FIMM - Chapter 5

FIMM
CHAPTER 5
I PERSoNAL FINANCIAL PLANNING
LEARNING OBJECTIVES
At the end of this Chapter, you should
. understand what is meant by the term 'personal financial planning'and how it differs from investment
'selling'
. appreciate the role of a financial planner, and the skills required of a competent financial planner
. recognise the main types of client while accepting that each client has different investment objectives,
expectations and needs
. be able to describe the six key steps in personal financial planning
. be aware of some of the more specialised aspects of personal financial planning - personal taxation,
investment planning, risk and insurance protection and estate planning.
I sECTroN 5.r. ovERVrEw
ln certain parts of the world, the role of the financial planner has become highly significant. Many people
appoint a financial planner, in the same way that they have an accountant, a tax adviser, a stockbroker or a
lawyer. Personal financial planning is quickly becoming a field of practice in its own right.
Financial planning is defined under Section 2 of the Securities lndustryAct 1983 under the general definition
of 'lnvestment Adviser'. An investment adviser is someone who "carries on a business of analysing the
financial circumstances of another person and provides a plan to meet that other person's financial needs and
objectives, including any investment plan in securities, whether or not a fee is charged in relation thereto".
Financial planning is simply the process of meeting your life goals within a certain time frame through the
proper management of your present and future finances. These goals may include buying a house, savings
for children's education, savings for a comfortable retirement lifestyle, etc. The financial planner will take a
"big picture" view of your financial position and recommends actions that you need to take to achieve your
life goals. Such advice may include budgeting, higher rate of savings, fax planning, wealth creation and
preservation, realignment of your investments, risk management and retirement planning.
The unit trust industry in Malaysia is rapidly evolving to a stage where agents undertake to understand the
financial position and investment objectives of a client and analyse the best unit trust investment suitable
for the client. This investment analysis complements the development of the financial planning industry.
ln other countries, too, the unit trust industry has played a major role in the development of the financial
planning industry.
ln this Chapter, we will introduce the role of the financial planner. The discussion is not meant to be exhaustive,
but should serve as a broad overview of what is meant by the term 'personal financial planning'.
FlMtul
To be called/designated a Financial Planner, UTC are advised to pass certain professional financial
planning courseJ like the Certified Financial Planner (CFP) or the Chartered Financial Gonsultant
iCnfC) and be a member of the respective bodies before applying to the Securities Commission
for a licence to practise as a financial planner.
I sEcrIoN 5.2 wHAT IS 'PERSONAL
I nNnNCIALPLANNING'?
personal financial planning is a broad concept that has a client's financial needs and objectives at its core'
personalfinancial planning is an integrated process whereby a client is assisted with his or her
. Cash Management . Risk Management and lnsurance Planning . lnvestment Planning . Tax Planning . Retirement and Estate Planning.
Most individuals need to plan. An effective personal financial plan will help
. protect a client's assets from the effects of inflation
. ensure an adequate income, when it is needed
. provide a roadmap of a client's objectives for the medium and long term
. improve or maintain present - as well as future - lifestyle
. give 'peace of mind'with regard to the client's financial situation.
.
It is necessary to appreciate several features of personal financial planning to gain a full understanding of
the concept. Personal financial planning
. is a process. Personal financial planning is not simply a product. lt is the result of listening, consultation
and interactive fi nancial assessment
. is comprehensive. All aspects of a client's needs and requirements need to be fully explored and
explained
. seeks maximum utility. Utility is the economist's term for usefulness. This means that a personal
financial plan seeks to produce concrete and tangible results that provide client satisfaction
. recognises the individual. There probably should be no two identical financial plans as no two clients
are exacly the same. Each of us has a different set of personal circumstances, investment objectives,
a different risk aPPetite, and so on
. acknowledges the cycles of life. A personal financial plan is not a static document and needs to be
updated on a regular basis. A client's needs, objectives and views change over time, so the plan
should be updated and the investment portfolio (developed as part of the plan) assessed to ensure
that it continues to meet the client's needs and requirements.
