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Topic 4
Plan
preparation
Topic 4: Plan Preparation
Contents
Introduction
Learning outcomes
Required reading
Personal profile
Personal data
Financial Goals and Objectives
Assumptions
Planner’s Notes
General Design of the Financial Plan
The Format of the Plan
Employee Benefits
Income Tax
Financial Position
A summary
Suggested answers
Readings
Topic 4: Plan Preparation
Reading 4.1
Reading 4.2
Reading 4.3
Introduction
Now that we have gathered all the relevant data and undertaken a detailed client analysis, we
are in a position to begin detailed financial planning preparation for the client. The purpose of
this topic is to determine how funds for investment are best placed to suit the particular client.
Projections can be made to show how the financial planner’s recommendations will help
achieve the prospective client’s objectives, and these projections can become part of the
written financial plan document.
Learning outcomes
By studying this topic, you should be able to make informed responses to the following key
questions:
• How would you prepare and present a financial plan to your clients?
• How would you determine an asset allocation strategy to suit a client ’s risk portfolio?
• How can you select investment types to match the requirements of the specific
client?
• How can you select appropriate investment products for particular types of
investment?
• How would you determine and project the important aspects of a financial plan?
• In what ways can you present overviews, recommendations and projection to the
client in an informed and timely manner?
• What are the limitations in using financial planning software to develop a financial
plan?
Required reading
Readings
Reading 4.1 Donnelly’s Investing Times 1998, ‘Asset allocation: The key to achieving higher
returns’, no. 240, 30 September.
Reading 4.2 van Eyk Research 1997, Investment Outlook Report, van Eyk Research:
Investment Research and Advice, March, Sydney, pp.1 –25.
Reading 4.3 Pembroke, Godfrey 1997,Personal Financial Plan, Godfrey Pembroke Financial
Consultants Ltd, Melbourne.
Personal Profile
Topic 4: Plan Preparation
Personal Data
Children
Home
45, National Housing Soceity
Aundh, Pune
Ph: 2588 46 46.
Parents
Mr. Joshi Mrs.Joshi
Not Alive Father – 85
Mother - 82
DFP 6: Financial Plan Construction
provide a source of funds which, with capital growth, will be available for
emergencies and which can be drawn from day-to-day for living expenses not met
ensure funds are available for an overseas holiday and for updating vehicle, at the
ensure investments placed are at the conservative to moderate end of the risk
scale.
3. Have an investment portfolio and financial plan that are easy to follow and easy to
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Topic 4: Plan Preparation
• Based on the life insurance needs, what type of coverage should be purchased?
• What are the additional insurance policies to be purchased and how the additional
ASSUMPTIONS
• Calculations presented in this report do not assume any increase in the living
expenses.
• It is assumed that Mr.Joshi would retire at age 60 and will not take up any part / full
• The tax calculations assume that tax rates applicable for the assessment year 2004-
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Topic 4: Plan Preparation
Planner’s Notes
General design of the financial plan
If the economic outlook is good, the clients can maintain this asset allocation
strategy in the next five years but if the interest rates were to fall further, in
order to meet expenses, portfolio shuffling would become necessary.
During our discussion with the clients, we determined that brief reports of
financial planning primarily showing the details of projected income and
expenses, investments and asset allocation strategy is expected by the
clients. In this report we are providing statement of income and expenditure,
Fund flow position and statement of investments along with investment
income. This covers a planning time span of approximately 2 years –
investment strategies from today till the date of retirement and projections of
income and expenses for a year from Mr.Joshi’s retirement. It has also been
DFP 6: Financial Plan Construction
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Topic 4: Plan Preparation
In the enclosed financial plan, which is the outcome of our discussions and detailed analysis
of your current financial profile, we have indicated several steps that you need to take to start
moving toward your overall financial objectives We summarise below our specific
recommendations for your overall financial planning. After this summary, we include a list of
prioritised items to indicate the ranking of the steps that you now need to take to fully
implement your financial decisions and monitor your actions.
Recommendations:
• Establish an investment programme designed to provide an investment portfolio by
second quarter of 2005. This portfolio is designed to have diversified investments in
real estate, mutual funds, fixed deposits, equity shares and also annuities. Take
advantage of market declines, for making fresh investments in shares and mutual
funds.
• Start the construction of first floor of your residence by arranging the housing loan
with a bank or housing finance company. The aim is to complete the construction
around the time of your retirement, preferably before the end of 2005. It will give you
the tax advantage while you are earning and after retirement and also augment your
income.
• Decide on the purchase of life insurance plan coupled with disability rider to take
care of your liability on housing loan in case of any death / disability.
• Initiate premium contribution to deferred annuity plan (like Jeevan Suraksha) to take
care of your present income tax as well as future financial needs.
• Purchase a home owners’ policy to take care of the risks associated.
• Liquidate the present company deposits and invest Rs.150000 for a five year period
in AA rated company deposits which gives an income of 9%.
• Retain your present equity portfolio which is expected to perform in the coming years
as the economy is doing well. In case of a market rally, you may think of booking
partial profits and reinvest the same at declines.
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Topic 4: Plan Preparation
EMPLOYEE BENEFITS
As we have seen in Topic 3, Mr.Joshi, who is currently working in BDC Ltd is
to retire from his services in October 2005 and has approached you for
developing a financial plan that would take care of his retirement needs. An
active retirement is anticipated. As keen golfers, your clients will be spending
more time on the course. They also plan to combine travelling around the
country with playing at various golf courses.
Vidyulata Joshi is active and they both serve on various association
committees. In retirement, they expect to be taking even greater advantage
of the club’s facilities.
As a private sector employee, Mr.Joshi is eligible to receive Gratuity equalling
1 month’s salary for every completed year and part thereof of his service. The
medical benefits that he is receiving from his employer would continue after
the retirement. He is not eligible to receive any pension from his employer.
For drawing a financial plan, you need to estimate the amount of gratuity
receivable by your client on his retirement and also indicate the tax
exemptions, if any, and also calculate the likely tax liability on the money
receivable. This exercise would give you as well as your client an idea of the
net amount receivable and plan the investments suitable to your client needs.
The following table captures the retirement benefits receivable by your
client.
