FIN 205

Wealth Management
Lecture Notes
Semester 3 2021
 FIN205 – Wealth Management

Topic 1- Financial Planning & Time

Value of Money
 Learning Objectives

 Explain why personal financial planning is so

important.
 Describe the five basic steps of personal financial
planning.
 Set your financial goals.
 List fifteen principles of a solid financial strategy.
 Explain how career management and education can
determine your income level.

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 Learning Objectives

 Explain the mechanics of compounding.

 Use a financial calculator to determine the time value
of money.
 Understand the power of time in compounding.
 Explain the importance of the interest rate in
determining how an investment grows.
 Calculate the present value of money to be received
in the future.
 Define an annuity and calculate its compound or
future value.
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 Your Goals in Life

 Non-financial goals
 Family, moral, educational, religious, social, or political.
 Finances can affect your ability to attain these goals.

 Financial goals
 Financial independence is an important goal for many
people. It means having enough income or resources to
be self-reliant.
 One major financial choice is between consumption
today versus consumption in the future.
.

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The Building Blocks of Success

1-5
Why Personal Financial Planning?

 Need a financial plan because it’s

easier to spend than to save.
 Want a financial plan since it helps
you achieve financial goals.
 Use financial planning, not to make
more money, but to achieve goals.
 Control your finances or they will
control you.
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 Here’s What You Can Accomplish

 Manage the unplanned

 Accumulate wealth for special expenses

 Save for retirement

 “Cover/protect your assets”

 Invest intelligently

 Minimize tax payments

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 The Personal Financial Planning
Process

 Financial planning is an ongoing process – it

changes as your financial situation and position
in life change.
 Five basic steps to personal financial planning:
1) Evaluate your financial health
2) Define your financial goals
3) Develop a plan of action
4) Implement your plan
5) Review your progress, reevaluate, and revise your plan
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 Personal Financial Planning
Process

Step 1: Evaluate Your Financial Health

Examine your current financial situation.

 How wealthy are you?
 How much money do you make?
 How much are you spending and what are
you spending it on?

Assess your financial situation using careful

record keeping.
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4-10
4-11
 Personal Financial Planning Process

Step 2: Define Your Financial Goals

 Define your goals:
 Accumulate wealth for retirement.
 Provide funds for a child’s college education.
 Buy a new automobile.

 Over time, goals change.

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 Personal Financial Planning Process

Step 3: Develop a Plan of Action

 Flexibility  Protection
 Plan for life changes and  Prepare for the
the unexpected. unexpected with
 Liquidity insurance.
 Immediate use of cash  Minimizing Taxes
by quickly and easily  Keep more of what you
converting an asset. earn.

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 Personal Financial Planning Process

Step 4: Implement Your Plan

 Carefully and thoughtfully develop a
financial plan, then stick to it.
 Your financial plan is not the goal - it is the
tool used to achieve goals.
 Keep goals in mind and work towards
them.

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 Personal Financial Planning Process

Step 5: Review Your Progress, Reevaluate, and

Revise Your Plan
Review progress and be prepared to formulate a different
plan.
The last step in financial planning often returns to the first.
No plan is fixed.
Goals are fantasy without a plan.

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Establishing Your Financial Goals

Financial Goals Cover 3 Time Horizons

 Short-term -- within 1 year
 Intermediate-term -- 1 to 10 years
 Long-term -- more than 10 years

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 Short–Term Goals

 Accumulate Emergency Funds Equaling 3

Months’ Living Expenses
 Pay Off Bills and Credit Cards

 Purchase Insurance

 Purchase a Major Item

 Finance a Vacation or Entertainment Item

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Intermediate-Term Goals

 Save for Older Child’s College

 Save for a Down Payment or a Major
Home Improvement
 Pay Off Major Debt

 Finance Large Items (Weddings)

 Purchase a Vacation Home

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Long-Term Goals

 Save for Younger Child’s College

 Purchase Retirement Home

 Create a Retirement Fund to Maintain

Current Standard of Living
 Take Care of Elderly Family Members

 Start a Business

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 Stage 1 The Early Years—A
Time of Wealth
Accumulation
 Prior to age 50:  Develop a regular
 Purchase a home pattern of saving
 Prepare for child by asking:
rearing costs
 How much can be
 Save for a child’s
education saved?
 Establish an  Is that enough?
emergency fund  Where should the
 Start retirement savings be invested?
savings
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 Stage 2 Approaching
Retirement—The Golden
Years
 Transition years  Unplanned events,
between ages 50-60. such as corporate
 Retirement goals are downsizing, divorce, or
the center of attention. the death of a spouse,
 Continuously review have dramatic effects
your financial decisions, on your goals.
insurance protection
and estate planning.

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 Stage 3 The Retirement
Years

 After age 60, live off  Review insurance, consider

savings extended nursing home
 Retirement age
protection.
depends on savings.
 Less risky investment  Estate planning decisions
strategy are critical. Trim estate tax
bills, have wills, living wills,
 Preserving rather than
and health proxies.
creating wealth.

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 Fifteen Principles of
Personal Finance

 These principles form the foundation of personal

finance.
 They will provide you with:
 an excellent grasp of your own personal finance
 a better chance of attaining wealth and
achieving financial goals

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 Principle 1: The Risk–Return
Trade-Off

 Savings allow for more future purchases.

 Borrowers pay for using your savings.

 Investors demand a minimum return to

delay consumption - above anticipated
inflation.
 Investors demand higher return for
added risk.
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Principle 2: The Time
Value of Money

 Money has a time value.

 Money received today is worth more
than money received in the future.
 Compound interest - interest paid on
interest.

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 Principle 3: Diversification
Reduces Risk

 “Don’t put all your eggs in  Diversification reduces

one basket.” risk without affecting
expected return.
 To diversify, place money
in several investments, not  Won’t experience great
just one. returns or great
losses—receive an
average return.

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 Principle 4: All Risk Is Not
Equal

 Some risk cannot be diversified away.

 If stocks move in opposite directions,
combining them can eliminate variability.
 If stocks move in same direction, not all
variability can be diversified away.

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 Principle 5: The Curse of
Competitive Investment Markets

 In efficient markets, information is instantly

reflected in prices.
 Cannot earn higher than expected profits
from public information.
 Difficult to “beat the market” -- “bargains”
don’t remain so for very long.

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 Principle 6: Taxes Affect
Personal Finance Decisions

 Taxes influence the realized return of

investments.
 Maximize after-tax return.

 Compare investment alternatives on an

after-tax basis.

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 Principle 7: Stuff Happens,
or the Importance of
Liquidity

 Have funds available for the unexpected.

 Without liquid funds:
 Long-term investments must be liquidated.
 Results in lower price, tax consequences, or
missed opportunities.
 With nothing to sell:
 Pay higher interest to borrow money quickly.
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 Principle 8: Nothing
Happens Without a Plan

 People spend money without thinking, but

you can’t save without thinking about it.
 Saving must be planned
 Start off with a modest, uncomplicated plan.
 Later modify and expand your plan.
 Remember - financial plans cannot be
postponed.

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 Principle 9: The Best
Protection Is Knowledge

 Take responsibility for your financial affairs:

 Protect yourself from incompetent advisors.
 Take advantage of changes in the economy
and interest rates.
 Understand personal finance then apply it.

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 Principle 10: Protect
Yourself Against Major
Catastrophes

 Have the right insurance before a tragedy

occurs.
 Know your policy coverage.

 Insurance focus should be on major

catastrophes which can be financially
devastating.

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 Principle 11: The Time
Dimension of Investing

 Take more risk on long-term investments.

 Large-company stock prices go up 10.4%
annually over the past 78 years.
 20 year-olds investing retirement money
will likely earn more in the stock market
than other investment alternatives.
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 Principle 12: The Agency Problem—
Beware of the Sales Pitch

 The agency problem - those who act as

your agent may actually act in their own
interests.
 Insurance salespeople, financial advisors,
and stockbrokers receive commissions, so
select them carefully.
 Find an advisor who fits your needs, is
ethical and effective.
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Principle 13: Pay Yourself First

 For most people, savings are residual.

Spend what you like, save what is left.
 Pay yourself/save first so what you
spend becomes the residual.
 Reinforce the importance of long-term
goals, ensuring goals get funded.

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 Principle 14: Money
Isn’t Everything

 Extend financial plans to achieve future goals.

 See more than just $$$ - know what is important
in life.
 Money doesn’t bring happiness, but facing
expenses without the funding brings on anxiety.

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 Principle 15: Just Do It!

 Making the commitment to get started is

difficult, but the following steps will be
easier.
 One of your investment allies – TIME - is
stronger now than it ever will be.
 Take investment action now — just do it!

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TIME VALUE OF MONEY

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 Compound Interest and
Future Values

 Compound interest is interest on interest.

 If you take interest earned on an
investment and reinvest it, you earn
interest on the principal and the
reinvested interest.
 The amount of interest grows, or
compounds.
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 Compounding Example:
Suppose you invest $1,000 today, hold the investment
for 3 years, and earn 8% each year. How much will you
accumulate at the end of 3 years (the future value)?
_______________________________________
Year Beginning-of- Interest End-of-Year
Year Amount Earned Amount
1 $1,000 $80 $1,080
2 1,080 86.40 1,166.40
3 1,166.40 93.31 Answer $1,259.71

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 The Future-Value Interest
Factor (FVIF)

 Calculating future values by hand can

be difficult.
Use a calculator or tables.
 The future-value interest factor, found in a
table, replaces the (1 + i)n part of the
equation.

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 How Compound Interest
Works

FVn = PV (1 + i)n
What will the account look like  FVn = the future value of the
at the end of the second investment at the end of n
year if the interest is years
reinvested?  i = the annual interest rate,
PV = $1000 based on the beginning
i = 8% balance and paid at the end
FV3 = PV1 x (1 + i)n of the year
FV3 = 1000 x(1.08)3 =1,000x1.26  PV = the present value or
= 1260 current value in today’s
dollars

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 Future Value Example: Use
FV Table
 The previous future value table can be used to find the FV of
any amount.
 Simply multiply the investment by the number from the table.

Example 1: What is the future value of $500 invested at 6% for

10 years? $895.40
 Answer: Find 6% and 10 years on the table (1.7908)
 Multiply $500 × 1.7908 = $895.40

Example 2: What is the future value of $4,000 invested at 8%

for 30 years? $40,248
 Answer: $4,000 × 10.062 = $40,248
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 The Rule of 72

 How long will it take to double your

money?

 The Rule of 72 determines how many

years it will take for a sum to double in
value by dividing the annual growth or
interest rate into 72.

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 The Rule of 72

 A technique that is quite popular in estimating

the time that it takes for an investment to double
is called the rule of 72.
 If we know the interest rate for an investment,
we can use the rule of 72 to estimate how long it
will take for the money to double.
 Doubling Time (DT) = 72/interest rate
 Example: if the interest rate percent is 12
 DT = 72/12 = 6 years
 If an investment earns 12% per year, it will
double in value in 6 years (How could you
1-46 verify
this?)
 The Rule of 72

 Example: If an investment grows at an

annual rate of 9% per year, then it should
take 72/9 = 8 years to double.

 Use FV Table and the future-value interest

factor: The FVIF for 8 years at 9% is 1.993
(or $1993), nearly the approximated 2
($2000) from the Rule of 72 method.
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 Compound Interest with
Non-annual Periods
 Compounding periods may not always be annually.
 Compounding may be quarterly, monthly, daily, or even a
continuous basis.
 The sooner interest is paid, the sooner interest is earned
on it, and the sooner the benefits or compounding is
realized.
 Money grows faster as the compounding period becomes
shorter.

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 Simple Interest

 With simple interest, you don’t earn interest on

interest.
 Year 1: 5% of $100 = $5 + $100 = $105
 Year 2: 5% of $100 = $5 + $105 = $110
 Year 3: 5% of $100 = $5 + $110 = $115
 Year 4: 5% of $100 = $5 + $115 = $120
 Year 5: 5% of $100 = $5 + $120 = $125
 Compound Interest
 With compound interest, a depositor earns interest on
interest!
 Year 1: 5% of $100.00 = $5.00 + $100.00 = $105.00
 Year 2: 5% of $105.00 = $5.25 + $105.00 = $110.25
 Year 3: 5% of $110.25 = $5 .51+ $110.25 = $115.76
 Year 4: 5% of $115.76 = $5.79 + $115.76 = $121.55
 Year 5: 5% of $121.55 = $6.08 + $121.55 = $127.63
 Interest Rate Quotes and
Adjustments
 The Effective Annual Rate
 Indicates the total amount of interest that will
be earned at the end of one year
 Considers the effect of compounding
• Also referred to as the effective annual yield
(EAY) or annual percentage yield (APY)
 Interest Rate Quotes
and Adjustments (cont'd)
 Adjusting the Discount Rate to Different
Time Periods
Earning a 5% return annually is not the same as
earning 2.5% every six months.
 General Equation for Discount Rate Period
Conversion
Equivalent n-Period Discount Rate  (1  r )n  1

• (1.05)0.5 – 1= 1.0247 – 1 = .0247 = 2.47%

• Note: n = 0.5 since we are solving for the six month
(or 1/2 year) rate
Compounding Interest More
Frequently Than Annually
A general equation for compounding more
frequently than annually

n=no of years
m=frequency of compounding
 Compounding Interest More
Frequently Than Annually
(cont.)
If Fred places $100 in a savings account paying 8% interest
compounded annually, how much will he have at the end of
year 2 if compounding is done: (1) annually (2) semiannually
and (3) quarterly

FV1 = 100 x (1+ 0.08/1) 1x2 = $116.64

FV2 = 100 x (1+ 0.08/2) 2x2 = $116.99
FV3 = 100 x (1+ 0.08/4) 4x2 = $117.17
 Annual Percentage Rates

 The annual percentage rate (APR),

indicates the amount of simple interest
earned in one year.
 Simple interest is the amount of interest
earned without the effect of compounding.
 The APR is typically less than the effective
annual rate (EAR).
 Annual Percentage Rates
(cont'd)
 The APR itself cannot be used as a discount
rate.
 The APR with k compounding periods is a way
of quoting the actual interest earned each
compounding period:

APR
Interest Rate per Compounding Period 
k periods / year
 Annual Percentage Rates
(cont'd)
 Converting an APR to an EAR
k
 APR 
1  EAR  1  
 k 
 The EAR increases with the frequency of
compounding.
• Continuous compounding is compounding every
instant.
 Annual Percentage Rates
(cont'd)
Effective Annual Rates for a 6% APR with Different
Compounding Periods

 A 6% APR with continuous compounding

results in an EAR of approximately 6.1837%.
 Present Value
 Present value is the value of today’s
dollars of money to be received in the
future.
 Present value strips away inflation to
see what future cash flows are worth
today.
 Allows comparisons of dollar values
from different periods.

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Present Value
 Finding present values means moving
future money back to the present.
 This is the inverse of compounding.

 The “discount rate” is the interest rate

used to bring future money back to
present.

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Present Value
 PV = FVn[1/(1 + i)n]

 PV = present value of a sum of money.

 FV = future value of investment at the end of n years.
 n = number of years until payment will be received.
 i = annual discount (or interest) rate.

 The present value of a future sum of money is

inversely related to both the number of years
until payment will be received and the discount
rate.

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 Present Value (PVIF)

 Tables can be used to calculate the

[1/(1+i)n] part of the equation.
 This is the present-value interest factor
(PVIF).

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 Present Value

 Example: What is the  Using PV Table n = 10

present value of $100 row and i = 6% column,
to be received 10 years the PVIF is 0.558.
from now if the discount  Insert FV10 = $100 and
rate is 6%? PVIF 6%, 10 yr = 0.558 into
the equation.
 The value in today’s
dollars of $100 future
dollars is $55.80.

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 Present Value

 Example: You  PV = FVn(PVIF i%, n yrs)

have been  Using PV Table, n = 40 row
promised and i = 6% column, the PVIF
$500,000 payable is 0.097.
40 years from  Multiply the $500,000 by 0.097.
now. What is the  The value in today’s dollars
value today if the is $48,500.
discount rate is
6%?

1-64
 Present Value

 You’ve just seen that $500,000 payable 40 years

from now, with a discount rate of 6%, is worth
$48,500 in today’s dollars.

 Conversely, if you deposit $48,500 in the bank

today, earning 6% interest annually, in 40 years
you would have $500,000.

 There is really only one time value money

equation.

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Annuities

 An annuity is a series of equal dollar

payments coming at the end of each
time period for a specific time period.
 Pension funds, insurance obligations,
and interest received from bonds are
annuities.

1-66
 What is an Annuity?

 An annuity is simply a series of equal payments.

 Examples of annuities can be found everywhere: rent
payments, mortgage payments, car payments, etc.
 From an investment perspective, bonds will often involve
interest payments that are annuities.
 There are two types of annuities:
 An ordinary annuity (OA) assumes the payments occur at
the end of the period. Most future-value-of-$1-annuity
tables show ordinary annuities.
 An annuity due (AD) assumes the payments occur at the
beginning of the period.
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 Example: FV of an Ordinary
Annuity
Assume an investment of $3,500 is made at the end of each
of the next 3 years and earns 6%. What is the future value of
this investment at the end of year 3?
__________________________________________
First investment of $3,500 earns interest for 2 years.
(Remember that an ordinary annuity assumes payments are
made at the end of the year.)
Second investment of $3,500 earns interest for 1 year.
Third investment of $3,500 earns no interest.

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 Example: FV of an Ordinary
Annuity
Now 1 2 3

$3,500 $3,500 $3,500

The following is a timeline showing the investments at each point in time.
We want to find the future value at year 3.

- First payment: $3,500 × (1.06) × (1.06) = $3,932.60

- Second payment: $3,500 × (1.06) = $3,710
- Third payment: $3,500 × (1.00) = $3,500
- Total value (FV): $3,932.60 + $3,710 + $3,500 = $11,142.60 or
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- $3,500 x 3.184 = $11,144
 Compound Annuities
 A compound annuity involves depositing an
equal sum of money at the end of each year for
a certain number of years, allowing it to grow.
 Constant periodic payments may be for an
education, a new car, or any time you want to
know how much your savings will have grown
by some point in the future.

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 Compound Annuities

 Example: You  Future value of an annuity =

deposit $500 at the annual payment x future value
end of each year for
the next 5 years. If
interest factor of an annuity.
the bank pays 6%  Use Table column i = 6%, row n
interest, how much = 5, the FVIFA is 5.637.
will you have at the
 Annuity x FVIFA = FV
end of 5 years?
 $500 x 5.637 = $2,818.50 at the
end of 5 years.

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 Compound Annuities

 Example: You  You know the values of n, i, and

need $10,000 for FVn, but don’t know the PMT.
education in 8  You must deposit $1010.41 at
years. How the end of each year at 6%
much must you interest to accumulate $10,000
put away at the at the end of 8 years.
end of each year  Annuity x FVIFA = FV
at 6% interest to
have the college  ? x 9.897 = 10,000
money  Annuity = $1,010.41
available?
1-72
 Compound Annuities

 Example: You  FVn = PMT (FVIFA i%, n years)

deposit $2000 in an
 The future value after 40 years
IRA at the end of
each year, and it of an annual deposit of $2000
grows at 10% per per year is $885,160.
year. How much will
you have after 40
years?

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 Present Value of an Annuity
 To compare the relative value of
annuities, you need to know the
present value of each.
 Use the present-value interest factor
for an annuity PVIFAi,n.

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 Present Value of an Annuity

 Example: You are  Using Table, row

to receive $1,000 n = 10, i = 5%.
at the end of each  The present value of
this annuity is $7722.
year for the next
10 years. If the  PV = Annuity x PVIFA
interest rate is 5%,  = 1000 x 7.722
what is the  = 7722
present value?

1-75
 Converting an Ordinary
Annuity (OA) Into an Annuity
Due (AD)

 The conversion formula is:

FV(AD) = FV(OA) × (1 + i )
 This formula accounts for the fact that each
payment earns interest for one extra period.
 In the previous example, we calculated the
FV of an OA of $11,142.60. If payments were
made at the beginning of the period, then
FV(AD) = $11,142.60 × (1.06) =
$11,811.16 1-76
Amortized Loans

 Annuities usually involve paying off a

loan in equal installments over time.
 Amortized loans are paid off this way.

 Examples include car loans and

mortgages.

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 Amortized Loans

 Example: You borrow  PV=$6000, i=15%, n=4.

$6000 at 15% interest  Substituting into the
to buy a car and repay equation the PMT
it in 4 equal payments would be $2101.58.
at the end of each of (i.e. 6000= 2.855 x ?)
the next 4 years. What Use PV of Annuity tables
are the annual
payments? PV = Annuity x PVIFA
6,000 = ? X 2.855=
Annuity = 2,101
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 Perpetuities

 A perpetuity is an annuity that continues

forever.
 Every year this investment pays the same
dollar amount and never stops paying.
 Present value of a perpetuity =
payment/discount rate.

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Perpetuities and Annuities
(cont’d)
 The value of a perpetuity is simply the
cash flow divided by the interest rate.
 Present Value of a Perpetuity

C
P
V(
Cin
pe
r
pe
tu
i
ty
)
r
 Present Value of a
Perpetuity
 A perpetuity is a special kind of annuity.
 With a perpetuity, the periodic annuity or cash
flow stream continues forever.

PV = Annuity/Interest Rate
 For example, how much would I have to deposit
today in order to withdraw $1,000 each year
forever if I can earn 8% on my deposit?

PV = $1,000/.08 = $12,500
 PV of Growing Perpetuities

Consider a growing perpetuity that will pay $100 in one

year. Each year after that, you will receive a payment on
the anniversary of the last payment that is 6% larger than
the last payment. This pattern of payments will continue
forever. If the interest rate is 11%, then the value of this
perpetuity is closest to:

PV growing Perpetuity = C / r - g = 100 / (.11 - .06) =

$2000

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 Time Value Terms

 PV0 = present value or beginning amount

 i = interest rate
 FVn = future value at end of “n” periods
 n = number of compounding periods
 A = an annuity (series of equal payments
or receipts)
 Four Basic Models
• FVn = PV0(1+i)n = PV x (FVIFi,n)

• PV0 = FVn[1/(1+i)n] = FV x (PVIFi,n)

• FVAn = A (1+i)n - 1 = A x (FVIFAi,n)

i

• PVA0 = A 1 - [1/(1+i)n] = A x (PVIFAi,n)

i
End of Lecture
 FIN205 – Wealth Management

Topic 2- Savings, Financial

Markets & Financial Institutions
2-1
 Learning Objectives
 Identify the types of banks & banking services.
 Compare the costs and benefits of various
savings plans.
 Identify the factors used to evaluate different
savings plans.
 Compare the costs and benefits of different
types of payment accounts.
 Define consumer credit and analyze its
advantages and disadvantages.

2-2
 Learning Objectives
 Differentiate among various types of credit.
 Assess your credit capacity and build your credit rating.
 Describe the information creditors look for when you
apply for credit

2-3
 Financial Services
for Financial Planning
The following types of banking institutions are
prevalent in Malaysia:.
 Conventional Banking,
 Investment Banking,
 Islamic Banking,
 Offshore Banking

2-4
 Financial Services
for Financial Planning
 In Malaysia, conventional
banking is supervised by the
Central Bank of Malaysia, Bank
Negara Malaysia by the powers
vested in it through the Central
Bank of Malaysia Act 2009.
 Conventional banks in Malaysia
are required to comply with the
provisions under the Financial
Services Act, 2013.
 Currently there are 27
commercial banks in Malaysia
who offer retail banking services.
2-5
 Financial Services
for Financial Planning
Banking services in Malaysia are offered
through the following channels:
• Branch/Retail Banking

• Online Banking

• Phone Banking

• Mobile Banking

2-6
 Financial Services
for Financial Planning
ONLINE AND MOBILE BANKING
–Benefits of convenience and saving time along with
instant information access
–Concerns of privacy, security of data, ease of
overspending, costly fees, and online scams must also
be considered
–Traditional Electronic Banking
oAutomatic teller machine (also called ATM or a cash
machine) offer various transactions
oDebit card (also called cash card) used to make
purchases with your own funds
2-7
Financial Services
for Financial Planning
– Mobile Banking Services

2-8
 Types of Bank Services

 Advancing of Loans.
 Overdraft.
 Check/Cheque Payment
 Foreign Currency Exchange.
 Remittance of Funds.
 Credit cards.
 ATMs Services.
 Debit cards.
 Accepting Deposit.
 Priority banking/Private banking.

2-9
 Bank Deposits
The different types of bank deposits include-
 Current deposits are deposits which can be withdraw by the depositors
as and when they want without any notice. This account comes with a
cheque book
 Saving deposits are deposits which can be withdraw by the depositors ,
but normally , there is a limit on the total number of withdraw which a
depositor can make during a week or year. For deposits, if the amount to
be withdraw is large, a notice is also to be given.
 Time deposits is the third type of deposit. These are for a fixed period of
time and can be withdraw after the period is over. These deposits are
also called as Fixed Deposits.
 A Foreign Currency Time Deposit Account - An account that offers a
fixed interest rate for your chosen tenure (ranging from 1 to 12
months).Provides an easy way for you to save in a foreign currency.

2-10
 3 Reasons Why FD is better
than Savings Account
 Better interest rates.

Interest Rate Principal Interest Earned

Savings
0.25% RM 10,000 RM 25
Account
FD 3.25% RM 10,000 RM 325

 Makes us more discipline with our savings.

