Financial Planning Fundamentals
Session Six
Southern
Methodist
University
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Education Funding
Significant Financial Burden
• College funding is consistently on the top of the financial concerns of those surveyed
Students Staying Longer
• Trends show students taking longer than four years to finish their education
- “Cramming four years into five”
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Southern Methodist University
2007-08 Average Published 2007Four Year College Costs
College Expense Tuition Room & Board Total Expenses Grants and Tax Benefits Net Expenses Public School $6,185 $7,404 $13,589
One Year % Incr
Private School $23,712 $8,595 $32,307
One Year % Incr
6.6% 5.3% 5.9%
6.3% 5.0% 5.9%
($3,600) $9,989
($9,300) $23,007
*Source – College Board Trends in College Pricing 2007
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Southern Methodist University
Information Gathering
Goal-Setting Process
• Determine type of university - Public - Private - Community (junior) college (2 years maximum) • Estimate costs - Tuition, room and board, transportation, books, supplies, equipment and fees • Adjust for inflation - 6%-10% per annum • Forecast the total estimated 4+ year cost
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Southern Methodist University
Education Planning
The steps are the same as Retirement
• Determine the current cost/year • Determine the inflated cost/year in the first year of college • Determine the total amount needed in the first year of college • Determine the amount of investments needed
- Lump sum, level, serial
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Southern Methodist University
Obtaining Federal Financial Aid
Steps to Obtain Financial Aid
• Obtain the Free Application for Federal Student Aid
- From high school counselor, or prospective college admissions office - On the web @ wwwfafsaedgov
6
Southern
Methodist
University
Obtaining Federal Financial Aid
Steps to Obtain Financial Aid
• Determine the Expected Family Contribution (EFC)
- Estimates how much of a family’s resources should be available to assist in paying for the education
7
Southern
Methodist
University
Obtaining Federal Financial Aid
Calculate the Financial Need
Tuition/Cost of Attendance – Expected Family Contribution (EFC) Financial Need
8
Southern
Methodist
University
Obtaining Federal Financial Aid
Reduce the EFC
• Parent’s income/assets will not count toward the EFC if the student is not their dependent • Student is considered independent if he/she meets any one of six conditions - Over age 23 - Married - Working on Masters or Doctorate degree - Has legal dependents (other than spouse) - Is an orphan or ward of the court - Is a US Armed Forces veteran
9
Southern Methodist University
Obtaining Federal Financial Aid
Reduce the EFC
• Student is considered independent if he/she meets any one of six conditions
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Over age 23 Married Working on Masters or Doctorate degree Has legal dependents (other than spouse) Is an orphan or ward of the court Is a US Armed Forces veteran
Southern Methodist University
Obtaining Federal Financial Aid
Reduce the EFC
• Create a trust for the child
- Diminishes the family’s assets through gifting - Assets will be included in the child’s own calculation
• Request an adjustment to the EFC
- Financial aid administrators can, at their discretion, adjust the cost of attendance or the data in calculating a student’s EFC, if circumstances require
11
Southern
Methodist
University
Federal Financial Aid Programs
Federal Pell Grants
• EFC is used to determine • eligibility • For undergraduate students who have not yet earned a degree
- Full or part-time students are eligible
• Amount varies and is based upon level of Federal Funding
- 2007-2008 grant amount is $4,310
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Southern Methodist University
Federal Financial Aid Programs
Stafford Loans
• Primary type of of financial aid by the US Department of Education • Two Types
- Direct Stafford Loans
• Funds are provided by the US Government
- Federal Family Education Stafford Loans (FFEL)
• Funds are provided by a bank or other lender
13
Southern
Methodist
University
Federal Financial Aid Programs
Stafford Loans
• Maximum Loan (2007-2008)
- $3,500 1st yr, $4,500 2nd yr, $5,500 3rd yr+
• Depending on Loan Subsidization based on EFC and need
- Subsidized loans - no interest until the repayment begins (after education) - Unsubsidized loans - below market interest ≤ 8.25%
• Students can obtain a one time deferment