Vasant is in the highest tax bracket of 30% and he is liable to pay tax on the
balance amount in the previous year 2005-06. The tax liability of Mr.Vasant works
out to Rs. 54600/- The net amount (after tax) receivable is estimated at
Rs.4,77,400.
DFP 6: Financial Plan Construction
Once you have determined a prospective client ’s risk profile and appropriate financial
strategies, the next step is to determine the amount of exposure the prospective client should
have to the various investment markets (asset sectors). Some prospective clients, and
perhaps even some financial planners, might consider that it would be more appropriate to
place all their funds in the most appropriate investment market relative to the prospective
client ’s risk profile, objectives, and the current state of the economy and investment cycle.
For instance, if there was a young person who had no dependants, was highly paid and
unlikely to need Rs.1,00,000 available for investment for the next 5 years, why shouldn’t that
person place all their funds in the share market or an equity fund, which the financial planner
believed would be the best performing investment sector over that period?
There are many reasons why this would be inappropriate. Over time, so many things can
alter the client’s position: personal circumstances, economic circumstances and tax laws can
and do change. Therefore, you must understand the need to reduce investment risk by
diversifying the investment portfolio among the various asset sectors. Certainly, a young
person may have a preference for shares, and that too Information Technology shares, but
they should still diversify their portfolio.
Reading
Reading 4.1 provides further information about asset allocation and
how it provides the key to achieving higher returns.
Economic outlook
The economic outlook may influence the level of exposure to each asset sector
recommended by the adviser, particularly when short-term strategies are considered. For
instance, if interest rates are on the decline, and income is required, a high exposure to fixed
interest investments may not be appropriate.
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Topic 4: Plan Preparation
Short-term (i.e. tactical) asset allocation strategies try to time the market for investment
decisions. This is indeed a difficult, if not impossible task. Also, the relevant transaction costs
associated with the short-term asset allocation moves may be quite high, negating any gains
from such moves.
However, planners should be focused on the long-term investment objectives of clients, and
recognise that economic and market conditions are most often cyclical and/or unpredictable.
The record of economists in predicting economic conditions attests to the dangers of moving
assets into and out of particular markets primarily based on market forecasts. Most evidence
suggests that, as a general rule, timing asset allocation moves into and out of markets
according to predicted market trends is an unsuccessful tactic for a planner to follow.
This is not to say that economic forecasts should be ignored, but that financial planners
should be very wary in considering that information, and keep a long- term (strategic)
approach to asset allocation in mind, to consider the target allocation, and to re-balance the
portfolio as appropriate.
Reading
A good example of economic analysis to determine asset allocations is
provided in Reading 4.2.This is the Investment Outlook Report by van
Eyk Research. That it is outdated and pertains to another market is
not important: its purpose is to provide you with a comparison with the
current situation, and shows you how much the market can change in
a relatively short period. Financial planners who subscribe to reports
of this kind are provided with extensive economic data and analysis,
which should assist them in determining the most appropriate asset
allocation for their prospective clients.
This reading is provided to the students only to familiarise with the
concepts and for application of the concepts as adapted to our
situations.
2: Fair
3: Poor
Portfolio guidelines
Planners differ not only in the way in which risk profile is assessed but also in the number of
portfolios they make available for use by their advisers.
As we saw in Figure 3.4 of Topic 3, the prescriptive questionnaire used by one planner
produced six portfolios. In this section we look at another planner whose outline below
produces five portfolios.
Financial consultants, Godfrey Pembroke (1997), outline the following portfolio guidelines:
Five Benchmark portfolios should satisfy the investment needs of most clients.
The benchmark asset allocation is a long-term strategic allocation across various
asset classes based on historical returns and the outlook for those assets over at
least a 5-year time horizon.
The current guidelines provide a range within which a current asset allocation should
be structured. The ranges are provided to take account of shorter-term outlooks for
investment markets as well as to accommodate the particular circumstances of
individual clients.
The benchmark portfolios are constructed to satisfy the needs of clients with differing
attitudes to risk and reward and differing income requirements. The basic attributes
of each benchmark portfolio are summarised as follows:
Portfolio Cash Fixed Interest Shares Property
Aust Int’l Aust Int’l
Conservative
Current 25 45 0 15 0 15
Benchmark 20-30 40-50 0-5 10-20 0-5 10-20
Conservative Balanced
Current 20 40 0 20 0 20
Benchmark 15-25 35-45 0-5 15-25 0-5 15-25
Balanced
Current 10 15 5 35 10 25
Benchmark 5-15 10-20 0-5 30-40 10-20 20-30
Growth
Current 10 15 5 40 10 20
Benchmark 5-20 10-20 0-5 30-50 10-25 10-30
Aggressive Growth
Current 5 5 0 50 20 20
Benchmark 0-20 0-10 0-5 35-55 10-30 10-30
Conservative
This portfolio aims to produce a high level of secure income with a strong emphasis
on preservation of capital. The possibility of a negative total return over a one-year
period is low, although it may occur in a time of severe market downturns in more
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Topic 4: Plan Preparation
than one asset class. Capital growth on this portfolio is expected to be very modest
over the medium to long term.
Conservative balanced
This portfolio has a strong focus on secure income. There is also the expectation of a
modest level of capital growth over the medium to long term. The income stream is
relatively stable and provides some tax-effectiveness with its exposure to shares and
property. The possibility of a negative total return is relatively low, although it may
occur in times of severe market downturns in more than one asset class.
Balanced
This portfolio provides a balanced exposure to a range of asset classes, and aims to
produce an appropriate mix of both income and capital growth over the medium to
long term. Investors must be prepared to accept moderate fluctuations in the value of
the portfolio with negative total returns likely to occur, on average, at least once every
10 years. The income from this portfolio should be reasonably tax-effective because
of its exposure to shares and property.
Growth
This portfolio has an emphasis on growth in asset value rather than producing income
for expenditure requirements. However, it may still include high-yielding assets such
as shares and property. The relatively high exposure to shares and property will
mean frequent fluctuations in the value of the portfolio with negative total returns
likely to occur, on average, at least once very 5 to 7 years.
Aggressive growth
This portfolio aims to maximise total returns over a period of more than 5 years,
preferably closer to 10 years. It has a high exposure to growth assets such as shares
and property and it will experience considerable fluctuations in capital value in
response to changes in market conditions. Investors must be prepared to accept
these market fluctuations as the price which has to be paid for superior long-term
returns. The portfolio is likely, on average, to produce negative total returns at least
once every 5 years.
