Fundamentals of financial planning

and subjective term. A lot of people think that they need a lot of stuff. However, what they really need may not be essential to their daily lives. In other words, what they think they need is actually what they want or desire. Therefore, while the needs approach is more scientific in that it tries to estimate the consumption needs of surviving members and relate these to insurance coverage, the key issues of how much is necessary and for how long they should be protected are still ―open‖ questions that financial planners will have to answer. Once these issues are resolved, hopefully with the support and understanding of the client, the calculation of the consumption amount and the estimation of the major expenses for the period become a mere exercise of time value of money calculation. 5. The permanent-income hypothesis can help to provide a useful consumption strategy for clients through consumption smoothing. The permanent-income hypothesis can also be used to estimate the amount of life insurance protection. The relevant equation is Total lifelong income = Total consumption + Bequest We can estimate the ideal annual consumption level for clients simply by assuming that clients would spend all their lifelong income on consumption. In this case, the total consumption would be determined by the income earned. Therefore, life insurance coverage should be related to lifelong income. To cater to the surviving family’s needs, we can reduce the consumption level by the amount spent by the insured. After estimating the total consumption needs of the family in terms of present value, the financial planner can use that amount as the basis for the life insurance needed for the family. In theory, the calculation must be repeated annually—the reason being that, as the total lifelong consumption reduces through time, so does the insurance coverage. In practice, it is quite difficult to reduce the insurance coverage from year to year. Thus using a combination of term life and whole life insurance to create a matching pattern of the upward and downward trends in insurance needs in various life stages is an effective strategy to match cyclical insurance needs in a client’s life cycle. In fact, there exist some life insurance products that provide a decreasing life insurance coverage through time. Such a decreasing term life insurance policy is a very useful tool in dealing with the declining insurance needs in the later stages of a client’s life cycle. However, there are certain limitations of relating insurance needs to consumption smoothing. One of the major assumptions for consumption smoothing is that total lifelong income is a good indicator of the total consumption of an individual. There are cases where this assumption may not be valid. First, this assumption does not allow for the extensive use of debt with the intention of defaulting or using an insurance policy to cover the debt of the deceased. In this case, consumption can far exceed the income earned. Second, this assumption may not be valid as well if the income level of the client is too low or too high. We can divide clients into three major categories according to their incomes: (1) low income; (2) middle income; and (3) high income. Individuals in the low-income group may not have enough money to buy proper insurance coverage. The high-income group may earn too much