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Southern Methodist University
Federal Financial Aid Programs
Stafford Loans
• Loans can be cancelled in certain situations - Death of either student or borrower - Disability of the borrower - Student becomes a elementary or secondary teacher of low-income students (for at least five years) - Loan is discharged in bankruptcy - School is closed before the education is complete - School falsely certifies the loan
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Southern Methodist University
Federal Financial Aid Programs
PLUS Loans (Parent Loans for Undergraduate Students)
• Provided under the Direct Loan and FFEL programs • Available to undergraduate students’ parents with good credit • Maximum loan - cost of the education less any financial aid
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Southern Methodist University
Federal Financial Aid Programs
PLUS Loans (Parent Loans for Undergraduate Students)
• Older Loans (before 7/1/2006) - Variable interest rate ≤ 9% • Loans 2007-2008 academic year - Direct & FFEL - 8.02% • 4% Origination Fee • Repayments must begin within 60 days of loan disbursement (during education) • One time deferment (forbearance) is allowed (up to 3 years)
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Southern Methodist University
Campus-Based Federal CampusFinancial Aid Programs
Consolidation Loans
• A loan that allows borrowers to consolidate various types of federal student loans into one loan with a single payment schedule • Loan interest rate ≤ 8.25%
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Southern
Methodist
University
Campus-Based Federal CampusFinancial Aid Programs
FSEOG (Federal Supplemental Education Opportunity Grant)
• Offered to undergraduate students with low EFCs • Money is guaranteed to be funded
- $100 - $4,000 per year (avg $766) - Amount based upon student’s need, time of application, and the school’s level of funding
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Southern
Methodist
University
Campus-Based Federal CampusFinancial Aid Programs
Federal Work-Study Program
• Provides jobs that pay at least minimum wage
- For educational expenses either undergraduate or graduate students - Total amount is limited by the award received through the program
• Based upon EFC • May be either full or part-time status
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Southern Methodist University
Campus-Based Federal CampusFinancial Aid Programs
Perkins Loans
• Offered to undergraduate students with extremely low EFCs • Loan is made with government funds by the school • Fixed 5% interest rate • Repayments must begin within 9 months of finishing school and end within 10 years
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Southern Methodist University
Campus-Based Federal CampusFinancial Aid Programs
Perkins Loans
• One time deferment (forbearance) allowed • The loan can also be cancelled if the student takes a fulltime position in a qualifying job
- Agency that provides services to high risk children and families - Provider of early intervention services for the disabled - Nurse, medical technician, law enforcement officer, or teacher in a designated teacher shortage area - Armed forces in areas of hostilities or imminent danger - Education component of the Head Start Program - Vista or Peace corps volunteer
22
Southern
Methodist
University
State Financial Aid
States have programs similar to the federal programs
• Rely heavily on financial need and require superior academic performance • Must be resident of the providing state • Must attend a university located in the providing state
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Southern Methodist University
Other Financial Aid Sources
Aid Directly from the Institution
• Loans, scholarships, discounts, campus jobs • Monthly installment plans for tuition
Aid from Armed Forces Civic Organizations, Churches, Clubs Employer Sponsored Educational Assistance
• Tuition, fees, books, supplies, and equipment - Up to $5,250 is income tax free
24
Southern
Methodist
University
Tax Advantaged Education Investment Choices
(Summary - See Exhibit 9 Kaplan page 71) §529 Qualified Tuition Plans (QTPs)
• Prepaid Tuition Plans • Savings Plans
Coverdell Education Savings Accounts Series EE Bonds Roth IRAs Retirement Plan Loans
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Southern Methodist University
§529 Qualified Tuition Plans
Created under the Small Business Job Protection Act of 1996
• Provided for by the federal government and administered by the states
Provisions
