Difference between revisions of "Planit:Understanding The Life Goals Analysis"

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Latest revision as of 05:16, 19 October 2012

Understanding the PlanPlus Life Goals Retirement Analysis (LGRA)And Long Term Cash Flow Spreadsheet (LTCFS)

The Concept Behind the Long Term Life Goals Analysis

The PlanPlus Life Goals calculation is one of the most powerful calculations available for illustrating to a client the impact of their savings programs, investment portfolio decisions and various financial life goals. The calculation is very robust, and as a result it may appear complicated. The reality is that it has been structured to model the real world as closely as possible.

To make your review of this topic as effective as possible, it’s suggested that you print out the two sample reports that are included with this document. The first is the Life Goals Retirement Analysis – Your Current Situation (LGRA) and the second is a Long Term Cash Flow Spreadsheet (LTCFS). Having these in hand as you review the remainder of this document will help tremendously in understanding concepts as they are explained.


Capital Pools

On the LTCFS you’ll see that the client’s total portfolio is segregated into five possible capital components that we’ll call “pools” for ease of reference:

  • Line #1 Client’s registered (or tax sheltered)
  • Line #2 Spouse’s registered (or tax sheltered)
  • Line #3 Education capital
  • Line #4 Client’s non-registered (open investments)
  • Line #5 Spouse’s non-registered (open investments)

Each of these capital pools are tracked over the client’s lifetime and are impacted by a number of factors including

  • The Asset Allocation of each portfolio
  • The re-balancing of the pools to maintain their asset allocation
  • The Rate of Return on each portfolio (based on the asset allocation)
  • New Savings and Withdrawals from the portfolios each year

In the sample LTCFS that’s included with this document we have highlighted different events during the client’s lifetime so that you can see how these events affect the client’s capital, savings and other aspects of their situation. Let’s take a look at some of these events.

Asset Allocation – The asset allocation of the client’s total current portfolio can be identified in either of two ways. First, if detailed data entry was done, the system will identify the asset allocation for each pool of investments based on the asset class for each individual investment entered. Alternatively if summary level data entry on assets was done, the advisor manually identifies the overall asset allocation for the total current portfolio. (i.e. 10% Cash, 70% Fixed Income and 20% Canadian Equity). Based on the client’s responses to a series of risk tolerance questions, a target asset allocation will be presented that is suitable to the client’s risk profile. It will be the current and target allocation that will determine the projected rate of return for either portfolio.

Rebalancing the Pools – Each year all of the capital pools are rebalanced to the stated asset allocation (current or target). In the case of the registered or tax sheltered portfolios, the rebalancing of the pool each year has no significant impact except to cause the rate of return to remain the same for that pool. Because the funds are tax sheltered, there is no impact on tax or cash flow when rebalancing takes place.

In the case of the non-registered or open investments, the rebalancing within each pool may result in a capital gain. The Adjusted Cost Base (ACB) of each pool is tracked year over year and any capital gain realized when rebalancing takes place is then added into the tax calculation for that year. There is no impact on the cash flow other than the indirect effect of potentially higher taxes. (Note that for jurisdictions where capital gains tax is not applicable, this is recognized in the calculation as well).

Rate of Return – Once the asset allocation has been identified, the projected rate of return for the current or target portfolio is calculated using a weighted return calculation using the historical returns for each asset class. Consider this simple example:

Goals1.jpg


For the registered or tax shelter pool, each year the rate of return as determined by the asset allocation is applied and added to the capital. The Education savings pool accumulates on the same basis as the Client’s tax shelter pool.

In the case of the open pools, the calculation is slightly more complex. Using the rates of return for individual asset classes and the stated allocation of the pool, the system will break the overall return into interest or fully taxable investment income and dividends, which are subject to the dividend tax credit in some countries. These two amounts are “paid” into cash flow so the system does not assume automatic reinvestment of all investment income. These investment income amounts can be seen on lines 17 – 20 on the LTCFS. The growth or capital gains portion of the return is added directly to the capital pool and accrued.


New Savings

Registered (Tax Sheltered) Savings – If there are any registered (tax sheltered) savings, these are added to the appropriate capital pool each year. You’ll see these saving amounts on lines 29 and 30 of the LTCFS. The system assumes beginning-of-year contributions so income is earned on contributions in the current year.