FIMM
I sncuoN 5.3 AREAS rN FTNANCTAL
I PLANNING
CASH MANAGEMENT
Cash management or budgeting is very important as it allows the individual to analyse his total income
against his expenditure, identify his essential and non-essential expenditure and the amount he can set
aside for savings. lf he wishes to save more, he can reduce his non-essential expenditure or defer less
important expenditure.
RISK MANAGEMENT AND INSURANCE PLANNING
Risk Management and lnsurance Planning is the process of identifying the source and extent of an individual's
risk of financial, physical and personal loss, and developing strategies to manage exposure to risk and
minimise the probability and amount of potential loss.
INVESTMENT PLANNING
lnvqstment planning is the process of determining how to invest current assets and future savings based
on an individual's short and long-term financial goals, current financial situation and risk tolerance. A good
investment plan identifies financial goals and assigns a Ringgit figure and time frame to those goals. After the
goals, Ringgit amount and time frame have been selected, appropriate financial instruments are purchased
to rneet those goals, Most investment plans in Malaysia are commonly made for retirement, children's
education and wealth accumulation.
TAX PLANNING
j
lncome tax planning may be defined as the development and implementation of appropriate strategies to
reduce, affect the timing of, or shift either current or future income tax liabilities. Recommended strategies
are based not only on the tax consequences themselves, but also in light of the individual's overall financial
goals.
RETIREMENT AND ESTATE PLANNING
Retiiement planning is essentially having a plan where the last phase of an individual's life, i.e. upon
retiring, is taken care of by his savings, investments and passive income. Simply stated, estate planning
is a method for determining how to distribute the individual's assets during his life and at death. lt is the
process of developing and implementing a master plan that facilitates the distribution of assets after death
and according to the individual's wishes.
FIMM
I SECTION 5.4 STEPS IN FINANCIAL PLANNING
The common approach in financial planning involves six key steps:
1. UNDERSTANDING THE CLIENT
Conducting a cash flow analysis, risk profiling, knowing the client's goals, etc.
2. DATAGATHERING
Collecting information from client regarding his tax status, income sources, expenditure, existing
insurance protection and investments, existing estate plans, etc.
3. ANALYSING DATA
Determining the financial standing of the client, net worth, cash flow, etc. to see if the client could meet
financial goals or not. Surplus or shortfalls may be addressed with the information provided.
4. PREPARING THE PLAN
Formulating strategies to meet financial goals based on the information acquired.
5. IMPLEMENTING THE PLAN
Carrying out the plan based on what has been agreed upon by the client.
6. REVIEWING THE PLAN
Reviewing the client's financial plan on a regular basis (usually every six months) to see if the client's
financial standing, income and clients' lifestyle / commitments or risk profile has changed, or if the
portfolio's performance is on track to meet the client's financial goals. The review proc€ss would also
determine if necessary action has to be taken to readjust the client's financial plan.
I srcuoN 5.5 SKTLLS REeUTRED oF A
I NNENCIAL PLANNER
It should be clearthat several different skills, including technical skills, are required to be a personal financial
planner.
Less obvious though are the people skills. A high level of interpersonal skills is vital if the client is to feel
comfortable in providing the financial planner with full details of personal data and financial information.
Some clients willfeel very uncomfortable in providing these details - indeed, some will refuse to provide it.
But it is not reasonable to expect a client to ask a financial planner to produce a plan that suits the client's
circumstances and objectives without full and frank disclosure of all the information needed to produce it.
A client should feel at ease in providing information and one of the skills required of a financial planner is
listening. Both during the data gathering stage and in receiving feedback from a client on suggestions or in
annual reviews of the plan, the financial planner must listen for 'clues' as to the client's thoughts and fears.
A planner must understand the need to empathise with a client whose portfolio performance is perhaps less
than expected due to unforeseen market movements.
An understanding of body language can be useful since many clients may say one thing but, through body
language, mean the opposite!
FTMM
I srcrloN 5.3 AREAS IN FINANCTAL
I prnNNrNG
CASH MANAGEMENT
Cash management or budgeting is very important as it allows the individual to analyse his total income
against his expenditure, identify his essential and non-essential expenditure and the amount he can set
aside for savings. lf he wishes to save more, he can reduce his non-essential expenditure or defer less
important expenditure.