• No specific annual limit on contributions • Undergraduate or graduate education • No AGI phase-out
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Southern Methodist University
§529 Qualified Tuition Plans
§529 Benefits
• Tax-deferred growth • Distributions from state-sponsored plans are excludible from gross income • Generally charge low commissions • Many states provide state income tax deductions for contributions • Contributor controls the assets
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Southern Methodist University
§529 Qualified Tuition Plans
Prepaid Tuition Plans
• Tuition is prepaid at current prices for enrollment in the future • Risks (different for each university’s plan)
- The student will not meet admissions criteria - May prevent student from attending another college
• Student may receive a scholarship at another college • Student may find it more desirable to attend another college
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Southern Methodist University
§529 Qualified Tuition Plans
Savings Plans
• Owner contributes cash to the account
- Limited to the cost of education established by the sponsoring state
• Over $230,000 in some states, depending on plan
• Contributions grow tax deferred until withdrawn
- Distributions withdrawn for qualified education expenses are tax free
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Southern
Methodist
University
§529 Qualified Tuition Plans
Savings Plans
• Old Law: Distributions made after 12/31/10 will be subject to income taxation unless ETGRAA 2001 provisions are renewed or extended • New Law: The Pension Protection Act of 2006 made the §529 tax provisions of the ETGRAA 2001 permanent
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Southern Methodist University
§529 Qualified Tuition Plans
Savings Plans
• Contributions grow tax deferred until withdrawn
- Non qualified distributions will be included in taxable income and subject to a 10% penalty to the extent they represent earnings in the plan
• Penalty is waived upon the participant’s death, disability or receipt of a scholarship
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Southern Methodist University
§529 Qualified Tuition Plans
Savings Plans
• Contributions grow tax deferred until withdrawn
- May claim HOPE credit or Lifetime Learning credit and exclude the distribution from gross income if it is not used for the same expenses for which credit was claimed (NO “DoubleDipping”!)
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Southern Methodist University
§529 Qualified Tuition Plans
Savings Plans
• Contributions qualify for the annual gift tax exclusion ($12,000 in 2008, indexed for inflation)
- Up to five contributions can be “bunched” and made in one year (current year and four additional years)
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Southern
Methodist
University
§529 Qualified Tuition Plans
Savings Plans
• Owner is permitted to change beneficiaries
- Must roll distribution over to a family member within 60 days to avoid taxation and penalty - Amount rolled over is treated as a gift from the donor beneficiary to the donee beneficiary, subject to all of the gift and generation skipping transfer rules
34
Southern
Methodist
University
Coverdell Education Savings Accounts
Authorized by Taxpayer Relief Act of 1997 (TRA 1997)
• Formerly Education IRAs
Contributor deposits cash to the account
• Contributions are not tax-deductible • Beneficiaries can have multiple accounts, but aggregate contributions cannot exceed $2,000 per beneficiary • Beneficiary must be under age 18 at time of contribution • AGI phase-outs apply
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Southern Methodist University
Coverdell Education Savings Accounts
Contributions grow tax deferred until withdrawn
• Distributions withdrawn for qualified education expenses are tax free • Qualified education expenses include those for elementary and secondary school as well as those for undergraduate or graduate school • Non qualified distributions will be included in taxable income and subject to a 10% penalty to the extent they represent earnings in the plan
36
Southern
Methodist
University
Coverdell Education Savings Accounts
Contributions grow tax deferred until withdrawn • Beneficiary must use proceeds by age 30 or lose ability to make tax-free withdrawals • Account can be rolled to a family member to continue tax-free status • May claim HOPE credit or Lifetime Learning credit and exclude the distribution from gross income if it is not used for the same expenses for which credit was claimed (NO “Double-Dipping”!)
