lack sufficient motivation for saving. • Short term rewards vs. Long term payoff. Need time to build assets. • Making a financial plan explicit increases likelihood of success • Extremely important when more than one person involved (couples / families)
  • 6. WHAT ARE FINANCIAL ADVISORS? • Term can be used by anyone. Be extremely wary. • Two accreditations are well respected: CFP & CFA. • Most have a very high variable cost (1%+) and high minimums ($1M+) • There is evidence that financial planners significantly help people avoid behavioral errors. Vanguard estimates that value at 150 bps! * • Communication about money is often dysfunctional for couples. Financial advisors force transparency & joint planning, which is essential. • Industry is rife with conflict of interest & high commissions. • Will likely be disrupted by personalized, data- driven automated solutions over the next 10 years. * Quantifying Vanguard Advisor’s Alpha https://www.vanguard.com/pdf/ISGQVAA.pdf
  • 7. WHY DO FINANCIAL ADVISORS CHARGE SO MUCH? • A financial advisor has a very small client base, typically between 50 - 75 clients. • A financial advisor has to cover high fixed costs (expensive office) and high variable costs (their salary & support team) • If an advisor wants to make $100,000, and their business has overhead of $100,000, they need $4,000 per client per year, just to break even. • The higher quality the advisor, the larger that problem becomes. • Solution: high minimums, high fees, hidden product placement kickbacks / commissions.
  • 8. TYPES OF GOALS e.g. build an emergency fund, retire
  • 9. WHAT ARE FINANCIAL GOALS? • Any goal with significant financial requirements (assets / income) • Time frame matters. Short-term, medium-term, long-term, indeterminate & conditional goals. • Examples • Emergency Fund • Get out of Debt • Buy a car • Buy a house • Start a business • College • Retirement * http://brokegirlrich.com/doin-it-by-the-decade-the-wealthy-barber-review/
  • 10. HOW TO PROJECT SAVINGS GOING FORWARD? • Cash accounts, assume FDIC rates for the appropriate time frame. • For diversified portfolio, use historical rates of return, adjusted for inflation. • Inflation can be estimated from the difference from US Treasuries to TIPS. (about 1.9%) • Simple method: assume annual rate, divide by 12 for monthly, build out projection month by month. • More sophisticated: Monte Carlo uses statistical projection to estimate a huge number of potential outcomes, and assign probabilities.
  • 11. SIMPLE GOAL: EMERGENCY FUND • One of the most important short term goals. • Priority: Liquidity & Safety • Typical target: 3-6 months of expenses, in an FDIC-insured bank account. • Simple projection: monthly savings x number of months. • Example: $12,000 emergency fund might require $1,000 in savings per month for a year.
  • 12. MORE COMPLEX GOAL: HOUSE • US Census: 63.9% homeownership rate (as of Q3 2017) • Two key components: down payment & income requirement (cash flow) • Down payment typically 20%. For $1M house, that’s $200K. Plus closing costs. • Common debt / income ratio for banks is 36% (pre- tax). In high cost areas, might stretch to 40% or more. • Do you have flexible timeline? If so, you likely can afford some level of market risk. If not, stick to cash. • Houses dramatically lower liquidity (hard to get $ out) and mobility (relocation for work) • Long term track record for real estate is positive: combination of beating inflation & leveraged investment.
  • 13. MORE COMPLEX GOAL: COLLEGE • Very expensive goal. Wealthfront estimates that sending my son to Stanford in 2027 will cost $358,942. Inflation adjusted! • College costs have increased faster than inflation (Wealthfront uses 1.1% faster than inflation as the long term trend) • Limited time frame. You have 40-50 years for retirement. 18 years is not a lot of time for compounding to become significant. • 529 College Savings Plans have significant tax advantages, at the cost of liquidity. • Layered planning for multiple children rewards over-saving early.