RISK MANAGEMENT AND INSURANCE PLANNING
Risk Management and lnsurance Planning is the process of identifying the source and extent of an individual's
dsk of financial, physical and personal loss, and developing strategies to manage exposure to risk and
minimise the probability and amount of potential loss.
INVESTMENT PLANNING
lnve,stment planning is the process of determining how to invest current assets and future savings based
on an individual's short and long-term financial goals, current financial situation and risk tolerance. A good
investment plan klentifies financial goals and assigns a Ringgit figure and time frame to those goals. After ihe
goals, Ringgit amount and time frame have been selected, appropriate financial instruments are purchased
to meet those goals, Most investment plans in Malaysia are commonly made for retirement, children's
edui:ation and wealth accumulation.
TAX PLANNING
lncome tax planning may be defined as the development and implementation of appropriate strategies to
reduce, affect the timing of, or shift either current or future income tax liabilities. Recommended strategies
are based not only on the tax consequences themselves, but also in light of the individual's overall financial
goals.
RET]REMENT AND ESTATE PLANNING
Retirement planning is essentially having a plan where the last phase of an individual's life, i.e. upon
retiring, is taken care of by his savings, investments and passive income. Simply stated, estate planning
is a method for determining how to distribute the individual's assets during his life and at death. lt is the
process of developing and implementing a master plan that facilitates the distribution of assets after death
and according to the individual's wishes.
FIMM
We have previously discussed the issue of ethics. A high standard of ethics and professionalism must be
adhered to by a financial planner. Simply, this is where the client's interests are put ahead of the interests of
the planner. The result is that the client builds up a relationship of 'trust'with the planner - and 'trust' is the
most valuable "ingredient" in this long-term relationship between the financial planner and the client.
I sucuoN 5.6 PERSoNAL FTNANCTAL
I prnNNrNG AND THEUTC
Of the five areas in Financial Planning, the area most relevant to the UTC is lnvestment Planning. Thus, we
shallfocus a little more on this area.
5.6.1 THE UTC'S ROLE IN INVESTMENT PLANNING
\-/ As a UTC, you must acquire analytical skills and experience in financial matters that make you especially qualified to provide objective investment advice. You can help reduce your clients'confusion and concern
about investment decisions by performing the following functions:
. putting investment planning in perspective by educating your clients that investment decisions are
preceded and based on investment strategies that are established to meet the financial goals within
a certain time frame
. educating your clients regarding the risk, liquidity, tax and management characteristics of the
investments to help clients manage their investment risk and undertake the appropriate strategies
necessary to achieve stated financial goals
. advising clients on the use of credit risks and the costs involved, investment decisions related to
corporate benefit plans, and investment strategies such as dollar-cost averaging
. discussing and recommending investment classes or specific investments.
5.6.2 SPECIFIC ACTIVITIES OF THE UTC IN INVESTMENT PLANNING
\-' The specific activities you undertake in investment planning depend on many factors, including the structure
of your professional practice and your client's goals and the nature and complexity of their financial situation.
ln a comprehensive investment planning engagement, you should:
. determine the client's financial objectives and their order of importance
' analyse the client's financial position and cash flow Suggest changes to improve the client's cash
position and analyse priorities, if necessary
' determine the client's priorities for the allocation of financial resources among stated non-investment
objectives, such as the amount of emergency funds and the acquisition of additional insurance
. calculate the remaining assets that will be available to meet investment goals
. gather and analyse the data necessary for developing the client's investment profile, including
. indications about the client's general disposition toward risks
. determine the risk and return characteristics of the client's current investments
FIMM
. state financial assumptions
. determine the adequacy of the client's resources for achieving stated investment goals and analyse
the appropriateness of the client's current investment strategies. lf resources are insufficient, consider
revising the allocation of resources, changing goals, or using investments with higher risks and yields
that are acceptable by the client
. provide the agreed-on level of investment planning service
. provide the agreed-on level of implementation service
. provide any agreed-on investment monitoring services
. provide any agreed-on ongoing services and update the plan as necessary
. document the investment planning procedures, the client's decisions, and your continuing
responsibilities.