Source: Godfrey Pembroke 1997, Economic and Investment Review, Godfrey
Pembroke Ltd., Melbourne.
Looking at the guidelines that Godfrey Pembroke had given above, we can try to generate a
similar guideline without involving international investments
Portfolio Cash Fixed Interest Shares Property
Conservative 20–30 40–50 10–20 10–20
Conservative
15–25 35–45 15–25 15–25
Balanced
Balanced 5–15 40–50 40–50 5–`0
Aggressive
0–20 0–10 60–80 10–30
Growth
Portfolio analysis
Let us now look more closely at the out workings for the table above by defining some
associated terms.
DFP 6: Financial Plan Construction
Asset sectors
These are the sectors against which the client ’s overall investment is to be assessed and into
which the various investments have been, or are to be channelled, viz: cash, fixed interest,
shares, and property.
Asset allocation
For a particular risk profile, the asset allocation is the specific percentage recommended to be
invested in each asset sector. From the foregoing discussions and the adapted guideline
given in the table above, for example, the aggressive growth portfolio has the following asset
allocation:
Asset sector %
Cash 5
Fixed interest 5
Shares 70
Property 20
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Topic 4: Plan Preparation
Cash (5-20)
Fixed interest (10-20)
Shares (40-60)
Property (10-30)
Benchmark ranges, while useful to be aware of, seldom take high priority in a plan and are
often not shown at all, appearing only in the CIB.
Risk and return
Included with a planner ’s risk profile asset allocation table, an indication will often be
provided of the minimum investment term for that particular asset allocation, as well as a
return objective.
Where there is a high percentage of defensive assets in a conservative portfolio, the
timeframe can be as short as one year because the risk is low and hence so also is the return
objective, which might be, for example,3%above inflation (i.e. real return).
In this case, the planner ’s research might also suggest that the likelihood of a negative return
is, for example,1 year in 17.
At the other end of the scale, an aggressive portfolio timeframe might be 7 years and the
likelihood of a negative return,1 year in 5,with an expected real return objective of, for
example,7%.
These charts may also provide other information such as past and forecasted returns, and are
therefore useful in establishing the risk/return relationship.
To this same end, a plan could include a table of historic asset sector returns and also a
graph illustrating how risk and return are related.
Planner Variation
It is worth reiterating that planners vary in the number of risk profile portfolios they employ,
and in the asset allocations they ascribe to those portfolios; hence they vary their asset
balances, and also their minimum investment terms and expected returns.
An illustration of the strategic asset allocation for another planner’s growth risk profile is:
Asset sector %
Cash 2
Fixed interest 13
Shares 70
Property 15
giving a defensive vs. growth asset balance of 15%vs.85%
Each planner’s asset allocation strategy is developed from external and internal research that
obviously differs depending upon its source.
Asset allocation variance
If a client has, for example, a growth risk profile then, as said, the asset allocation will be that
prescribed by the planner.
When advising the client, the financial planner recommends a risk profile, hence an asset
allocation, which leads to an expected level of risk and return.
When the planner then recommends particular strategies and products, the overall result
must ultimately show adherence of the implemented asset allocation to the original risk profile
asset allocation recommended. If not, then the client is going to experience more or less risk
and return than they expected, accepted and signed off on. A planner should avoid
recommending a Rolls Royce then delivering a VW!
DFP 6: Financial Plan Construction
The theory of establishing a risk profile asset allocation, therefore, is wasted unless it is
followed through in practice. If a client wants to take, for example, a balanced risk profile
outlook, you abrogate your responsibility putting them into another asset allocation.
The best way to establish whether your risk profile and after-implementation asset allocations
are compatible is to use a table. Usually they will vary, but even if not, it is still better to show
them.
If a growth portfolio had been recommended and was based upon the guidelines that we
adapted from Godfrey Pembroke chart, and your after-implementation asset allocation turned
out to be as shown, then the following variance would occur:
Asset allocation
Risk profile Implemented Asset Portfolio variance
Asset sector Asset allocation allocation
% % %
Cash 5.0 10.0 +5.0
Fixed interest 5.0 10.0 +5.0
Shares 70.0 65.0 -5.0
Property 20.0 15.0 -5.0
The variance column identifies the percentage by which the risk profile and implemented
asset allocations vary.
In your preliminary analysis you should have worked toward eliminating any significant
variances. Compatibility of the after-implementation asset allocation depends on your skill as
a financial planner. You cannot just identify the risk profile asset allocation then let the
implemented asset allocation fall where it may.
Theory must be married with practice.
The key to the expected risk/return outcome for a given portfolio is how closely you are able
to match these asset allocations. Normally, a 5%variance in any asset sector is considered
acceptable and likewise with the defensive vs. growth asset balance.
So, scrutiny of individual asset sectors above suggests acceptability because none vary by
more than 5%. However, the defensive v growth asset balance is 20%vs. 80% and should
have been 10%v 90%and requires correction.
If you are not careful, your recommended asset allocations can easily stray one or two risk
profile positions above or below what you carefully analysed their risk profile to be. Think of it
this way. If your client loses money and sues you and you are asked in court why you did not
implement what you recommended, what will you say?
When a variance occurs in asset sectors, defensive v growth asset balances, you must first of
all ask yourself whether you can correct the anomaly. If not, then you must include some
comment about it. The client is entitled to know why this situation has come about.
How do you propose that the implemented asset allocation will be brought in to line with the
recommended risk profile asset allocation? Will it be by excess growth in an asset sector
over time because savings are being progressively channelled into it; by sale of another asset
and reweighting of the portfolio, or other reasons? What is the timeframe over which this
reconciliation is achieved? Will reweighting upon annual review be the key?
Remember, research indicates that expected risk/return results for a given risk profile are
heavily influenced by close adherence to the diversification principles inherent in the
associated asset allocations.
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Topic 4: Plan Preparation
Diversification
Diversification of investment funds is a method of reducing investment risk and volatility. We
will look at diversification in Question 4.1.
‘Worst-case’ scenarios
You will have noticed in the van Eyk report (Reading 4.2,section 2.2) that the authors
provided a range of potential returns for each of the portfolios.
