Financial Planning - a 101 Guide
Just starting work, or finally got down to looking at the numbers in your life? Here is a quick guide on getting started with Financial Planning – an ongoing process that helps you to achieve comfort and financial freedom!
What is Financial Planning?
Financial planning refers to an in-depth review of your monetary situation; and from that information, developing a strategy to reach quantifiable goals.
For example, you would like an income of S$2,500, adjusted for inflation, by the time you retire in the year 2047. A financial representative would work out the total amount you need to save and invest to reach this target, as well as type of assets you should buy to meet the goal (e.g. endowment plans, unit trusts, equities, bonds, and so forth). This would constitute a financial plan for retirement.
For a financial plan to work, there are a few key components it must include.
First, a financial plan must be customised to the individual’s needs and objectives. There’s no “one-size-fits-all” approach to financial planning.
For example, if you are an only child, you may need to make greater provisions for your elderly parents later. If you aspire to retire younger, say at age 55, you will have to set aside more monthly savings than usual. Never rely on over-simplified plans or theories, which claim to be true for everybody.
Second, financial planning as an ongoing process. It’s never a one-off formula that’s devised over an hour, and then rigidly followed to the end.
Many things may happen between today and your retirement. Your portfolio of assets – and long term financial goals – may have to change. Factors such as marriage, becoming self-employed, litigation, or an economic recession can all require changes to your plan.
As such, it’s important to speak to a qualified financial representative at least once every six months. This is to fine tune your range of assets (e.g. portfolio rebalancing), and to revise your savings and investment amounts to match your goals.
Finally, financial plans must always have quantifiable goals. An example of this would be “accumulate S$50,000 to make down payment on a flat by age 32”, or “build a stock portfolio that pays S$1,000 a month in dividends in the next 25 years”. Financial planning should not involve vague goals, such as “make more money”.
Where do I start with Financial Planning?
As mentioned above, there is no financial plan that suits every single person. It’s recommended that you speak to a qualified financial representative, in devising a financial plan for yourself. That being said, you can consider the basic elements of a financial plan.
Begin your financial planning with risk management.
There is no point having a long term investment plan, if you have no way to hedge against risks. Risks refer to factors such as falling ill, unexpected retrenchment, serious accidents, and so forth. These are unplanned situations that end up costing you a lot of money.
If you don’t have a way to protect yourself from these risks, your financial plans will constantly be derailed. For example:
You invest all of your monthly income to buy S$100,000 worth of shares. At some point, you develop a severe illness, and your medical fees end up costing S$70,000.
As you have no savings, you are forced to sell off your shares for the money. But at the time you sell, the market is in a recession; your $100,000 worth of shares may sell for lesser.
In this case, depending on your selling price, you would end up in debt from your medical fees, whilst your entire investment portfolio of shares has been wiped out.
This is why it’s important to build up your savings, and protect yourself through insurance, before you even consider goals like retirement. At the very least, you should be insured against:
- Critical illness
- Total & Permanent Disability
- Personal accidents
- Death (this protects your family, if you are the sole breadwinner)
Depending on your situation, a financial representative may identify other risks that you need to insure against. For example, if you are a doctor, you will also require malpractice insurance, to protect you in the event of litigation.
Besides insurance, it’s important to build up an emergency savings fund. This should consist of up to six months of your expenses. Your savings fund is not an investment – this money must be available on short notice, to cover emergency expenses. As such, savings should not be placed in inflexible financial products, in which instant withdrawal is not possible.
Next, work out your long term retirement goals
The simplest way to do this is to determine your desired Income Replacement Rate (IRR). This is the percentage of your current income that you want to get when you retire. So if your current income is S$50,000 per annum, and you have a desired IRR of 70 per cent, your post-retirement income must be S$35,000 per annum.
To be safe, your post-retirement income should last until the age of 85 to 90, given the long life expectancy in Singapore. As a loose rule of thumb, an IRR of 70 per cent helps you to enjoy more or less the same lifestyle you have at present. If you plan on a simple retirement, you might aim for an IRR of just 50 per cent. But it’s not unheard of for people to aspire toward IRRs of even 120 per cent, if you plan to live better at retirement. Next, you should consider your desired age of retirement. This is not necessarily the “official” age of 65. You may aspire to retire at 45, or you may enjoy your job and want to work till 75. Your desired IRR, plus your intended retirement age, determine the “lump sum” that you must save up before retiring.
For example, say you are 25 years old, and you intend to get S$2,500 per month after retirement. You also want to retire at the age of 55. Assume an inflation rate of three per cent per annum*, you would need to accumulate around S$1.87 million by the time you are 55.