5.6.3 PERSONAL FINANCIAL PLANNING IS NOT INVESTMENT'SELLING'
It is vital to recognise that personal financial planning is quite different from investment'selling'. While 'selling'
is often associated with a'one-off'act, personalfinancial planning encompasses a comprehensive approach
to advice delivered on an ongoing basis to a client. A'sale'of a financial product is often the culmination
of a properly drawn-up and carefully considered personal financial plan. However, it is not the reason for
drawing up a personalfinancial plan.
Personal financial planning involves an understanding of a client's financial affairs, goals and personal
objectives. lt requires the application of technical, communication and other interpersonal skills. These skills
are then used to write the personal financial plan to the client, and to implement the agreed plan - perhaps
in part by the purchase of appropriate UTS and other financial products.
It is important to appreciate that personal financial planning generally involves a relationship with other
professionals appointed by a client. A financial planner cannot be an expert in all the technical aspects
necessary to produce an appropriate personal financial plan. A financial planner must interact with other
professional advisers with whom the client currently has a relationship. For example, a client may have
appointed an accountant, a taxation adviser, stockbroker and lawyer. Liaison with all these professionals
would be an important part of ensuring that the client's personal financial plan can be completed.
X SECTION 5.7 CLIENT TYPES
Clients have differing financial objectives and capacities to save. However, there are certain similarities
amongst clients and these usually relate to what stage a client is at in the life cycle.
There are, generally, four main stages in the life cycle of a client.
FTMIUI
STAGE ONE: APPROXIMATELYAGE 21 - 30 YEARS
At this early stage of life, a client may be single or newly married. His or her income level may be sufficient
to meet living expenses, and as such, there is little opportunity for saving. Thoughts of retirement are, of
course, a long way into the future. There may be no significant financial responsibilities (for example, family
members to support).
From an investment perspective, if the client has purchased a home, he or she can perhaps begin to build a
small nest egg by investing into growth-oriented UTS. Perhaps some additional risk can be taken by investing
in more specialised and aggressive UTS. The client may be able to tolerate higher volatility in investment
returns over the short-term, as the focus will be on returns over long periods.
STAGE TWO: APPROXIMATELY AGE 31 - 44 YEARS
Commonly, such clients are married with young children and have purchased a home. Tertiary education
expenses may be several years away and retirement is still a long way off. The client's current financial
responsibilities can be protected through appropriate levels of life insurance cover, and readily accessible
savings.
Depending on the level of financial commitments, there may now be a greater opportunity to save and
invest. A client can consider investing for long-term capital growth using growth or balanced UTS. lf there
are more significant savings available, the client can consider investing in some higher-risk UTS to maximise
returns over the long-term. EPF balances may now be sufficient to be transferred to UTS that meet these
objectives.
STAGE THREE: APPROXIMATELYAGE 45 - 60 YEARS
A client in his / her mid 40s may now be more financially secure and has reached a career peak. He or she
may have a high savings capacity to invest for retirement. Tertiary education expenses for children may be
imminent.
When the client is approaching age 55 and above and while insurance protection is still very important,
there may be a requirement to change the investment asset mix. Perhaps more conservative UTS should
be considered, such as income as well as balanced funds. Such UTS could produce lower growth but with
reduced risk, and the total portfolio can provide the client with financial independence upon retirement.
STAGE FOUR: APPROXIMAIELYAGE 61 YEARS AND ABOVE
A client's children have grown up and have finished their education and house mortgages are fully paid.
Perhaps the client has now retired, so his or her earnings may have significantly decreased and a priority will
be to maintain income that can be generated out of capital. lf not, with decreased financial responsibilities,
it may be an appropriate opportunity to prudently increase the capital base prior to retirement. An objective
must also be to attempt to maintain the purchasing power of the capital, whilst at the same time reducing the
risk of loss. The client must consider contingencies, such as medical needs, in setting his or her investment
portfolio. Perhaps a combination of income and balanced UTS will prove most appropriate. Aggressive
UTS, which may produce high returns but with considerable volatility and perhaps significant losses, are
not suitable for retirees.