 Allows segregation of funds for different
purposes - your placement can be put into
separate FD receipts for different purposes.
2-11
 Common mistakes in
managing cash
1) Overspending from impulse buying and
using credit
2) Not having enough liquid assets (cash and
checking account) to pay current bills

2-12
 Common mistakes in
managing cash

3. Using
savings or borrowing to pay for current
expenses

4. Failing
to put unneeded funds in an interest-
earning savings account or investment
program

2-13
 Financial Services
for Financial Planning
PREPAID DEBIT CARDS
– Fasted growing payment method

– Issued by traditional financial institutions,

retailers (such as Supermarkets), and non-bank
companies
– Major concern is extensive number of fees a
user can encounter due to few current
regulations for these cards
– Benefits include lowering consumer debt by
helping to control spending and buying on credit
2-14
 Financial Services
for Financial Planning
OPPORTUNITY COSTS OF FINANCIAL SERVICES
–Higher rate of return may be obtained at the cost of
lower liquidity (inability to obtain your money quickly)
–Convenience of a 24-hour ATM should be considered
against service fees
–The “no fee” checking account with a $500 non-interest-
bearing minimum balance means lost interest of nearly
$400 at 6 percent compounded over 10 years

2-15
 Financial Services
for Financial Planning
FINANCIAL SERVICES AND ECONOMIC CONDITIONS
– Changing interest rates, rising consumer prices and
other economic factors also influence financial
services
– Be aware of current trends and future prospects for
interest rates (next slide)
– Read The Wall Street Journal, business periodicals
such as Businessweek, Forbes, Fortune, and other
online sources.

2-16
 Financial Services
for Financial Planning
Changing interest rates and decisions related to financial
services

2-17
 Financial Institutions

THE “UNBANKED” AND HIGH-COST FINANCIAL

SERVICES
 Pawnshops
o Make loans on possessions but charge higher fees
than other financial institutions; used for quick cash;
charge can be 3 to over 100% pa interest
 Cheque-cashing outlets
o Charge 1-20% of the face value of a check; 2-3%
per month is average cost

2-18
 Financial Institutions
 Payday Loans
o Referred to as cash advances, check advance loans,
postdated check loans, and delayed deposit loans;
charge can be 780% pa or more (2% per day)
 Rent-To-Own Centers
o Lease products to consumers who can own the item if
they complete a certain number of weekly or monthly
payments; Charge can be over 300% pa
– Car Title Loans
o Provide loans with automobile title as security for a
high-interest charge usually over 200% pa
2-19
 Evaluating Savings Plans

Identify the factors used to evaluate different

savings plans.

RATE OF RETURN
 Percentage or yield is the increase in value of your
savings due to interest
 Example: a $100 savings account that earned $5
has a yield of 5 percent ($5/$100)

COMPOUNDING
 More frequent compounding means earning more
interest on “interest previously earned”
2-20
 Evaluating Savings Plans
 ANNUAL PERCENTAGE YIELD (APY)
Purpose is to provide consistency when comparing
different savings options at different institutions
Formula:
▪ To calculate the APY
= (100) x (Interest/Principal)
NOTE: Formula is applicable when the number of days in the term is 365 or when
the account does not have a stated maturity

Example: Interest of $60 on principal of $1,200

=(100) x ($60/$1,200)
= 5% (APY) 2-21
 Interest Rates - Overnight
Policy rate
 The overnight policy rate (OPR) is an overnight
interest rate set by Bank Negara Malaysia (BNM)
used for monetary policy direction. It is the target
rate for the day-to-day liquidity operations of the
BNM.
 The overnight policy rate (OPR) is the interest rate
at which a depository institution lends immediately
available funds (balances within the central bank)
to another depository institution overnight.
 Roughly around 3% 2-22
 OPR

Changes in the OPR trigger a chain of events that affect

the base lending rate (BLR), short-term interest rates,
fixed deposit rate, foreign exchange rates, long-term
interest rates, the amount of money and credit, and,
ultimately, a range of economic variables, including
employment, output, and prices of goods and services

2-23
 Base Rate

 BR is that it is a rate determined by each

bank based on how much it costs to borrow
the money to be lent to borrowers
 It is the base interest rate that banks refer to
internally before deciding how much to
charge (i.e. interest rate) for your home loan.
(approx. 3.9%pa)
 The BR will be determined by the banks’
benchmark cost of funds (COF) and the
statutory reserve requirement (SRR). 2-24
Effective Lending Rate

 The actual interest imposed on loan

amount after factoring in its
operational costs, average customer
risk margin and the compounded
interest. (Base Lending Rate ± Margin
around 4.80%)
 ELR may vary from one bank to
another as it calculated by bank after
takes into account the bank's cost of
funds and other administrative costs.
2-25
 Repurchase Agreement

 In a Repo or Repurchase Agreement, the bank sells its

money market instruments approved by Bank Negara
Malaysia to an investor, with an understanding to buy back
the instruments at an agreed price (interest rate - eg1.5%) on
a specific future date.
A Repo offers flexibility because the tenor ranges from 1 day
to 1 year and investors can retire the transaction earlier
(Reverse Repo), subject to rate adjustment, should they need
the funds prior to maturity.

2-26
Foreign Currency Account

 Bank may accept currency deposits

for major foreign currencies like USD,
EURO and AUD, besides MYR
deposits. Tenors ranging from 1 day
to 1 year.

2-27
 Negotiable Instrument of
Deposit
A Negotiable Instrument of Deposit (NID) is a
financial instrument issued by banks for the
deposit of a specific sum of money for a fixed
period of time at a prefixed interest rate
(around 2.5%).
An NID can be bought or sold before the date
of maturity.

2-28
 Evaluating Savings Plans

 INFLATION
Letting r denote the real interest rate, i denote the nominal
interest rate, and let π denote the inflation rate, the Fisher
equation is:
(1 + i) = (1 + r) (1 + π).
i= the nominal interest rate, r =the real interest rate, π = the
inflation rate
The approximate version of this formula is:
Real Return = Nominal Return – Inflation

 TAX CONSIDERATIONS
 Taxes reduce interest earned on savings
 Taxes are not withheld from savings and investments; you may owe
2-29
additional taxes at year-end as a result of earnings on saving
 Example: Return after Tax &
Inflation
Tax rate : 20%
Inflation rate : 3%
Rate of return : 6%
What is the effective rate of return after tax and
inflation?
Return after tax = 6% - (6% x 20%) = 6% - 1.2%
= 4.8%
Effective rate of return after tax and inflation =
4.8% - 3% = 1.8% 2-30
 Evaluating Savings Plans
 LIQUIDITY
 Allows you to withdraw money on short notice without
a loss of principal or fees

 SAFETY
 FDIC and NCUA insures up to $250,000 per person
per financial institution
 Savings of up to RM 250,000 is guaranteed by the
PIDM (Perbadanan Insurance Deposit Malaysia) per
institution so if you have less than than, you don’t
have too much to worry about. If you have more to
save, you can get protection on your entire savings
by dividing your savings into several accounts/bank
institutions.
2-31
Payment Methods

Compare the costs and benefits of different

types of payment accounts.
ELECTRONIC PAYMENTS
– Debit Cards

– Online Payments

– Mobile Transfers

– Stored-Value Cards (eg Touch & Go)

– Smart Cards ( eg MyKad)

2-32
 Payment Methods
 Checking Account (Current Account)
 Very liquid investment
 Overdraft protection: an arrangement that
protects a customer who writes a check for an
amount that exceeds the checking account
balance; it is a short-term loan from the
depository institution where the checking
account is maintained
• Saves overdraft fees and bounced checks
• Results in high interest rate on borrowed amount
2-33
 Payment Methods

MANAGING YOUR CHECKING ACCOUNT

i) Opening a Checking Account
o Individual or joint account (The remitter is the person who wrote
and signed the check. The payee is the person getting paid).

ii) Making Deposits

o Deposit ticket (Bank in Slip)
o Endorsements
▪ Blank endorsement (Cash Cheque)
▪ Restrictive endorsement (Account Payee Only, For Deposit
Only)
▪ Special endorsement (Payee transfers the chq to another
person) 2-34
 Payment Methods

– Money order
o Purchase at financial institution, post office, store
– Traveler’s check
o Sign each check twice
o Electronic traveler’s checks - prepaid travel card

2-35
 Payment Methods

 Electronic funds transfer (EFT) refers to any

financial transaction that takes place
electronically.
 Funds move instantly without paper.

2-36
 Payment Methods

 Examples of EFT include:

 Debit card transactions
 ATM transactions
 Direct deposit of paycheck
 Paying mortgage and utility bills

2-37
 Automated Teller Machines

 An ATM or cash machine provides cash instantly

and is accessed through a credit or debit card.
 Obvious appeal is convenience.
 To use ATM, just swipe card, enter PIN, and indicate
amount of cash.

2-38
 What is Consumer Credit?

Define consumer credit and analyze its

advantages and disadvantages.

 CREDIT is an arrangement to receive cash,

goods or services now, and pay for them in the
future
 CONSUMER CREDIT is the use of credit for
personal needs (except a home mortgage)

2-39
 What is Consumer Credit?

ADVANTAGES OF CREDIT
– Immediate access to goods and services
– Permits purchase even when funds are low
– A cushion for financial emergencies
– Advance notice of sales
– Easier to return merchandise
– Convenient when shopping

2-40
-
 What is Consumer Credit?

– One monthly payment

– Safer than cash
– Needed for hotel reservations, car rentals,
and shopping online
– Can take advantage of float time/grace
period
– May get rebates, airline miles, extended
manufacturer’s warranties, or other bonuses
– Indicates financial stability

2-41
 What is Consumer Credit?

 DISADVANTAGES OF CREDIT
– Temptation to overspend
– Failure to repay loan may lead to loss of
income
– Misuse of credit can create serious long-term
financial problems, damage to family
relationships, and a slowing of progress toward
financial goals
– It does not increase total purchasing power
– Credit costs money

2-42
 Types of Credit

Differentiate among various types of credit.

CLOSED-END CREDIT
 One-time loans for a specific purpose that you
pay back in a specified period of time and in
payments of equal amounts
 Installment sales credit, Installment cash credit,
and Single lump-sum credit
– Mortgage, automobile, and installment loans for
furniture, appliances, and electronics
2-43
 Types of Credit

OPEN-END CREDIT
– Use as needed until reaching line of credit max
– You pay interest and finance charges if you do not
pay the bill in full when due
– Credit cards issued by departments stores, Bank
credit cards, Overdraft protection, Incidental credit,
and Revolving check credit (bank line of credit)

2-44
 Types of Credit

CREDIT CARDS
o Eight out of ten U.S. households carry one or more credit
cards
o One-third are convenience users and pay balances in full
each month
o Two-thirds are borrowers, carrying a balance over and
paying finance charges
o Some use cards for cash advances, paying a transaction
fee and interest
o Co-branding - linking a credit card with a business
offering points or rebates on products and services
2-45
-45
 Types of Credit
SMART CARDS

Smart cards, or “memory cards,” are a variation of a

debit card. Have an embedded computer chip

Combine credit cards, a driver’s license, a health care

ID with your medical history and insurance information,
etc.

- Instead of withdrawing funds from a designated bank

account, you withdraw from an account that’s actually
stored magnetically on the card.
- Perform the same services as a debit or credit card
- Allocated funds can run out
2-46
 Debit Cards

 A debit card is a cross between a credit card and a checking

account. Looks like a credit card but acts like a checking
account.
 With debit cards, you are spending your own money, as
opposed to borrowing money with a credit card.
 Often called bank cards, ATM cards, cash cards, and check
cards
 Electronically subtracts from your account at the moment you
make a purchase (no delay in payment)

 2-47
 Types of Credit

STORED VALUE (OR GIFT) CARDS (eg Merchant gift

cards and prepaid phone cards)
oResemble a debit card.
oUsed in lieu of paper gift certificates.

oUsed for business purposes (travel expenses).

oBankruptcy can make the cards worthless.

Stored value cards can be either:

oSingle purpose or “closed-loop” cards which can be used at
only one store.
oMulti-purpose or “open-loop” cards which can be used just
like a credit card and can be reloaded.
2-48
-
Types of Credit – Charge Card
TRAVEL AND ENTERTAINMENT CARDS
oThese cards are not really credit cards

oMonthly balance is due in full

oDiners Club or American Express cards

oAmerican Express is now also issuing credit

cards

2-49
 Types of Credit
SMART PHONES
oUse of mobile phone to make purchases, called mobile
commerce (Mobile Wallets- Eg GrabPay)

HOME EQUITY LOANS

oBased on the difference between current market value of
your home and the amount owed on the mortgage
oBorrow up to 85% of the appraised value of the home less
amount still owed
oIt is set up like a revolving line of credit

2-50
 Types of Credit

– PROTECTING YOURSELF AGAINST

DEBIT/CREDIT CARD FRAUD
o Sign new cards as soon as they arrive
o Treat cards like money and keep them secure
o Shred anything with your account number on it
o Don’t give your card number over the phone unless you
initiate the call and don’t write it on postcards
o Get card & receipt after every transaction and check for
errors by comparing receipts to bills
o Notify the card issuer if you don’t get your billing statement or
if your card is lost or stolen
o Check your credit report regularly

2-51
-
 Types of Credit

WHEN YOU MAKE PURCHASES ONLINE

o Use a secure browser
o Keep records of online transactions
o Review monthly statements-can do so online
o Read policies of the websites you visit concerning
refunds, site security, and privacy
o Keep personal information private unless you know who
is gathering it and why
o Shop at businesses you know and trust
o Never give out your password to anyone online
2-52
o Do not download files sent by strangers -
 Measuring Your Credit
Capacity
Assess your credit capacity and build your credit
rating.

CAN YOU AFFORD A LOAN?

– Ask yourself if you can still meet all essential
expenses and still afford the monthly loan
payments
– Ask yourself what do you plan to give up in order
to make the monthly payment?

Are you prepared to make this trade-off?

2-53
6-
 Measuring Your Credit Capacity
• GENERAL RULES OF CREDIT CAPACITY

Debt Payments-to-Income Ratio =

Your monthly debt payments*
< 20%
net monthly income
*Exlcuding your house payment which is a long-term liability

Consumer credit payments should not

exceed a max of 20% of your net (after-
tax) income 2-54
 Measuring Your Credit Capacity

Debt To Equity Ratio

Total Liabilities
= Should be < 1

Net Worth*

*Excluding the value of your home and the amount of its

mortgage
2-55
 Applying for Credit
Describe the information creditors look for when
you apply for credit.
WHAT CREDITORS LOOK FOR: 5 CS
Character - Do you pay bills on time?
Capacity - Can you repay the loan?
Capital - What are your assets and net worth?
Collateral - What property do you have to pledge that
the lender can repossess if you default on
the loan?
Conditions - What economic conditions could affect
your ability to repay the loan?

2-56
End of Lecture
 FIN205 – Wealth Management

Topic 3 – Taxation Issues for Investors

 Learning Objectives

 Describe the importance of taxes for personal

financial planning.
 Calculate taxable income and the amount owed for
income tax
 Prepare a income tax return.
 Select appropriate tax strategies for different
financial and personal situations.

12-2
 Taxes and Financial Planning
 An effective tax strategy is vital for successful financial
planning

 Understanding tax rules and regulations can help you

reduce your tax liability

12-3
 Taxes and Financial Planning

To help you cope with the many types of taxes you

should:
o Know current tax laws and regulations that affect
you
o Maintain complete tax records
o Plan purchases and investments to reduce your
tax liability
o Take advantage of tax benefits while paying your
fair share of taxes

12-4
 Taxes and Financial Planning
3 TYPES OF TAXES
1.Taxes on Purchases – Goods & Services tax (GST –
6%) replaced by Sales & Service tax (Consumption tax -
6%) – Regressive Tax
2.Taxes on Disposal of Property : Real Property Gains tax

3.Taxes on Earnings :Income tax – Progressive Tax

4.Import Duty (2% to 60%)
5.Excise tax (Selected goods manufactured or imported eg
alcohol, cigarettes : Duty: 0% to 50%)

12-5
 Real Property Gains Tax
Effective 1/1/2019

DISPOSAL Citizens / PR Non-Citizens Companies

1) LESS OR
EQUAL TO 3 30% 30% 30%
YEARS

2) LESS OR
EQUAL TO 4 20% 30% 20%
YEARS

3) LESS OR
EQUAL TO 5 15% 30% 15%
YEARS

4) MORE THAN
5% 10% 10%
5 YEARS

12-6
 Calculating Your Taxes
On Earnings

Taxable (Chargeable Income)

= Total Annual Income – Tax
Exemptions (Personal Reliefs,
Adjustments) = Adjusted Gross
Income(AGI)– Tax Deductions
12-7
Chargeable Income -
Example

12-8
 Chargeable Income -
Example

Tax on first RM50,000 = RM1,800

Tax on balance (RM65,850-RM50,000) x 14%= RM2,219 12-9
Total Tax = RM1,800 +RM2,219=RM4,019
 Filing Status

 Taxpayers must specify a filing status

for their tax return because different rates
are associated with each status.
 Single
 Married filing jointly
 Married filing separately

12-10
Income Tax Fundamentals
Calculate taxable income and the amount
owed for federal income tax.

Step 1: Determining Adjusted Gross

Income
o Identify Taxable/Chargeable Income, which is
net income, after deductions, on which income
tax is computed

12-11
 Income Tax Fundamentals

o ADJUSTMENTS TO INCOME
Adjusted gross income (AGI) is gross income after
certain reductions have been made. These reductions
are called adjustments to income and include the
following:
 Personal Tax Reliefs

12-12
4-
 Income Tax Fundamentals

Determining adjusted gross income

o TYPES OF INCOME INCLUDED IN GROSS INCOME

 Earned income includes wages, salary, commissions,
fees, tips or bonuses
 Investment income (also known as portfolio income) is
money from dividends, interest, or rent from
investments
 Passive income is from business activities where you
do not directly participate - limited partnership
 Other income includes alimony, awards, lottery
winnings, and prizes

12-13
 Gross Income

 Gross income: all reportable income

from any source, including salary, interest
income, dividend income, and capital gains
received during the tax year including:
 General Taxable Income
 Perquisites
 Benefits in Kind (BIK)

12-14
 General Taxable Income

a) Wages, Salaries & Bonusses

b) Business or Profession
c) Dividends
d) Interest (except bank deposit interest)
e) Rent
f) Royalties
g) Pensions
h) Annuities

12-15
 Perquisites

Perquisites are taxable benefits that can be converted to cash and are
given to an employee from his/her employer. Examples of which
include:
 Bill Claims

 Company Credit Card

 Loan from Company

 Sponsored Club Membership

 Sponsored Child Tuition Fees

 Company Insurance Premiums

 Personal Driver, Guard or Maid

 Special Staff Discounts

 Gift Vouchers

12-16
 Benefits in Kind (BIK)

Benefits in Kind (BIK) are taxable benefits that cannot be converted to

cash and are given to an employee from his/her employer. Since
Benefits in Kind do not have a direct monetary value, there are two
ways to determine the value of a BIK, the formula method or the
prescribed value method.

Examples of Benefits in Kind include company provided automobiles,

lodging and household furnishing & electronics.

Formula Method:
Value of asset = Annual Value of Benefit
Life span of asset

12-17
 Tax Exempt Income

Tax exempt income are items which are

completely removed from your taxable
income, unlike tax reliefs which are
deductions upon your taxable income.

12-18
 Tax Exempt Income

The following items are qualified for tax exemption:

•Leave passage
•Medical and dental benefit
•Retirement gratuity
•Gratuity paid out of public funds
•Gratuity paid to a contract officer
•Compensation for Loss of Employment
•Pensions
•Death gratuities
•Scholarships
12-19
 Tax Exempt Income

The following items are qualified for tax exemption:

•Income of an individual resident in Malaysia in respect of his

appearances in cultural performances approved by the Minister
•Income Remitted from Outside Malaysia
•Fees or Honorarium for Expert Services
•Income Derived from Research Findings
•While the following items are included under taxable income,
they are tax exempted if they fall under certain criteria.
•Interests
•Dividends
•Royalties
12-20
 Exemptions, Personal Tax
Reliefs & Deductions
 Exemptions/Personal Tax reliefs are an
amount that can be deducted from a person's
annual income to reduce the amount on which
tax is paid.
 It is actually a way for you to lessen your
chargeable income.

12-21
 Income Tax Fundamentals

Step 2: Computing Taxable

Income
PERSONAL RELIEF & DEDUCTIONS

A Personal relif f & tax deduction is an amount

subtracted from adjusted gross income (AGI) to arrive
at taxable income.

Tax deductions are an additional amount that can be

deducted from a person's annual income to reduce your
chargeable income.
12-22
 Personal Tax Reliefs

These are the following personal reliefs available

for Malaysian Residents:
Individual Relief Types Amount

Self and dependent RM9,000

Insurance & other policies

Life insurance and EPF including not through salary deduction RM7,000

For pensionable public servants: up to RM7,000 life insurance

For non-public servants: up to RM3,000 for life insurance and up to RM4,000
for EPF

Deferred annuity and Private Retirement Scheme (PRS) – with effect from RM3,000
year assessment 2012 until year assessment 2021

Insurance premium for education or medical benefit including not through RM3,000
salary deduction

Contribution to the Social Security Organisation (SOCSO) RM250

12-23
 Allowable Tax Deductions (For
Year Of Assessment 2019)

Examples include:
RM
 Education Fees (Individual) 7,000
 Insurance premium for education or medical benefit 3,000
 Lifestyle - Purchase of books, journals, magazines and
publications,computer, sports equipment, monthly bill for internet
subscription 2,500
 Disabled Individual 6,000
 Basic supporting equipment (for disabled self, spouse, child or
parent) 6,000
 Medical expenses for serious diseases 6,000

12-24
 Allowable Tax Deductions
 Disabled child 5,000
 Medical expenses for parents 5,000
 Disabled Wife / Husband 3,500
 Child age 18 years old and above, not married and receiving full-time tertiary
education 2,000
 Premium on new annuity scheme commencing payment from 01/01/2010
Up to1,000
 Deferred Annuity and Private Retirement Scheme (PRS) Up to 3,000

12-25
 Allowable Tax Deductions -
Donations
Donations are only tax deductible if they are
made to a Government approved charitable
organisation or directly to the Government; and
you must keep the receipt of the donation.

12-26
 Income Tax Fundamentals

Step 3: Calculating Taxes Owed

o TAX RATES
▪ Use your taxable income with the appropriate tax
table or tax schedule
▪ The percent tax rates are the marginal tax rates
on the last dollars of taxable income
⃰ For example, after deductions and
exemptions, a person in the 19% tax bracket
pays 19 cents in taxes for every dollar of
taxable income in that bracket
12-27
-
 Tax Rates Marginal Tax Rate

Chargeable Income Calculations (RM) Rate % Tax(RM)

0 - 5,000 On the First 2,500 0 0

5,001 - 20,000 On the First 5,000 1 0

Next 15,000 150

20,001 - 35,000 On the First 20,000 3 150

Next 15,000 450

35,001 - 50,000 On the First 35,000 8 600

Next 15,000 1200

50,001 - 70,000 On the First 50,000 14 1,800

Next 20,000 2,800

70,001 - 100,000 On the First 70,000 21 4,600

Next 30,000 6,300

100,001 - 250,000 On the First 100,000 24 10,900

Next 150,000 36,000

250,001 - 400,000 On the First 250,000 24.5 46,900

Next 150,000 36,750

400,001 - 600,000 On the First 400,000 25 83,650

Next 200,000 50,000

600,001 - 1,000,000 On the First 600,000 26 133,650

Next 400,000 104,000

Exceeding 1,000,000 On the First 1,000,000 30 237,650

Next ringgit -

Tax rates are Progressive, so you only pay the higher rate on the amount
12-28
above the rate
 Example

Chargeable income: RM65,850

Income Rate Tax

First RM5,000 0% RM0

Next RM15,000 1% RM150

Next RM15,000 3% RM450

Next RM15,000 8% RM1200

Next RM15,850 14% RM2,219

Total chargeable income: RM65,850 Total tax: RM4,019

12-29
 Taxable Income and Taxes

 Taxable income: adjusted gross income less

deductions and exemptions
 Calculating Taxes
 Dependent upon taxable income and
filing status
 Progressive tax—a tax system where a
positive relationship exists between an
individual’s income level and tax rate

12-30
 Income Tax Fundamentals
o CALCULATING YOUR TAX
▪ A person’s average tax rate is based on the total tax
due divided by taxable income. This rate is less than a
person’s marginal tax rate

⃰ For example, if a person with a taxable income of

$30,000 has a total tax bill of $3,000, their average tax
rate is 10%, ($3,000 / $30,000)

12-31
 Income Tax Fundamentals

TAX CREDITS/REBATES
▪A tax credit/rebate is an amount subtracted directly from
the amount of taxes owed. An example is a $400 rebate
for married couples who have a chargeable income of
less than RM35,000 per year
Tax Credit vs. Tax Deduction
⃰$100 Tax Credit/rebate reduces your taxes by $100
⃰$100. Tax Deduction reduces taxes by $26 if you are in
the 26% bracket

12-32
 Tax Rebate -Example
Chargeable income after tax reliefs RM34,610

Total tax RM880.50

As the chargeable income is less than RM35,000, this married taxpayer is eligible for an additional
RM400 tax rebate

Total tax after tax rebate = RM880.50 – RM400

= RM480.50

There are two types of tax rebate applicable for Year of

Assessment 2019.
 Wife/Husband tax rebate of RM400 for those with
chargeable income of less than RM35,000
 Zakat/Fitrah, which is subject to the maximum of tax
charged
12-33
 Paying Your Income Taxes
PCB / MTD System: Potongan Cukai Bulanan /
Monthly Tax Deductions.

Your employer will automatically deduct a certain

amount from your salary every month to pay for
tax on your behalf, going towards paying your tax
for the year. This type of deduction is different
from the basic Employees Provident Fund (EPF)
and Social Security Organization (SOCSO)
monthly deductions.
12-34
 Taxes Filing : Residents
 The 2020 tax assessment year follows the calendar
year, so the 2020 tax year is effective from 1st
January 2020 to 31st December 2020.

 The taxpayer who has no business income is

required to file his/her tax return (Form BE) by 30
April of the following year (that is 2020 tax return
covering the income period from 1 January 2020 to
31 December 2020 has to be filed by 30 April
2021).
12-35
 Tax Planning Strategies

Select appropriate tax strategies for different

financial and personal situations.
Legal: Practice Tax Avoidance
o Legitimate methods to reduce your tax
obligation to your fair share but no more
o Financial decisions related to purchasing,
investing, and retirement planning are the
most heavily affected by tax laws
Illegal: Do not practice Tax Evasion
o Illegally not paying all the taxes you owe,
such as not reporting all income 12-36
 Tax Planning Strategies
 To minimize taxes owed:

Accelerate • If you expect to have the same

deductions or a lower tax rate next year.