From this basic figure, you can determine the required rate of return from your various assets, as well as the amount you need to invest over time.
(Get a financial representative to handle the calculations for you; you may need to adjust your expectations, based on the reality of your earnings).
*The inflation rate refers to the rising price of goods over the years. The rate of three percent per annum is a healthy rate of inflation for most developed economies.
After working out how much you need, consider the appropriate assets
Now that you have a clear goal in mind (the amount you need to retire), you can start considering what assets to invest in – for instance, insurance endowment plans and unit trusts.
Insurance endowment plans help to build up savings over a fixed policy term and providing some basic insurance protection, such as death benefits and coverage for critical illness, or Total & Permanent Disability.
Unit trusts are funds. These consist of investors pooling their money, and leaving it to a fund manager to invest. The fund manager will buy and sell various assets with the monies, to generate a return for the investors.
Unit trusts tend to specialise in a particular asset, such as equities (stocks), bonds, or commodities like gold and oil. Unit trusts tend to deliver higher returns than endowment plans, over long periods such as 10 years. You should always be reminded that with higher expected returns come higher risks.
You can also consider fixed income products, such as bonds. Bonds are essentially debt instruments, and you (the bond holder) effectively loan money to a government or company (the bond issuer). In return, you will get fixed interest repayments in the form of a coupon (usually every six months). When the bond matures, you will also be paid the par value of the bond.
For example, say you buy a bond with a par value of S$20,000, over 10 years, with a coupon of four per cent. You would get a coupon of S$800 every six months (four per cent of S$20,000). On the 10th year, when the bond matures, you will get S$20,000, and the bond will terminate.
One key advantage of bonds is that, unlike unit trusts or endowment plans, you know for sure how much money you’re going to get. The bond-issuer must pay the fixed coupon and par value, regardless of how good or bad the economy is.
You will need a mix of these asset types, in your investment portfolio. Never put all your money into one specific asset; always diversify to avoid risk. A financial representative or wealth manager can help you determine the correct combination of assets, depending on your risk appetite.
In addition, note that your portfolio will need to be tweaked (rebalanced) periodically. As your needs and situation changes, your asset allocation will
Finally, control your debt to meet your goals
All the financial planning in the world is useless, if you allow your debt to go out of control. A POSB credit card, for instance, has an interest rate of almost 26 per cent per annum2. It is impossible for the average Singaporean to “out-invest” credit card debt.
Likewise, personal loans and credit lines have interest rates of 9 to 14 per cent per annum and 7 to 20 percent per annum on average respectively3 . If you allow these debts to grow out of control, they will wipe out any investment returns you make.
The only truly “cheaper” debt in Singapore is your home loan. HDB loans charge 2.6 per cent per annum4, whilst private bank loans are around 1.8 to 2 per cent per annum5 .
As such, you should always prioritise payment of your credit card and personal loans first. Deal with your mortgage last, as it’s the least damaging to your financial plans.
As a rule of thumb, you should never allow your monthly obligations (debt repayments) to exceed 30 per cent of your monthly income. If you exceed this ratio, then focus on paying off your debt before you start investing. Only set aside money for savings and insurance, while you pay down your debts. You should also note that, when you take a loan to buy your house, there is a Total Debt Servicing Ratio (TDSR) of 60 per cent. This means your total monthly debt – inclusive of the home loan, credit card, education loans, and so forth – cannot exceed 60 per cent of your monthly income6. Letting your debt run amok can thus stop you from buying a house.
Note that having to rent is problematic, as your retirement is much less secure without a paid-up home. Also, if you buy a house late, you may be saddled with mortgage repayments even into your retirement.
The last mile of your financial planning
As you grow older, your financial planning will need to change. This is most evident in the decade prior to retirement.
One of the key changes will be reallocating your assets, such as switching from unit trusts to bonds. You may even place more of your money in simple fixed deposits, rather than investing it. This is because when you are in your retirement, and your priority should be protecting the wealth you’ve accumulated, rather than growing it.
If you’re near retirement and haven’t spoken to a financial representative for some time, it’s a good idea to do so.
Likewise, you will probably want to switch your assets to more passive forms of income generation. For example, the coupon from bonds or rental income from any property assets are well suited to retirement.
The final stage of your financial planning is no longer about yourself. Instead, you need to make the transition into estate planning. At this point, you will need to consider setting up trusts and wills, as well as CPF nominations, to protect you loved ones when you’re gone. A financial representative or wealth manager is instrumental here.
8th January 2022