Of course, the four stages are generalised and as we have said, every client is different. lt is nevertheless
useful for prospective UTC to see how a 'typical'client's life cycle can link with an investment portfolio
involving UTS to achieve a client's objectives.
FTMM
I srcrloN 5.8 DTFFERENCE BETwEEN A
I nNENCIAL PLANNER AND UTC
EXAMPLE 1
'A introduces himself as a unit trust agent to his client and does a needs analysis. After asking questions on
the latter's financial capability, understanding his investment goals and risk appetite, 'A then recommends
a unit trust product. During the whole meeting, he maintains himself as a unit trust agent to his client. He
only needs a UTC licence.
EXAMPLE 2
'4, a unit trust agent introduces himself as a financial planner and does a needs analysis with his client
and, after asking questions on the latter's financial capability, understanding his investment goals and risk
appetite, recommends a unit trust product. 'A is a financial planner and needs an lA licence simply because
he calls himself a financial planner. Of course, he also needs a UTC licence. Because the financial planner
in the above scenario uses the financial planning skill sets to talk about investments, he is doing singlepurpose
financial planning as against comprehensive financial planning. Comprehensive financial planning
would cover cash management, insurance planning, wealth creation, enhancement and preservation, tax
planning, business succession, trusts and wills.
I srcrION 5.9 REMUNERATIoN oF A
I nNaNCIALPLANNER
ln overseas markets, but less commonly in Malaysia, clients are charged an advisory fee by the financial
planner. ln markets such as the United Kingdom and Australia, a significant proportion of sales of UTS is
through the 'independent financial adviser' (planner) distribution channel. lndependent financial advisers
are professional individuals or franchisees who specialise in advising clients on where to invest their funds
in order to achieve their desired investment outcomes, usually following completion of a financial plan.
Advisory fees can either be based on time spent in developing a plan, or on the size of the portfolio of the
client. lf they are related to time, then obviously the longer the amount of time spent in advising a client,
the higher the charge. Similarly, a larger portfolio will attract a higher fee than a smaller one where the fee
basis is based on the amount of funds under review. ln the United States, some investment advisers levy
their fees on the basis of the performance of the investment products used in a plan,
Personal financial planning can be a profitable business, especially if the financial planner can earn fee
income from the client, in addition to the commission-based remuneration received from UTMC and other
product man ufacturers.
ln Malaysia, it is more common for financial planners to be remunerated by way of commission payments
from product manufacturers in the same way as UTC. The disadvantage of this method is that the reward
to the financial planner is transaction-driven, since a payment is received only following completion of an
investment transaction. Commission payments are, therefore, very much based on sales of investments
or other financial products, and some argue that this is inappropriate when advising clients on setting
and achieving financial goals. A client may question whether the purchase of a particular investment was
motivated by the commission payment likely to accrue to the financial planner, rather than perform objective
and independent assessment to ensure the particular investment satisfies the client's goals.
FIMM
A service-based reward to a financial planner reduces the need to 'sell'financial products and emphasises
the ongoing and advisory nature of the service provided. Some regard a service-based reward as more
'independent' and'professional'.
Helping clients meet their investment goals is one of the most satisfying accomplishments that a UTC can
achieve. The UTC would definitely benefit from the growth of assets that they manage as well as enjoy repeat
sales, increased size of business and obtain good referrals from satisfied clients. Remember, client's wealth,
their children's future and retirement, are all dependent on a competent and professional UTC.
X sECTroN 5.10 suMMARY
We have seen that personal financial planning is a complex process involving a number of key steps, and
in which recommending UTS may form only a relatively small, although important, part.
Above all, personal financial planning is client-focused, and the successful financial planner must gain the
trust of his or her client to be able to produce and implement a personal financial plan that is to achieve the
client's goals and objectives.
Afinancial planner is a generalist (in the same way as a family doctor). The financial planner must be aware
that specialist technical knowledge and input is required in devising an appropriate financial plan, and must
also learn to work alongside, and with the cooperation of, a client's other professional advisers.