Delay the
• If you expect to have the same
receipt of
or a lower tax rate next year.
income

Delay • If you expect to have a higher

deductions tax rate next year.

Accelerate the
• If you expect to have a higher
receipt of
tax rate next year.
income 12-37
End of Lecture

12-38
 FIN205 – Wealth Management

Topic 4- The Housing Decision

 Learning Objectives

 Make good buying decisions.

 Choose housing that meets your needs.
 Decide whether to rent or buy housing.
 Calculate the costs of buying a home.
 Get the most out of your mortgage.

4-2
Housing Alternatives for
Different Life Situations

4-3
 Your Housing Options

Purchase A House:
 Popular choice for most individuals.
 Offers space and privacy.
 Offers greater control over style decoration
and home improvement.
 Requires more work than the other
choices, including maintenance, repair,
and renovations.
 Most potential for capital appreciation.
4-4
 Your Housing Options

 A Cooperative (Co-op) is a building owned by a

corporation in which residents are stockholders.
 Residents buy stock, giving them the right to occupy a
unit in the building.
 The larger the space and the more desirable the location,
the more shares you have to buy.
 Difficult to get a mortgage.
 Pay monthly homeowner’s fee for taxes and
maintenance.
4-5
 Your Housing Options

 A Condominium (Condo) is an apartment complex that

allows individual ownership of the unit and joint
ownership of land, common areas, and facilities.
 Allows direct ownership of the unit with a proportionate
ownership in land and common areas.
 Pay monthly fee for interest, taxes, utilities, and grounds
keeping.

4-6
Your Housing Options

 Apartments and other rental housing offer:

 Affordability
 Low maintenance situations
 Little financial commitment
 Chosen by young, single people.
 May be a lifestyle decision.
 Limited upkeep and no long-term commitment.
 Offers lack of choice regarding pets or
remodeling.

4-7
Housing Rental Activities

4-8
Renting Your Residence

ADVANTAGES OF RENTING

 Easier to move (mobility)

 Fewer maintenance and repair responsibilities

 Lower initial costs

4-9
 Renting Your Residence

DISADVANTAGES OF RENTING
 No tax benefits

 Limits regarding remodeling

 Restrictions regarding pets and decorating

 Costs including a security deposit, utilities,
and renter’s insurance

4-10
 Renting Your Residence
Legal Details Of A Lease

oDescription and address of property

oName and address of the owner/landlord (lessor)
oName of tenant (lessee)
oEffective date and length of the lease
oAmount of security deposit
oAmount and due date of rent

4-11
9-11
Renting Your Residence

o Location where rent is due

o Date and amount for late rent payments
o List of included utilities and appliances
o Restrictions on certain activities (pets,
remodeling)
o Tenant’s right to sublet the rental unit
o Charges for damages or for moving out later
(or earlier) than lease expiration date
o Conditions where landlord may enter rental
unit

4-12
9-12
Home Buying Process

4-13
 Valuation of a Home

 Market analysis: an estimate of the price

of a home based on the prices of similar
homes in the area
 Usually based on price per square foot
 Information can be obtained from a real
estate broker or appraiser

4-14
Valuation of a Home (cont’d)

4-15
 Valuation of a Home (cont’d)

 Economic impact on home values

 Economic conditions affect the valuation of
homes
 As demand for homes increase, prices rise
 When economic conditions weaken, and
demand declines resulting in lower home
prices

4-16
4-17
 Valuation of a Home (cont’d)

 Impact of the financial crisis on home values

 Mortgage defaults
 Impact on home prices -
 Resolving the crisis
• Housing and Economic Recovery Act of 2008
 Lessons from the crisis
 Correcting the mortgage application process

4-18
 Valuation of a Home (cont’d)

 Effects on business activity and

zoning laws
 Business activity nearby increases demand for
housing in an area
 Zoning laws may affect desirability

 Obtaining a second opinion on your valuation

 Remember that brokers represent sellers!

4-19
Valuation of a Home (cont’d)

 Negotiating a price
 Most sellers will accept less than their
asking price
 Seller may accept your offer, reject it,
or suggest a revision
 A contract will stipulate the agreed
upon price and any other conditions

4-20
Smart Buying in Action:
Housing

 Determine what you need versus

what you want.
 Decide what is important to you:
 Consider location – country, suburbs,
or city
 Consider the neighborhood – safety,
convenience, schools

4-21
 Smart Buying in Action:
Housing

One-time Costs Recurring Costs

 Down payment
 Mortgage payments
 Closing/settlement costs  PITI includes principal,
 Points/ Interest in advance interest, taxes, insurance
 Loan origination fee
 Application fee Maintenance and
 Appraisal fee Operating Costs
 Title search
 Repairs and maintenance
items

4-22
 Decision to Own a Home
versus Rent
 Consider financial assessment before
considering personal preferences

 Estimating the total cost of renting and owning

 Renting–rent payment, security deposit
 Owning–down payment, mortgage payment,
closing costs, maintenance, taxes and insurance
• Owning also has tax advantages

4-23
 Renting Versus Buying

Buying Renting
 Many up-front and  No large up-front costs
one-time costs other than a security
deposit
 Beneficial for those who
itemize their deductions  Beneficial if staying only
for the short-term
 Mortgage payments
are a form of forced
savings

4-24
Rent vs Buy

4-25
 Home Buying Process

Implement the home-buying process.

STEP 1: DETERMINE HOME OWNERSHIP NEEDS
Benefits of Home Ownership
 Pride of ownership (“American dream”)
o Stability of location
 Financial benefits
o Deduct property taxes and mortgage interest
o Potential increase in value of your home
o Building equity in your home
 Lifestyle flexibility - express your individuality (decorating)
4-26
 Home Buying Process

 Drawbacks of Home Ownership

 Financial uncertainty
• Obtaining money for the down payment
• Obtaining mortgage financing
• Home values could drop

 Limited mobility
• Can take time to sell your home

 Higher living costs

• Home improvements
• Rising real estate taxes 4-27
 Home Buying Process

 Assess Types of Housing Available

 Single-family dwelling
 Multiunit dwelling
- Duplex, townhouse
 Condominium
- You own your individual unit in a building of units
- It is not a type of building structure but rather a legal
form of home ownership
 Cooperative housing
- Non-profit organization - members own shares and rent
a unit in a building with multiple units 4-28
Home Buying Process
• What delays in the construction process will be
considered legitimate?
• Is the contractor licensed and insured?
• Is the contractor willing to provide names,
addresses, and phone numbers of satisfied
customers?
• Are there any complaints about this contractor?
• Written contract should have a time schedule,
cost estimates, description of work, and a
payment schedule.

4-29
Home Buying Process

STEP 2: FIND AND EVALUATE A PROPERTY TO

PURCHASE
Selecting a Location
 Be aware of zoning laws
 Assess the school system if you have children

4-30
 Home Buying Process

 Using a real estate agent

 They present your offer, negotiate the price,
assist you in obtaining financing, and
represent you at the closing
 Conduct a home inspection or hire an
inspector
 Mortgage company will want an appraisal

4-31
 Home Buying Process

STEP 3: PRICE THE PROPERTY

 Determining the Home Price
 Consider recent selling prices in the area, current demand
for housing, the length of time the home has been on the
market, the owner’s need to sell, financing options, and
features of the home
 Negotiating the Purchase Price
 Counter-offers are common
 Earnest money (Down-payment)
 Contingency clauses, such as...
o Buyer must be able to obtain financing
4-32
o Sale contingent on the sale of the buyer’s current home
 Home Buying Legal Process

 The first step to purchasing property in Malaysia

is to hire a real estate lawyer to assist in the
transaction.
 Once property is selected, a Letter of
Offer/Acceptance (Letter of Intent) is signed, and
a 2% deposit is expected from the buyer.
 Within 14 days, the Sale and Purchase
Agreement is signed. The buyer must pay
another 8% deposit (Total Deposit 10%). From
the date of the signing, the buyer has a maximum
4-33
of three months to accomplish full payment.
 Home Buying Legal Process

 The Sale and Purchase Agreement must be

stamped at the Stamp Office. After the
examination on the property of the valuation
department, Stamp Duty is paid to the Stamp
Office. The transfer must be registered at the
Land Office Registry.

4-34
 Home Buying Process
TRANSACTION COSTS
Who Pays?
Stamp Duty 1% - 3% buyer
Lawyer/Solicitor´s
0.4% - 1% buyer
Fees
Other Fees* MYR180 (US$49) buyer
Real Estate Agent´s
3% seller
Fees
Costs paid by buyer 1.50% - 5.10%
Costs paid by seller 2.00% - 2.75%
ROUNDTRIP
TRANSACTION 3.40% - 7.85%
COSTS
Other Fees*are around MYR180. This include stamping fee (MYR10 per document),
adjudication fee (MYR10), search fee for title at land office (MYR60 ), and registration
fee (MYR100 ).

4-35
 Legal & Other Cost
Breakdown
 Loan agreement legal fees = 1% for first RM500,000 (of
loan amount), 0.8% for the next RM500,000 and 0.5% to
0.7% for subsequent amount
 Stamp duty for loan agreement = 0.5% of loan amount
 Loan Facility Agreement legal disbursement fee = A few
hundred ringgit
 Fee for transfer of ownership title = A few hundred ringgit
 Government tax on legal agreements = 6% of total lawyer
fees
 Bank processing fee for loan = RM50 to RM200
4-36
 Legal & Other Cost
Breakdown
 Stamp duty for the transfer of ownership title (also known as
a memorandum of transfer or MOT) = 1% for the first
RM100,000; 2% on the next RM400,000, and 3% on the
subsequent amount
 Sale & Purchase Agreement (SPA) legal fees = 1% for first
RM500,000, 0.8% for the next RM500,000 and 0.5% to
0.7% for subsequent amount
 Stamping for SPA = Less than RM100
 SPA legal disbursement fee = A few hundred ringgit

4-37
 Legal Fees (Who Pays?)

 If the Buyer appoints the solicitor and seller use the same
solicitor, then buyer is being protected while the seller
isn’t which means that the solicitor will focus on the
buyer’s perspective.
 If the Buyer and seller hire different solicitor’s, both
parties will be protected by their own solicitor. For
example, seller’s solicitor drafts the S&P Agreement and
the buyer’s solicitor will check on it. If there is some terms
are incorrect, the buyer’s solicitor will return its agreement
to seller’s solicitor for amendment.

4-38
 Determining What You
Can Afford
 Before house hunting, ask yourself:
 What is the maximum amount the bank will lend
me?
 Should I borrow up to this maximum?
 How big a down payment can I afford?

4-39
 What is the Maximum Amount
the Bank Will Lend Me?
 Lenders look at:
 Your financial history – steadiness of income, credit report,
and FICO score(Using mathematical models, the FICO
score takes into account various factors in each of these
five areas to determine credit risk: payment history, current
level of indebtedness, types of credit used and length of
credit history, and new credit.)
 Total household debt payments doesn’t exceed more than
36 percent of your gross monthly income (known as your
debt-to-income ratio).
 Your ability to pay – lenders use ratio of a maximum 28% =
PITI*/monthly gross income 4-40

(PITI* - principal, interest, taxes, and insurance)

 What is the Maximum
Amount the Bank Will Lend
Me?
 For mortgage loans, lenders look at:
 the Loan-To-Value (LTV) ratio. This assesses the lending risks before
approving your mortgage. The LTV ratio is calculated based on the
property’s net price, and not the price stated in the Sales and
Purchase Agreement (SPA), as the price in the SPA might include
promotions/rebates, which reduces the cost of owning a home.
 The LTV ratio for a homeowner’s first property determines how much
the bank will lend you (roughly about 90%), but if it’s your third home,
it’s capped at a maximum of 70%. The higher your LTV ratio, the
higher the risk is. Hence if you’re approved for a 90% financing
mortgage loan, it will cost you more.

4-41
 How Much Should You
Borrow?

 A mortgage is a large financial commitment of

future earnings.
 Look at your overall financial plan before
deciding on how much to borrow.
 Prequalifying – lender confirms the loan size
based on ability to pay and down payment.

4-42
 Financing the Purchase:
The Mortgage
 Sources of mortgages:
 S&Ls and commercial banks are the primary
sources of mortgage loans.
 Mortgage bankers originate loans, sell them to
banks or pension funds, have fixed rate mortgages.
 Mortgage brokers are middlemen who place loans
with lenders for a fee but do not originate those
loans. They do the comparison shopping.

4-43
 Conventional and
Government-Backed
Mortgages
 Conventional loans - from a bank or S&L and
secured by the property.
 If default - lender seizes property, sells it to
recover funds owed.

4-44
 Conventional and
Government-Backed
Mortgages
 Government-backed loans – lender makes loan and
government insures it. VA (Veterans Affairs) and FHA
(Federal Housing Administration) account for 25% of all
mortgage loans.
 Advantages:
 Lower interest rate
 Smaller down payment
 Less strict financial requirements
 Disadvantages:
 Increased paperwork
 Higher closing costs
 Limits amount borrowed 4-45
 Fixed-Rate Mortgages

 Monthly payment doesn’t change regardless

of changes in market interest rates.
 If rates are low, a fixed rate mortgage locks in
the low rates for the life of the loan.
 An assumable loan can be transferred to a
new buyer.
 Prepayment privilege allows early cash
payments to be applied to principal.
4-46
Financing with a Fixed-Rate
Mortgage
 Fixed-rate mortgage: a mortgage in
which a fixed interest rate is specified
until maturity
 Preferred when interest rates are
expected to rise
 May be assumable under some
conditions

4-47
Financing with a Fixed-Rate
Mortgage (cont’d)
 Amortization table
 Basis for monthly mortgage payment
amount for a fixed-rate mortgage
 Allocation of the mortgage payment—
each payment represents a partial
payment of principal and a partial
payment of interest

4-48
4-49
Financing with a Fixed-Rate
Mortgage (cont’d)
 Impact of the mortgage amount on
the monthly payment
 The larger the mortgage amount, the
larger the mortgage payment

 Impact of the interest rate on the

monthly payment
 The larger the interest rate, the larger
the mortgage payment
4-50
Exhibit : Allocation of Principal Versus Interest
Paid per Year on a $72,000 Mortgage (cont’d)

4-51
Financing with a Fixed-Rate
Mortgage (cont’d)
 Impact of the mortgage maturity
on the monthly payment
 The longer the maturity, the lower the
monthly payment
 The longer the maturity, the more
interest you pay over the live of the
loan

4-52
Financing with a Fixed-Rate
Mortgage (cont’d)

4-53
 Characteristics of a Fixed-
Rate
Mortgage (cont’d)
 Estimating the monthly mortgage payment
 Many mortgage loan Web sites offer
mortgage calculators to estimate monthly
payments based on a specific mortgage
amount, interest rate, and maturity (USE PV
of Annuity -PV = Monthly Installment x
Annuity Factor

$60000 loan,30 yrs, 8% - Annuity Factor is

11.258 : 60,000 = Yearly installment x4-5411.258
Characteristics of a Fixed-
Rate
Mortgage (cont’d)

4-55
4-56
 Adjustable-Rate Mortgages
(ARM) – Variable Rate
 With an ARM, the interest rate fluctuates based
on current market interest rates within limits at
specified intervals.
 Borrowers are better off with an ARM if interest
rates drop.
 Initial Rate - “teaser rate” can be deceptively low
and available for only a short time period.

4-57
 Adjustable-Rate Mortgages
 Interest Rate Index – rates on ARMs are tied
to an index not controlled by the lender, such
as 6- or 12-month U.S. Treasuries.
 Margin – the amount over the index rate that
the ARM is set.
 Adjustment Interval – how frequently the rate
can be reset.

4-58
 Adjustable-Rate Mortgages

 Payment Cap – sets dollar limit on how much

the monthly payment can increase during any
adjustment period.
 If interest rates go up, the monthly payment
may be too small to cover the interest due.
 This results in negative amortization. The
unpaid interest is added to the unpaid loan
balance, increasing its size.
4-59
 Adjustable-Rate Mortgages
 ARM Innovations:
• Convertible ARM – convert traditional ARM to a
fixed rate loan during 2nd – 5th years.
• Reduction-option ARM – one-time optional interest
rate adjustment to market interest during 2nd – 6th
years.
• Two-step ARM – interest rate is adjusted at end of
7th year, then constant for life.
• Price level adjusted mortgage – low initial rate,
payments and interest change with inflation.
4-60
 Financing with
Adjustable-Rate Mortgages
 Adjustable-rate mortgage (ARM):
a mortgage where the interest owed changes
in response to movements in a specific
market-determined interest rate
 Advantage is that rates could go down;
disadvantage is that rates could increase
 Initial rate—usually relatively low
 Interest rate index—determines whether
mortgage rate goes up
4-61
 Frequency of rate adjustments—varies
 Other Mortgage Loan
Options
 Graduated payment mortgage: a mortgage
where the payments are low in the early
years and then rise to a higher level over
time

 Balloon payment mortgage: a mortgage

where the monthly payments are relatively
low, but one large payment is required after a
specified period to pay off the mortgage loan
4-62
 Other Mortgage Loan
Options
 Balloon Payment Loan – small monthly
payments for 5-7 years, then entire loan due.
 Graduated Payment Mortgage – payments set
in advance, rising for 5-10 years, then level
off.
 Growing Equity Mortgage – designed to let
homebuyer pay off mortgage early.

4-63
 Other Mortgage Loan
Options
 Shared Appreciation Mortgage – borrower
receives below-market interest rate and
lender receives a portion of future
appreciation.
 Interest Only Mortgage – combination of
interest only payment at beginning, then pay
both interest and principal for remainder of
loan.
4-64
 Mortgage Refinancing

 Mortgage refinancing: paying off an existing

mortgage with a new mortgage that has a
lower interest rate
 Rate modification—may be available to some
fixed-rate mortgage holders
 Refinancing analysis—compare the monthly
savings to the cost of refinancing
 Must pay additional closing costs
4-65
 How a Mortgage Fits
Within Your Financial Plan
 Key mortgage loan decisions for your
financial plan are:
 What mortgage amount can you afford?
 What maturity should you select?
 Should you consider a fixed-rate or an
adjustable-rate mortgage?

4-66
 Adjustable-Rate Versus
Fixed-Rate Mortgages

Adjustable-Rate Fixed-Rate
 Primary benefit to  Usually a better choice
homeowner is low initial over adjustable.
interest rate.  Know your payments
 Rate gap between 1-2%. never change.
 Qualify for larger loan  Allows for control and
because PITI is lower. planning.

4-67
 Selecting a Home

 Purchasing a home may be the single

biggest investment you will ever make and
requires serious consideration
 Decide on a price range and then identify
a home you want
 Compare the cost of buying to the cost of
renting
 Consider a condominium
4-68
 Selecting a Home (cont’d)
 Criteria used to select a home
 Price
 Freehold or Leasehold
 Convenient location
 Maintenance
 School system
 Insurance
 Taxes
 Resale value–consider real estate commission
 Personal preferences
4-69
 Selling Your Home

 DETERMINING THE SELLING PRICE

 Appraiser estimates the current value
 Real estate agent markets your home
 If “FOR SALE BY OWNER,” use a lawyer or title
company to assist with contract and closing
 LISTING WITH A REAL ESTATE AGENT

4-70
End of Lecture
 FIN205 – Wealth Management

Topic 5- Property and Motor Vehicle

Insurance
 Learning Objectives
 Understand, buy, and maintain
homeowner’s insurance in a cost-effective
way.
 Recover on a liability or a loss to your
property.
 Buy the automobile insurance policy that is
right for you.
 Evaluate factors that affect the cost of auto
insurance
 File a claim on your automobile insurance.
5-2
 Background on Insurance

 Property insurance ensures that damages to

your auto and home are covered
 Also protects your personal assets from liability
 Liability: the amount that you may be required
to pay someone for damages that you caused
 Its primary function is to maintain your existing
level of wealth

5-3
 Insurance and Risk
Management: An Introduction
TYPES OF RISKS
–Risk:Uncertainty or lack of predictability, such as to loss that
a person or property, covered by insurance, faces
–Perilis the cause of a possible loss, such as fire, windstorm,
robbery, disease, or death
–Hazard increases the likelihood of a loss, such as driving
drunk, or defective house wiring

5-4
10-4
 Classification of Risk

 Pure and Speculative Risk

 A pure risk is a situation in which there are
only the possibilities of loss or no loss
(earthquake)
 A speculative risk is a situation in which
either profit or loss is possible (gambling,
investing in shares)

5-5
 Types of Pure Risks

1- Personal Risks

2- Property Risks

3- Liability Risks

5-6
 Managing Risk

 Risk: exposure to events or perils that can cause

financial loss
 Risk management: Organized, planned strategy
to protect your assets and family
Decisions about whether and how to protect against
risk:
 Accept
 Avoid risk
 Reduce risk
5-7
Steps in the Risk Management Process

5-8
 Managing Risk (cont’d)

 Accept risk
 Feasible when likelihood of financial loss
is low
 Avoid or Reduce Risk: Insure against risk.
Buying insurance differs from other purchases in
that there is no immediate benefit
- Remember that you do not have control over
adverse events
- Premium: the cost of obtaining insurance
5-9
 Managing Risk (cont’d)

 Economic impact on the decision to insure

against risk
 When economic conditions are favorable,
people are willing to purchase or increase
insurance coverage
 When economic conditions are weak, they
tend to reduce insurance
 Consider the possible danger in reducing
insurance coverage
5-10
 Property and Liability
Insurance
i) POTENTIAL PROPERTY LOSSES
 Home, automobiles, furniture, clothing, and personal
belongings

 Physical damage
- Hazards such as fire, wind, water and smoke.
- Destruction of property or temporary loss of use

 Loss of Use
- Due to robbery, burglary, vandalism, or arson

5-11
 Property and Liability
Insurance
ii) LIABILITY PROTECTION
–Liability: legal responsibility for cost of another person’s
losses or injuries
–Negligence
 Failure to take ordinary, reasonable care, such as
failure to supervise children in a pool
- Strict Liability
 A person is held responsible for intentional or
unintentional actions
- Vicarious Liability
When you are held responsible for the actions of
another person, such as your child throwing a ball
through a neighbor’s window 5-12
 Role of Insurance
Companies
Types of insurance
Many types of insurance available
• Most popular forms are property and casualty insurance, life
insurance and health insurance

5-13
Role of Insurance
Companies (cont’d)

5-14
 Role of Insurance
Companies (cont’d)

 Underwriters: from an insurance perspective,

underwriters are hired to calculate the risk of
specific insurance policies, decide what policies
to offer, and what premiums to charge

 Group insurance company policies for employers

- Allows a company’s employees to obtain discounts

5-15
 Role of Insurance
Companies (cont’d)
 Role of insurance agents and brokers
 Insurance agent: recommends insurance policies
for customers
 Captive insurance agent: works for one particular
insurance company
 Independent insurance agent: represent many
different insurance companies

5-16
 Homeowner’s Insurance

 Homeowner’s insurance: provides insurance

in the event of property damage, theft, or
personal liability relating to your home
 Covers events from flood to burglary
 Homeowner’s insurance structured in six
packages, each covering different perils in
different amounts

5-17
 Homeowners Insurance

Explain the insurance coverage and policy types

available to homeowners and renters.

HOMEOWNER’S INSURANCE COVERAGES

• Damage to or destruction of your house and other
structures, plus trees, shrubs and plants
• Additional living expenses
• Personal property in or away from home
• Personal property floater - high value items eg
jewelery
• Household inventory with documentation
5-18
5-19
 Homeowners Insurance

Personal liability and related coverages

oMedical payments coverage for minor injuries caused by

you, your family members, or pets, occurring on your property
or away from home

oPersonal liability- $100,000 or more

 Umbrella policy - also called a personal catastrophe
policy-supplements basic personal liability coverage
 $1,000,000 or more in liability coverage

5-20
 Homeowner’s Insurance
(cont’d)
Property damage
 Cash-value policy: pays you for the value of the
damaged property after considering depreciation
 Replacement-cost policy: pays you for the actual
cost of replacing the damaged property
• Minimum limit—many insurers require at least 80% of
replacement cost
• Financial institutions may require enough insurance to
cover your mortgage 5-21
 Homeowner’s Insurance (cont’d)

 Other structures on property may also be

covered
 Personal property is covered up to a specified
amount
 Home inventory: contains detailed information
about your personal property that can be used
when filing a claim

5-22
 Homeowner’s Insurance (cont’d)

 Personal property replacement cost coverage

is available
 Personal property floater: an extension of the
homeowner’s insurance policy that allows you
to itemize your valuables
 Home office provision may be requested or
you could purchase a separate policy

5-23
 Homeowner’s Insurance (cont’d)

 Liability
 Included to cover any lawsuits resulting from an
event occurring in your home or on your
property
 Other types of provisions
 Additional living expenses
 Loss of use provisions

5-24
 Homeowner’s Insurance
Premiums
 Factors that affect homeowner’s insurance
premiums
• Value of insured home
• Deductible - the amount of expenses that must
be paid out of your pocket before an insurer will
pay any expenses.
• Location
• Degree of protection
• Discounts
5-25
5-26
 Packaged Policies: HO’s

6 basic homeowner’s policies:

 HO-1: Basic form homeowner’s insurance – very
narrow coverage, not available in most states.
 HO-2: Broad form homeowner’s insurance –
covers a set of perils such as fire, lightning, etc.
 HO-3: Special form homeowner’s insurance –
most comprehensive because it covers all direct
physical losses to your home.

5-27
 Packaged Policies: HO’s

 HO-4: Renter’s or tenant’s insurance - same as

the HO-2 but aimed at renters.
 HO-6: Condominium owner’s insurance – covers
the personal property of a co-op or condo owner.
 HO-8: Modified coverage – older homes
homeowner’s insurance – insures older homes
for the repair costs or actual cash value rather
than replacement cost.
5-28
 Section I: Property Coverage

4 basic coverages in Section I of all HO policies (except HO-4):

 Coverage A: Dwelling – protects house and attachments, such as
attached garage.
 Coverage B: Other structures – protects unattached structures, such as
detached garage or landscaping.
 Coverage C: Personal property – protects personal property used by
policyholder regardless of location.
 Coverage D: Loss of use – provides benefits if your house can’t be
used due to an insured loss.