37
Southern
Methodist
University
Other Education Savings Strategies
Hope Scholarship Credit • Authorized by TRA 1997 • Tax credit for tuition and enrollment fees
- Expenses must be incurred during the first two years of post-secondary education - Can benefit the taxpayer, spouse, or dependent
I HOPE I Pass
• Annual maximum $1,800/student (2008)
- 100% of the first $1,200 - 50% of the next $1,200
• AGI phase-outs apply
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Southern Methodist University
Other Education Savings Strategies
Lifetime Learning Credit
• Authorized by TRA 1997 • Tax credit for qualified tuition and enrollment fees - Qualified expenses for undergraduate and graduate programs, or to improve job skills - Annual maximum credit is $2,000 per family - Provides annual reimbursement at a 20% rate ($10,000 of expenses for full credit) - Can be claimed for an unlimited number of years • AGI phase-outs apply
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Southern Methodist University
Other Education Savings Strategies
Uniform Gift to Minors Act
• Allows parents to put cash and securities in a custodial account for a child - If the child is under age 18 (new in 2006), or is a student under age 24 (new for 2008) all income over $1,800 (in 2008) is taxed at the income tax rate of the parents - If the child is older than the ages above, all income is taxed at the child’s tax rate - Full ownership at the age of majority (21 in Texas) - Included in the assets used to calculate financial aid
Uniform Transfer to Minors Act
• Similar, but also allows real estate
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Southern Methodist University
Other Education Savings Strategies
Interest on Educational Loans
• Up to $2,500 of interest deduction allowed
- Student loans must have been used for qualified tuition, enrollment fees and other related expenses - Expenses must be for undergraduate and graduate education
• AGI phase-outs apply
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Southern Methodist University
Other Education Savings Strategies
Equity Lines of Credit
• Home equity loans (where permitted) are a secured line of credit, collateralized by the equity in the home • Interest rate may be lower than that of an unsecured student loan - Varies from state to state if home equity is included in the financial aid calculation - May improve chances for financial aid by lowering the equity • Should be used as a last resort since the payback period is usually long and risk of foreclosure is increased
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Southern Methodist University
Class End
Investment Goals
Common Investment Goals.
• • • • Capital accumulation. Preservation of capital. Maximizing returns. Minimizing risk.
Investment goals are frequently in conflict.
• Must prioritize goals to achieve best results. • Keep clients’ focused on the Financial Mission, not the short-term fluctuations and returns.
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Southern Methodist University
Investment Risks
Risk
• The chance that the actual outcome (return) may be different than the expected outcome (return).
Systematic Risks.
• Impacted by broad macroeconomic factors that affect all securities. • Non-Diversifiable.
Unsystematic Risks.
• Unique to a single security, company, industry, or country. • Diversifiable.
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Southern Methodist University
Investment Risks
Risk and Return
• There is a direct relationship between risk and return.
- As risk increases, the expected return increases, and visa versa. - An investor should be adequately compensated for the level of risk he is willing to take on. - An investor should not take any more risk than is necessary to achieve the desired/required return.
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Southern Methodist University
Measuring Risk
Standard Deviation. Beta.
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Southern
Methodist
University
Standard Deviation (σ)
• Measures total risk.
- Includes both systematic and unsystematic risks.
• Measures how far returns vary from the average (mean). • The most common measure of risk (volatility).
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Southern
Methodist
University
Standard Deviation (σ)
67% of Returns were here 95% of Returns were here Return
Example Return = 8% Std Dev = 6% Expected Return: 67% Chance return is 2% to 14% 95% Chance return is - 4% to 20%
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±2σ
Southern Methodist University
±1σ
Beta (β)
Beta
• Measures systematic risk only. • Compares a diversified portfolio’s volatility to the market. - Market β = 1.00. - Higher β > 1.00 - Lower β < 1.00
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Southern Methodist University
Beta (β)
Example
Portfolio A Portfolio B 0.70 0.80 0.90 1.00
β = 0.70 β = 1.30
1.10 1.20 1.30
Portfolio A 30% Less Risk
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Market Risk
β = 1.00
Southern
Portfolio B 30% More Risk
Methodist University
Modern Portfolio Theory
Modern portfolio theory
• Developed by Harry Markowitz.
- 1990 Nobel Prize winner.
Mamma was right! • Don’t put all of your eggs in one basket! (i.e. Diversify among portfolio asset classes.)
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Southern Methodist University
Efficient Frontier
Which portfolio would you choose?
Portfolio A B C Expected Standard Return Deviation 11.00% 11.00% 11.00% 13.00% 13.90% 14.10%
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An efficient portfolio is one with either: 1. The lowest risk, given a specified level of return, or 2. The highest return, given a specified level of risk.
Southern Methodist University
The Efficient Frontier
E xp e cte d R e tu rn
E ffic ie n t F ro n tie r
B A C
D
The Efficient Frontier is the collection of all efficient portfolios.
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R isk
Southern
Methodist
University
Markowitz’s Three Rules Markowitz’
1. Same return – choose lower risk. 2. Same risk – choose higher return. 3. Choose higher return with lower risk.
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Southern
Methodist
University