Non-Registered (Open) Savings – There are two ways the system can trigger savings into the open pools. The first is based on the savings the client identifies in their cash flow for the current year. The second way money can be saved is in cases where a surplus cash flow is identified in a given year. Such surpluses will also be saved. We’ll look at an example of this a little later in this document. Note that both planned savings and surplus cash flow that is saved is all identified on lines 31 and 32 of the LTCFS.

Withdrawals

Prior to Retirement - There may be instances prior to retirement where there is a capital shortfall in a given year. This typically will be caused by a goal in that year. In these instances, the system will make a withdrawal from the open portfolios to eliminate the shortfall to the extent that funds are available. These withdrawals can be seen on lines 24 and 25 of the LTCFS. The system will not make withdrawals from the tax sheltered capital pools prior to retirement. This is to protect these retirement funds from encroachment during the client’s earning years.

After Retirement – When the client retires, the system, as a default will apply what we call “use as required” withdrawals from the pools. This means that we always use the open funds first and let the tax-sheltered money continue to accumulate as long as possible. When all open capital has been depleted, or when the client is required to take minimum withdrawals from the tax sheltered capital, the system will start withdrawing tax sheltered funds. These withdrawals from the tax sheltered capital pools can be seen on lines 21 and 22 of the LTCFS.

Education Capital Withdrawals – In the case of the Education savings pool, this can only exist if an education goal has been entered. If no education goals exist, the funds are rolled into the open pool for the client. The system accumulates education funds and pays them out as needed based on the education goals. If there are surplus funds still in place after the last year of the last education goal, the funds are rolled into the open pool. (Line 23 on LTCFS)

Capital Rollovers on Death – Where the stated mortality year for a client and a spouse are different, on death of the first person, the system will transfer all of the tax sheltered and open capital to the survivor assuming no taxation due to spousal rollovers. Where a client and a spouse are assumed to die in the same year, the client is assumed to die first.

On the second death, all remaining capital pools are “liquidated” triggering the taxation of any tax sheltered pools and capital gains on the open pool in the hands of the second deceased.

Revenue Streams

There are a variety of revenue sources or income for a family in the analysis. Associated with each source of income is the ability to state what portion of the income will be taxed.

Salary – The system defaults to the fact that the client and spouse will continue to earn their salary each year from the current year until the year before they retire. The salary is indexed at the client’s inflation rate. (Lines 6 and 9 on the LTCFS)

CPP/QPP – In Canada the system automatically defaults a CPP/QPP income based on the percentage eligibility identified on the Personal Information screen. It applies the percentage eligible multiplied by the current maximum benefit to identify the CPP income amount. If the retirement age is before age 65 the system will automatically apply the 6% reduction per year in the benefit amount to a maximum reduction of 30% for retirement at or before age 60. (Lines 7 and 10 on the LTCFS)

Old Age Security – In Canada unless the client is flagged as not eligible for OAS (which is based on years of residency in Canada), the system will generate a default OAS income amount. Because of the sophisticated tax calculation used in this system it is not necessary for the advisor to worry about OAS Clawback, as this would be recognized automatically and be included in the tax calculation. (Lines 8 and 11 on the LTCFS)

Life Insurance – If the client or spouse has permanent life insurance coverage, this amount will appear as non-taxable revenue on their death. In the case of the first death the benefit would be paid to the survivor and, assuming benefits are in excess of expenses that year, be added into the open pool. On the second death the amount is paid into the estate and may be used to offset tax liability on the second death. Where joint first to die or joint last to die insurance coverage exists, these amounts will be paid out in the calculation accordingly. (Lines 15 and 16 on the LTCFS)

Other Revenues – On the Pensions and Other Revenues screen, you can enter any other form of income the family may receive over their lifetimes. With each revenue stream you specify the recipient (for attribution rules), amount taxable and so on. Something like an inheritance would be identified as 0% taxable while “Consulting income” might be 100% taxable. (You’ll see examples of other revenues on lines 12, 13 and 14 of the LTCFS).

Income from Investments

Investment Income – Is calculated based on the open pools and is determined by the asset allocation. It primarily represents the interest component of the portfolio return. For example in most cases all of the return on cash and fixed income will appear here, as it is interest income. Dividends on international funds (usually 25% of the return) are also included here since they are taxed just like interest income. A table on the server maintains the logic for the treatment of the interest/dividend/growth split on the return for each asset class. The LTCFS illustrates the investment income on lines 17 and 19.