5-29
 Section II: Personal Liability
Coverage

 Protects policyholder and family from financial

loss if someone is injured on their property or
as a result of their actions.
 Covers the medical expenses of anyone
injured by the policyholder, their family, or by
their animal.
 Like a small medical insurance policy, covering
up to $1000 for medical expenses to non-
family members who are injured in your home.
5-30
Supplemental Coverage

 Coverage C of Section I provides

protection for your personal property.

 Additional coverage can be added

through an endorsement.
 Written attachment to an insurance
policy to add or delete coverage.

5-31
 Supplemental Coverage

 Personal Articles Floaters – extended coverage

for all personal property regardless of location
(except kids at school)- Jewellery
 Earthquake Coverage – specifically excluded
from coverage in standardized HO policies,
supplemental earthquake insurance is an
important addition in high risk areas.
 Flood Protection – includes coverage from flood
and water damage from storms.

5-32
 Supplemental Coverage

 Inflation Guard – updates coverage based on

an index of replacement costs that continually
updates the cost of the home.
 Personal Property Replacement Cost
Coverage – pay actual cash value of the loss.
 Added Liability Insurance – raise above
$100,000.
 Personal umbrella policy protects against
lawsuits and judgments up to $10 million.
5-33
 Renter’s Insurance
 Renter’s insurance: an insurance policy that
protects your possessions within a house,
condo, or apartment that you are renting
 Renter’s insurance policy provisions
 Specifies maximum coverage for personal
assets
 Also covers liability from damages to a
person on your property

5-34
 Coinsurance and the
“80-Percent Rule”
 Co-insurance provision requires you pay a portion of your
losses if you don’t have adequate insurance.
 Companies use the 80% rule, requiring you carry 80% of
the home’s replacement cost.
Eg : A buildings replacement cost actually valued at $1,000,000 has an
80% coinsurance clause but is insured for only $750,000. Since its
insured value is less than 80% of its replacement value, when it
suffers a loss, the insurance payout will be subject to the under
reporting penalty - For example, if it suffers a $200,000 loss, the
insured would recover $750,000 ÷ (0.80 × 1,000,000) × 200,000 =
$187,500 (less any deductible). In this example, the underreporting
penalty would be $12,500. 5-35
 The Bottom Line

 How much homeowner’s insurance do you need?

 Cover the replacement of your home if complete loss
 Protection against inflation eroding coverage
 Special disaster coverage in flood or earthquake areas
 Home office coverage
 Adequate personal property coverage
 Possessions needing special coverage (coins, jewelry)
 Additional liability coverage if assets are greater than liability
limits

5-36
 Home Insurance Cost Factors

Analyze factors that influence the amount of

coverage and cost of home insurance.
 Look for a policy with full coverage rather than
a coinsurance clause, where you have to pay
for part of a loss
 Which type of claim settlement method is used?
- Actual Replacement value vs cash value (cost
less depreciation)

5-37
 Home Insurance Cost Factors
• How Much Coverage do you Need?

5-38
10-38
 Keeping Your Costs Down –
Insurance Credit Scoring
 There appears to be a link between your
credit score and your insurance loss ratio.
 Insurance loss ratio measures claim
frequency& amount and cost for homeowner’s
and auto insurance. (Loss claimed /Premium
paid)

 The lower your insurance credit score, the

higher your homeowner’s rate will be.
 To manage your insurance score, improve
5-39
your credit score.
 Keeping Your Costs Down –
Discounts and Savings

 3 factors determine the cost of your

homeowner’s policy:
 Location of your home
 Type of structure
 Level of coverage and policy type

 Keep costs down by selecting a financially

sound insurer with low comparative rates.
5-40
 Keeping Your Costs Down –
Discounts and Savings

 High deductible discounts – pay less for

larger deductibles.
 Security system/smoke detector discounts
– save 2-5%.
 Multiple policy discounts – discount for
more than one policy with insurer.
 Pay your insurance premiums annually.

5-41
 Keeping Your Costs Down –
Discounts and Savings

 Other discounts – fire-resistant homes,

age over 55, long-time policyholder.
 Consider a direct writer – no agents, so no
salaries or commissions.
 Shop around – premiums vary by 25%.

 Double-check your policy – don’t want

errors once you file a claim.
5-42
 What To Do in the Case of
a Loss
Checklist
 Report your loss immediately.
 Make temporary repairs to protect your
property.
 Make a detailed list of everything lost or
damaged.
 Maintain records of the insurance settlement
process.
 Confirm the adjuster’s estimate.

5-43
 Filing a Claim

 Contact insurance company immediately if

damage occurs
 Claims adjuster estimates damage
 Present your home inventory
 Get an independent estimate
 Appeal low estimates by insurance company

5-44
Motor Vehicle Insurance

5-45
 Auto Insurance

 Auto insurance protects you from financial

loss from damage or liability resulting from
automobile accidents
 Cost has increased in recent years
 Personal injury attorneys

 No-fault insurance programs: do not hold a

specific driver liable for causing the accident
• Idea is to reduce costs
5-46
 Auto Insurance (cont’d)
 Auto insurance policy provisions
 Insurance policy: contract between an
insurance company and policyholder
 Auto insurance policy: specifies the coverage
provided by the insurance company for a
particular individual and vehicle

5-47
 Auto Insurance (cont’d)

 Coverage A: Liability Coverage

 Bodily injury liability coverage: protects
against liability associated with injuries
caused by the policyholder
 Property damage liability coverage: protects
against losses that result when the
policyholder damages another person’s
property with his car

5-48
 Auto Insurance (cont’d)

 Policy limits
• often described as 100/300/50
• $100,000 per person injured in an accident
• $300,000 for all people combined
• $50,000 for property damage

 Financial responsibility laws: laws that

require individuals who drive cars to
purchase a minimum amount of liability
insurance

5-49
Auto Insurance (cont’d)

 Coverage B: Medical Payments

Coverage: insures against the cost of
medical care for you and other
passengers in your car when you are
at fault in an accident
 Applies only to insured car

5-50
 Auto Insurance (cont’d)

 Coverage C: Uninsured or Underinsured

Motorist Coverage
 Uninsured motorist coverage: insures against
the cost of bodily injury when an accident is
caused by another driver who is not insured
 Underinsured motorist coverage: insures
against bodily injury and drivers who have
insufficient coverage

5-51
 Auto Insurance (cont’d)

 Coverage D: Collision and Comprehensive

Coverage
 Collision insurance: insures against costs of
damage to your car resulting from an
accident in which the policy holder is at fault
 Comprehensive coverage: insures you
against damage to your car that results from
floods, theft, fire, hail, explosions, riots and
various other events
5-52
 Auto Insurance (cont’d)
 Deductible: a set dollar amount that you are
responsible for paying before any coverage is
provided by your insurer
 Other provisions are available for an additional
premium
 Summary of auto insurance provisions
 Contained in standard insurance policy
 Expenses incurred by auto insurance companies
cover claims and lawyers’ fees
5-53
Auto Insurance (cont’d)

5-54
 Personal Automobile Policy

 Personal automobile policy (PAP) contains

liability and property damage coverage:
 Part A: Liability Coverage (Bodily & PropertY)
 Part B: Medical Expense Coverage
 Part C: Uninsured Motorist’s Protection
Coverage
 Part D: Damage to Your Automobile Coverage

5-55
 Personal Automobile Policy
 Part A: Liability coverage – protection if
you’re legally liable for bodily injury and
property damage caused by your vehicle.
 Combined single limit – applies to both
bodily injury and property damage liability.
 Split-limit coverage – separate coverage
for bodily injury and property damage.

5-56
Personal Automobile Policy

 Part B: Medical expense coverage –

pays medical bills and funeral
expenses within 3 years by those
injured in an accident involving your
vehicle.
 Policy limits range from $1000 -
$10,000 per person, with no limit on
the number of individuals covered in
an accident.
5-57
Personal Automobile Policy

 Part C: Uninsured motorist’s

protection coverage – protects you
against an uninsured driver, a
negligent driver with insolvent
insurance, or a hit-and-run driver.

 It is important to have uninsured

motorist driver’s protection because
15% of all drivers don’t have any
insurance. 5-58
Personal Automobile Policy

 Part D: Damage to your automobile

coverage including both collision loss
and comprehensive coverage.
 The collision loss portion provides
benefits to cover damages resulting
from an accident with another vehicle
or object.
 Comprehensive physical damage
coverage covers damage from fire,
theft, larceny, etc. 5-59
5-60
 Exclusions
 The PAP provides broad coverage, but there
are exceptions. You’re not covered if:
 There is intentional injury or damage.
 You’re using a vehicle without owner’s
consent.
 You’re driving another’s car on a regular basis.
 You own the car but it is uninsured.
 You are carrying fee-paying passengers.
 You are driving in a speed contest or race.
5-61
 No-Fault Insurance

 Based on the idea that your insurance

company should pay for your losses,
regardless of who is at fault.
 Over half the states have no-fault insurance.

 Imposes limits on medical expenses and

other claims.

5-62
 Determinants of the Cost of
Automobile Insurance

 Type of automobile: the sportier car, the

higher the insurance cost.
 Use of automobile: the less you use your
car, the lower the cost of insurance.
 Driver’s personal characteristics:
unmarried males pay the highest rates -
age, sex, and marital status affect rates.
5-63
 Determinants of the Cost of
Automobile Insurance

 Driver’s driving record: if you have

received tickets or had accidents, you’ll
pay a higher price.
 Where you live: urban areas with more
accidents and theft will have higher
insurance costs.

5-64
 Determinants of the Cost of
Automobile Insurance

 Discounts that you qualify for: cars with

safety features and drivers that have been
identified as safe drivers will receive
discounts.
 Insurance credit score: if you have a lower
credit score, you’ll pay a higher rate.

5-65
Auto Insurance Premiums

 Characteristics of your car

 Value of car
 Repair record of your car

 Your personal characteristics

 Your age
 Your mileage
 Your driving record

5-66
 Auto Insurance Premiums
(cont’d)
 Your location
 Your driver training
 Your school performance

 Your insurance company

 Always obtain several different quotes
 Several Web sites offer quotations
 Compare prices at renewal time

5-67
 Keeping Your Costs Down

 Shop comparatively
 Consider only high quality insurers
 Take advantage of discounts
 Buy a car that is relatively inexpensive to insure
 Improve your driving record
 Raise your deductible
 Keep adequate liability insurance

5-68
 If You Are in an Auto
Accident
 Contact police immediately
 Request information from the other driver(s),
including insurance information
 Obtain contact information from witnesses
 Take pictures of any evidence
 If in a serious accident, then meet with a
lawyer to know your rights
5-69
 If You Are in an Auto
Accident (cont’d)
 Write down details of accident
 Ask for a copy of police report
 File a claim with your insurance company
immediately
 Save receipts for any expenses and submit to
insurance company
 Don’t sign anything or admit guilt
5-70
 Umbrella Personal Liability
Policy
 Umbrella personal liability policy: a
supplement to auto and homeowner’s
insurance that provides additional personal
liability coverage
 Especially important for wealthy people
 Must show proof of existing coverage

5-71
 How Home and Auto
Insurance Fits Within Your
Financial Plan
 Key decisions about car and homeowner’s
insurance for your financial plan are:
 Do you have adequate insurance to protect
your wealth?
 How much insurance should you plan to
have in the future?

5-72
5-73
End of Lecture
 FIN205 – Wealth Management

Topic 6- Health, Disability & Long-Term

Care Insurance
 Chapter Objectives
 Identify and compare the types of private health
care plans
 Explain the different private health care
insurance policies
 Describe the contents of health care plans
 Explain the use of government health care plans
 Describe long-term care insurance
6-2
 Explain the benefits of disability insurance
Health Insurance Payment
Structure

6-3
 Background on Health
Insurance
 Health insurance: insurance offered by private
insurance companies or the government that
covers health care expenses incurred by
policyholders for necessary medical care
 Critical component of financial planning

6-4
 Background on Health
Insurance (cont'd)
 Cost of health insurance
 About 1 in 5 workers is uninsured
 Your health insurance decision is not whether
to obtain it, but which health plan to purchase
and how much coverage to purchase
 Many options available

6-5
 Health Care Costs

• WHY DOES HEALTH CARE COST SO MUCH?

– Use of sophisticated, expensive technologies

– Increases in the variety and frequency of treatments

– Increasing number and longevity of elderly people

– Increasing number of accidents, crimes that require

emergency services

6-6
 Health Care Costs

– Labor intensiveness, rapid earnings growth for health care

professionals
– Using more expensive medical care than necessary
– Malpractice Insurance
– Built in inflation in health care delivery system

6-7
 Health Care Costs

WHAT IS BEING DONE ABOUT THE HIGH COSTS OF

HEALTH CARE?

–Careful review of fees and charges

–Establish incentives for...
– Preventive care
– Services provided out of the hospital where medically
acceptable
–Encourage prepaid group practices (HMO, PPO)
–Support community health education programs so people
take better care of themselves

6-8
 Health Care Costs
• WHAT CAN YOU DO TO REDUCE PERSONAL
HEALTH CARE COSTS?

– Consider a high-deductible health plan

– Ask for less expensive generic drugs
– Use a mail-order or on-line pharmacy for long term drugs
– Review follow-up procedures with doctor
– Investigate non-urgent procedure
– Review billing statements for errors
– Appeal unfair decisions by your health plan

6-9
 Health Care Costs

– Stay well - focus on prevention

o Eat a balanced diet, keep your weight under
control
o Avoid smoking, don’t drink to excess
o Get enough rest, relaxation, and exercise
o Drive carefully, watch out for accident and fire
hazards in the home

6-10
 Health Insurance

 Basic Health Insurance:

 Hospital Insurance - covers costs associated
with a hospital stay.
 Surgical Insurance - covers cost of surgery.
 Physician Expense Insurance – covers
physicians’ fees outside of surgery.
 Dental and Eye Insurance
 Dread Disease and Accident Insurance –
covers specific diseases or accidents.
6-11
 Basic Health Care Choices

What types of plans are available?

 Traditional fee-for-service – reimbursed for
medical expenditures and choice of doctor.
 Managed health care – most expenses covered
but limited choice of doctors and hospitals.

6-12
 Private Health Insurance

 Private health insurance: health insurance

that can be purchased from private
insurance companies to provide coverage
for health care expenses
 Types of private health insurance coverage
 Most common are fee for service (indemnity)
plans or managed care plans

6-13
 Private Heath Care Plans
i) Fee-for-service plan or traditional indemnity plans
(Individual):
 Doctor or hospital bills you directly, company reimburses
 Coinsurance or percentage participation provision
 Co-payment or deductible. A co-payment or copay is a
fixed payment for a covered service, paid when an
individual receives service. Insurance companies use
copayments to share health care costs to prevent moral
hazard. Though the copay is often a small portion of the
actual cost of the medical service, it is meant to prevent
people from seeking medical care that may not be
necessary (e.g., an infection by the common cold)
6-14
 Private Heath Care Plans

ii) Managed health care (Employer sponsored)—a

health insurance policy under which individuals
receive services from specific doctors or hospitals that
are part of the plan.
Offered by health management organization (HMO,
PPO,POS )
 Receive all health care at one location
 Visit fee or co-payment

6-15
 Private Health Insurance
(cont'd)
 Health maintenance organization (HMO):
 A Health Maintenance Organization, or HMO,
provides employers a way to take care of all their
employees’ health care needs with reduced costs by
negotiating with specific doctors, hospitals, and clinics.
These specific providers must be used by the
employee for the reduced fees to be provided to their
medical insurance plan

 a primary care physician provides general

health services and refers patients to a
specialist as necessary.
6-16
 Private Health Insurance
(cont'd)
Preferred provider organization (PPO):
 An employer can also provide employees with reduced
costs billed to their health insurance plan. Similar to a
HMO, but the employees can choose the physician they
want to see instead of being solely restricted to the HMO
providers. An employee can choose between a member
or non-member provider.
 You pay less if you use providers that belong to the
plan’s network. You can use doctors, hospitals, and
providers outside of the network for an additional cost..
 Allows individuals to select a health care provider and
covers most of the fees for services; a referral6-17
from a
doctor is not required to visit a specialist
 Private Health Insurance
(cont'd)
• Discount on charge arrangement: an arrangement
in which the preferred provider organization (PPO)
pays a specific percentage of the health care
providers’ charges
Eg Ann incurred total charges by a hospital of $20,000, and the percentage paid
to the provider is 70 percent. How much does Ann have to pay? - Her insurer
would pay $14,000.

• Per diem (day) rate arrangement: an arrangement

in which the preferred provider organization (PPO)
pays a specific percentage (fixed amount per day
per patient regardless of actual cost) of the health
care provider’s charges
6-18
 Point of Service plan (POS)
 Under a POS plan, employees can choose their
own physician that has previously agreed to
provide services at a discounted fee (like HMO).
In a POS the employee would have to use the
chosen physician as a gateway first before
moving on to a specialist. But like a PPO,
patients may go outside of the provider network
for health care services. When patients venture
out of the network, they’ll have to pay most of the
cost, unless the primary care provider has made
a referral to the out-of-network provider. Then
6-19
the medical plan will pay the total fee.
 Private Health Insurance
(cont'd)
 Premiums for private health care insurance
 Higher for family coverage
 Self-employed, unemployed or those whose
employer doesn’t offer health care may
purchase private coverage
 Quotes and applications available online

6-20
 Private Health Insurance
(cont'd)
 Comparison of private health insurance plans
 Trade-offs between flexibility in selecting
physician (PPO) and premium (HMO is lower)
 HMOs and PPOs offer brochures with
comparative information

6-21
Private Health Insurance
(cont'd)

6-22
6-23
 Contents of Health Care
Insurance Policies
 Identification of insured persons
 Location
 Pre-existing conditions
 Cancellation and renewability options
 Other coverage
 Rehabilitation
 Mental health
6-24
 Contents of Health Care
Insurance Policies (cont'd)
 Pregnancy
 Dental insurance: insurance that covers part
or all of the fees imposed for dental services,
including annual checkups, orthodontics, and
oral surgery
 Vision insurance: insurance that covers part
or all of the fees imposed for optician and
optometrist services, including annual
checkups, glasses, contact lenses, and
surgery 6-25
 Contents of Health Care
Insurance Policies (cont'd)
 Determinants of unreimbursed medical expenses
 Deductible
 Coinsurance
 Stop-Loss provision (takes effect after a certain
amount has been paid in claim- sets a upper limit
on what can be claimed)
 Coverage limits
 Expenses not covered by private insurance plans
(Exclusions).These should be included in your
6-26
budget
 Deductible, Co Insurance,
Stop Loss
 Assume that Peter has an insurance policy
with a $1,000 deductible, 80/20 co-insurance
and a $5,000 stop-loss provision. Let’s also
assume he has a hospital bill for $2,000.
How much is he responsible for?

6-27
 Deductible, Co Insurance,
Stop Loss
 He is responsible for the first $1,000 of the
bill due to the deductible. He is then
responsible for 20% of the remaining $1,000
bill or $200. His total out-of-pocket expenses
for this bill are $1,200.

6-28
 Deductible, Co Insurance,
Stop Loss

 Now let’s assume he has another bill for $25,000 (due to a

surgery) in the same year. Since he has already paid his
deductible, he will go straight to the co-insurance. He will be
responsible for 20% of the bill or $5,000.
 However, he has a stop-loss provision of $5,000. Since he
already paid $1,200 from a previous bill, he will only be
responsible for $3,800 of the surgery bill. This is due to
having met his $5,000 stop-loss. The insurance company will
now pay any additional bills that come in during the same
calendar year.
6-29
 Government-Sponsored
Health Care Plans
 Worker’s Compensation (Socso)
 Federal Govt Plans—Medicare, Medicaid
(US only)

6-30
 Group Versus Individual
Health Insurance

Group Individual
 Insurance is sold to a  Policy is tailor-made for
specific group of you.
individuals who are  Tends to be more
associated – usually expensive than group
employees. insurance.

6-31
 Finding the Perfect Plan

 Look for a plan where the full cost of basic

services are covered, and is non-cancelable.

 Consider:
 Who’s Covered? – individuals or family
 Terms of Payment – define your financial obligation
 Pre-existing conditions
 Guaranteed Renewability
 Exclusions – certain illnesses or injuries
 Emotional and Mental Disorders – policies vary

6-32
 Long-Term Care Insurance
 Long-term care insurance: insurance that covers
expenses associated with long-term health conditions
that cause individuals to need help with everyday tasks
 Provided by private insurance companies
 Covers care in a nursing home, assisted living
facility, or at home
 Premiums quite expensive
 Protects against the financial costs of Alzheimer’s,
strokes, or chronic diseases.
 Requires that insured cannot perform “activities of daily
living.”
6-33
 Long-Term Care Insurance

Consider these provisions:

 Type of Care – nursing home, adult day care, or
hospice care for terminally ill.
 Benefit Period - can range from 1 year to
lifetime.
 Waiting Period – can range from 0 days – 1 year.
 Inflation Adjustment – protected from inflation.
 Waiver of Premium – insurance stays in force
while receiving benefits.
6-34
 Long-Term Care Insurance
(cont'd)
 Long-term care insurance provisions
 Eligibility to receive benefits
 Types of services
 Amount of coverage
 Elimination period (period of time from illness detected to
point in time when you receive benefits)
 Maximum period to receive benefits
 Continued coverage
 Inflation adjustment
 Stop-loss provision
6-35
 Long-Term Care Insurance
(cont'd)
 Factors that affect long-term care insurance
premiums
 Provisions of policy
 Age
 Health condition

 Reduce your cost of long-term care

insurance
 Shop around and compare premiums
6-36
Long-Term Care Insurance
(cont'd)
 Determining the amount of coverage
 Consider your family’s health history
 Consider your financial situation

6-37
 Should you get Long-Term
Care Insurance?
 Look at your family's health history and try to determine what your
chances will be of needing long-term care coverage.
 Consider your future income and see if living in a nursing home or
needing assistance at home would be financially affordable.
 If you need a long-term care policy, it is best to get one while you are
younger so the premiums will be lower. Employers often offer these
policies as part of a group plan.
 You would want a policy with a reasonable amount of coverage per day
and coverage that will increase with inflation.
 Ensure that you will receive benefits for a long enough period of time to
cover your needs. Like other forms of insurance, there is a trade-off
between cost and coverage
6-38
 Disability Insurance

 While related to health insurance, disability insurance is

more like earning-power insurance.
 Occupation impacts the cost
 Most employers provide some level of disability insurance
as part of the benefits package.
 You should have enough disability insurance to maintain
your standard of living if you are not able to work.

6-39
 Disability Insurance

 Disability income insurance: insurance that

provides income to policyholders in the
event that they become disabled

 Definition of disability
 Most liberal is “own occupation” definition
 Most restrictive is “any occupation”
definition

6-40
 Disability Features That
Make Sense

 Definition of Disability – when you can’t perform your “own

occupation.”
 Residual or Partial Payments – may offer partial pay.
 Benefit Duration – short term is ½ year - 2 years.
 Waiting Period – time when no benefits occur.
 Waiver of Premium – waives payments when disabled.
 Noncancelable – cannot be cancelled due to disability.
 Rehabilitation Coverage – provides retraining.

6-41
 Disability Insurance (cont'd)

 Sources of disability income insurance

 Individual disability insurance
 Employer disability insurance
 Insurance from Social Security
• Income determined by amount of Social
Security contributions you have made

 Insurance from Workers’ Compensation

6-42
 Disability Insurance (cont'd)

 Disability insurance provisions

 Amount of coverage
• May be a dollar amount or a percentage of your
income

 Probationary period: the period extending

from the time your disability income
application is approved until your coverage
goes into effect

6-43
 Disability Insurance (cont'd)

 Waiting period: the period from the time you

are disabled until you begin to receive
disability income benefits
 Length of time for disability benefits
 Non-cancelable provision
 Renewable provision

 Deciding on disability insurance

 Contact private companies or employer
6-44
 How Health and Disability Insurance Fit
Within Your Financial Plan

 Key decisions about health and disability

insurance that should be included within
your financial plan are:
 Do you have adequate insurance to protect
your wealth?
 How much insurance should you plan to
have in the future?

6-45
6-46
End of Lecture 6

6-47
FIN205 – Wealth Management

Topic 7- Life Insurance

 Learning Objectives

 Reduce your financial risk through insurance.

 Determine your life insurance needs and design a life

insurance program.

 Describe the major types of coverage available and the

typical provisions that are included.

7-2
 The Logic Behind Insurance:
Risk Management
 An insurance policy spells out what losses
are covered, what the policy costs, and
who receives payment.
 Health insurance provides protection
against devastating medical bills.
 Life insurance protects your family if you
die.

7-3
 Background on Life
Insurance
 Life insurance: insurance that provides
a payment to a specified beneficiary when the
policyholder dies
 Role of life insurance
 Maintain financial support for dependents
 Leave money for heirs

 Psychology behind the life insurance decision

 Easier to focus on happy events
 Hard to pay ongoing premiums for benefit you might
7-4
not need
 Life Insurance: An Introduction

 Purpose of life insurance: Protect someone who

depends on you from financial loss related to your
death.
 Other reasons are:
 Pay off a home mortgage or other debts at the time of
death
 To leave as part of your estate
 To save money for retirement or for income or education
for children
 To cover medical expenses and funeral costs
7-5
 Life Insurance: An Introduction

 THE PRINCIPLE OF LIFE INSURANCE

– Mortality tables provide odds on your dying,
based on your age and sex

 HOW LONG WILL YOU LIVE?

– Your premium is based on your life expectancy
and the projections for the payouts for persons
who die

7-6
 Determining Your
Life Insurance Needs

DO YOU NEED LIFE INSURANCE?

– Do you have people you need to protect financially

– Do you have a partner who works?

7-7
 Determining Your
Life Insurance Needs
DETERMINING YOUR LIFE INSURANCE OBJECTIVES

– How much money do you want to leave your dependents

should you die today?

