Financial Planning 101 series - The Financial Pyramid
Updated: Jan 29
Welcome to 7th Street Financials series of original content on financial planning. The goal of this series will be to help educate you on a wide number of topics related to your financial wellbeing. At this point I don’t know how many installments there will be but my hope is to publish a new article each week for roughly a year but we’ll see what level of detail I feel is needed and how many ideas I get for topics.
This series will begin with topics related to personal finance fundamentals, then will get into education savings, insurance planning, investments, retirement and estate planning. Taxes will be considered throughout all of these topics.
This series is not intended to be taken as advice specific to your situation or replace the need to have a financial planner. Hopefully this will be educational and help you be more informed about issues with your own finances or get you thinking about things that you haven’t yet. With that being said, let’s kick things off.
The first topic to be covered is what is referred to as the financial planning pyramid. When I talk to most people they immediately want to talk about when they can retire and wanting to know if their investments are okay. And let’s be honest, these are the cool topics. The stock market has entire tv channels devoted to it and you can track it or your investments easily online or your phone. Almost everyone looks forward to the day they can retire and dream of kicking back and enjoying a more care free life. And for most people their investments will be what carries them to and through retirement so naturally that is the focus.
The truth is from a comprehensive financial planning perspective these are not the first topics I want to address with a client. The first two levels of the pyramid are actually defensive in nature meaning they are meant to protect your assets. These items aren’t exciting, they don’t generate big returns and you won’t receive a statement that gets you dreaming about a trip to Hawaii. Instead these are the items that let you sleep at night when life throws you a curveball because you don’t have to worry about how you will get through the situation financially. Think about it like the HVAC system in your house. When putting money into improving your house people get excited about new colors on their wall, comfortable furniture, or new flooring that transforms a room. Nobody gets excited about updating the existing air conditioner to a newer more efficient unit but you’re really glad you have it come July and it is 95 degrees outside.
One key thing to note with the pyramid is that it is not intended to be a strictly sequential way to handle your personal finances. In fact, in most cases, you should be addressing multiple layers at the same time. For instance, while the base layer may call for building emergency cash savings it doesn’t mean you shouldn’t be putting funds into your 401k plan at work until the cash emergency goal is met. Instead, it should be used to call out that putting all of your focus on maxing out on an optional employee stock purchase plan might not make the most sense when your savings account balance is in the same range as your body weight.
Here is a diagram I like from Financial Legacy Advisors that I feel is a good representation of the financial planning pyramid. In future topics I will get into much more detail of each individual level. For today, let’s cover the highlights of each level and gain an understanding of why the investments and retirement talk are not the immediate focus.
1. The starting block of the pyramid is your financial position. This layer includes emergency savings, debt management and liquidity. But cash and the amount of it on hand for emergencies, along with how it factors into debt management and liquidity makes it the main player of the financial base.
2. The second level is risk management. This is more commonly known as insurance. This includes life, health, auto, home, disability and liability plus any specific insurance that might need be needed for a business or a specific line of employment.
These first two layers provide your financial safety net. If you lose a job you have cash to cover bills until you get a new job. If your car needs an expensive repair you have cash to pay for it instead of taking on expensive debt. If there is an accident, insurance is there so that repairs or damages do not have to be made out of pocket. In the case of serious injury or death, insurance is there to replace lost income or pay for other major expenses that would otherwise not be covered without that person’s income.
To help explain why these two levels are addressed first, let’s run through an example. A husband and wife, age 30, have two kids (age 3 and 5), and each makes $60,000 in annual income. They have decided to put a focus on saving for retirement and their children’s education. They have been able to accumulate $100,000 total in their respective 401k plans, each child has $10,000 in their college savings plan and they have well balanced and diversified portfolios. Due to this focus they put a large amount in investments each month and are not left with much spare cash at the end of the month after paying other debt (mortgage and car loans), bills and living expenses. They have a house worth $250,000 (they owe $200,000), have $2500 in cash savings and each has $200,000 in life insurance. Neither has any disability insurance. The husband is involved in a car accident and is badly injured. The wife’s health insurance policy through work will help with the medical bills but they will be on the hook for covering the policy’s $5,000 deductible and the remaining 20% of hospital costs until they hit the policies out of pocket maximum. Eventually the husband will not be able to continue in his current job and will be limited to part time work.
Let’s review the issues this brings up.
