Charting a Course to Financial Freedom--the Five Pillars of Financial Planning

Talent, luck and hard work may be factors in achieving financial success, but financial freedom is achieved through planning, effort and strategic management. Those who achieve it do so because they have created a road map to get there.

Imagine taking a road trip to a destination you've never been without knowing the distance you must travel, the time needed to get there, or the route to follow. Without a plan and a road map, your chances of making it to your destination on time are not good. If planning and preparation are important in preparing for a road trip, how much more essential are they in charting your journey to financial freedom? Financial freedom requires both a plan and a disciplined approach to accomplishing it.

Developing that plan is complex and individualized, but the components used in creating it are pretty straight forward. We use a five pillar approach to financial planning to help our clients navigate the journey and construct a solid plan. The five pillars of financial planning—investments, income planning, insurance, tax planning, and estate planning— are a simple but comprehensive approach to financial planning. They are foundational in the course for financial freedom in any financial plan. Missing any one of these can put your financial future at risk.

The First Pillar—Investments

Wealth is simply an abundance of possessions or money and is achieved by living within your means and saving money. The period in which you accumulate wealth is referred to as the accumulation phase of your financial plan. The period when you begin withdrawing money from your assets in the form of “income” and living expenses is referred to as the distribution phase. Traditionally, this is known as retirement, but we call it “freedom”. Investing is the process of putting the wealth you've accumulated to work for you, so you can be free.

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The most important consideration in achieving financial freedom is where you put your money. Because wealth isn't usually determined by a single investment, but by how it's allocated, asset allocation is overwhelmingly the most important aspect of investing.

Asset allocation is simply the process of spreading your money into different buckets—or not putting all of your eggs into one basket. It might also be referred to as egg allocation. Asset allocation is the most important investment decision you'll make in your lifetime.

The buckets of portfolio allocation include: stocks, bonds, cash, commodities and gold. Within each of these buckets are other buckets (like Russian nesting dolls). For instance, the stock bucket might include buckets for US domestic stocks, international stocks, emerging market stocks, large cap stocks, mid cap stocks, small cap stocks, value stocks and growth stocks. The proportion allocated into each bucket depends on a variety of factors, including what's happening in the economy, inflation, interest rates, and markets around the world. How these are allocated is crucial to your success and implementation can be very complicated.

Our asset allocation process and the creation of our portfolios use indexes of market segments to achieve results. This process allows us to produce investment results, control risks and control costs.

The Second Pillar—Income Planning

Income planning is the process of creating a detailed strategy for determining how much income you'll need to live the retirement lifestyle you want. For some this includes moving to reduce expenses; for others it means making provision for travel plans. Similar to creating and implementing a cash flow plan or a budget, income planning is about looking at plans for the future and deciding how to implement them. Following a simple three-step plan can be instrumental in helping you develop a retirement income plan that will last throughout your lifetime. That requires:

  • Estimating what you will need in retirement.
  • Determining the sources of that income.
  • Starting with a reasonable withdrawal (and being prepared to change it).
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One simple way to estimate the income you will need at retirement is to take a percentage of your current income as a starting point. Assuming you will have fewer expenses in retirement, you might start with 80 percent of your current income, adjusting up or down depending on your particular situation.

Determining where that income comes from requires looking at a variety of sources, including Social Security income, pensions, IRAs, 401(k)s and other tax deferred accounts, as well as annuities and taxable accounts.

Once you determine how much your retirement expenses will be, the big question becomes how much you can afford to withdrawal each month without risking outliving your savings.

As with any future plans, income planning is only our best guess at how things will be when we convert savings to income, but by allowing lead time and implementing a simple plan, coming up with a retirement income plan is not impossible.

The Third Pillar—Insurance

Insurance is simply risk management. By transferring the risk of potential loss to someone else—usually an insurance company—insurance allows you to protect yourself against potential loss and financial hardship at an affordable rate. It's an important step in financial planning.

By allowing risk to be spread among a large group of people, everyone benefits from insurance. Types of risks include everything from protecting family from loss of income after your death to protecting yourself against lawsuits. Other types of insurance include homeowner's insurance, auto insurance, medical and health insurance, disability insurance, umbrella insurance and life insurance. Though we are not insurance agents, we can help you find those with the specific expertise you need.

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Life insurance can offer lots of bells and whistles. Although this can be helpful, it also adds a lot of confusion. Whereas term life insurance is fairly inexpensive and straight forward, “permanent” life insurance is more complex. “Permanent” insurance is a catchall phrase for a wide variety of life insurance products with a cash-value feature, including whole life, variable life and universal life. These types of policies not only can build cash value over time, but provide death benefits to your beneficiaries.

Though insurance can be complex, having the best coverage for your situation is an important part of your financial plan.

The Fourth Pillar—Tax Planning

Tax planning during the accumulation phase and tax planning during the distribution phase are very different. During the accumulation phase, when you enter the workforce and start saving for later in life, you will be making payroll contributions to the Social Security system and contributing to a 401k or IRA. Tax strategy comes down to reducing the current year's tax obligation and deferring taxes that must be paid in the future by taking advantage of deductions, writing off expenses, and paying into a tax-deferred savings planning permeates the financial planning process. Its purpose is to ensure tax efficiency in a system where taxes can be a significant drag on your ability to build wealth. Careful tax planning allows you to defer, or flat out avoid, taxes by taking advantage of beneficial tax-law provisions, increasing and accelerating tax deductions and tax credits, and generally making maximum use of all applicable breaks available under the Internal Revenue Code.

The distribution phase is the time you begin making withdrawals or Required Minimum Distributions (RMDs) from tax-deferred savings. During this phase, you begin paying taxes at your ordinary income tax rate on any investment gain that is withdrawn. You will also pay taxes on the full amount of the withdrawal if it's from a tax-deferred account.

Thousands of rules and hundreds of strategies are available to help you get the most benefit from tax-deferred accounts. Since a mistake here can cost thousands of dollars, it's very important to work with financial advisors and accountants with expertise in tax planning.

The Fifth Pillar—Estate Planning

The fifth and final pillar of your financial plan is estate planning. Simply put, estate planning is deciding how your assets will be distributed after you die (or are unable to make your own financial decisions).

An estate is simply everything you own: bank accounts, investment accounts, life insurance, a home, property or other real estate, furniture, or any smaller assets you have in your name. Though some estates are bigger than others and may require more planning, everyone has an estate.

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A good estate plan can include several elements: a last will and testament, a power of attorney, a living will and a healthcare power of attorney. For some people a trust is also a good option. A trust is a legal entity that allows you to put legal conditions on how certain assets will be distributed upon your death and can be an important part of your tax strategy.

Though not everyone needs a trust, to avoid the costs of probate court and leaving important decisions to a judge, most people with assets should execute a will. An estate plan does not need to be expensive and having one is an important part of ensuring your wishes are met after you're gone.

Financial freedom is a power step in achieving the freedom to spend your time as you see fit. Whether you are just beginning your journey or you've been on the road a while, developing a conscious strategy of managing opportunities is an important part of making it to your destination. Our goal is to help bring clarity to your thinking about your financial life by helping you develop a comprehensive plan to financial freedom.