Schematic for Goals-Based Planning

This diagram shows the relationships between the key components of a goals-based household financial plan. It shows how the plan builds upon the simple basic information of income and expenses to create a full multi-period lifecycle plan based on the household balance sheet.

What is a goals-based plan? Simply, it’s a plan to achieve financial goals. The major goals are funding retirement at the household’s attained standard of living, providing for children’s education, and owning a home. Retirement is a must-do goal, since few have other alternatives to funding their own retirement.

A goals-based plan lays out the steps for achieving these goals, which among other things, includes saving and investing. An investment-based plan, on the other hand, is focused on maximizing total market returns. The assumption of an investment-based plan is that if you get good returns, you’ll figure out how to reach your goals.

A goals-based plan, on the other hand, assumes there are many things that go into a successful plan that can have as much or more impact on the success of the plan as market returns, such as managing household risk exposures, maximizing your human capital, developing sensible financial habits, tax planning, and lifecycle-based investing rather than chasing market returns. Market returns only have an overriding importance when they’re the only leg of the stool you’re standing on.

The schematic view of a goals-based plan starts with the transactions of daily life—the cash flow of income and expenses, totaled up over a year. This annual cash flow can either be a simple top-down summary (Expenses = Income – Savings) from easily discoverable information like income and savings, or a more detailed bottom-up line-by-line budget analysis. The ratio of annual expenses to savings is a fundamental indicator of financial health (Fundedness in the diagram).

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The annual cash flow of income and expenses can then be extended out to full household life expectancy—the full plan cash flow. This lays out the expected financial path of the household over the remaining lifecycle. The full plan cash flow underlies the household balance sheet, which calculates the present value of those cash flows compared to the present value of household human, social, and financial capital.

That balance sheet calculation provides the fundamental math for managing plan risk by allocating household resources to upside/floor/longevity/reserves. The U/F/L/R allocation drives the plan implementation including any investments in an upside portfolio, at-risk or dedicated floor, longevity investments such as delayed Social Security benefits and/or simple income annuities, and cash management for reserves. When floor is dedicated (Floor Builder in the diagram), the balance sheet reflects the change by maintaining the U/F/L/R allocation even as the portfolio balance is reduced by the amount dedicated—when the floor is fully dedicated, the portfolio may be entirely upside.

The balance sheet is also the fulcrum for determining the annual savings needed today to cover the household income floor in the future at retirement (Savings Builder in the diagram). This is critical for those still some time from retirement, since years of under-saving are difficult to make up later on after much of the household human capital has already been converted to income and expended.

In sum, a goals-based plan starts with either a summary or detailed annual income expense cash flow, builds a remaining lifecycle cash flow, then a NPV balance sheet from the cash flow and household capital, and from the balance sheet, generates the upside/floor/longevity/reserves allocation to achieve the goals and manage the household risks to the plan. It’s a straightforward process, easily accomplished with a tool built for the purpose.

-- Michael Lonier, RMA℠