A. How do they pay for the $5,000 deductible on the health insurance policy? They only have $2500 in cash savings and still need to come up with another $2500. Even if we assume the husband has short term disability and continues to receive his income for now that money is need to cover bills unless you slash the investments.
B. How do they pay for the 20% of medical costs they are responsible for? This could easily be several thousand more dollars.
C. How do they continue to meet their monthly obligations? Their income has been cut and there is no long term disability that will continue to pay up to 75% of the husband’s salary. It is unlikely they can get by on the wife’s $60,000 salary even if they drastically cut the amount earmarked for retirement and college.
D. While they had a great plan in place for retirement savings, their ability to continue making contributions is severely limited now meaning that they will be largely reliant on the growth of the existing $100,000. Assuming an annual return of 7% over 35 years, the current retirement savings would grow to a little over $1,000,000 by their age 65. That might sound like a good amount but with inflation that would be like trying to retire on $450,000 today. Had disability insurance been in place to contribute to covering bills and allowing the wife to continue making contributions to her retirement plan in the amount of $6,000 per year they could have had over $2,900,000 which would be a much more comfortable retirement.
E. Likewise, while they had a great plan to save for the children’s college the accident largely ended their ability to make further contributions. The current $10,000 projects to grow to $24,000 and $27,500 respectively. While that is a nice contribution it is not nearly enough to pay for four years of college (by the time the children start college, a four year education can expect to cost in the ballpark of $125,000) as had been their original goal. Had they been able to continue making contributions of $300 per month per child they would have accumulated $97,000 and $118,000 respectively.
F. This doesn’t even begin to address the costs that could be involved from the accident if another vehicle was involved. There could be lawsuits, victim’s medical bills and vehicle damage. Do they have the proper amounts of auto and/or umbrella liability coverage to cover these losses?
G. What would have happened if the husband had died in the accident? Would the wife had been able to make ends meet with the $200,000 she would have received from life insurance? That is enough to pay off the mortgage but not enough to cover any future living expenses.
This example illustrates why no matter how good a plan might be at the higher levels of the pyramid the base needs to be there as the foundation to help support the plan and ensure it can continue on in case of an unexpected life event.
So, now that we have established why financial position and risk management are the base let’s move onto the next levels of the pyramid where we start to get into the items people tend to think more often.
3. Wealth accumulation – Now we can begin talking about investments. This includes participating in your employer’s sponsored plan, contributing to an IRA or ROTH IRA, a taxable brokerage account, real estate or other vehicle designed for long term growth of money. This can also be for non-retirement goals such as kids education, a dream vacation or other targeted financial goal. This also involves portfolio management and making sure that the investments you have are well diversified and fit with your risk tolerance.
4. Tax Planning – I would prefer to see tax planning actually listed on the side running the length of the pyramid because really we want to be considering taxes in all of these phases. Taxes may not play a major role in cash savings but there are tax considerations woven into every other layer of the pyramid. Not that every decision needs to be made with the goal of paying the smallest amount of tax possible but you want to make sure you understand the tax impact of the choices you have at each level of the pyramid.
5. Retirement planning – At this stage we can really start to map out what the retirement lifestyle will look like. This factors in various income streams including pensions, Social Security, and part time work against projected expenses to see how much retirement savings are needed to fill the gap. In your 30’s and 40’s this can be hard to do and many people use a rule of thumb like 80% of current income will be needed in retirement. As you get closer to retirement you will be able to have a much better of what those actual expenses will look like based on your lifestyle.
This layer also covers how best to draw down your retirement savings, factoring in required minimum distributions (RMDs), when you should start taking Social Security, what type of Medicare plan is best for you and examining if long term care insurance will be needed.
6. Estate Planning – Finally, the top of the pyramid, the end game. Most people will think of this as their will, and while the will is an important document there is more to estate planning than a will. There are many things to think about distributing your assets at the end beyond what is stated in the will and naming guardians for children. Assets that are titled or have named beneficiaries are not covered by the will and these beneficiaries need to be reviewed. There might be a desire to establish medical directives, gifts to charity and establish trusts to hold assets for a specific purpose amongst many options for handling one’s estate. Taxes can play a key role in determining what types of assets are best to pass on to certain beneficiaries.
As you can see there is much more to financial planning than reviewing investments being used for retirement. This can be used to help establish the roadway to an overall sound financial picture.
I hope you find this information helpful and gets you thinking about more than just your investments when it comes to your overall financial picture. Look for the next installment which will focus on specifics within the financial position layer.
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