– When do you want to retire, and what income do you

think you’ll need?

– How much will you be able to pay for your insurance

program?

7-8
 Determining Your
Life Insurance Needs
ESTIMATING YOUR LIFE INSURANCE NEEDS
1.The Easy Method
o You will need 70% of your salary for seven years
while your family adjusts

2.The DINK (dual income, no kids) Method

o ½ debts + funeral expenses

7-9
 Determining Your
Life Insurance Needs
3)The “Nonworking” Spouse Method - Multiply the number of
years until the youngest child reaches 18 by $10,000
4) The “Family Need” Method- Determines the funds
necessary to meet the needs of a family after primary
breadwinner’s death. More thorough than the first three
because it also considers employer provided insurance,
Social Security benefits, and income and assets
5) Earnings Multiple Approach - Buy insurance that is 5-15
times your annual gross income.
6) Income Replacement Approach
7) Human Value Approach
8) Capital Retention Method

7-10
 Needs Approach

What needs must be met after the death of the breadwinner?

 Immediate needs at time of death
 Debt elimination
 Immediate transitional funds
 Dependency expenses
 Spousal life income
 Educational expenses for children
 Retirement income

7-11
Income Replacement
Approach
It assumes that the goal of life insurance
is to replace the lost earnings of a family
breadwinner who has died.

Under this approach, the insurance

purchased is based on the value of the
income the insured breadwinner can
expect to earn during his or her lifetime.

7-12
 Income Replacement
Approach
 Let’s say that you’re 45 years old and your net
monthly expenses are $3,000.
 By multiplying your monthly expenses by 12, we get
your annual expenses of $36,000.
 Multiply this number by the amount of working years
you have left—we’ll say that you plan to retire at age
65. That means you have 20 working years left.
$36,000 x 20 years = $720,000.
 For income replacement, you need a life insurance
policy with a $720,000 death benefit. 7-13
 Human Value Approach
“Present value of the family’s share of the
deceased breadwinner’s future earnings”. The
human value is calculated as: estimated
average annual earnings until expected
retirement, reduced by taxes and
(incremental) expenses for self-maintenance
of the insured then multiplying by the number
of working years and discounting appropriately
to calculate present value.
 Ideally one could build in other income
7-14
sources, real earning increases and inflation
 Human Value Approach

Example: Ralph is 35 and expects to earn an

average of $40,000 a year until retirement until
age 65. Of the $40,000, $25,000 is devoted to
the care and maintenance of his family, the
remaining $15,000 goes for taxes and living
expenses.

Based on the basic assumptions, we can see

that Ralph's family will need and use $750,000
7-15
($25,000*30 years).
 Capital retention (capital
needs)
 Unlike the needs approach which assumes
liquidation of the life insurance proceeds, the
capital retention approach preserves the capital
needed to provide income for the family. The
income producing assets are then available for
distribution later to the heirs.”

7-16
 Capital retention (capital
needs)
 The capital retention approach involves:
Determining additional assets, on top of
currently available assets for income
generation (i.e. need to prepare a balance
sheet to identify available income producing
assets), required to generate the needed family
income after death of one spouse.

7-17
 Types of Life Insurance
Companies
Stock life insurance companies are owned by the
shareholders
 76% are of this type
 Sell non-participating policies (insurance co does not
distribute any gains or profits to policyholders).
 If you want to pay the same premium each year, choose
a non-participating policy with its guaranteed premiums

7-18
 Types of Life Insurance
Companies
Mutual life insurance companies

 24% are of this type

 Owned by the policyholders
 With participating policies (dividends paid is used to
build up the cash value of the policy) the premiums are
higher than non-participating policies
 Part of the premium is refunded to the policyholders
annually. This is called the policy dividend

7-19
 Life Insurance - The Basic
Policy
 Face amount
 Dollar amount of life insurance protection stated on the
face of the policy
 Cash value
 Equal to the savings accumulated during the existence
of the policy. Insured can typically borrow against this
value
 Surrender value
 Amount returned to the policyholder at termination
 Equal to the cash value plus surrender dividends minus
outstanding loans and surrender charges

7-20
 The Basic Policy

 Lives covered
 Single life policy: Taken out on the life of one
person
 Joint life policy: Covers more than one person; pays
out at the death of the first
 Survivorship joint life policy: Pays out at the death
of the last individual
 Family policy: Coverage for several family members
in one policy
 Premium - Periodic payment on policy
7-21
 The Basic Policy

 Dividend
 A partial return of premium determined by the
earnings of the insurer
 Non-participating insurance
 Stock insurance companies
 Premiums not dependent upon the future
earnings and mortality experience of the company
 Participating insurance
 Typically mutual insurance companies
 May return part of the premium as a dividend if
company has favorable earnings 7-22
 The Basic Policy

 Beneficiary
 Person or entity that receives proceeds
 Co-beneficiaries
 Two or more persons or entities that receive
proceeds
 Contingent beneficiary
 Also called the secondary beneficiary
 Receives proceeds if primary beneficiary
7-23
dies
before you do
 Do You Need Life
Insurance?

 Insurance is based on “risk pooling” - where

individuals share the financial risks they face.
 The size of the premium depends on the
probability you will die.
 Face amount - amount of insurance provided
at death.
 Owner - policy holder.
 Beneficiary – designated to receive the
proceeds.
7-24
 Major Types of Life Insurance

There are 2 major types of life insurance:

 Term insurance – pure life insurance.
 Cash-value insurance – has a life insurance
and a savings component.

7-25
 Term Insurance and Its
Features
 Pays the death benefit if insured dies during
the coverage period.
 Has no cash value (i.e. no savings element).
 Sole purpose is to provide death benefits to
beneficiaries.
 Primary advantage is affordability.
 Disadvantage is that the cost increases each
time the policy is renewed.

7-26
 Determinants of term
insurance premiums
• The longer the term, the higher the premium
• The older the policyholder, the higher the
premium
• The greater the amount of insurance coverage,
the higher the premium
• Premiums higher for males than females
• Premiums higher for smokers
• Premiums higher for those with medical
problems
7-27
 Renewable Term Insurance

 The “term” in a life insurance contract can be

from 5 to more than 20 years.
 Coverage terminates if not renewed.

 Renewable term insurance allows for renewal

up to a specified age, regardless of health.
 Each time the contract is renewed, the
premium is increased.

7-28
 Re-entry Term Insurance

 Term insurance is guaranteed renewable at

one of 2 possible premium levels in the future.
 Regular evaluations of your health determine
which premium you are eligible for.
 Lower rate if you pass the medical exam.
 Higher rate if you fail the medical exam.

7-29
 Decreasing Term Insurance

 Premiums remain constant but the face

value declines.
 Assumes over time your wealth will increase
and your needs will decrease.
 Some policies decline at a constant, steady
rate, others at accelerating rates.

7-30
 Group Term Insurance

 Term insurance provided without a medical

exam, to a specific group of people.
 The group may be employees of the same
company or professional group.
 The employer may pay part of the premium.
 Usually less expensive than an individual
policy.

7-31
 Credit or Mortgage Group
Life Insurance
 Life insurance provided by a lender for its
debtors.
 Provides enough coverage for an individual’s
outstanding debts.
 If debtor dies while policy is in effect, proceeds
are used to pay off the debt.
 Set up as a form of declining insurance.

7-32
 Convertible Term Life
Insurance
 Life insurance that converts into cash-value
life insurance, at your discretion, regardless
of your medical condition and without a
medical exam.
 This allows you to continue your coverage
when your term expires.

7-33
 Cash-Value Insurance
and Its Features
 Provides both a death benefit and an
opportunity to accumulate cash value
(savings).
 Permanent type of insurance – you pay the
premiums and eventually you will get paid.
 3 basic types:
 Whole Life
 Universal Life
 Variable Life 7-34
 Whole Life Insurance
and Its Features
 Provides a death benefit when the insured dies, turns 100, or
reaches the maximum stated age.
 Face value is paid provided premiums were paid.
 In early years, deductions are made from the premium. The
remaining goes into savings (cash value).
 The policyholder can borrow against the cash value.
 Non-forfeiture right gives the policyholder the policy’s cash
value in exchange for giving up the death benefit. It is the
benefits that accrue to the insured when the policy lapses from
non-payment of premium.

7-35
 Whole Life Insurance
and Its Features
Modified Whole Life Combination Whole Life

 Premiums begin below  Includes elements of whole

comparable whole life life and decreasing term
and gradually rise until insurance. Face amount
final premiums are above remains constant while
comparable whole life. coverage shifts from term
to whole life.

7-36
 Whole Life Insurance
and Its Features
Although it does provide for both savings and
permanent needs, there are disadvantages of
whole life:
 Not the same level of death protection that term
insurance provides for the same price.
 Yield on the cash value investment portion of
the policy isn’t competitive with yields on
alternative investments.
7-37
 Universal Life Insurance
and Its Features

 A type of cash-value insurance combining term

insurance with tax-deferred savings with flexible
premiums and benefits.
 Pay the dictated premium which goes into savings,
once expenses and mortality charges are
subtracted.
 Policyholder can increase or decrease the premiums
to affect the cash value of the policy.

7-38
 Universal Life Insurance
and Its Features
 Universal life funds have 3 parts:
 The mortality charge or term insurance
 The cash value or savings
 Administrative expenses

 With fluctuating returns and high expense

charges, you may not end up with the
anticipated amount of savings.

7-39
 Term Versus Cash-Value
Life Insurance
 For most individuals, term insurance is the
better alternative.
 It provides life insurance needs at a low cost.
 The advantage of cash-value insurance is the
tax advantages.
 Growth of the cash-value is tax-deferred.
 Life insurance is not considered part of your
estate.
7-40
 Whole Life (WL) vs Universal
Life (UL)
 Both UL and WL policies combine a permanent life insurance component
with an investment component.
 Because of the level premiums for the permanent life insurance component,
the cost of insurance will be higher than an equivalent amount of Term
(temporary) insurance.
 The investment component of both UL and WL grows on a tax-deferred
basis. Making a straight withdrawal from the investments in a UL or WL
policy will subject you to taxation on all the growth. It is treated as income
and taxed at marginal tax rates. The money you put in (the principal) is not
taxable, since it is after-tax dollars to begin with.
 When you die, the full amount of the investment component plus the
insurance component is paid to your beneficiaries – tax free.

7-41
 Whole Life (WL) vs Universal
Life (UL)
 For WL, you have no say in how the investment component is invested .
You pay set premiums for a pre-determined amount of time (like 20 years).
 A participating whole life policy can earn dividends or interest on top of the
guaranteed cash value, based on the insurance company's results. You can
choose for the dividends to purchase extra term insurance, extra permanent
insurance, or have it go directly into the investment component.
 Eventually once the dividend payments are large enough, you can choose
to have them pay for the cost of the insurance premiums.

7-42
 Whole Life (WL) vs Universal
Life (UL)
With less flexibility around the choice of investments and annual
premium amounts, WL is ideal for somebody who knows they
can pay and maintain a set premium amount for many years.
Somebody who cites themselves as lacking discipline to invest
might choose WL because of this inflexibility (thus using it as a
forced savings plan of sorts).

7-43
 Whole Life (WL) vs Universal
Life (UL)
For UL, you can choose how much is put in the investment component .
The premium payments for UL are very flexible. You must maintain the cost
of the life insurance (death benefit), and then you can contribute as much or as
little as you wish to the investment component (savings component). Once
there is an accumulated balance in the investment component, you can choose
to have the life insurance premiums paid from the investments so you do not
have to pay further premiums out of pocket after time.
UL is best used for people who have large (but undetermined) amounts of
money they wish to invest with an eye to shelter the growth from taxation.

7-44
Term vs WL vs UL

7-45
 Variable Life Insurance
A form of permanent life insurance, Variable life insurance
provides permanent protection to the beneficiary upon the
death of the policy holder. This type of insurance is generally
the most expensive type of cash-value insurance because it
allows you to allocate a portion of your premium dollars to a
separate account comprised of various instruments and
investment funds within the insurance company's portfolio
such stocks, bonds, equity funds, money market funds and
bond funds.
The major advantage to variable policies is that they allow
you to participate in various types of investment options
while not being taxed on your earnings (until you surrender
the policy).
However, due to investment risks, when the invested funds
perform poorly, less money is available to pay the premiums
7-46
 Fine-Tuning Your Policy:
Contract Clauses and Riders
There are 10 common features in all insurance policies:
• Beneficiary provision
• Grace period
• Loan clause
• Non-forfeiture clause
• Policy reinstatement clause
• Change of policy clause
• Suicide clause
• Payment premium clause
• Incontestability clause
• Settlement options

7-47
 Fine-Tuning Your Policy:
Contract Clauses and Riders
 Beneficiary provision – allows for the naming
of a primary and contingent beneficiaries.
 Grace period – automatic extension for
premium payments, usually 30 days after
payment is due.
 Loan clause – allows you to take loans against
the cash value of the policy.

7-48
 Fine-Tuning Your Policy:
Contract Clauses and Riders
 Non-forfeiture clause – gives the policyholder
the cash value in exchange for giving up death
benefit.
 Policy reinstatement clause – the conditions
necessary to restore a lapsed policy.
 Change of policy clause – allows policy holder
to change the form of the policy.

7-49
 Fine-Tuning Your Policy:
Contract Clauses and Riders
 Suicide clause – the policy will not pay for
suicide deaths within 2 years of purchase.
 Payment premium clause – defines the
alternatives available regarding the payment of
premiums.
 Incontestability clause – insurance company
cannot dispute the validity of the contract after
a specified number of years.
7-50
 Fine-Tuning Your Policy:
Contract Clauses and Riders
Settlement options to receive benefits:
 Lump-sum settlement – usually no taxes due on
the full face value of the contract.
 Interest-only settlement – leave benefits on
deposit and receive only the interest.
 Installment-payment settlement – cash value
distributed over a fixed time period.
 Life-annuity settlement – beneficiary receives
income for life.
7-51
 Riders

 A special provision added to the policy providing extra

benefits or limiting the company’s liability.
 Waiver of Premium for Disability – pays your premiums if you
become disabled.
 Accidental Death Benefit – increases benefit if insured dies from
an accident and not natural causes.
 Guaranteed increase insurance protection without a medical exam.
 Cost-of-Living Adjustment – COLA increases death benefit at rate
of inflation.
 Living Benefits – early payout for terminally ill.

7-52
 Buying Life Insurance

 Choose an efficiently-run insurance company

by evaluating their rating
 A.M. Best, Standard & Poor’s, Moody’s, and Duff &
Phelps rate an insurance company’s ability to pay off.
 Select the right agent by evaluating their
designations.
 CLU – chartered life underwriter
 Compare costs of competing policies.
 Traditional net cost method
 Interest-adjusted net cost method

7-53
 Traditional Net Cost

Premiums Paid
- Dividends
- Cash Value at the End of the Period
= Net Cost

Disadvantage: Ignores time value of money

7-54
 Interest Adjusted Net Cost

Accumulated Value of Premiums at Interest

- Accumulated Value of Dividends at Interest
- Cash Value at End of Period
= Total Interest Adjusted Cost

7-55
 Buying Life Insurance

FROM WHOM TO BUY?

 SOURCES
 Examine both private and public sources
 Look up the company’s rating,
in A. M. Best or other rating agencies
 Talk to friends or colleagues

 RATING INSURANCE COMPANIES

 Research ratings on the web
http://www.ambest.com

7-56
 Buying Life Insurance

CHOOSING YOUR INSURANCE AGENT

–Can friends or parents make recommendations?
–Does the agent have professional designations such
as Chartered Life Underwriter (CLU)?
–Isthe agent willing to find a policy that is right for you
or does he push a certain type of policy?
–Do they ask about your financial plan?
–Do you feel pressured?

7-57
 Buying Life Insurance

COMPARING POLICY COSTS

Compare policy costs which are affected by:
 How selective they are in whom they insure
 Their cost of doing business
 Return on their investments
 Mortality rate among policyholders
 Policy features and competition from other firms

7-58
 Buying Life Insurance
OBTAINING A POLICY
1.Apply

2.Provide medical history

3.Usually no physical for a group policy
4.Read every word of the contract
5.After you buy it, you have ten days to change your
mind
6.Give your beneficiaries and lawyer a photocopy

7-59
Buying Life Insurance

7-60
 Life Insurance Proceeds

Evaluate the payout options for life insurance.

Death (or Survivor Benefits)

–To cover the immediate expenses resulting from
the death of the insured
–To protect dependents against a loss of income
resulting from premature death of primary wage
earner

7-61
 Life Insurance Proceeds
Common Settlement Options
i) Lump-sum Payment
Face amount paid in one installment

ii) Proceeds left with the company

 Pays interest to the beneficiary

iii) Limited installment payment

 In equal installments for a specific number of
years after your death

iv) Life income option

 Payments to the beneficiary for life
7-62
 Life Insurance Proceeds

 Annuity: Financial contract written by an insurance

company that provides you with a regular income
- Payments may begin at once (immediate annuity)
or at some future date (deferred annuity)
 Income from Life Insurance Policies
– People buy annuities to supplement retirement
income and to shelter income from taxes.
Annuities are tax-deferred investment plans

7-63
 Life Insurance Proceeds

SWITCHING POLICIES
–Switch if benefits exceed costs of getting another
physical, and paying policy set-up costs
–The older you are, the higher the premium will be
–Are you still insurable?
–Can you get all the provisions you want?

7-64
How Life Insurance Fits
Within Your Financial Plan
Key decisions about life insurance for
your financial plan are:
 Do you need life insurance?
 What type of life insurance is most
appropriate for you?
 How much life insurance should you
plan for in the future?

7-65
End of Lecture
 FIN205 – Wealth Management

Topic 8- Investing in Stocks

 Learning Objectives

 Set your goals and be ready to invest.

 Understand how taxes affect your
investments.
 Calculate interest rates and real rates of
return.
 Manage risk in your investments.
 Allocate your assets in the manner that is
best for you.
8-2
 Learning Objectives

 Identify and describe the primary and

secondary securities markets.
 Trade securities using a broker.

 Locate and use several different sources

of investment information to trade
securities.

8-3
 Learning Objectives

 Invest in stocks.
 Read stock quotes in the newspaper or
financial periodicals.
 Classify common stock according to basic
market terminology.
 Value stocks.
 Understand the risks associated with
investing in common stock.
8-4
 Investing Versus Speculating

With speculation, assets don’t generate an income

return and their value depends entirely on supply and
demand.

Examples include:
 Gold coins
 Baseball cards
 Non-income producing real estate
 Gems
 Derivative securities

8-5
 Setting Investment Goals

 When you make a plan, you must:

 Write down your goals and prioritize them.
 Attach costs to them.
 Determine when the money for those goals will
be needed.
 Periodically reevaluate your goals.

8-6
 Setting Investment Goals

 Formalize goals into:

 Short-term – within 1 year
 Intermediate-term – 1-10 years
 Long-term – over 10 years

8-7
 Setting Investment Goals

Focus on which goals are important by asking:

 If I don’t accomplish this goal, what are the
consequences?
 Am I willing to make the financial sacrifices
necessary to meet this goal?
 How much money do I need to accomplish this
goal?
 When do I need this money?

8-8
 Investment Choices

Lending Investments Ownership Investments

 Savings accounts and  Preferred stocks and

bonds. common stocks which
represent ownership in
 Debt instruments issued a corporation.
by corporations and
the government.  Income-producing real
estate.

8-9
 Look at Risk-Return Trade-
Offs

 Risk is related to potential return.

 The more risk you assume, the greater the
potential reward – but also the greater
possibility of losing your money.
 You must eliminate risk without affecting
potential return.

8-10
 Sources of Risk in the
Risk-Return Trade-Off

 Interest Rate Risk – the higher the interest

rate, the less a bond is worth.
 Inflation Risk – rising prices will erode
purchasing power.
 Business Risk – effects of good and bad
management decisions.

8-11
 Sources of Risk in the
Risk-Return Trade-Off

 Financial Risk – associated with the use of

debt by the firm.
 Liquidity Risk – inability to liquidate a
security quickly and at a fair market price.

8-12
 Sources of Risk in the
Risk-Return Trade-Off

 Market Rate Risk – associated with overall

market movements.
 Bull markets – stocks appreciate in value
 Bear markets – stocks decline in price

8-13
 Diversification

 “Don’t put all your eggs in one basket.”

 Extreme good and bad returns cancel out, resulting in
a reduction of the total variability or risk without
affecting expected return.
 Not only eliminates risk but also helps us understand
what risk is relevant to investors.

8-14
 Systematic and Unsystematic Risk

 As you diversify, the variability or risk of the portfolio

should decline.
 Not all risk can be eliminated by diversification.
 The risk in returns common to all stocks isn’t
eliminated through diversification.
 Risk unique to one stock can be countered and
cancelled out by the variability of another stock in the
portfolio.

8-15
 Systematic and Unsystematic
Risk
Systematic Risk (Beta) Unsystematic Risk
 Market-related or non-  Firm-specific,
diversifiable risk. company-unique, or
 That portion of a stock’s diversifiable risk.
risk not eliminated through
diversification.  Risk that can be
eliminated through
 It affects all stocks.
diversification.
 Compensated for taking on
this risk.  Factors unique to a
 Eg changes in specific stock.
macroeconomic factors
such interest rates,
inflation, and the business
8-16
cycle.
 Risk and Return: The Capital Asset
Pricing Model (CAPM) (cont.)

 The required return for all assets is

composed of two parts: the risk-free
rate and a risk premium.

The risk premium is a The risk-free rate (RF) is

function of both market usually estimated from
conditions and the asset the return on US T-bills
itself.

8-17
 Risk and Return: The Capital Asset
Pricing Model (CAPM)

 After estimating beta, which measures a specific

asset or portfolio’s systematic risk, estimates of
the other variables in the model may be obtained
to calculate an asset or portfolio’s required return.

8-18
 Risk and Return: The Capital Asset
Pricing Model (CAPM) (cont.)

Beta coefficient is
given by the
following formulas:

β = Covariance of Market
Return with Stock Return
divided by
Variance of Market
Return

8-19
 How to Measure the
Ultimate Risk on Your
Portfolio
 For risk associated with investment returns,
look at:
 Variability of the average annual return on
your investment.
 Uncertainty associated with the ultimate dollar
value of the investment.
 How the ultimate dollar return on the
investment compares to that of another
investment. 8-20
 How to Measure the
Ultimate Risk on Your
Portfolio
 If investment time horizon is long and you invest
in stocks, there is uncertainty about the ultimate
value of investment, so take on additional risk.
 Take on more risk as time horizon lengthens.

 No place to hide in a crash, both stocks and

bonds are affected.

8-21
 Asset Allocation

 How your money should be divided among

stocks, bonds and other investments.
 Investors should be diversified, holding
different classes of investments.
 Common stocks more appropriate for the
long-term horizon.
 Asset allocation is the most important
investing task.
8-22
 Asset Allocation and
Approaching Retirement

The Golden Years (Age 50-60)

 Preserve level of wealth and allow it to
grow.
 Start moving into bonds.- less risky

 Maintain a diversified portfolio.

 Own 60% stocks and 40% bonds.

8-23
 Asset Allocation and
Approaching Retirement

The Retirement Years (Over Age 60)

 Spending more than saving.
 Income is primary, capital appreciation secondary.
 Safety through diversification and movement away from
common stocks.
 Early on, own 40% stocks, 40% bonds, 20% T-bills. Later
own 20% common, 60% bonds, and 20% T-bills.

8-24
 What You Should Know
About Efficient Markets

 Deals with the speed at which new

information is reflected in prices.
 The more efficient the market, the faster
prices react to new information.
 If the stock market were truly efficient,
then there would be no benefit from stock
analysts.
8-25
Why Consider Stocks?

 When you buy common stock, you

purchase a part of the company.
 Returns come from:
 Dividends - the company’s distribution
of profits to stockholders.
 Capital appreciation - the increase in
the selling price of a share of stock.

8-26
 Why Consider Stocks?

 Neither dividends nor capital appreciation is

guaranteed with common stock.
 Dividends are paid at the board’s discretion.
 Can be cash or additional stock.
 Capital appreciation takes place when the
company does well.

8-27
 Why Consider Stocks?

 Over time, common stocks outperform all

other investments.
 Stocks reduce risk through diversification.

 Stocks are liquid.

 Growth is determined by more than interest

rates.

8-28
 The Language of Common
Stocks
 Limited Liability – in case of bankruptcy,
loss limited to amount of investment.
 Claim on Income – receive earnings after
debt holders and preferred stockholders.
 Earnings distributed through dividends or
reinvested into company.
 Dividends are not automatic – they must be
declared by board of directors.

8-29
 The Language of Common
Stocks
 Claims on Assets – paid after all creditors.
 Voting Rights – elect board of directors,
approve changes in corporation’s rules.
 Voting done in person or by proxy.
 Stock Splits – substitute more shares for
existing ones, thereby lowering the price.
- No immediate gain in wealth for stockholder.

8-30
 The Language of Common
Stocks
 Stock Repurchases – company buys back its
own stock.
 Book Value – subtract firm’s liabilities from
assets.
 Earnings Per Share – level of earnings for
each share of stock.
- Compares performance of different companies.

8-31
 The Language of Common
Stocks
 Dividend Yield – amount of annual dividend
divided by market price of stock.
 Calculates return if stock price and dividend is
unchanged.
 Market -to-Book or Price-to-Book Ratio –
measures how highly valued the firm is.

8-32
 The Dow

 The Dow Jones Industrial Average (DJIA or Dow) is the

oldest and most widely quoted index.
 Created by Charles Dow in 1896 to gauge the well-being
of the market, was based on 12 companies.
 Dow currently has 30 stocks, with GE the only original
Dow component.
 DJIA weighs stocks on relative prices.

8-33
 The S&P 500 and Other
Indexes

 The Standard and Poor’s 500 Stock Index is broader

than the DJIA. It may better represent the market’s
movements.
 The Russell 1000 is comprised of the 1000 largest
companies.
 The Russell 2000 is comprised of companies ranking
in size from 1001-3000.
 Wilshire 5000 is made up of all the stocks on the
NYSE, AMEX, and NASDAQ.