These different potential scenarios are useful when explaining risk situations and volatilities to
clients. You may also wish to paint a ‘worst-case ’ scenario to help explain investment risks to
prospective clients.
for you as a long-term investor, knowing that if a rise in the value of the
same magnitude occurred, there would be a 10 per cent increase in the
portfolio.
Question 4.2
In broad general terms, how do the following factors impact on the asset
allocation process for a particular client?
• client risk profile
• appropriate investment strategy
• the economic outlook
• diversification of funds
• provision for non-core exposure
• worst case scenarios.
Eight variables
A financial planner must be able to explain why a certain type of investment has been chosen
and why it is suitable for the prospective client. In matching a type of investment with a client,
you should consider the following variables:
1.Growth
What opportunity is there to achieve capital growth? How is it achieved? Historically, what
levels of growth have been achieved?
2.Income
Is this an income-only investment or is there opportunity for income and growth? When is the
income paid and how much can be expected?
3.Taxation
What are the taxation consequences with regard to capital gains, income tax, taxation of lump
sum retirement benefits, tax treatment of additional benefits under voluntary separation
schemes of employers, tax-deferred or tax-free income, for example?
4.Risk
How volatile is this investment type in the short, medium and long term?
5.Liquidity
How easily could the investment be turned into cash? How is this done?
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Topic 4: Plan Preparation
6.Manageability
Will this type of investment require infrequent or regular monitoring and review? How can this
be done? Are there switching options?
7.Asset allocation
Where does this investment type have its funds placed —cash, fixed interest, shares,
property or overseas, for example? What are the minimum and maximum levels of exposure?
8.Costs
What costs are associated with the investment —entry/exit fees, management fees, trustees,
administration costs, commissions?
An income fund concentrates primarily on less volatile cash and fixed interest
investments. It also provides some diversification amongst asset sectors to
achieve some tax-efficient growth. Typically, exposure of an income fund would
be 60 to 70 per cent in fixed income assets and the remaining in equities or
other growth securities.
This asset allocation generally provides a high level of income with some capital
growth.
In the long term, we would anticipate returns in the order of 3 –5 per cent pa
ahead of inflation.
Security of these funds is moderate to high in the longer term. Most of the funds
aim to provide positive returns on a yearly basis; however, negative returns can
occur over this (and shorter) periods. This is especially so in extreme market
conditions (e.g. when fixed interest markets fall into decline). The unit price is
therefore not guaranteed. Redemption of funds is usually available within 7
0days but can take up to 28 days.
Balanced funds
This is like a more aggressive income fund because balanced Funds tend to
seek exposure to longer-term growth assets. Thus, in the short run, they are
more volatile and are therefore best suited to medium-to long-term investors or
for funds, which may not be required for some time. Higher share exposure
usually means higher returns and greater tax efficiency. Costs and all else are
as for the income funds.
Returns for the balanced funds my company recommends can be expected to
be about 4 –6 per cent pa in the longer term; i.e. higher long-term returns when
compared to income funds. Typically, these funds would aim for equal exposure
to fixed income and growth assets in their portfolio.
Growth funds
The term growth fund is used to describe a Mutual fund which targets shares for
investment. Essentially, therefore, it is a vehicle into the share market, but one,
which provides the investor with plenty of information and diversification.
Seventy per cent or more of the funds in an equity fund will generally be
invested in the share market. The balance will be liquid funds.
In the past, long-term returns could be excellent while short-term returns can be
very volatile.
Since dividend income is not taxed in the hands of the recipient and long-term
capital gains enjoy a favourable tax treatment, these funds could be used as
part of long-term investment portfolios targeting tax-efficient income and capital
growth.
Advantages of mutual funds
While there will always be a place for direct investments (for wealthy individuals,
investors with special interests or ambition to self-manage, when there are
special opportunities to take advantage of, and so on), mutual funds make
sense for most investors who are inexperienced and, in any event, unable to
access necessary research information or to analyse that information.
Other advantages of professionally managed funds over direct investments are
as follows:
Cost efficiency —most stockbroking firms charge between 0.5 to 1 per cent for
every transaction made by a client (to buy, sell or switch). The buying and
selling price differences, transaction fees and stamp duty charges of a
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Topic 4: Plan Preparation
professionally managed direct. share portfolio may exceed the total costs of an
average equity fund.
Diversification —even Rs.100 000 can ’t be spread very far when buying
shares direct. When using managed funds, even Rs.10 000 can be cost-
efficiently spread amongst investment sectors and within investment sectors.
Professional management —investors in mutual funds have professionals
working on their behalf. The investor does not need to worry about difficult
tenants, renegotiating rents, altering leases, taking up rights issues and so on.
Liquidity —investors in most mutual funds can access their funds within two
weeks.
Disadvantages of mutual funds
The following may be considered as disadvantages of mutual funds:
• Loss of personal control over decision-making —the fund manager
makes the decisions.
• Pooled funds mean investors do not own a particular asset.
• The fund manager and/or the fund ’s risk profile may change and
become unsuitable for the investor.
• Management fees and costs may be high.
• Returns may be lower than some direct investments.
Question 4.3
Why is it essential that such detailed accounts of investment types be
provided to the client?
INVESTMENTS
2.to gather, organise and present data and information to the client on the investments which
have been researched objectively.
Making projections
When selecting an investment type and specific product, you have to make a number of
projections about its future performance. Financial planners must be able to readily justify all
projections used in preparing a financial plan and to warn clients that projections are just that,
and that other outcomes are possible too.
Question 4.4
Design a brief checklist of issues to consider when you are making
projections about the future of recommended investment products.
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Topic 4: Plan Preparation
Similarly, since you are enjoying a good life expectancy and likely to cross
the income tax threshold, we recommend buying a deferred annuity plan
immediately (without waiting for retirement) on both your names with an
annual premium outlay of Rs.10,000/- per person. We can choose the
deferred annuity policy (say, Jeevan Suraksha Plan offered by LIC of India)
to vest at the age of 65. The benefits are, during the period up to age 65, the
premium paid would be eligible for deduction from income chargeable to tax.
The policies would provide a regular income after vesting which would be
very useful after the age of 65, when the expenses could have increased due
to inflation as well as any deterioration in health. But the income when
received would be subject to tax. Because we are choosing a vesting age of
65, you would have become eligible for income tax concession as Senior
Citizens and hence the tax burden would ease because of that.