The changes occurring in Malaysia indicate an exciting time ahead forthe financial planning industry. UTMC
and UTC are well placed to benefit from this.
FIMM
Snrr,rrsr QunsrroNs ON CHepmn 5
1. Define the term 'personalfinancial planning'. Explain clearly the difference between personal financial
planning and investment'selling'.
2. List and describe the four main stages in the life cycle of a client. ls it reasonable to classify each
client into one of these categories?
3. List the six key steps in designing a personal financial plan.
4. Detailthe four main functions performed by the UTC in hisiher role in lnvestment Planning
5. What are the five main areas in financial planning? Give a brief description of each.
6. What skills do UTC need to be financial planners?
7. Discuss some of the ways a Financial Planner receives remuneration.
L Why is investment planning more applicable to UTC than the other areas in financial planning? Provide
some of the specific activities of the UTC in investment planning.
FIMM
APPENDIX 1:
EFFECT OF INFLATION, TAXATION AND COSTS ON
INVESTMENT RETURNS
The impact of inflation, tax and investment costs on investment returns needs to be carefully considered
when making investment decisions. Many investors ignore the impact of inflation, tax and investment costs,
only to find that their investment returns and wealth are much less than they envisaged.
Most believe they understand inflation, yet many investors let themselves become a victim of its insidious
impact on investment returns and wealth. lnflation, to most people, simply means price increases. But to
the investor, it has far wider ramifications.
lnvestors need to preserve the purchasing power of their original investments, and be earning a rate of
return from those investments that beats the inflation rate. ln periods of high inflation, the purchasing power
of financial assets decreases. RM100,000 today simply cannot buy what it did ten years ago. The reason:
inflation. By the same token, an investor, who thinks he or she needs to save a particular sum for the future,
needs to think clearly whether that amount will be adequate in terms of prices and costs in, say, 15 years'
time.
The second factor that reduces returns to investors is taxation. Again, it is no secret that all income is
assessed for tax, yet many overlook the taxation implications of the investments they choose. ln Malaysia,
there are different tax treatments for different types of investments. However, when planning to accumulate
a specified amount of capital in the future, the current and future tax implications must be considered.
Tax acts as an erosion of the returns achieved from investment and its impact needs to be clearly
recognised.
1. MEASURING THE IMPACT OF TAXATION AND INFLATION ON INCOME RETURNS
The table illustrates the combined effect of taxes and inflation on investment income.
Assume that the various rates of tax shown in column 1 are applied to investment income received by an
investor, and that the average annual inflation rate is 5%. For the range of investment income returns shown
in column 2, the effective return after taking into account tax and inflation is shown in column 5.
6:8,:.:r:1.,i::.i"': t:,:::i::ra:i'at.rg$:i:::,r.,t:t:r::tlt::,:l::::::,rr,,,i:.,. -1:5
+2&.,
*5;.5
* Note: These rates are assumed for illustrative purposes. Refer to actual rates of income tax for a particutar
year of assessrnenf and to current forecasfs of inflation. The table ignores the effect of inflation on the
rnvesfor's capitalfrom which the income return is deived.
'30,,.:,,,,,,'.,,,:,:,,ll::t:.l::,...i.{0;O,-'-,::,,:l,l,l,,1;.:::"... -,,.:,:f$;1 lr : ":::: :-ir::::::::::l-i.,5
li: iil.r:i,:i:::::..ir:::'i:i,:.1:..:::l{S;$::.,1,.11r.11;;,11,1:,,,'.-:; :_,1O}5,.,: .- .:,'.:il:.,r':: ::i:,,:r:., :r:
FIMM
The impact of both tax and inflation on income returns is significant, especially at higher tax rates. A 10o/o pa
nominal rate of income return to an investor with a 10% tax rate reduces to an effective return of only 4% pa,
after taking into account tax and inflation - a significant difference. At a marginal rate of 30%, the effective
return falls to a negligible 2o/o pa. Cleady, inflation and tax have significant implications for investors, UTC
and financial planners.
The table of effective rates of return highlights the desirability of designing an investment portfolio that
includes investments that are expected to produce capital growth over and above the rate of inflation. lf a
client's portfolio can be structured to minimise the effects of both taxation and inflation, then the client should
be in a much better position to protect existing capital and to build real wealth over time.