8-34
 Bursa Malaysia - Indices
Benchmark Indices
FTSE Bursa Malaysia EMAS Index (FBMEMAS) - constituents of the FTSE Bursa Malaysia
Top 100 Index and FTSE Bursa Malaysia Small Cap Index.
FTSE Bursa Malaysia EMAS Industry Indices - 10 Industries, 19 Supersectors and 39 Sectors.

FTSE Bursa Malaysia Small Cap Index - top 98% of the Bursa Malaysia Main Market
excluding FTSE Bursa Malaysia Top 100 Index constituents.
FTSE Bursa Malaysia EMAS Shariah Index - Shariah-compliant constituents of the FBMEMAS
that meet the screening requirement of the SAC.
FTSE Bursa Malaysia Small Cap Shariah Index - Shariah-compliant small cap constituents of
the FBMEMAS that meet the screening requirement of the SAC.
FTSE Bursa Malaysia ACE Index - all eligible companies listed on the ACE Market.

FTSE Bursa Malaysia Palm Oil Plantation Index - based on FBMEMAS and comprising
companies earning a substantial proportion of revenue from palm oil activities.
FTSE Bursa Malaysia Fledgling Index - eligible constituents listed in the fledgling segment.

FTSE4Good Bursa Malaysia Index - constituents are selected from the top 200 Malaysian
stocks in the FTSE Bursa Malaysia EMAS Index, screened in accordance with the transparent
and defined Environmental, Social and Governance (ESG) criteria.
8-35
 Bursa Malaysia - Indices

Other Indices
FTSE Bursa Malaysia KLCI - 30 largest companies in FBMEMAS by full
market capitalisation.
FTSE Bursa Malaysia Mid 70 Index - the next 70 companies in FBMEMAS.

FTSE Bursa Malaysia Top 100 Index - sum of constituents in the above two
indices.
FTSE Bursa Malaysia Hijrah Shariah Index - 30 largest Shariah-compliant
companies in FBMEMAS screened by Yasaar Ltd and the Securities
Commission's Shariah Advisory Council (SAC).
FTSE Bursa Malaysia Asian Palm Oil Plantation Index - (MYR and USD
versions) - companies earning a substantial proportion of revenue from palm
oil activities in the Asia Pacific Region.

8-36
 Market Movements

 A bear market is characterized by falling

prices.

 A bull market has rising prices.

 Names come from how the animals attack:

 Bears swipe downward with their paws.
 Bulls fling their horns upward.

8-37
 General Classifications
of Common Stock

 Blue-Chip Stocks – issued by large,

nationally-known companies with sound
financials, solid dividend and growth
records.
 GE and P&G are examples.

8-38
 General Classifications
of Common Stock

 Growth Stocks – companies with sales

and earnings growth well above their
industry average.
 Microsoft is an example.

8-39
 General Classifications
of Common Stock

 Income Stocks – mature firms paying high

dividends with little increase in earnings.
 Speculative Stocks – carry more risk and
variability, difficult to forecast, and traded
on the OTC.

8-40
 General Classifications
of Common Stock

 Cyclical Stocks – earnings move with the

economy, dropping during a recession.
 Defensive Stocks – are not nearly as
affected by economic swings, and perform
better during a downturn.
 Examples include insurance and auto
parts firms.
8-41
 General Classifications
of Common Stock

 Large caps, mid caps, and small caps – refer

to the size of the issuing company – its market
capitalization.
 From 1926-2004, small-cap stocks
outperformed large-cap stocks.

8-42
Analyzing Stocks

 Technical analysis: the valuation of

stocks based on historical price
patterns
 Fundamental analysis: the valuation
of stocks based on an examination of
fundamental characteristics such as
revenue or earnings, or the sensitivity
of the firm’s performance to economic
conditions
8-43
 Technical Analysis Approach

 Focuses on demand and supply, using

charts and computer programs to identify
and project price trends.
 Believes that 2 factors reinforce trends in
the market.
 Greed pushes money into a rising market.
 Fear pulls money out of a declining market.

8-44
 Technical Analysis
Approach

 Looks into the past for trends or patterns

to give clues as to where investors might
be heading.
 Looks for prices where stocks get “stuck”
– known as support and resistance levels.

8-45
Fundamental Analysis

 Analyzing a firm’s financial condition

 Balance sheet: a financial statement
that indicates a firm’s sources of funds
and how it has invested its funds as of
a particular point in time
 Income statement: a financial
statement that measures a firm’s
revenues, expenses, and earnings
over a particular period of time
8-46
 The Price/Earnings
Approach

 The price/earnings ratio measures a

stock’s relative value.
 The P/E ratio = price per share/eps

 It indicates how much investors are willing

to pay for a dollar of the company’s
earnings.
8-47
 The Price/Earnings
Approach

 The more positive investors feel about a

stock, the higher the P/E ratio.
 A P/E ratio of 20 means it is “selling at 20
times earnings.”
 The higher the firm’s earnings growth rate,
the higher the P/E ratio.
 The higher the investor’s required rate of
return, the lower the P/E ratio.
8-48
 The Discounted Dividends
Valuation Model

 The value of any investment is the present

value of the returns received from the
investment.
 The value of a share of stock should be
the present value of the future dividends.

8-49
Stock Valuation Models:
The Basic Stock Valuation Equation

8-50
7-50
 Stock Valuation Models:
Constant Growth Model

 The constant dividend growth model

assumes that the stock will pay dividends
that grow at a constant rate each year—
year after year forever.

8-51
7-51
 The Discounted Dividends
Valuation Model

 What about a company that does not pay

dividends right now?
 Earnings eventually turn into dividends.

 As a company earns more, the level of

future dividends grows larger, and the
price should rise.

8-52
 The Discounted Dividends
Valuation Model

To determine the value of common stock:

 Estimate the future dividends.
 Estimate the required rate of return.
 Discount the dividends back to present
values at the required rate of return.

8-53
 Numerical Measures That
Influence Investment
Decisions
 WHY CORPORATE EARNINGS ARE IMPORTANT
– Corporate earnings play a large part in the increase
or decrease in the price of a stock
– Earnings per share (EPS) are the corporation’s
after-tax earnings divided by the number of
outstanding shares of common stock. An increase
in earnings is generally a healthy sign.
– Price-earnings (P/E) ratio is the price per share
divided by the earnings per share.

8-54
 Numerical Measures That
Influence Investment Decisions

 OTHER FACTORS THAT INFLUENCE THE

PRICE OF A STOCK

o Dividend payout = Annual dividend amount

EPS
o Dividend yield = Annual dividend amount
Price per share

8-55
Numerical Measures That
Influence Investment Decisions

o Total return = Dividends + Capital gain

o Annualized holding period yield =

Total return___ X 1
Original investment N
N = Number of years investment is held

8-56
 Numeric Measures That
Influence Investment
Decisions
o Beta
 A measure of volatility compared to the S&P 500
Stock Index

o Book value per share

Assets-Liabilities
Shares Outstanding

8-57
 Numeric Measures That
Influence Investment
Decisions

o Market-to-Book Ratio

Market value per share

Book value per share

 A low market to book may indicate an undervalued stock

 A high market to book may indicate an overvalued stock

8-58
14-58
 Why Stocks Fluctuate in
Value

 Interest Rates and Stock Valuation – inverse

relationship between interest rates and the
value of a share of common stock.
 As interest rates rise, investors demand a
higher return.
 As required return rises, the present value of
future dividends declines.
 As inflation declines, interest rates drop.
8-59
 Why Stocks Fluctuate in
Value

 Risk and Stock Valuation – as the stock’s

risk increases, so does the investor’s
required rate of return.
 Investors demand additional return for
taking on additional risk.

8-60
 Why Stocks Fluctuate in
Value

 Earnings Growth and Stock Valuation – as

earnings grow, so does the firm’s ability to
pay dividends.
 The more earnings a company has, the
more it can give out in dividends.
 Earnings growth is viewed as the cause of
any increase in dividends.
8-61
8-62
 Investment Strategies - Dollar
Cost Averaging

 Purchasing a fixed dollar amount of stock

at specified intervals.
 Same dollar amount each period will
average out the fluctuations.
 Buy more shares at a lower price, fewer
shares at higher prices.

8-63
 Investment Strategies - Buy and
Hold
 Involves buying stock and holding it for a
period of years.
 Why consider this?
 Avoids timing the market.
 Minimizes brokerage fees and transaction
costs.
.

8-64
 Investment Strategies - Dividend
Reinvestment
Plans (DRIPs)
 Automatically reinvest the dividends in the
firm’s stock without brokerage fees.
 Use a DRIP to reinvest rather than spend your
dividends.

8-65
 Risks Associated with
Common Stocks

The Risk-Return Trade-off

 Without the risks, we would not expect the
high returns that common stocks offer.
 A great deal of potential risk if the firm
does poorly, a great deal of reward if it
does well.

8-66
 Risks Associated with
Common Stocks

Diversification Reduces Risk

 In a well-diversified portfolio, only
systematic risk remains.
 As a portfolio increases to 10-20 stocks,
60% of total risk is eliminated.
 Measure systematic risk using (β)eta.

8-67
 Principles Associated
with Common Stocks

Diversification Reduces Risk

 βeta for the market = 1

 βeta > 1 means the stock has above
average systematic risk.
 βeta < 1 means the stock has below
average systematic risk.
 Most βetas are positive because they
move with the market. 8-68
 Principles Associated
with Common Stocks
The Time Dimension of Investing
 One year returns are quite variable,
making short-term investments risky.
 As investment horizons increase, invest in
riskier assets.
 In the long-term, you’ll do better with
stocks rather than other investments.
 Investors can take more long-term risks
because they have more time to adjust
their consumption and work habits. 8-69
 Principles Associated
with Common Stocks
The Time Dimension of Investing
.

8-70
Stock Quotations

 Price quotations readily available from

the Internet, stock brokers or financial
newspapers
 Provide information about the price of
each stock over the previous day or a
recent period

8-71
 Stock Quotations (cont’d)

Bid Price - $49.95 (broker buy price)

Ask Price- $50.05 (broker sell price)
The spread is the difference between the asking price
and the bid price = 10 cents.

8-72
Securities Markets

 A place where you buy and sell

securities.
 Includes stocks and bonds.

 Securities are issued by corporations

to raise money.
 After the initial issue, securities are
traded among investors.

8-73
 Primary Markets

 Place where new securities are traded.

 2 types of primary market offerings:
 Initial public offering (IPO) - the first time a
company’s stock is traded publicly.
 Seasoned new issues - stock offerings by
companies that already have stock trading
in the marketplace.

8-74
 Primary Markets

 Primary market activities require the help of an

investment banker to serve as the underwriter.
 The underwriter is a middleman who buys the
entire issue from the company, then resells it to
the public.

 The managing investment banker will form a

syndicate of other investment banking
companies to underwrite the security.
8-75
 Primary Markets

 Tombstone ads are placed in newspapers

to announce the offering and provide
details.
 A prospectus describes the issue and the
issuing company’s financial prospects.

8-76
 Secondary Markets - Stocks

 Previously-issued securities trade in the

secondary markets.
 Secondary markets can be either:
 Organized exchange – a physical location
where stocks trade.
 Over-the-counter market – transactions
conducted over phone or computer.

8-77
 Secondary Markets - Stocks

 There are 9 organized Regional Exchanges:

exchanges in the U.S. • Pacific Stock Exchange
• Chicago Stock Exchange
• Philadelphia Stock
National Exchanges: Exchange
• New York Stock Exchange( NYSE) • Cincinnati Stock Exchange
• American Stock Exchange (AMEX) • Intermountain Stock
Exchange
• Spokane Stock Exchange
• Boston Stock Exchange

8-78
 Bursa Malaysia Index Series
Benchmark Indices
 Bursa Malaysia EMAS Index (FBMEMAS) - constituents of the FTSE Bursa Malaysia Top
100 Index and FTSE Bursa Malaysia Small Cap Index.
 Bursa Malaysia EMAS Industry Indices - 10 Industries, 19 Supersectors and 39 Sectors.
 Bursa Malaysia Small Cap Index - top 98% of the Bursa Malaysia Main Market excluding
FTSE Bursa Malaysia Top 100 Index constituents.
 Bursa Malaysia EMAS Shariah Index - Shariah-compliant constituents of the FBMEMAS
that meet the screening requirement of the SAC.
 Bursa Malaysia Small Cap Shariah Index - Shariah-compliant small cap constituents of the
FBMEMAS that meet the screening requirement of the SAC.
 Bursa Malaysia ACE Index - all eligible companies listed on the ACE Market.
 Bursa Malaysia Palm Oil Plantation Index - based on FBMEMAS and comprising
companies earning a substantial proportion of revenue from palm oil activities.
 Bursa Malaysia Fledgling Index - eligible constituents listed in the fledgling segment.
 4Good Bursa Malaysia Index - constituents are selected from the top 200 Malaysian stocks
in the FTSE Bursa Malaysia EMAS Index, screened in accordance with the transparent and
defined Environmental, Social and Governance (ESG) criteria.
2-79
 Bursa Malaysia Index Series
Other Indices
 Bursa Malaysia KLCI - 30 largest companies in FBMEMAS by full
market capitalisation.
 Bursa Malaysia Mid 70 Index - the next 70 companies in FBMEMAS.

 Bursa Malaysia Top 100 Index - sum of constituents in the above two
indices.
 Bursa Malaysia Hijrah Shariah Index - 30 largest Shariah-compliant
companies in FBMEMAS screened by Yasaar Ltd and the Securities
Commission's Shariah Advisory Council (SAC).
 Bursa Malaysia Asian Palm Oil Plantation Index - (MYR and USD
versions) - companies earning a substantial proportion of revenue
from palm oil activities in the Asia Pacific Region.

2-80
 Cash Versus Margin
Accounts

Cash Accounts Margin Accounts

 Investor pays in full.  Investors borrow a
 Payment due in 3 portion of the purchase
business days. price.
 Initial margin is 50%.
 Maintenance margin is
the minimum you must
maintain.

8-81
 Margin Account
Initial Margin = Initial market value of shares – Amount of Loan from Broker
Initial market value shares

Actual Margin = Current market value of shares – Amount of Loan from Broker
Current market value shares
The minimum value of the AM that is permitted by the broker is called the
Maintenance Margin (MM).

8-82
 Margin Account
Let's say you purchase $20,000 worth of securities by borrowing $10,000 from your
brokerage and paying $10,000 yourself (50% initial margin). Once the margin
account is opened and operational, you can borrow up to 50% of the purchase price
of a stock. Pay $10,000 and Borrow $10000 from broker

If the market value of the securities drops to $15,000, the equity in your account
falls to $5,000 ($10,000-$5,000 = $5,000). Assuming a maintenance requirement of
25% of Market Price, you must have $3,750 in equity in your account (25% of
$15,000 = $3,750). Actual Margin = 15,000-10,000/15,000= 0.333 > Maintenance
Margin of 0.25.
Thus, you're fine in this situation as the $5,000 worth of equity in your account is
greater than the maintenance margin of $3,750. But let's assume the maintenance
requirement of your brokerage is 40% instead of 25%. In this case, your equity of
$5,000 is less than the maintenance margin of $6,000 (40% of $15,000 = $6,000).
8-83
As a result, the brokerage may issue you a margin call of$1,000.
Purchasing and Selling
Stocks
 Selecting a broker
 Analyst recommendations
• May be overly optimistic
• Must disclose ownership of stocks they
recommend

 Individual broker skills

• Information available on the Internet

8-84
 Purchasing or Selling Stocks
(cont’d)
 Brokerage commissions
• Discount brokerage firm: a brokerage firm
that executes your desired transactions but
does not offer investment advice
• Full-service brokerage firm: a brokerage firm
that offers investment advice and executes
transactions

8-85
 Purchasing and Selling
Stocks (cont’d)
 Placing an order
 Name of the stock
 Ticker symbol: the abbreviated term that is used to identify a stock for
trading purposes
Symbol Open High Low Last Chg %Chg Vol ('00)

SUMATEC 0.255 0.265 0.245 0.250 0.000 0.00 2,365,544

 Buy or Sell—specify what you want to do

 Number of shares
• Round lot: shares bought or sold in
multiples of 100
• Odd lot: less than 100 shares of stock 8-86
 Purchasing and Selling
Stocks (cont’d)
 Market order or limit order
• Market order: an order to buy or sell a stock at its
prevailing market price
• Limit order: an order to buy or sell a stock only if the
price is within the limits that you specify
 Day orders: expire at the end of a trading day
during which they were made, if they were not
filled
 Stop orders
Stop order: an order to execute a transaction when the
stock price reaches a specified level; a special
8-87form of
 Purchasing and Selling
Stocks (cont’d)
 Stop orders
• Buy stop order: an order for a brokerage firm
to buy a stock when the price rises to a
specified level
• Sell stop order: an order for a brokerage firm
to sell a stock when the price falls to a specified
level

 Placing on order online

 Low commission 8-88
 Purchasing and Selling
Stocks (cont’d)

 Buying stock on margin

 On margin: purchasing a stock with a portion
of the funds borrowed from a brokerage firm
 Federal Reserve limits margin to 50 percent
 Margin call: a request from a brokerage
firm for the investor to increase the cash
in the account in order to bring the margin
back up to the minimum level
8-89
 Purchasing and Selling
Stocks (cont’d)
 Short selling stock
 Short selling (shorting): a process by which
investors sell a stock that they do not own
 Borrow stock from another investor and will
have to return it

8-90
End of Lecture
 FIN205 – Wealth Management

Topic 9- Investing in Bonds

 Learning Objectives

 Invest in the bond market.

 Understand basic bond terminology and compare the
various types of bonds.
 Calculate the value of a bond and understand the
factors that cause bond values to change.

9-2
 What Is a Bond?

 A bond is simply a loan. It is a marketable IOU.

 Bond parties
 The issuer who is borrowing money
 The investor who lends the money
 The loan
 Specifies interest payments
 Has a maturity, such as 20 years
 The bond certificate
 Is your evidence of ownership
 Is easily traded in the bond market 9-3
 Your Rights as a Bondholder

 Bondholders are creditors. They have rights comparable to

the rights of other creditors.
 A bond indenture is the contract between the issuer and
the bondholders that spells out the rights of the
bondholders.
 It is similar to a loan agreement that you sign when you
borrow money.
 Protective covenants are restrictions on the issuer. These
are included in the indenture and they are intended to
strengthen the bondholders’ position.

9-4
 Basic Bond Terminology
and Features

 Par value – the face value or amount returned

at maturity.
 Usually $1000 for corporate bonds.
 Bonds selling at 99½% are selling for $995.

 Coupon Interest Rate – the percentage of par

value that will be paid out annually in the form
of interest.
 8½% coupon pays $85 annually.
9-5
 Payment Characteristics
of Bonds

 Semiannual interest payments:

 Most bonds have a fixed rate of return, which are the
interest payments that are made every 6 months.
 The amount of the payment is determined by multiplying
the bond’s coupon rate by the face value of $1,000.
 Example: An 8% bond pays $80 in interest per year
(0.08 × $1,000) divided into two payments of $40
semiannually.

9-6
 Zero Coupon Bonds

 Zero coupon bonds do not pay interest during

the life of the bond.
 Interest is earned by paying less than the face
value of $1,000 to buy the bond.
 Example: you pay $500 today to buy a bond
that will be redeemed in eights years for $1,000
 A savings bond is an example of a zero coupon
bond. You buy it for $50 and it is redeemed for
$100 in the future. 9-7
 Retirement Methods

 Redeemed at maturity
 Earlier redemption due to a “call”
 Interest rates have declined and the issuer
wants to refinance. They call the existing bonds
and issue new bonds at a lower interest rate.
This is similar to refinancing a home mortgage.
 Sinking funds involve a plan to retire a portion
of the outstanding bonds each year rather than
retiring all of the bonds at the maturity date.
 Convertible bonds can be converted into
common stock. 9-8
 Investing in Corporate Bonds

 Trading costs can be high

 Commission cost
 The bid-ask spread

 Callable bonds are bonds that can be called prior

to maturity.
 No interest is paid after the call date
 Mutual funds may be the best way for individual
investors to invest in bonds.
9-9
 Government-Issued Bonds

 U.S. Treasury Securities

 U.S. Agency Bonds
 Conventional
 Mortgage-backed

 Municipal Bonds
 General obligation (GO) bonds
 Revenue bonds

9-10
 Why Consider Bonds?

 Bonds reduce risk through diversification.

 Bonds produce steady income.

 Bonds can be a safe investment if held to

maturity.

9-11
 Basic Bond Terminology
and Features

 Indenture – a legal document that provides

specific terms of the loan agreement.

 It includes:
 A description of the bond.
 The rights of bondholders.
 The rights of the issuing firm.
 The responsibilities of the bond trustees.
9-12
 Basic Bond Terminology
and Features

 Call Provision – entitles issuer to repurchase

(“call”) back the bonds at stated prices.
 If interest rates decline, the issuer will call the
bonds and replace with lower-cost debt.
 Sinking Fund – issuer sets aside money on a
regular basis to pay off bonds at maturity.

 Firm calls or repurchases in the open market.

9-13
 U.S. Treasury Bonds

 The characteristics are the same as corporate

bonds:
 Face value of $1,000
 A maturity date such as 10 years
 Semiannual coupon payments

 Investors can buy these directly from the

Federal Reserve Bank
 Free of default risk

 May be subject to price risk but the degree

depends on the time to maturity 9-14
 Treasury Bonds/Notes
Quotation Example
A typical quote has five headings for each note
and bond:
ISSUE BID ASK CHANGE YIELD
6 1/2 8/15/25-N 105.08 12 +3 5.57

Figures under the "issue" heading identify the specific security by the interest rate
established by the Treasury when the security was first sold (in this case, 6 1/2
percent) and the maturity date (Aug. 15, 2025). The "N" indicates that the issue is
a note—an issue with an initial maturity of two to 10 years. (Treasury coupon
securities with initial maturities in excess of 10 years are called bonds.) In the
market, this note is referred to as "the 6 1/2s of August 2025.

9-15
 Treasury Bonds Quotation
Example
A typical quote has five headings for each note
and bond:
ISSUE BID ASK CHANGE YIELD
6 1/2 8/15/25-N 105.08 12 +3 5.57

Note and bond prices are quoted in dollars and fractions of a dollar. By market
convention, the normal fraction used for Treasury security prices is 1/32. In the
report, the decimal point separates the full dollar portion of the price from the 32nds
of a dollar, which are to the right of the decimal. Thus the bid quote of 105.08 means
$105 plus 8/32 of a dollar, or $105.25, for each $100 face value of the note.

The number "12" under "ask" further abbreviates the presentation of the price sought
by a seller. It shows only the 32nds of a dollar; the full dollar portion of the price
carries over from the bid price. In the example above, it stands for 105—the whole
dollar amount of the bid price—and 12/32, or $105.375 per $100 face 9-16 value
 Corporate Bonds

 Corporate bonds - allow firms to borrow

money, are a major source of funding.
 Denominations in $1000.
 Secured bond – backed by collateral.
 Unsecured bond – a debenture.
 Hierarchy of bonds – subordinated
debentures are low on the list.

9-17
 Treasury and Agency Bonds

 U.S. government is the largest issuer of

debt.
 Government spends more than it takes in.

 To finance an unbalanced budget, it can:

 Sell assets.
 Raise taxes.
 Borrow more money.

9-18
 Treasury and Agency Bonds

 Viewed as risk-free - given the

government’s ability to tax and print
money.

 With no default risk and no call risk, they

pay a lower interest rate.
 Most government interest payments are
exempt from state and local taxes.
9-19
 Treasury and Agency Bonds

 Treasury-issued debt has maturities

from 3 months to 10 years.

 Until 2001, 30-year bonds were issued.

 70% of the debt has maturities of 5 years
or less.
 Government issues include bills, notes,
and bonds.
9-20
 Treasury and Agency Bonds

Government Debt Maturity When Issued

 Treasury Bills  3, 6, or 12 months
 Treasury Notes  2, 3, 5, or 10 years
 Treasury Bonds  Over 10 years

9-21
Municipal Bonds

 Munis are issued by states, counties,

cities, and other public agencies.
 Over $1 trillion in outstanding value.
 Tax exempt from federal government
and by state (as long as you live
where the bonds were issued).
 Capital gains, from selling early, are
taxed.
9-22
 Special Situation Bonds

 Zero Coupon Bonds – no interest payments.

 Sold at a discount, returns par value at
maturity.
 Acts like a savings bond, appeals to those
wanting a lump sum payment in the future
without concerns of reinvesting interest.
 Although interest is not received annually, the
investor is taxed on interest income.
 Federal government issues STRIPS.

9-23
Special Situation Bonds
 Junk Bonds - low-rated bonds or high-
yield bonds.
 Have ratings of BB or below.
 Major issuers of junk bonds are new
firms that have not yet established a
performance record.
 With a greater risk of default, they
have interest rates 3-5% above AAA
long-term bonds.
 Most are callable.
9-24
Reading Corporate Bond
Quotes in the Wall Street
Journal

 Selling price is quoted as a percent of

par.
 Price listed at 101 -- 101% x $1000 =
$1010.
 Include accrued interest.
 Invoice price is the sum of the quoted
price and accrued interest.
9-25
Corporate bond quotations

 Coupon rate
 Maturity
 Current yield
 Volume
 Closing price
 Net change in the price from the
previous day

9-26
 Reading Treasury Quotes in
the Wall Street Journal

 Treasury and agency securities trade in

thirty two-seconds (1/32).
 Price listed as 102:31 = 102 31/32
 If par value is $10,000 then price is
$10,296.88. (10000x1.02 + 31/32X100)
 Paper lists both bid and ask prices.

9-27
9-28
 Evaluating Bonds

 Current Yield - refers to the ratio of interest

payment to the bond’s market price.
 Yield to Maturity – true yield received if
bond is held to maturity.
 Considers the annual interest payments as
well as the difference between the bond’s
current market price and maturity value.