Yield on investment: After having done these, the next step is to invest with
an eye on the return receivable with a slightly higher risk involved. We can
think of shares and mutual fund investments, which are slightly more risky but
are capable of giving a higher return than Government Backed investments.
We can also think of Corporate Fixed Deposits giving a higher rate of interest
than banks. For this keeping the security of the investment in mind we have
to choose only such companies that enjoy a AAA rating or equivalent. Hence
we are recommending investments in Income Fund and Balanced Fund of a
renowned Mutual Fund. Considering the stage of life that you are in, we are
recommending a ‘conservative’ approach and hence not recommending a
Growth Fund investment.
Funds for emergencies (Liquidity needs): In order to be able to raise
resources required to meet emergencies or urgent expenses, some funds
have to be invested in such a way that they can be accessed at short notice
without loss to the funds. Hence, we are recommending keeping in some
money in the Bank Deposits with the facility of automatic conversion as Fixed
Deposit (like the Quantum Optima Deposits of ICICI Bank or Suvidha
accounts of Citibank, etc). These funds when remaining invested would earn
interest at Bank Fixed Deposits, while still being available for withdrawal
round the clock through ATMs.
We have also recommended that the following investments are retained and
used as a source of funds to meet emergencies and to supplement your
living expenses for the first few years. This will allow your other investment
funds to be invested more efficiently and for the longer term.
Investments retained
Equity shares Mrs. Joshi 1011420
Mutual Funds: Both
Balanced Funds 75000
Income Funds 50000
PPF (including the further
accretions) 155432
Note: The PPF account showed a balance of Rs.125,000 on the date of the
first interview. Interest @ 8% will be credited on 31 st march 2005. Also, for
the purpose of saving tax for the current year 2004-05, Mr. Joshi deposits
Rs.20,000/ in the account before 31st march 2005. Hence the balance
Rs.155432. You would have studied in the module on “investment planning”
that PPF accounts have a term of 15 years. This term of 15 years would
have normally ended on 15th May 2004. But for reasons described above,
the account is extended for another 5 years to start with.
Projections
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Topic 4: Plan Preparation
[Whilst the answer to Question 4.1 indicated a particular asset allocation for
the Joshis’, this was based on strategy devised by a fund manager other than
your own and was intended to illustrate the divergence between planners.
In the following, research provided by your own dealer addresses the Joshis’
situation with a different asset allocation..]
The Financial statements and projections section of this report contains a
number of projections based on our understanding of your current investment
position. The Recommended investments section shows the recommended
portfolio, as it would look once in place. You may also note that total family
assets are detailed in the Financial statements and projections section of the
report.
Based on our investment recommendations, we have also provided a
projection of anticipated cash flows and income tax. As you can see from our
projections, we have produced a very effective taxation position.
Once in place, the total portfolio, including cash in the bank, will have an
asset allocation mix as follows:
Asset sector %
Cash & bank balances 4.99
Indian Fixed Interest 64.40
International Fixed Interest 0.00
Indian Equity shares 18.92
International shares 0.00
Mutual funds 2.34
Property 9.35
This mix should provide you with the level of diversity and spread to meet
your requirements for reduced risk but with some ability for capital growth
and protection from inflation.
Finally, we have provided projections of your financial position (with respect
to allocated income streams in the Investment cash flow summary in the
Financial statements and projections section).
Based on fairly conservative rates of projection, we have calculated that you
can meet your expenditure requirements with your investments and still
maintain the real value of your investments. This is demonstrated in the
Growth estimates section. That means that your investments should keep
pace with the projected rate of inflation and maintain their purchasing power.
Even after tax and the premium to be paid for the insurances that we have
recommended, you will be left with over Rs.388,000/- of combined income in
year 1 after retirement, against your estimated expenditure required of
Rs.240,000/.
This type of summary is useful in getting the general message and strategies across to the
prospective client; however, it does not contain sufficient detail to claim it covers all of the
necessary regulations. Some financial planners may want to include the extra necessary
detail in the main body of the plan. Otherwise, it can be included as appendices. The
following demonstrates one way of providing the detail.
• Infrastructure bonds
• RBI Tax Savings Bonds; and
• Mutual Funds
The first two investment avenues are selected mainly for the tax
advantages they offer. Investment in infrastructure bonds are for a period
of three years and are eligible for tax rebate under section 88 of Income
Tax Act. There are two types of these bonds issued by RBI – one
carrying tax free interest but at a lower rate of interest and the other
offering a higher return which is taxable. At present, tax free bonds carry
6.5% and taxable bonds 8%. Considering your estimated total income of
Mrs. Joshi and the income tax threshold limits, we have chosen tax free
bonds for investment.
Investing in a mutual fund scheme offers the following benefits:
• administrative simplicity
• investor choice from a host of open and close ended mutual fund
schemes
• Diversification
• Periodical portfolio review reports
• flexible options such as systematic investment / withdrawal,
reinvestment of dividend etc.
We will now continue with the recommendations section of the case study.
INSURANCE
30
Topic 4: Plan Preparation
32
Topic 4: Plan Preparation
CASH FLOW
This section looks at various sources of income and list down the various expenses. In
case of a retiring / retired persons income may be generated from a variety of sources
viz.,
• Amount receivable from pension schemes
• Income from house / commercial property
• Income from investments such as dividends, interest etc.,
• Income from mutual fund investments and small savings schemes
• Miscellaneous income like inheritances, lottery etc.,
Various sources of income receivable can be listed down for the easy and ready
reference of the client. As the details involve various assumptions, it is advisable to
spend some time with the clients to explain the calculations.
Case Study: Mrs & Mr.Joshi
Statement of Income
Statement of income received
As all this information is essential, please advise of any inaccuracies or omissions before
implementing the plan.
This section of the financial plan also examines the details of the charges (expenses) on
these incomes receivable by the clients. These expenses are generally grouped as
under:
• Living Expenses
• Life Insurance premiums and pension plan payments
• Other Insurance Premiums
• Housing loan & debt payments
DFP 6: Financial Plan Construction
• Investments
• Miscellaneous Expenses
• Taxes
The detailed analysis would show clearly whether the client would be in a position to
spare some amount for investment (this is possible if his income exceeds expenses) or
would be liquidating investments (when expenses are more than income received) to
make up the shortage.