Dividend Income – Like interest, dividends are calculated based on the asset allocation and returns of the open pools. The default assumes that 25% of the return on any Canadian Equity funds will be dividends and subject to a dividend tax credit. The LTCFS illustrates the dividend income on lines 18 and 20.

Withdrawals from Capital Pools

Registered (Tax Shelter) Pool Withdrawals – As mentioned previously, withdrawals are only made from the tax sheltered capital pools once the clients are retired. The amount of withdrawals is based on what’s needed or “use as required” which means that the money is withdrawn only after the open funds are depleted and a shortfall still exists. These withdrawals are identified on lines 21 and 22 of the LTCFS . When a withdrawal is made using the “use as required” method, the system applies a withholding tax of 20% in the year the funds are required and the balance of the tax liability is calculated and paid in the following year. The reason for this is that if the full tax liability was recalculated in the year of withdrawal, the amount that was required to be withdrawn would increase again and we would need to pull more from the tax sheltered pool, then the taxes would increase again and so on (an iterative endless loop).

In cases where withdrawals are based on the minimum mandatory required, the system will calculate both the minimum as well as the tax payable in the year of receipt. In some cases this may result in a surplus of money where the minimum is greater than what’s needed that year. In this case the surplus will be reinvested into he open pool.

Non-Registered (Open) Pool Withdrawals – As explained above, withdrawals can be made from the open capital pools in any year where a shortfall has been identified. These are illustrated on lines 24 and 25 of the LTCFS. For example, if the client had a $10,000 shortage in the year caused by a goal to do some home renovations, the software will withdraw that amount from the open capital pools, sufficient to fill the shortage. You may actually see a withdrawal that is less than the full $10,000 in cases where there is investment income that offsets some of that shortfall.

When funds are withdrawn the software will pro-rate the withdrawal across a client and spouse based on the amount of capital in each person’s pool. If the client has $100,000 in investments and the spouse has $50,000, the software will use $2 of the client’s money and $1 from the spouse.

So to summarize, a non-registered withdrawal is the amount that needs to be withdrawn from the open capital pools to fill any shortfalls identified in any given year.

Taxes Payable

The tax calculation in the Life Goals analysis is thorough and robust. The system uses full tax calculations federally for Canada and applies provincial rates (TONI) or percentages of federal as appropriate for each province or territory. Some of the items that are automatically handled by the calculation include:

Goals2.jpg

Note that for jurisdictions other than Canada, the appropriate changes to the tax calculation are recognized. The taxes are illustrated on lines 26 and 27 of the LTCFS.

Net Income

The net income can be simply calculated by adding up the various revenues and capital withdrawals and subtracting the amount of tax paid. (See Line 28 on the LTCFS).


Savings

The user can enter the following types of savings:

  • Personal tax sheltered Contributions – Go directly into the tax sheltered pool
  • Spousal tax sheltered Contributions – Go into the partner’s tax sheltered pool.
  • Open Savings – Goes into the open pools. It is important to recognize that in years where the client has a shortfall (expenses exceed income), although the money may go in the pool as savings, they may come straight back out again as an open pool withdrawal to fulfill a shortage. For example, if you are saving $10,000 in a given year but in that year you have an objective that causes a shortfall of $6,000, the actual amount that will get saved will be the difference or $4,000. This in fact illustrates a real life situation in that capital expenditures in a specific year will in effect offset the net savings for that same year.
  • Education Savings – Are saved into the Educational Savings pool.

These savings can be seen on lines 29 through 33 of the LTCFS.

Note that you may also see years where the savings are greater than what was planned. This occurs in cases where a surplus in any given year greater than the 5% sweep occurs. The software will add this into savings for that year and the funds will go into the open pools. It will try and split the savings equally between a client and spouse but it does track the income for attribution rules, which means that someone cannot save more money than they received. If required by the attribution rules, the system would maximize the allowable savings of the lower income person and the higher balance would go to the other spouse.


Life Goals

This section includes all those amounts that have been identified on the Objectives screen. Each objective is for a specific amount in todays after tax dollars, along with a future index rate. Some objectives are automatically generated by the system. Examples of life goals can be seen on the LTCFS on lines 34 – 39 inclusive.