9-29
 Evaluating Bonds

 Equivalent Taxable Yield on Municipal

Bonds:
 Appeal of munis is their tax-exempt
status.
 Make comparisons between munis
and taxable bonds.
 Calculation refers to tax bracket –
including federal, state, and local
taxes avoided by the muni.
 The higher the tax bracket, the more
attractive the muni. 9-30
 Expected Return from
Bonds
 Current yield (CY): annual interest divided by current price
 Example:
 Bond price (P) = $900
 Annual coupon interest (I) = $120
 The current yield calculation:
 CY = I/P = $120/$900 = 0.1333 or 13.3%
 The advantage of this calculation is that it is easy.
 The disadvantage is that ignores maturity.

9-31
 Yield to Maturity (YTM)

A yield to maturity is the return you would earn by buying a

bond today and holding it until it is redeemed by the issuer.
 Formula (approximation)

YTM = [ I + (1,000 – P)/N]/ [(P + 1,000)/2]

 Example: I = 120, P = 900, N = 5

YTM = [120+(1,000 – 900)/5]/ [(900 + 1,000)/2]

= [120 + 20]/ [950]
= 140/950 = 0.1474 or 14.74%

9-32
 Bond Valuation

 Bond owners receive interest payments for

a number of years, and then par value at
maturity.
 Value of a bond is the present value of the
interest payments plus the present value
of the repayment of par value at maturity.

9-33
 Bond Valuation

C = coupon payment
n = number of payments
i = interest rate, or required yield
M = value at maturity, or par value
9-34
 Bond Valuation

 The value of a bond should be

approximately the same as its price.
 The interest payments come in the form of
an annuity.
 The repayment of par comes in the form of
a single cash flow.

9-35
 Bond Valuation

 Uses time value of money

 Present value of the future coupon payments
 Present value of the principal payment

 Economic impact on bond values

 Higher rate of return is only realized if firms are
healthy enough to make payments
 This may not be true in unfavorable economic
conditions
9-36
 Bond Valuation
 What causes the required rate of return to
change?
 If the issuer becomes riskier, the required
rate of return should rise.
 A change in general interest rates,
increase in expected inflation, the required
rate of return should increase.
 When interest rates rise, the value of
outstanding bonds falls.
9-37
 Investing in Bonds

There are two ways to make money by investing

in bonds.
 The first is to hold those bonds until their
maturity date and collect interest payments on
them.
 The second way to profit from bonds is to sell
them at a price that's higher than what you pay
initially.

9-38
 Present Value of a Coupon
Bond
 A coupon bond’s present value (PV) has two
components:
 Present value of the coupon interest payments
 Present value of the future redemption value
(usually $1,000)
 But these payments are all in the future

 The future cash flows are discounted using the

bond’s yield to maturity (not the coupon rate) to
determine the present value of the bond.
9-39
 Present Value of a Coupon
Bond: An Example
 Data: YTM = 15%; coupon rate = 12%
($120 a Year); Redemption Value = $1,000;
5 Years to Maturity
 Using present value tables (appendix), find:
 PV of $1 for 15%, 5 Years = 0.4972
 PV of $1 Annuity for 15%, 5 years = 3.3522

 Present Value:
 = (0.4972 × $1,000) + (3.3522 × $120)
 = $497.20 + $402.26 = $899.46 9-40
Finding the Present Value
of a Bond

9-41
 Present Value of a Zero
Coupon Bond
 There is only one cash inflow with a zero
coupon bond – the future redemption value.
 To find the present value, use the present
value of $1 table in the appendix.
 Example: Find the PV of a zero coupon bond
that matures in 10 years with a YTM of 8%.
 PV of $1 = 0.463

 PV of the bond = 0.463 × $1,000 = $463

9-42
 Why Bonds Fluctuate in
Value
 Inverse relationship between interest rates
and bond values.
 When interest rates rise, investors demand
a higher return.
 Because of the fixed coupon rate, the price
must drop.
 Longer-term bonds fluctuate in price more
than shorter-term bonds.
9-43
 Why Bonds Fluctuate in
Value
 As a bond approaches maturity, the
market value approaches par value.
 When interest rates go down, bond prices
go up, but upward price movement on
bonds with a call provision is limited by the
call price.

9-44
 Risk from Investing in Bonds

 Default risk: risk that the borrower of funds

will not repay the creditors
 Risk premium: the extra yield required
by investors to compensate for the risk of
default
 Use of risk ratings to measure the default risk
• Ratings reflect likelihood that issuers will repay
their debt over time

9-45
 Risk from Investing in Bonds
(cont’d)
 Impact of the financial crisis on default risk
• Many firms experienced financial problems and
were unable to make bond payments
 Relationship of risk rating to risk premium
• The lower the risk rating, the higher the risk
premium offered on a bond

 Impact of economic conditions

• Higher risk of default when economic conditions
are weak
9-46
 Risk from Investing in Bonds
(cont’d)
 Call (prepayment) risk: the risk that
a callable bond will be redeemed by the
issuer
 Interest rate risk: the risk that a bond’s
price will decline in response to an increase
in interest rates
 Impact of a bond’s maturity on its interest
rate risk
• Bonds with longer terms more sensitive to interest
rate movements
9-47
 Risk from Investing in
Bonds(cont’d)
 Inflation risk- Inflation leads to higher
interest rates, which in turn leads to lower
bond prices.
 Market risk The risk that the bond market
as a whole would decline, bringing the
value of individual securities down with it
regardless of their fundamental
characteristics.
9-48
 Risk from Investing in
Bonds(cont’d)
 Selection risk The risk that an investor
chooses a security that underperforms the
market for reasons that cannot be
anticipated.
 Timing risk The risk that an investment
performs poorly after its purchase or better
after its sale.

9-49
 Risk from Investing in Bonds
(cont’d)
 Selecting an appropriate bond maturity
• Choose maturities that reflect your expectations
of future interest rates
• Consider investing in bonds that have a maturity
that matches the time you will need the funds

9-50
 Default Risk
 Default risk is the possibility that the issuer will
not make the interest payments and/or redeem
the bonds at maturity.
 This is not a problem with U.S. Treasury bonds
and most agency issues.
 It may be a problem with municipal bonds.
 It is a very serious problem with corporate
bonds.
 Investors can use credit-rating services such
as Moody’s to assess the default risk with
9-51
bonds.
 Interest Rate Risk

 Interest rate risk is the price volatility of a bond in

relationship to the changes in market rates of
interest.
 As interest rates increase, the YTM of a
previously-issued bond must also increase.
 As the YTM increases, the bond price decreases.
 If you own this bond, this results in a loss in your
investment.
 The flip side is true if interest rates fall. Then bond
prices increase and you have a gain on your
investment.
9-52
Price and Year to Maturity
Examples

9-53
 Bond Duration – A measure
of interest rate risk
Duration (measured in years) is used to measure how
sensitive a bond or a bond portfolio's price is to changes in
interest rates. The bigger the duration number, the greater
the interest-rate risk or reward for bond prices.

9-54
 Bond Ratings – A Measure
of Riskiness
 Moody’s and Standard & Poor’s provide ratings on
corporate and municipal bonds.
 Ratings involve a judgment about a bond’s future risk
potential.
 Default risk – ability to repay principal.
 Inability to meet interest obligations.
 The lower the rating, the higher the rate of return
demanded by investors.
 Safest bonds receive AAA, D is extremely risky.

9-55
BOND RATINGS

9-56
BOND RATINGS

9-57
 Investing in Bonds : Factors
to Consider
 What Are My Risk Profile and Target Return?
 What Are the Bonds’ Maturity Dates and Do the Terms
Meet My Investment Horizon?
 What Are the Risks?
 Can the Issuer Purchase the Bonds Back Before
Maturity?
 Are the Interest Payments Made at a Fixed or Floating
Rate?
 Can the Bond's Issuer Cover Its Debt Obligations?
 How Are the Bonds Secured?
9-58
Bond Investment Strategies

 Interest rate strategy: selecting bonds

for investment based on interest
rate expectations
 Purchase long-term bonds if you
expect interest rates to fall
 Passive strategy: investing in a
diversified portfolio of bonds that are
held for a long period of time
9-59
 Bond Investment Strategies
(cont’d)
 Maturity matching strategy: investing in
bonds that will generate payments to
match future expenses
 For example, parents might invest in a
bond that will mature at the right time to
pay for their child’s college education

9-60
 Bond Investment In
Malaysia
Retail bonds and sukuk may be issued and traded either on the
exchange (Bursa Malaysia) or over-the-counter (OTC) via appointed
banks.

Eligible issuers of bonds:

 the Malaysian Government and any company whose issuances are
guaranteed by the Malaysian Government;
 A public company listed on Bursa Malaysia (PLC);

 A licensed bank;

 Cagamas Berhad; and

 An unlisted public company whose bond and sukuk issuance is

guaranteed by Danajamin Nasional Berhad, Credit Guarantee and
Investment Facility or any of the eligible issuers above.
9-61
 OTC - Exchange Traded
Bonds and Sukuk (ETBS)
OTC - The traditional bond market has long been
dominated by sophisticated investors who can have
access to bonds at RM250,000 per odd lot, but even
then there is limited availability because standard lots
for corporate and government bonds are traded at
RM5 million and RM10 million, respectively
ETBS - Bonds that are traded on Bursa Malaysia are
usually traded in a minimum board lot size of 10 units
per lot. Given the principal price of RM100.00 per
unit, each board lot will cost RM1,000, excluding
9-62
transaction costs.
 Comparisons between Fixed Deposits,
Bond Funds and Individual Bonds

Fixed Deposits Bond Funds Individual Bonds

Initial Investment RM1,000 for most RM1,000 for most Minimum RM500,000
deposits funds for most bonds
Repayment of Principal Principal returned Principal at risk Principal returned at
at maturity maturity
Regular Income Usually fixed and Fluctuating income Usually fixed and paid at
paid at regular distributions regular intervals
intervals
Diversification To place fixed Diversified portfolio To purchase bonds from
deposits at multiple multiple suppliers to
banks to diversify diversify
Liquidity Inflexibility with Flexible Trade OTC
early redemption
fees
Maturity Date Fixed Maturity Date No Maturity Date Fixed Maturity Date

Management Investor Managed Professionally managed Investor Managed

9-63
How Bond Decisions
Fit within Your Financial Plan

 Key decisions about bonds for your

financial plan are:
 Should you consider buying bonds?
 What strategy should you use for
investing
in bonds?

9-64
End of Lecture
 FIN205 – Wealth Management

Topic 10- Investing in Mutual

funds
 Learning Objectives

 Weigh the advantages and disadvantages of

investing in mutual funds.
 Differentiate between types of mutual funds, ETFs,
and investment trusts.
 Classify mutual funds according to objectives.
 Select a mutual fund that is right for you.
 Calculate mutual fund returns.

10-2
 Mutual Funds

 A mutual fund is an investment company that

pools the funds of many individuals to invest in
stocks, bonds, and other investment securities.
 Investors buy shares in the mutual fund.
 The mutual fund buys: Shares in companies
and/or, bonds of companies, municipalities,
governments and/or, other investment securities
 A fund’s net asset value (NAV) is the total value of
all the assets the fund owns (minus any liabilities)
divided by the number of shares issued by the
fund. 10-3
Mutual Funds

10-4
Example: Fund X’s NAV

10-5
 Mutual Funds

 Pool investors’ money, investing in stocks,

bonds, and various short-term securities.
 Professional managers tend to the
investments.
 Allow investors to diversify, even with a
small investment.

10-6
 Why Invest in Mutual Funds?

 Advantages of mutual funds:

 Professional management
• Access to the best research to evaluate
investment alternatives.
 Minimal transaction costs
• Low commissions because of volume, which
may translate into higher returns.
 Liquidity
• Easy to buy and sell on phone or online.
10-7
 Why Invest in Mutual Funds?

 Advantages of mutual funds:

 Flexibility – over 8,000 funds to choose from,

covering many objectives and risk levels.

 Service – provide bookkeeping, checking

accounts, automatic additions or withdrawals.

 Avoidance of bad brokers – avoid potentially

bad advice, high sales commissions, and
10-8
churning.
 Why Invest in Mutual Funds?

 Disadvantages of mutual funds:

 Lower than market performance – mutual funds

underperform the market on average.

 Costs – sales fee or load can be as high as 8.5%

in addition to annual expense ratio at 3%.

 Risks – not all mutual funds are safe; specialized

funds may lack diversification outside a specific
10-9
industry.
 Why Invest in Mutual Funds?

 Disadvantages of mutual funds:

 Systematic risk - mutual funds do not diversify

away systematic risk. Even mutual funds will
suffer in a crash.

 Taxes – mutual funds trade frequently, so

investors may pay taxes on capital gains.
You cannot defer taxes.
10-10
 Mutual Fund-Amentals

 A mutual fund pools money from

investors with similar financial goals.
 You are investing in a diversified
portfolio that’s professionally managed
according to set goals.
 Investment objectives are clearly
stated.
10-11
 Mutual Fund-Amentals

 Make money 3 ways in a mutual fund:

 As the value of the securities in the fund
increases, the value of each mutual fund share
also rises.
 Most pay dividends or interest to shareholders.
 Shareholders receive a capital gains
distribution when the fund sells a security for
more than originally paid.
10-12
 Mutual Fund-Amentals

 Organization of a mutual fund:

 Fund is set up as a corporation or trust, owned
by shareholders.
 Shareholders elect a board of directors.
 Fund is run by a management company.
 Each individual fund hires an investment
advisor to oversee the fund.
 Contracts with a custodian, a transfer agent,
and an underwriter.
10-13
 Investment Companies

 A firm that invests the pooled money of

a number of investors in return for
a fee.
 Types of investment companies:
 Open-End Investment Companies
 Closed-End Investment Companies
 Unit Investment Trusts
 Real Estate Investment Trusts
10-14
 Open-End Investment
Companies
 These mutual funds are the most popular
form of investment companies.
 Open-end means the investment company
can issue an unlimited number of ownership
shares.
 Shares do not trade in the secondary market,
must buy or sell through the fund.
 Price based on net asset value (NAV).
 Not Managed. Once it is established, it is left
virtually unchanged. 10-15
 Open-End Funds

 They advertise extensively to attract investors.

 You can deal directly with the fund or through a
salesperson to buy and sell shares.
 Completing an application form is easy.

 Shares are purchased/sold at NAV (plus load,

if applicable).
 You can use many fund services.

10-16
 Closed-End Investment Companies

 Has a fixed number of shares, cannot issue

new shares.
 Shares sold initially by investment
company, afterwards they trade like a
common stock.
 Price based on demand, not NAV.

 They are actively managed

10-17
 Closed-End Funds

 These fund shares trade in the securities markets.

 You trade shares as you would the shares of any
company.
 While you do pay a broker’s commission, there are no
loads.
 Shares can trade at premiums or discounts to NAV.
 Discounts can be attractive because you are, in effect,
getting a bargain.
 If you buy the share at a discount, you, in effect, buy
$1.00 worth of securities for less than $1.00.

10-18
 Unit Investment Trusts

 A fixed pool of securities with each unit

representing a proportionate ownership in
the pool.
 They are not managed.

 Fund purchases a fixed amount of bonds or

shares holds them until maturity, then the
trust dissolves.

10-19
 Unit Investment Trusts
(UITs)
 Similar to an open-end fund
 Trust units (shares) are purchased from and
redeemed by the fund originator.
 Redemption is at current market value.

 Major difference
 A trust’s portfolio is unmanaged. Once it is
established, it is left virtually unchanged.
 This leads to very low operating costs.
 However, they have loads.

10-20
Creation of a UIT

10-21
 Mutual Fund vs Unit Trust

In Malaysia, the term Unit Trust and Mutual Fund is

used interchangeably. However the main
difference between the two is in their legal
structure.
 A mutual fund is an investment company that
issues redeemable shares
 A unit trust, because it is not a company, only
issue units. Unit investment trusts sell a fixed
number of units to unit holders, who receive a
proportionate share of net income from the 10-22
underlying trust.
 Management Fees &
Expenses
Fees can be broken down into two categories:
- Transaction fees paid when you buy or sell shares in a

fund (loads).
- Ongoing yearly fees to keep you invested in the fund

A load mutual fund charges a sales commission. They are sold through brokers,
financial advisors and financial planners.
 Class A – front-end sales load
 Class B – back-end load
 Class C – pay coming and going
The justification for a load fund is that investors are compensating a sales intermediary
(broker, financial planner, investment advisor, etc.) for his or her time and expertise in
selecting an appropriate fund.
10-23
A no-load fund doesn’t charge a commission.
 Load Versus No-Load Funds

 A load is a commission paid to buy or sell fund

shares.(called a “front-end” load) but some charge
a commission to sell (called a “back-end” load
 Loads range from 1% to over 9% of the NAV.
 No-load funds have no commission to buy
shares).
 The load pays the fund salesperson who should
provide investment advice for this fee.
 There is no evidence that load funds perform
better than no-load funds.
10-24
 Front End Load

 When you purchase shares in a load fund,

you pay a price in excess of the net asset
value, called the offering price.
 The difference between the offering price
and the net asset value is the load.
 Shares in no-load funds are sold at net asset
value.

10-25
 Front End Load

 For example, suppose a load fund has an

offering price of $100 and a net asset value of
$98. The front-end load is $2, which, as a
percentage of the $100 offering price is
$2/$100 = 2 percent.
 The way front-end loads are calculated
understates the load slightly. In our example
here, you are paying $100 for something only
worth $98, so the load is really $2/$98 = 2.04
percent. 10-26
 Management Fees and
Expenses
Fees can be broken down into two categories:
- Transaction fees paid when you buy or sell shares in a fund (loads).
- Ongoing yearly fees to keep you invested in the fund.

The ongoing expenses of a mutual fund is represented by the expense ratio.

This is sometimes also referred to as the management expense ratio (MER).
The expense ratio is composed of the following:
 The cost of hiring the fund manager(s) - Also known as the management
fee, this cost is between 0.5% and 1% of assets on average
 Administrative costs - These include necessities such as postage, record
keeping, customer service, cappuccino machines, etc.
 The last part of the ongoing fee (in the United States anyway) is known as
the 12B-1 fee. This expense goes toward paying brokerage commissions
10-27
and toward advertising and promoting the fund.
 Management Fees and
Expenses
 Invest in a fund with a low expense ratio
 Ratio compares funds expenses to total assets.
A mutual fund reported year-end total assets of $1,508 million and an expense
ratio of 0.90%. What total fees is the fund charging each year?
The fees are a percent of total assets. In this case, 0.90% x 1,508 million =
$13,572,000.
Example
A mutual fund charges a 5% upfront load plus reports an expense ratio of 1.34%.
If an investor plans on holding a fund for 30 years, what is the average annual
fee, as a percent, paid by the investor?
Load per annum - 5%/30 = 0.1667%
The expense ratio is an annual charge, so it remains 1.34%.
The total fees paid are 1.34% + 0.1667% = 1.5067%
 Look at the turnover rate - Measures the level of the fund’s
10-28
trading activity.
 Fund Turnover
 A turnover ratio is a simple number used to reflect the amount of a mutual
fund's portfolio that has changed within a given year. This figure is typically
between 0% and 100%. A turnover rate of 0% indicates the fund's holdings
have not changed at all in the previous year. A rate of 100% means the
fund has a completely new portfolio than it did 12 months ago
 It is calculated by taking the lesser of purchases or sales, dividing that
number by average monthly net assets. Securities with a maturity of less
than a year are not considered.
Example
XYZ fund purchased $100 million of stocks and $20 million of 6-month
Treasury bills. The fund also sold $120 million of equities and long-term
bonds during the year. The average amount of assets on a monthly basis
for the XYZ fund over the past year was $500 million. Thus, the turnover
ratio of the XYZ fund was 20% ($100 million divided by $500 million).
10-29
10-30
 Money Market Mutual Funds

 Invest in Treasury bills, CDs, and other

short-term investments, less than 30 days.
 Regarded as practically risk-free.

 Carry no loads, trade at a constant $1 NAV

(earns only interest), and have minimal
expenses.
 Tax-exempt money market fund invests only
in short-term municipal debt.
10-31
 Stock Mutual Funds

 Aggressive Growth Funds – maximize capital

appreciation while ignoring income. Have
wider price swings than other funds.
 Small-Company Growth Funds – similar to
aggressive growth funds but limited to
investments in small companies. Look to
uncover and invest in undiscovered
companies with unlimited growth potential.

10-32
 Stock Mutual Funds

 Growth and Income Funds – provide a

steady stream of income with the potential
for increasing value. Less risky, stable
dividends, less price movement.
 Sector Funds – specialized mutual fund
investing 65% of its assets in securities
from a specific industry. Less risky than an
individual stock, but more risky than a
traditional mutual fund.
10-33
 Stock Mutual Funds

 Index Funds – try to track a market index,

such as the S&P 500, by buying stocks in
that index. Provide diversification at a low
cost.
 International Funds – concentrate on
securities from other countries, may have
political and currency risks.

10-34
 Balanced Mutual Funds

 Hold both common stock and bonds.

 Objective is to earn steady income and
some capital gains.
 Aimed at those needing income to live on
and moderate stability in their investment.
 Ratio of stocks to bonds varies.

10-35
 Asset Allocation Funds

 Similar to a balanced fund, invest in stocks,

bonds, and money market securities.
 Differ in that they move money between
stocks and bonds to outperform the market.
 It is a balanced fund practicing market
timing.

10-36
 Life Cycle and Target
Retirement Funds
 Life cycle is the newest type of funds. An asset
allocation fund that tailors holdings to
investor’s characteristics, such as age and risk
tolerance.
 Target retirement funds are managed based
on when you plan to retire.

10-37
 Bond Funds

Bond Funds Individual Bonds

 $1000 investment buys a  Save mutual fund
diversified portfolio. expenses
 More liquidity  Bond funds do not mature,
 Professional management individual bonds do
 Have automatic
reinvestment

10-38
Bond Funds

Bond funds can be differentiated by the type of

bond and by maturity.

Type of Bond Maturity

• U.S. Government • Short-term
• Municipal • Intermediate-term
• Corporate • Long-term

10-39
 Bond Funds
U.S. Government Bond Funds
or GNMA (Government National
Mortgage Association) Funds

U.S. Treasury Bond Funds GNMA Funds

 Specialize in Treasury  Specialize in mortgage-backed
securities. securities.
 No default risk, but will  Carry interest rate risk
fluctuate with changes in and prepayment risk.
interest rates.

10-40
Mortgage Backed Security

 mortgage-backed
securities.

10-41
 Bond Funds

 Municipal Bond Funds – interest is generally

tax-exempt from federal taxes.
 Aimed at those looking to avoid taxes.
 Corporate Bond Funds – invest in various
types of corporate bonds, including high quality
and junk bonds.
 As interest rates rise, NAV goes down.

10-42
 Bond Funds

 Bond funds and their maturities:

 Short-term – 1-5 years in maturity
 Intermediate-term – 5-10 years in maturity
 Long-term – 10-30 years in maturity

 As interest rates change, long-term bonds

fluctuate more than short-term.
10-43
 ETFs or Exchange Traded
Funds
 First issued in 1993, these are hybrids between
a mutual fund and an individual stock or bond.
 An ETF, or exchange traded fund, is a
marketable security that tracks an index, a
commodity, bonds, or a basket of assets like an
index fund.
 Unlike mutual funds, an ETF trades like a
common stock on a stock exchange. ETFs
experience price changes throughout the day as
they are bought and sold
10-44
 ETF

ETFs have two levels of trading activity – primary and secondary..

Only APs can create or redeem units of an ETF. When creation
takes place, an AP assembles the required portfolio of underlying
assets and turns that basket over to the fund in exchange for
newly created ETF shares (primary market), Similarly,
for redemptions, APs return ETF shares to the fund and receive
the basket consisting of the underlying portfolio. Each day, the
ETF’s can be bought/sold on the secondary market.
10-45
 ETF’s

 .ETFs typically have higher daily liquidity

and lower fees than mutual fund shares,
making them an attractive alternative for
individual investors.
 Because it trades like a stock, an ETF does
not have its net asset value (NAV) calculated
once at the end of every day like a mutual
fund does.

10-46
 ETFs or Exchange Traded
Funds
 Advantages of ETFs:
 Trade on an exchange and can be bought
and sold throughout the day.
 Can be sold short or bought on margin.
 Allow an instant position in a sector or
country.
 Low annual expenses.
 More tax efficient than mutual funds.

10-47
 ETFs or Exchange Traded
Funds
 Disadvantages of ETFs:
 Pay a commission because they trade
like stocks.
 Don’t necessarily trade at NAV.
 Bid-ask spread because buying from
another investor.
 Expensive for those who trade often,
incur brokerage costs.

10-48
Buying a Mutual Fund

Step 1: Determining Your Goals

 Buying a mutual fund involves
determining your investment goals
and time horizon.
 Understand why you are investing:
 To receive additional income
 Supplement your retirement income
 Save for a child’s education

10-49
Buying a Mutual Fund

Step 2: Meeting Your Objectives

 Identify the fund’s objectives by
looking at objective classifications.
 Don’t assume the fund’s name reflects
the strategy or objectives.
 Morningstar provides an investment
style box to understand the
investment style.
10-50
 Buying a Mutual Fund
Step 2: Meeting Your Objectives
 Look in the prospectus for:
 Fund’s goals and investment strategy
 Fund manager’s past experience
 Any investment limitations the fund may have
 Tax considerations of importance to investors
 Redemption and investment process
 Services provided
 Performance over past 10 years
 Fund fees and expenses
 Fund’s annual turnover rate

10-51
Buying a Mutual Fund
Step 3: Evaluating the Fund
 Look closely at past performance and scrutinize
their costs.
 Past performance does not predict future
results, but it does give insight.
 Limit comparisons to funds with similar
objectives.
 Investigate how the fund did during upturns and
downturns.

10-52
Buying a Mutual Fund

Making the Purchase:

 Buy direct – use phone or internet.
 Buy through a mutual fund supermarket –
such as Fidelity or Schwab.