34
Topic 4: Plan Preparation
dwelling unit on the terrace of their house with a view to augmenting their income and
saving on tax liability. This construction activity will be financed through a bank loan,
which involves regular equated monthly instalments which are provided for in the financial
plan.
Investments:
Over a period of their working span, Mrs and Mr.Joshi have been making investments in small
saving schemes, equity shares, mutual funds and fixed deposits. A detailed analysis of existing
investments, additional investments of retirement benefits and investment income projections are
included in the financial plan.
Taxes:
Income from various heads are computed and appended to the financial plan. It is better
to estimate tax liability so that advance tax payments, if any, can be made in time. The
calculations shown in the financial plan are based on current tax rates.
We give below the details of expenses, grouped under the above major heads, of Mr and
Mrs.Joshi. These details are also included in the worksheet presented at the end of the
topic.
Statement of expenditure
Expenditure Total Annual
All living expenses 240000
EMI on house loan 103740
Insurance premium 33000
Premium for Deferred Annuity Plan 20000
Home Owners' Policy Premium (approx) 3500
Tax payable
Total expenses 400240
You would have noticed that income is not sufficient to meet the expenses in
the initial years because of housing loan payments. This shortfall is adjusted by
drawing money from investments as shown below:
Income Tax
Taxation is an important aspect of financial planning. You are well aware that
making taxation projection involves making appropriate assumptions,
providing explanation on the assumptions made and explaining in a lucid
DFP 6: Financial Plan Construction
36
Topic 4: Plan Preparation
Notes:
2. The premium paid for the mediclaim policy both group as well as the individual
policies are eligible for deduction from taxable income up to a maximum of
Rs.10,000/- p.a., u/s 80D. This limit will stand increased to Rs.15,000/- in case of
senior citizens.
3. The income from the RBI savings bond is totally tax-free and hence not added in
computing the Income tax.
4. The rebate u/s 88 is calculated @ 20% of the contributions made to the various
investments as their income chargeable to tax is less than Rs.150,000/- in case of
this being more than Rs.150,000/- the same would come down to 15% of investments
made.
Most importantly, these calculations are only indicative, you should be up to date with
the changes in the income tax calculation rules or utilise the services of a tax planner,
who may be available in your office for final calculation before advising the client.
The previous statement uses many assumptions and therefore only gives an indication of
future tax. It is not intended to be an accurate assessment of your future tax liability.
You should recognise that even this simple summary of taxation position and income received
can be daunting for people not used to dealing with figures. The financial planner should
spend time going through the report with the prospective client.
FINANCIAL POSITION
Preparation of a statement showing the financial position of the client is yet another important
aspect of personal financial planning. Preparation of such a statement would help the planner
in knowing the client’s financial situation and resources and identify financial goals and
objectives. Once the process of data collection is over, the planner prepares two important
documents viz., cash flow statement indicating the current income and expenses and financial
position statement indicating the sources and uses of funds. Projected statements of cash
flow and financial position incorporating the recommendations are also included in the
financial plan prepared by the planner. These projected statements illustrate future financial
statements if certain activities are implemented under specified assumptions. When the plan
is taken up for review, these statements may be compared with actual statements to see if the
client’s financial plan was implemented in proper spirit.
The financial position statement shows the client’s wealth at a specified time. Financial
planners can choose from many different formats of financial position statements. Usually, the
companies show their fund position by grouping the items under ‘Sources’ (indicating the way
money is received) and ‘Applications’ (listing the various items on which funds are used). By
looking at this statement in two successive time periods, one would easily understand the
increase or decrease in the wealth of an individual.
The following summary shows where your money has come from how we
have recommended that it is applied and the investments that we have
recommended.
Source and application of funds
Source Rs.
Bank Fixed Deposits 120000
Shares 1011420
Mutual Funds 125000
Company deposits 75000
PPF 155432
Gratuity (net of tax) 477400
Provident Fund 2799121
Leave Encashment benefits 206783
4970156
Application
Bank Deposits:
In the joint names of Mr &
a. Savings Bank 16639
Mrs. Joshi
In the joint names of Mr &
b. Fixed Deposits for 3 years @ 5.5% 100000
Mrs. Joshi
Rs. 100000 in the name of
c. Savings Bank account linked to FD 150000 Mrs. Joshi & Rs.50000 in
Mr.Joshi's name
Equity shares 1011420
Mutual Funds:
Balanced Funds 75000
Income Funds 50000
Systematic withdrawal plans 0
In the joint names of Mr &
Deposits with Grasim Inds Ltd 150000
Mrs. Joshi
Varishtha Pension Bima Yojana 266665 Mrs. Joshi
PPF 165432 10000 additional deposit
300000 each in both
P.O.Monthly Income Scheme 600000
accounts separately
1000000 each in both
Immediate Annuity from a L.I. Company 2000000
accounts separately
Infrastructure Bonds
Annual Income 60000
Regular Income Bonds 200000
38
Topic 4: Plan Preparation
Surplus
Net income 388460
Add: withdrawal from PPF account of Mrs. Joshi 15000
Total Income 403460
We will now provide an example of the types of financial statement and detailed projection
you should include. These could be arranged as appendices to keep the body of the plan
free of too much information.
Recommended investments
40
Topic 4: Plan Preparation
Note: As the overseas holiday and expenditure of Rs.75000/- are not investments
they are not included in recommended investments.
The recommended investments meet your retirement income needs of at least
Rs.2,40,000/ p.a., net of tax. The excess that we provide for would be able to take
care of any unexpected expenditure. Also, if need arises, you can withdraw money
from the PPF account, since it is already beyond 15 years.
Note:
DFP 6: Financial Plan Construction
4000000
3500000
3000000
2500000
Rs.
2000000
1500000
1000000
500000
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Asset Sector
Note: These estimates are based on the expected exposure to each sector by each
investment in the recommended portfolio. This will change over time.
The use of graphs helps simplify data for the prospective client and helps to break up the text,
thus improving presentation.
42
Topic 4: Plan Preparation
Financial planning is made with certain financial objectives. These objectives should be
defined clearly and be measurable in money terms. For example, it is not enough to say "I
want to retire comfortably". Such an objective should be stated, as "I want to retire with the
ability to spend Rs. 2,00,000 annually, adjusted for inflation".