  • Current Lifestyle – Is generated based on Total Family Income minus planned savings minus taxes from the cash flow screen. The system assumes that this level of lifestyle expenditure will remain, indexed at inflation, until the year before retirement. If both the client and spouse are retired this goal is not displayed. (Note: Based on how this is calculated, it is actually the after tax spendable income, NOT pre-tax).

In the long term analysis there is an adjustment applied to the current lifestyle called the “sweep”. This adjustment (default is 5%) effectively says “if there is a surplus or deficit that is +/- 5% of the current lifestyle, sweep it under the table.” In other words if my lifestyle was 100,000 per annum the sweep would be +/- $5,000. If the client is short $5,000 or less or has a surplus of $5,000 or less, we adjust the lifestyle accordingly and assume it does not impact their investments. This prevents small fluctuations in the client’s cash flow from causing unrealistic savings or capital erosions from occurring. This illustrates what really happens in most families. If they have small variances in their income or expenses, they tend to spend less or spend more as opposed to saving more or taking money out of their savings.

  • Retirement Lifestyle – Defaults to the same value as the current lifestyle, but may be edited by the advisor. Although you see many systems default to a percentage of current lifestyle, such as 70%, this isn’t the case here as the number is already an after tax spendable income goal. Thus it’s consistent with systems that will use a default percentage.
  • Education Goals – When a dependent is added to the Client Information Screen, the advisor can set an education goal. This can be done by either entering a target annual funding amount manually or by using the university lookup table. When you use the university look up table, the system will automatically currency convert tuition payments from foreign colleges and universities into the currency of residence of the client. Only Education Goals created from the Client Information Screen can utilize funds specified in the Education Pool.
  • Other Goals – On the Objectives screen the advisor can enter multiple goals. Each goal is expressed in current dollars after tax with a specified inflation rate. The ability to add these other goals allows you to do a “Life Goals” analysis as opposed to a one dimensional single need analysis.

Total Outflows - This number is calculated by adding up the specified savings and financial goals to get the total expenses after taxes.


Shortfall to Achieve Objectives

This is the net cash flow in a given year and is calculated by simply taking the Net Income and subtracting the Total Outflows. In cases where there is less money coming in there is money going out, a shortfall is identified.

You could say that this is the “bottom line”. When a family has a shortage in a given year (less income than expenses), and does not have enough in the capital pools to fill the hole, a very real shortage exists. In the real world this means they could not pay their bills or could not fund a particular goal.

When there is a shortfall to achieve objectives in practical terms the client’s desires exceed their ability to meet them based on their current savings and investment patterns. In some cases changes in these areas may make sufficient difference to eliminate the effective deficit, or the client may need to consider adjusting their future expectations – things like retirement age or income target etc.


Estate Surplus

The software will calculate the Estate Surplus based on the total of any remaining capital, after tax, after the second death. This is the amount that would be available to other beneficiaries.


Present Values

Although the calculation itself is carried out year by year, each stream of income, taxes payable or goals is then present valued to create a “cash in the bank” equivalent today. The default rate for the present value is the inflation rate plus 2% (in other words a 2% real rate of return), which historically is what a moderately risky investor may hope to achieve. If you have an inflation rate of 4% it would mean a 6% discount/after-tax rate of return assumption.

Keep in mind that the actual rates of return experienced by the client will not be 6% after-tax; this is a figure for present value illustration purposes only. In practice, if a client invested in $100,000 in cash earning 5% and we paid this money out over 20 years, the present value could be less that the $100,000 in the bank today.

The primary purpose of the present value calculation is to allow a basis of comparison between the wide array of goals and income streams with variable index rates spread over differing numbers of years. The present value number lets us see “the cash in the bank equivalent” for each item today. It also illustrates the client’s situation using numbers that are not so overwhelmingly large that they become difficult for a client to relate to.


Conclusion

The long-term analysis is, as originally mentioned, designed to illustrate what happens in real life as closely as possible. It shows the inflows of all revenues and the outflow of all expenses and identifies any year when there is a shortfall (causing encroachment on capital via a Non-Registered capital withdrawal) or a surplus (resulting in more that can be saved that year). By using this approach you are able to incorporate all of a client’s life goals into the long-term analysis and develop a view of the client’s entire lifetime.


Life Goals Retirement Analysis - Your Current Situation

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