2. THE IMPACT OF INFLATION ON INVESTMENT OBJECTIVES
All long-term investment portfolios should, as far as possible, be constructed with the objective of keeping
pace with inflation, and to provide for capital growth to increase the real value of the portfolio.
But how much will be required to meet a particular financial objective in, say, 15 years' time?
The table highlights the way in which inflation needs to be considered when making investment decisions. lt
shows the amount required to be accumulated at the end of a period to maintain the real value of RM100,000
under different inflation expectations.
For example, assuming that there is an inflation rate of 5% pa for 20 years, the purchase cost of an apartment
currently valued at RM100,000 will be RM265,329 (assuming that apartment prices change at the same
rate as general inflation). For an investor with an investment portfolio currently valued at RM100,000 to be
able to purchase the apartment in 20 years'time, the purchasing power of the portfolio will need to grow at
a rate of at least 5o/o pa (ignoring taxes). Even if the portfolio returns 5% pa over the period, the investor is
no better off. To increase wealth, the investor requires an investment return in excess of the inflation rate.
3. RULE OF 72
There is a simple rule that can be used in determining and measuring the impact of inflation and the result
of the compounding of investment returns - the 'rule of 72'.
The 'rule of 72' helps us to provide a client with an estimate of, for example:
. the loss in real value of a given amount of funds with a particular inflation rate . how long it will take to double a given sum of money invested at a given rate of return.
The formula is:
FTIUIM
Example:
Aclient has RM150,000 and wants an indication of how long it would take to halve its real value with an
assumed inflation rate of 3%% pa.
20.6 years (20 years 7 months)
Example:
A client has RM100,000 and wants to know how long it would take to double his or her money at an assumed
investment return of 7/zo/o pa.
9.6 years (9 years 7 months)
The following tables (compiled using the Rule of 72) demonstrate the effects of inflation on the real value of
money, and how long it will take to double the value of an investment.
3.1 HOW LONG WILL IT TAKE TO HALVE THE REAL VALUE OF MONEY?
Clearly, the higher the inflation rate, the more quickly the real value of money is halved.
3.2 HOW LONG WILL IT TAKE TO DOUBLE THE VALUE OF AN INVESTMENT?
72
3.5
72
7.5
FIM]UI
4. THE EFFECT OF CHARGES ON INVESTMENT RETURNS
Assume that an investor has RM100,000 for investment in UTS, and that the investor is able to invest for
a period of 20 years.
The investor is offered a choice of three UTS that will meet his or her requirements in terms of risk and
return. Each UTS has a different fee structure:
UTS t has an initial entry cost of 8% with an MER of 2o/o pa
UTS 2 has an initial entry cost of 5% with an MER of 2o/o pa
UTS 3 has no initial entry cost with an MER of 1o/o pa.
Assuming similar prospective investment returns, which UTS should be chosen?
The impact on the investment returns over the period due to the differences in charges is quite striking:
Between UTS 1 and UTS 3, there is a RM131 ,633 difference in the final amount of capital accumulated over
the 2O-year period, reflecting the additional fees payable to UTMC of UTS 1 over that period - an effective
saving to the unitholder of UTS 3.
ln the above example, it is easy to see which UTS an investor is likely to choose. ln practice, the decision
is not always as simple. For example, the table assumes that all three UTS will generate exactly the same
return.
UTMC investing in the same share market will often produce different returns depending on many different
factors, including investment styles. Studies overseas have shown, too, that it is not always the case that
the higher the fees, the better the performance - in fact, the opposite may apply!
One thing is clear though - that for every 1o/o pa more in fees and charges, there is an additional 1o/o pa.
investment return that is required to produce the same return to the investor. Over time, and taking into
consideration the compounding effect of charges on returns, there can be a significant impact on investment
performance. lt is, therefore, important for a financial planner to ensure that allowance is made for the costs
of investing when estimating investment returns.
Together with the impact of inflation and tax, investment costs are another drain on investment returns sought
by clients to achieve financial goals.