The basic aim of preparing a financial plan is to meet certain capital needs at a future date.
Unless the client is clear about the purpose of financial planning, your efforts would not result
in the desired benefits. Therefore, you should emphasise with your client the importance of
identifying his financial / capital needs. For example, a client may have one or more of the
following capital needs:
1. To retire at age 60 with an annual income of Rs.3,00,000. I am now 40 years of age
2. To completely pay off the housing loan by the time I retire 20 years later.
3. To pay for my five year old daughter’s college education that would cost me Rs.
1,50,000 per year for 4 years.
The first step is to clearly write down the capital needs. These needs are to be expressed in
terms of the amount required and the future date on which required as shown below:
Example Amount required When required
Number
1 Rs. 3,00,000 p.a. Each year beginning from the 20th year from now
and may be up to 40th year.
3 Rs. 1,50,000 p.a. Beginning from the 12th year from now till 16th year
from now.
It would be a better idea to prepare such a statement of financial goals covering as many
requirements as possible as this is the basis on which the financial plan would be prepared. If
the financial capability is found to be inadequate to meet all these goals then they have to be
prioritized.
Sometimes financial needs change with investor’s changing circumstances. The financial plan
is not static. It has to be reviewed from time to time to account for the changing
circumstances.
The client’s capital needs depend on the age, stage in the career path, size of the family,
needs of the other family members, etc. Some of the needs can be identified with precision
while others can only be tentatively determined. There may be unanticipated needs as well for
which provisions have to be made. These needs may be generally classified as
(1) Retirement needs: A financial planner discusses two broad aspects retirement with
clients. One is determining the total amount of money that a client needs for
retirement and the second aspect is to advise clients on the options available. The
case study covered in this module primarily discusses the capital needs of a client, Mr
and Mrs.Joshi, who wants to plan for retirement. From the data collected and
analysed, it is necessary to calculate the required level of savings and investments
today and in future years to achieve the client’s retirement income. If savings are not
possible, whether depletion of investments is advisable, how long the capital would
last and the longevity of the clients are the factors to be borne in mind. You need to
DFP 6: Financial Plan Construction
encourage the clients to make a set of reasonable assumptions about future life
styles. This will serve as a basis for estimating the client’s minimum and maximum
retirement expectations. Basically, the financial planner looks at retirement needs in
three phases: accumulation, conservation and distribution, which are dealt in detail in
the module on retirement planning.
(2) Capital needs at death: Consider a single-earner family with young children and
dependent parents. The income available is limited. The primary need of the client is
to replace the bread winner’s income in case of premature death. Life policies, whole
life or term or endowment insurance is the solution suggested by the financial
planner, depending on the need. The main focus here is to suggest sufficient amount
of coverage by taking in to account the insurance need and the limited budget.
Take another illustration. A person who has retired or has got one /two years for
retirement with no financial liability would not have any life insurance or capital needs
of large extent. What he would like to provide for in his financial planning is certain
amount that would be required by his heirs to take care of funeral and related
expenses.
A middle aged man with housing loan and educational loan as liabilities on his
balance sheet would like to take a credit shield that would protect his survivors of
these liabilities in case of death. The financial planner has to assess, after a detailed
discussion with the client, the type of capital needs that may arise at the time of death
and suggest a suitable insurance / investment plan.
(3) Capital needs at disability: It is important for a financial planner to determine, from
the data collected, whether there is a need for income replacement protection for the
client in question. This need arises from the possibility of the loss of earnings during
the period of disability. At most ages, the probability of a serious, long-term disability
is considerably greater than the probability of death. Financial planner should
examine the benefits that are offered by the client’s employment in case of disability
and also study the individual insurance covers taken. After matching the capital
needs with available benefits, any additional source for the replacement of earnings
can be suggested for the client.
General and special capital needs: In addition to the above needs, there may be some
general and special needs of the clients which are to be provided for in the financial plan.
General needs would include the capital required to meet educational expenses of
children, construction of dwelling unit, medical expenses at old age, replacement /
purchase of capital goods like car, refrigerator, household furniture, washing machine
etc. or the capital needed to pursue the hobby like photography, golf etc.,. Special needs
of the clients would be the expenses required for taking care of the aged parents / adult
children till they get employment, providing venture capital for starting a business etc.,
The general and special needs vary with the clients and the financial planner, after a
careful analysis, should make suitable recommendations to take care of the needs of the
clients.
In the financial plan prepared, a separate section on capital need analysis may be
presented which would describe the needs for capital in the event of premature death or
disability of the client. At death, current life insurance proceeds are included in the
computation of cash flow to provide for current expenses and make investments for future
cash needs of survivors. In the case of disability, the amount of lumpsum / annual
payments provided by employer / insurance policies will be included in the computation of
cash flow and the analysis of possible need for additional capital.
Financial planner, in order to explain the capital needs, should prepare two reports viz.,
a)Capital Needs Report and b)Cash Flow Report. The former report details the overall capital
needed compared to available income and investments, the later report reflects detailed cash
44
Topic 4: Plan Preparation
needs in the next 5 years or 10 years and so on. Both reports provide important information
for evaluating the consequences of losing income and capital through disability / death.
Once this statement is prepared and explained to the clients, you can show him how these
surplus funds can be utilised for achieving the financial goals of the clients. Note that this
illustrative case deals with a scenario where client has a surplus money and his business
income take care of most of his needs. What if there is a sudden discontinuance of the
income (say by death / disability). Projections of needs and income by considering the capital
payments from insurance and other means should be included in a separate statement for the
clear understanding of the client. For example, this entrepreneur has taken an insurance
policy for Rs.25 lakhs which is receivable on his death. Then the financial planner may
prepare a capital need analysis considering this capital and show the sufficiency /
inadequacy of the capital. For instance, in our illustration, the financial planner may suggest
repayment of housing loans and reduction of living expenses. He may also suggest increase
the budget for medical or any other expenses depending on the need. He would also suggest
a fresh investment plan for parking the capital that is received.
3.The financial planner can become too reliant on the software and lose understanding of the
underlying technical issues.
4.The options for the client can be artificially narrowed by extensive reliance on software that
is less than comprehensive.