  • 14. COMPLEX: RETIREMENT • Extremely complicated goal. • Four interrelated problems • Projecting income for 40+ years • Replacing income for 30+ years • Tax efficiency • Planning for multiple people • Long term asset allocation (diversified portfolio) • Asset location (where to put which investments) • Tax-deferred accounts 401(k), IRA, Roth IRA, etc. • Beware of the life insurance charlatans
  • 15. COMPLEX: RETIREMENT • Projecting Income Can use wage inflation as a proxy • Replacing Income Can use the “4% rule” as a first approximation • Tax Efficiency Leverage tax-deferred accounts, like 401(k) plans. Roth accounts have significant advantages for some high income savers. • Family Planning Ensure you know the retirement plans of each partner, and have estimated timing for major expenses for children. Look at total household income & assets collectively.
  • 16. COUPLES how financial planning changes with a partner
  • 17. PLANNING FOR TWO (OR MORE) • Financial planning is difficult. Requires projecting the future & prioritizing choices • Exponentially harder with couples, because of different timelines, priorities & possibilities. • Key issues include communication, transparency, relationship & values. • Money & related issues are some of the most common reasons relationships fail.
  • 18. COUPLES: BUDGETS & SPENDING • How to manage budgeting / spending with two people? • One account approach: one joint account, fully shared. • Two account approach: separate accounts, coordination on bill paying. • Three account approach: two personal accounts & one joint account. • None of these tactics solve the core problem: communication & values. • “magic” number for size of expense to discuss • Warning: Joint liability for credit is a serious commitment. Not to be taken lightly. JOINT ACCOUNTPERSONAL 1 PERSONAL 2 PERSONAL SPENDING PERSONAL SPENDING COMMON BILL JOINT SAVINGS JOINT INVESTMENTS COMMON BILL COMMON BILL COMMON BILL 401K / IRA 401K / IRA
  • 19. COUPLES: SAVING & INVESTING • Retirement accounts (401k & IRA) are individual. • Brokerage accounts can be individual or joint. Equity compensation is individual. • Social security can be individual or joint, depends on how you claim. • Varying incomes, careers, time lines and complicate savings rates. • Quality of benefits at different companies can vary significantly (e.g. Google 401(k) vs. a startup 401(k)) • Likely needs to be revisited as situations adapt / change. JOINT ACCOUNTPERSONAL 1 PERSONAL 2 PERSONAL SPENDING PERSONAL SPENDING COMMON BILL JOINT SAVINGS JOINT INVESTMENTS COMMON BILL COMMON BILL COMMON BILL 401K / IRA 401K / IRA
  • 20. LIFE INSURANCE how does it work? when does it make sense?
  • 21. LIFE INSURANCE: WHY DOES IT EXIST? • Death Insurance • There are costs associated with death. • People with dependents need a way to provide for them after death. • Retirement plans often take decades to execute. Life insurance can replace income that was never received due to death. • There is a fundamental economic benefit to pooling risk around uncertainty. When a person will die is the original actuarial case for adding value this way. • Life insurance has several tax benefits. The owner is not taxed on the potential benefit size, and the beneficiary is not taxes on receipt.
  • 22. LIFE INSURANCE: WHAT TYPES ARE THERE? • Term Life Insurance is the plain vanilla variety. You pay monthly for a time period to ensure payment to a beneficiary if you die. Payout can be level or decreasing. • Whole Life Insurance provides a death benefit no matter how old you are. AKA “permanent” life insurance. • Universal Life Insurance is similar to whole, but with greater flexibility to change death benefit & cash value. • Variable Life Insurance has fixed premiums and death benefit can increase based on rate of return of the cash value. • Every combination you can imagine has been tried. This is a $2 Trillion industry in the US. • High expenses & fees, with punitive clauses for exiting agreements makes life insurance a poor financial product choice for long term investment. Stick with term life insurance. LIFE INSURANCE TERM PERMANENT LEVEL VARIABLEUNIVERSALWHOLEDECREASING
  • 23. LIFE INSURANCE: HOW MUCH DO YOU NEED? • Think of costs associated with death. • Think of dependents and expenses that require your income for funding. House. College. Retirement. • Think about the time frame before you will have accumulated the assets to pay those costs out of pockets. • Costs are non-linear because probability of dying increases with age. 30 year policy is not just 3x a 10 year policy. • Very inexpensive for young people. • Typically purchased at marriage or during planning for a child. *