Good financial planners should know how to arrive at answers manually so that they can test
the accuracy of any models or projections being used. We have not discussed this issue in
detail but you should realise that incorrect software would not constitute an adequate defence
for a financial planner . On the contrary, it may be seen as an indictment of negligence on the
part of a planner.
Question 4.5
Devise a checklist for helping to verify output from a software
package which claims to produce financial plans.
You should use computers and the software provided throughout the industry, bearing with
these points in mind:
1.A computer can only provide the skeleton or framework for the plan; it is your responsibility
to ensure the final plan suits the client and their circumstances, needs and objectives.
2.You should not rely on the computer to dictate the most appropriate strategy; you should
decide on the strategy after careful analysis of any computer generated data as well as any
other qualitative or quantitative data you have collected.
3.You must always know how to derive the computer ’s answers manually to:
• ensure complete understanding of the output
• enable checking to be done on the accuracy of the computer input and output.
4.It is you who is held professionally and ethically responsible for advising your clients
appropriately.
5.It is essential that recommended investments are scrupulously analysed by you, regardless
of their appearance on an approved or recommended list.
Question 4.6
Discuss the implications of the following true cases of deficiencies in
financial planning software:
(a) projections of a superannuation benefit being based on
percentage contributions of salary, but salary increases being
projected at 8 per cent p.a., while real increases have averaged 4
per cent;
(b) incorrect software treating the pension received from the
superannuation scheme of the employer as fully taxable (without the
benefit of standard deduction);
(c) the code for an income fund being mixed with that of a growth
fund when entering a client ’s portfolio details in the electronic
monitoring system.
46
Topic 4: Plan Preparation
A summary
In this topic, we have concentrated on the manner in which funds for investment can best be
placed for particular clients. We have also developed further the case study that we began
earlier in this unit to demonstrate the essential features of plan preparation. Briefly, we have:
• considered the factors which determine asset allocation and link investment
strategies to particular asset sectors;
• demonstrated that diversification of investment funds contributes to reducing risk and
volatility;
• demonstrated the relationship between type of investment and variables such as
capital growth, income, taxation, risk, liquidity, manageability, asset allocation and
costs —and how these variables can be explained to the client;
• established the basis on which investment recommendations are made;
• outlined the importance of client-centred management in the preparation of the
particular financial plan; and
• reviewed the limitations of computer-generated planning and financial planning
software.
DFP 6: Financial Plan Construction
Suggested answers
Question 4.1
(a) As Question 3.1 suggests, more information is required before a positive risk profile
determination could be made, but a preliminary determination might suggest that the Joshis
are ‘conservative’ due to their present position, age, experience, financial objectives, amount
of resources, requirement for security of income, nominal interest in growth, interest in a
pension, and guaranteed income.
(b)Asset allocation
Asset sector (%)
Cash 20
Fixed interest 40
International fixed interest 0
Shares 20
International shares 0
Property 20
Cash (15-25)%
Fixed interest (35-45)%
International fixed interest (0-5)%
Domestic shares (15-25)%
International shares (0-5)%
Property (15-25)%
Question 4.2
The factors listed are interdependent. We must never lose sight of the fact that the endpoint
for our financial plan is satisfaction of the client ’s financial needs and objectives.
However, in general terms, we must consider the client’s risk profile to ensure the appropriate
mix of secure and more adventurous investments. The investment strategy must take into
account the client ’s need for income against growth, the timing of that income, taxation
exposure, social security considerations, etc. Diversification is crucial from a risk-reduction
point of view. Once the client’s minimum exposure requirements in specific assets are
determined, the non-core exposure can then be related to the current economic outlook.
‘What if ’ analysis ((worst-case scenarios, etc.) should be applied to each asset sector and the
aggregate outcome to ensure that we have considered all possible eventualities.
Question 4.3
48
Topic 4: Plan Preparation
Though there are no direct regulations governing the recommendations of financial planners,
as on today, on issues relating to full disclosure to the client, etc, it is only expected that such
regulatory mechanisms would evolve with the passage of time. Apart from complying with
such regulations, there is an obvious need for the client to feel satisfied that the
recommendations are appropriate. A good knowledge of the recommended products and
their relation to the variables of income, growth, taxation, etc. will assist the client to evaluate
the proposals you make and build confidence. Such presentations are also a marketing tool
for you —the client will appreciate the professional presentation of his/her plan and will
hopefully recommend your services to friends and relatives.
Question 4.4
A checklist to meet professional requirements when making investment product projections
could include the following:
Checklist of the issues
Have you:
1. ensured that clients are aware of all qualifications applying to the advice and the
implications of such advice?
2. maintained office procedures to ensure data is current and reflects current market
information?
3. avoided extravagant performance claims?
4. not claimed to be giving independent advice unless there is, in fact, no connection between
the financial planner and the product?
5. disclosed any commercial relationship or pecuniary interest with any institution (this could
avoid claims of deceptive conduct)?
6. limited disclaimers to certain stipulated areas rather than blanket exclusions?
7. projected long-term return rates for investment products rather than short-term ones?
8. notified the client of all costs and taxes and accounted for these factors in calculations?
9. mentioned and allowed for the impact of inflation?.
Question 4.5
Some of the items to include in your checklist:
1.Determine whether the information contained in the software is up to date; for example, by
maintaining a current list of rates and thresholds.
2.Determine whether the appropriate data such as taxation rates, indexation rates, earning
rates, etc., are being entered correctly.
3.Assess whether the financial planner using the package has the necessary skills to
understand the financial planning implications of the technical number crunching being
undertaken by the computer.
4.Investigate whether the options for the client are being artificially narrowed by less than
comprehensive software.
Question 4.6
(a) The potential future superannuation benefit would be exaggerated and unrealistically
computed. Such a lack of competence shown by a financial planner would damage clients’
confidence.
(b) Incorrect net and real returns would be calculated. These would be a loss of opportunity
cost as projections would be misleading.
Subsequent advice and decisions based on the incorrect data would be inappropriate.
DFP 6: Financial Plan Construction
(c) The client ’s objectives to generate a certain income would not be achieved. These would
be a loss of opportunity cost. The cost of administrative and corrective actions would have to
be taken into account. Lack of due care and diligence on the part of the financial planner,
who has not ensured that adequate controls are in place to detect input error, could be
claimed by the client.
50