10-53
 Important Mutual Fund
Services
 Reinvestment plans: Can reinvest dividends and
capital gains
 Transactions by telephone and Internet

 Fund switching within a fund family

 Can sell shares of one fund and reinvest in
shares of another fund within the fund family
 Be careful of loads though

10-54
Quotations of Mutual Funds

 Quotations available from financial

publications
 Open-end funds
• Column 1—Investment company in bold
type with funds listed beneath
• Column 2—NAV
• Column 3—Net change in NAV
• Column 4—Return year to date

10-55
Quotations of Mutual Funds
(cont’d)

10-56
 Selecting a Mutual Fund
 Evaluate performance.
 Review the fund’s current portfolio.

 Examine expenses and portfolio turnover.

 Review evaluations in popular magazines and

newspapers.
 Consult a professional evaluation service such
as Morningstar or Lipper Analytical Services.

10-57
 Performance
Measurements

 Growth of $10,000 over time

 Example: A cumulative total return of 173.8% means
that the $10,000 invested 10 years ago has earned
$17,380 and the investment is now worth $27,380
 Assumes that all dividends are reinvested as they are
earned each quarter
 Average Annual Total Return (AATR)
 Expresses the cumulative return as a yearly average
 [(Ending Value/Beginning Value)^1/n] -1
 (27,380/10,000)1/10 - 1 = 10.59%
10-58
The Reinvestment
Assumption

10-59
 Risk-Adjusted Rate of Return
(RAROR)
 Adjusts a fund’s AATR by its beta value and
compares this adjusted return to the overall
market return
 RAROR = (AATR/Beta) – S&P 500 Return

 Example: AATR = 10.59%; Beta = 0.94; S&P

500 Return = 11.07%
 RAROR = (10.59%/0.94) – 11.27%
= 11.27% – 11.07% = + 0.20%
This fund outperformed the S&P 500 return.
10-60
 Interpreting RAROR

 A positive RAROR indicates good fund

management.
 A negative RAROR indicates poor fund
management.
 It is important to have positive RAROR
consistently over time – do not rely too heavily
on one year’s number.

10-61
 Treynor Ratio

The Treynor ratio is calculated as:

(Average Return of the Portfolio - Average Return of the Risk-

Free Rate) / Beta of the Portfolio

The Treynor ratio named after Jack L. Treynor (sometimes called the
reward-to-volatility ratio), is a measurement of the returns earned in
excess of that which could have been earned on an investment that has
no diversifiable risk (e.g., Treasury bills or a completely diversified
portfolio), per each unit of market risk assumed.
The higher the Treynor ratio, the better the performance of the portfolio
under analysis.
10-62
 Sharpe Ratio

 Sharpe ratio = (Mean portfolio return − Risk-

free rate)/Standard deviation of portfolio return.
 The Sharpe ratio has become the most widely used method for
calculating risk-adjusted return; however, it can be inaccurate when
applied to portfolios or assets that do not have a normal distribution of
expected returns.
 Generally, the greater the value of the Sharpe ratio, the more attractive
the risk-adjusted return

10-63
 Other Evaluation Items

 Review the fund’s current portfolio

 Is there adequate diversification?
 Review the fund’s operating expenses
 Usually expressed as a percent of net assets
 Low expense ratios are desirable
 Compare to other funds with similar investment
objectives
 Examine the portfolio turnover percent
 Turnover percent measures the trading frequency
 High numbers = high trading

10-64
 Conclusion

 Mutual funds are used to diversify our

investments, thus reducing risk.
 Unit investment trusts (UITs) offer an
alternative to mutual funds and a different
set of advantages.
.

10-65
End of Lecture
 FIN205 – Wealth Management

Topic 11- Investing in Real Estate

& Other Alternatives
Learning Objectives

 Identify types of real estate investments.

 Evaluate the advantages of real estate

investments.

 Asses the disadvantages of real estate

investments.

 Analyze the risks and rewards of investing in

precious metals, gems, and collectibles.

11-2
 Investing in Real Estate

DIRECT REAL ESTATE INVESTMENTS

Your Home As An Investment
 A place to live
 A major asset of most households

 As the investor, you hold legal title to the property

 Passive income - Income from a business or trade in which

you do not materially participate

 Possible hedge against inflation. Be aware of possible real

estate “bubbles”
11-3
 Investing in Real Estate - Tax

o Rental income from the renting of residential properties is

subject to income tax in Malaysia and Real Property Gains
Tax when sold. You can claim some of your costs for the
upkeep and renting of the property as income deductions.
These deductions are:
o Assessment and quit rent
o Interest on loan
o Fire insurance premium
o Expense on rent collection
o Expense on rent renewal
11-4
o Expense on repair
 Investing in Real Estate

Commercial Property

o Land and buildings that produce lease or rental

income

o Most common investment of this type is a duplex or

small apartment building. It also includes hotels,
office buildings, stores, and many other types of
commercial establishments

11-5
 Investing in Real Estate

Undeveloped Land

o Can be tremendous gains but this type of

investment poses enormous risks. All the money
is riding on a single parcel of land

o Most people buy land with the idea of subdividing

the land

11-6
 Investing in Real Estate
INDIRECT REAL ESTATE INVESTMENTS

Real Estate Syndicates or Limited Partnerships

o A syndicate is a temporary association of
individuals or firms organized to perform a specific
task that takes a large amount of capital. Can be
organized as a corporation, trust, or limited
partnership
o Syndicates provide professional management and
limited liability for its members as well as
diversification, if several properties are owned

11-7
 Investing in Real Estate
Real estate investment trusts (REIT)
o REITs are similar to a mutual fund or investment
company and trade shares on stock exchanges or
over the counter.
o Equity REITs own and operate income-producing
properties; 90% of REITs
o Mortgage REITs loan money or invest in
mortgages; 7% of REITs
o Hybrid REITS own both properties and mortgages

11-8
 Investing in Real Estate

 A REIT, or Real Estate Investment Trust, is a

company that owns or finances income-
producing real estate. Modeled after mutual
funds, REITs provide investors of all types
regular income streams, diversification and
long-term capital appreciation. REITs
typically pay out all of their taxable income
as dividends to shareholders.

11-9
 REIT’s in Malaysia
 Small starting capital
Most property investments require a significant amount of money to
start. Even with a 90% loan, a RM500,000 property would require at
least RM50,000 down payment plus extra for legal fees and stamp
duties. But to get started with MREITs, you just need to buy a
minimum of 100 shares on Bursa Malaysia.
 Get exposure to top shopping malls and commercial buildings

 Earn regular dividends

The frequency of dividend payout for REITs is quarterly or bi-

annually, making them an ideal investment for retirement income. To
make it even more attractive, the dividend payout for REITs tend to
be pretty high (4 to 8%) as they need to pay out at least 90% of their
11-10
net income to be eligible for tax treatment.
 REIT’s in Malaysia

 Ease of buying and selling MREITs

As MREITs are traded on the stock market, buying and selling them is
generally easier compared to physical properties.

 Minimal effort required

REITs hire professional management teams to manage the tenants and
upkeep of the properties

11-11
REIT’s in Malaysia

11-12
 REIT Benefits
REITs offer investors a number of benefits, including:
 Diversification: Over the long term, Equity REIT returns have
shown little correlation to the returns of the broader stock market.
 Dividends: Stock exchange-listed REITs have provided a
consistent income stream to investors.
 Liquidity: Stock exchange-listed REIT shares can be easily bought
and sold.
 Performance: Over most long-term horizons, stock exchange-listed
REIT returns outperformed the S&P 500, Dow Jones Industrials and
NASDAQ Composite.
 Transparency: Stock exchange-listed REITs operate under the
same rules as other public companies for securities regulatory and
financial reporting purposes.
11-13
 Advantages of
Real Estate Investments
 A POSSIBLE HEDGE AGAINST INFLATION
 EASY ENTRY as a limited partner, such as investing
$5,000 to own part of an apartment building
 LIMITED FINANCIAL LIABILITY— limited partners liability
is initial investment
 NO MANAGEMENT CONCERNS for limited partnerships,
REITs
 FINANCIAL LEVERAGE
Use of borrowed funds for investment purposes; allows
you to acquire a more expensive property than you could
buy on your own
11-14
 Disadvantages of
Real Estate Investments

 ILLIQUIDITY
 DECLINING PROPERTY VALUES
 LACK OF DIVERSIFICATION
 LACK OF A TAX SHELTER
 LONG DEPRECIATION PERIOD
 MANAGEMENT PROBLEMS—direct real estate

11-15
 Investing in Precious Metals,
Gems, and Collectibles

• A hedge against inflation

• A safe haven during political or economic upheaval
• Need a storage place

11-16
 Investing in Precious Metals,
Gems, and Collectibles
- Can be risky due to price variations
GOLD
– lower interest rates often result in higher gold
prices
– Bouillon includes bars and wafers
– Gold Bouillon Coins
– Gold Stocks
– Gold Certificates

11-17
 Investing in Precious Metals,
Gems, and Collectibles
SILVER, PLATINUM, PALLADIUM AND RHODIUM

 Silver prices have fluctuated from $24.25 an

ounce in 1932, to over $50 an ounce in early
1980, and then back to less than $24.00 an ounce
in April 2013.

 The last three are industrial catalysts and are

used mostly in automobile production

 Can be both a hedge against inflation and a safe

haven during political or economic upheaval

11-18
 Investing in Precious Metals,
Gems, and Collectibles
PRECIOUS STONES
 Precious stones like diamonds, sapphires,
rubies, and emeralds can be a hedge against
inflation
 Appeal to investors because of their small size,
ease of concealment, inflation hedge, and great
durability

11-19
Investing in Precious Metals,
Gems, and Collectibles
Risks include..
o Not easily turned into cash

o Difficult to know if you are getting a good stone

o De Beers Consolidated Mines of South Africa

controls 85% of the world’s supply of rough
diamonds

o Expect to buy at retail and sell at wholesale

11-20
 Investing in Precious Metals,
Gems, and Collectibles
COLLECTIBLES
 Includes rare coins, works of art, antiques,
stamps, rare books, sports memorabilia, rugs,
Chinese ceramics, paintings and other items
that appeal to collectors and investors
 Can be a good investment and a hobby, or a
financial disaster
 It’s “buyer beware.” Be careful of investment
scams and forgeries
 Know dealer’s reputation and be wary of
promises. Get a second opinion
 Use common sense & comparison shop 11-21
 Investing in Precious Metals,
Gems, and Collections
Collectibles on the Net

o Easier to compare items

o Easier to find items

o The number of collectibles websites is

growing very rapidly - eBay is the biggest
auction site

11-22
 Investing in Precious Metals,
Gems, and Collectibles
 DISADVANTAGES OF PURCHASING
COLLECTIBLES OVER THE INTERNET

 You can’t touch and feel the item and examine

it for flaws

 There may also be some security risk since you

don’t know who’s getting your cash or credit
card number

11-23
End of Lecture
 FIN205 – Wealth Management

Topic 12- Retirement Planning

 Learning Objectives

 Understand the changing nature of retirement planning.

 Set up a retirement plan.
 Contribute to a tax-favored retirement plan to help fund
your retirement.
 Choose how your retirement benefits are paid out to
you.
 Put together a retirement plan and effectively monitor it.

13-2
 Why Retirement Planning?

MISCONCEPTIONS ABOUT RETIREMENT PLANNING

–My expenses will decrease when I retire

–My retirement will only last 15 years

–Social Security & my company pension will pay for my

basic living expenses

13-3
 Why Retirement Planning?

– My pension benefits will increase to keep pace with

inflation

– My employers health insurance plan will cover my

medical expenses

– There’s plenty of time for me to start saving for

retirement

– Saving just a little bit won’t help

13-4
 Why Retirement Planning?

THE IMPORTANCE OF STARTING EARLY

To take advantage of the time value of money
 If from age 25 to 65 you invest $300 a month (@ a
9% return), then at age 65 you’ll
have a nest egg of $1.4 million
 Wait ten years until age 35 to start $300-a-month
investing and you’ll have about $550,000 at age 65
 Wait twenty years to begin investing $300-a-month at
age 45 and you’ll have only $201,000 at age 65

13-5
Sources of
Retirement Income

13-6
 Key retirement planning
decisions
1) Which retirement plan to pursue. If your
employer offers a retirement plan, it should be
the first plan you consider because your
employer will likely contribute to it.

13-7
 Key retirement planning
decisions
2) How much to contribute.
Some retirement plans give individuals the freedom to contribute
as much as they like up to a specified maximum level. While you
do not necessarily know how much money you will need at
retirement, you can calculate the amount of your savings based
on annual contributions.

Variables to consider when deciding how much to save are

whether you will be supporting anyone besides yourself at
retirement, your personal needs, the expected price level of
products at the time of your retirement, and the number of years
you will live in retirement. 13-8
 Key retirement planning
decisions
3) How to invest your contributions.
With a defined-contribution plan, you do not need to worry
about the tax consequences of your investment; all the
money you withdraw at retirement will be treated as ordinary
income for tax purposes. Most financial advisors suggest a
diversified set of investments. In general, stocks generate
higher long-term returns, but bonds provide some balance in
case stocks perform poorly. Your retirement plan should
consider the number of years to retirement. If you are far from
retirement, riskier investments that bring higher returns are in
order. As you get closer to retirement, your investment
choices should become more conservative. 13-9
 Employer-Sponsored
Retirement Plans
 Defined-benefit plans
 Specifies monthly benefit you will receive at retirement
 Defined-contribution plans
 Specifies amount you pay today
 Future benefits are uncertain
 Allows you to invest the funds as you wish

 Supplementary savings plans - Private Retirement Scheme

13-10
 Employer-Sponsored Retirement
Plans

 Designed to help you save for retirement

 Employees and/or employers contribute
 A penalty is imposed for early withdrawal
 Your contributions are tax-deferred, but
taxed as ordinary income when withdrawn
after retirement if you retire before 60.

13-11
 Employer-Sponsored Retirement
Plans

Pensions received by an individual are exempt

under the following conditions:
Retires at the age of 60 or at the compulsory
age of retirement under any written law; or
Retires due to ill health.

For an employee in the public sector who elects

for optional retirement, his pension will be taxed
until he attains the age of 60 13-12
 Employer-Sponsored
Retirement Plans (cont’d)

 Defined-benefit plan: an employee-sponsored

retirement plan that guarantees you a specific
amount of income when you retire based on
your salary and years of employment
 Vested: having a claim to a portion of the
money in an employer-sponsored retirement
account that has been reserved for you upon
your retirement even if you leave the company

13-13
 Defined-Benefit Plans

 You receive a promised or “defined”

payout at retirement.
 Usually non-contributory retirement plans,
where you do not need to pay into them.
 Payout is based on age at retirement,
salary level, and years of service.

13-14
 Defined-Benefit Plans

 Employer bears investment risk – you’re

guaranteed the same amount regardless of
how the stock or bond markets perform.
 Plans lack portability – cannot take the plan
with you when you leave.
 Not all are funded pension plans, with
unfunded plans paid out of firm’s earnings.

13-15
 KWAP (Kumpulan Wang
Persaraan Perbadanan)

 This is a government pension plan for civil

servant .
 It is a defined benefit retirement plan. Rate of
Contribution is 17.5% of the pensionable
employee's basic salaries.
 KWAP or the Retirement Fund (Incorporated) was
established on 1st March 2007 under the Retirement
Fund Act 2007(Act 662) replacing the repealed
Pensions Trust Fund Act 1991 (Act 454). 13-16
 Functions of KWAP

The functions of KWAP are as follows:

Management of contributions from the Federal
Government, Statutory Bodies, Local Authorities
and other Agencies;

Administration, management and investment of

the Fund in equity, fixed income securities, money
market instruments and other forms of investments
as permitted under the Retirement Fund Act 2007
(Act 662).​​ 13-17
Employer-Sponsored
Retirement Plans (cont’d)

 Defined-contribution plan: an
employer-sponsored retirement plan
that specifies guidelines under which
you and/or your employer can
contribute to your retirement account
and that allows you to invest the funds
as you wish

13-18
 Defined-Contribution Plan

 Your employer alone, or in conjunction

with you, contributes directly to an
individual account set aside for you.
 It is like a personal savings account but
your eventual payments are not
guaranteed.
 What you receive depends on how well
the account performs.

13-19
 Employee Provident Fund
(EPF/KWSP)
 The Employees Provident Fund Act 1991 (Act
452) provides retirement benefits for members
of the EPF through management of their
savings contributions.
 The EPF (also called the KWSP) is a social
security institution which administers their
members retirement fund using a defined
contribution plan

13-20
 Employee Provident Fund
(EPF/KWSP)
 EPF is different from a government pension
which is a defined benefit retirement plan.
 The main difference is that with the EPF, your
final payout is determined by the contributions
(from both you and your employer) and the
investment returns, and with a public pension
the final payout is fixed and your pension
becomes a liability to the Public Services
Department
13-21
 Employee Provident Fund
(EPF/KWSP)
Rate of Contribution to the EPF

For employees earning below RM5,000, the

portion of employee's contribution is 11% of their
monthly salary while the employer contributes
13%.
For employees who receive wages/salary
exceeding RM5,000 the employee's contribution
of 11% remains, while the employer's contribution
is 12%. 13-22
 Employee Provident Fund
(EPF/KWSP)
Dividend
Your contributions kept in the EPF will accumulate
and draw dividends every year. Thus, your
savings will increase from year to year until you
retire and withdraw all your savings. The EPF
act guarantees a minimum of 2.5% Dividend
annually.

13-23
 Income entitled to EPF
Contributions
 Salary
 Payment for unutilised annual or medical leave
 Bonus
 Allowance (except travelling allowance)
 Commision
 Incentive
 Arrears of wages
 Wages for maternity leave
 Wages for study leave
 Wages for half day leave
 Other payments under services contract or otherwise

13-24
 Employee Provident Fund
(EPF/KWSP)
Tax Incentive
Your share of contributions to the EPF is tax deductible up
to RM6,000 (inclusive of life insurance premiums).

In addition, the savings that you withdraw under the

various withdrawal schemes are also exempted from
income tax.

13-25
Private Retirement Scheme
(PRS)

PRS is a defined contribution pension

scheme which allows people (or their
employers) to voluntarily contribute
into an investment vehicle for the
purposes of building up their retirement
income.

13-26
 Private Retirement Scheme
(PRS)

 In a Malaysian retirement framework, it is to be

complemented with (and not a substitute for)
the mandatory contributions made by both
employee and employers to the EPF scheme.
 Having a voluntary scheme in addition to the
EPF also allows private company employees
and self-employed persons to voluntarily
contribute towards their retirement in a
systematic way.
13-27
 Similarities of PRS with the
EPF:

1. Retirement Purpose: Both the EPF and PRS

schemes are for building up a person's
retirement assets and income.
2. Tax Benefit: Tax relief is given for contributions
to both schemes (up to RM6,000 a year for
EPF, a seperate RM3,000 for PRS)

13-28
 PRS Providers

The PRS Providers are fund management firms which are approved by
the PRS administrators to manage the investment vehicles that
contributions get paid into.
The eight PRS Providers approved (as of 25th April 2013) are:

AmInvestment Management Sdn Bhd;

AIA Pension and Asset Management Sdn. Bhd

CIMB-Principal Asset Management Berhad

Affin Hwang Asset Management Berhad

Manulife Asset Management Services Berhad

Public Mutual Berhad

RHB Asset Management Berhad

Kenanga Investors Berhad

13-29
 Tax Benefits

 In the Malaysian Government's Budget

2012, there is a specified tax relief of up to
RM3,000 for 10 years beginning 2012 for
contributions to the PRS. This is similar to
the tax relief given to EPF contributions.
 A tax exemption is also given on all income
generated by the PRS Funds.

13-30
 PRS vs EPF
Feature Differences PRS EPF
Contribution Type Voluntary Mandatory

No statutory minimum or Statutory minimum (11%

Contribution Amount
maximum Employee, 12-13% Employer)

Contribution Frequency No statutory interval Statutory Monthly Contribution

Contribution Paid to Individual PRS Providers EPF Directly

Yearly Personal Tax Relief RM3,000 RM3,000

From Sub-Account B only, and Account 2 only, specific reasons

Partial Withdrawal
8% Tax Penalty no penalty

Freedom of Selection (among Freedom only on Partial Amount

Selection of Fund Investments
PRS Providers) (EPF-MIS)

No statutory minimum
Dividend Policy (depends on Fund Minimum 2.5% p.a.
performance)

13-31
 Your Retirement Planning
Decisions
 Which retirement plan should you pursue?
 An employer-sponsored plan is usually the best
choice if your employer contributes
 How much to contribute?
 As much as you can as early as you can!
 Social Security will not provide sufficient funds
 Increase contribution as salary increases

13-32
 Facing Retirement – The
Payout

 Your distribution or payout decision affects:

 How much you receive
 How it is taxed
 Whether you are protected against inflation
 Whether you might outlive your retirement
funds

13-33
An Annuity or Lifetime
Payments
 Single Life Annuity – receive a set
monthly payment for your entire life.
 Annuity for Life or a “Certain Period” –
receive payments for life. If you die
before the “certain period,” your
beneficiary receives payment until that
“certain period.”

13-34
An Annuity or Lifetime
Payments
 Joint and Survivor Annuity – provides
payments over the lives of you and
your spouse.
 Options:
 50% survivor benefit – pays 50% of
original annuity to surviving spouse.
 100% survivor benefit – continues to
benefit the surviving spouse at the
same level.
13-35
 Annuity

Advantages Disadvantages
 Receive benefits  No inflation protection.
regardless of how long  Not flexible in the case
you live. of an emergency.
 May pay medical  Difficult to leave money
benefits while payout is to heirs.
being received.

13-36
 A Lump-Sum Payment

 Receive benefits in one single payment.

 You must make the money last for your

lifetime, and for your beneficiaries after you
are gone.

 You can invest the money as you choose.

13-37
 Putting a Plan Together
and Monitoring It

 Most individuals will not have a single source

of retirement income.
 Investment strategy should reflect investment
time horizon.
 As retirement nears, switch to less risky
investments.
 Monitor before and after retirement.

13-38
Pay Now, Retire Later

Step 1: Set Goals

 Figure out what you want to do when you retire.

 How costly a lifestyle will you lead?
 Do you want to live like a king?
 Do you have costly medical conditions?
 Will you relocate or travel?

 Decide on the time frame for achieving your

goals.

13-39
 Pay Now, Retire Later

Step 2: Estimate How Much You Will Need

 Turn your goals into dollars by estimating how much
you will need.
 Begin with living expenses, calculate the cost to
support yourself, and don’t forget about paying
taxes.

13-40
 Pay Now, Retire Later

Step 3: Estimate Income at Retirement

Once you know how much you need, figure out how
much you’ll have.
Estimate Social Security benefits and determine what

your pension will pay.

13-41
 Pay Now, Retire Later

Step 4: Calculate the Inflation-Adjusted Shortfall

Compare the retirement income needed with the retirement
income you’ll have.

13-42
 Pay Now, Retire Later

Step 5: Calculate How Much You

Need to Cover This Shortfall

Know your annual shortfall.

Decide how much must be saved by retirement to
fund this shortfall.

13-43
 Pay Now, Retire Later

Step 6: Determine How Much You Must

Save Annually Between Now and
Retirement

 Put money away little by little, year by year.

 Cannot make up the shortcoming in all at once.

13-44
 Pay Now, Retire Later

What Plan Is Best For You?

 Many options are available.
 Most plans are tax-deferred, earnings go
untaxed until removed at retirement.
 Advantages of tax-deferred plans:
 Contribute more because they may be
untaxed.
 Earn money on money that would have gone
to the IRS.
13-45
 Estimating Your
Future Retirement Savings
Estimating the future value of one investment
 Example:
You consider investing $5,000 this year, and this
investment will remain in your account until 40
years from now when you retire. You believe that
you can earn a return of 6% per year on your
investment. Using FVIF, you expect the value of
your investment in 40 years to be:
13-46
 Estimating Your Future
Retirement Savings (cont’d)
Value in 40 years = Investment x FVIF (i = 6%, n = 40)
= $5,000 x 10.285
= $51,425

13-47
Estimating Your Future
Retirement Savings (cont’d)
 Estimating the future value of a set of
annual investments
 Relationship between size of annuity
and retirement savings
• If you invested $3,600 per year for 40
years, your return at 8%, you would have:
$5,000 x 259.06 = $1,295,300

13-48
Estimating Your Future
Retirement Savings (cont’d)
 Relationship between years of saving
and your retirement savings
• If you invested $5,000 for 30 years
instead of 40 years, your savings would
be only $395,000 (assuming a 6% annual
return)

13-49
 Possible Complications
Checklist
 Changes in inflation can have drastic effects on your
retirement.
 Once you retire, you may live for a long time.
 Monitor your progress and monitor your company.
 Don’t neglect insurance coverage.
 An investment planning program may make things easier.

13-50
 The seven steps involved in
retirement planning include:

1) Setting goals: This first step requires figuring

out just what you want to do when you retire.

2) Estimate how much you will need to meet

goals: This step helps you turn goals into
estimated dollar figures. A key step is to
determine basic retirement living expenses.

12-51
 The seven steps involved in
retirement planning include:

3) Estimate income available at retirement: This

step includes estimating Social Security benefits
and pension estimates from your employer.

4) Calculate the annual inflation-adjusted

shortfall: At this step, you compare your
retirement income with estimated living
expenses. A deficit would indicate the need for
additional savings.
12-52
 The seven steps involved in
retirement planning include:
5) Calculate the funds needed at retirement to
cover any shortfall: This step helps you determine
how much money you will need to come up with
each year to support yourself in retirement.
6) Determine how much you must save annually
between now and retirement: In step 5, you
determine how much you need to support yourself
in retirement. In this step, you determine how much
money you need to save each year to meet your
objective. 12-53
 The seven steps involved in
retirement planning include:
.
7) Put the plan in play and save: This is the
hardest step of all. Once a need has been
determined, it is essential that the developed
plan be put into effect.

12-54
 Case Study

Kevin and Whitney, both age 35, recently reviewed their future
retirement income and expense projection. They hope to retire
in 25 years. They determined they would have a retirement
income of $25,000 each year in today’s dollars before tax
($10,000 from their pension and $15,000 from their savings),
but they would actually need $67,500 before tax in retirement
income to retire comfortably.
Required:
How much must Kevin and Whitney save annually for 30 years
of retirement if they wish to meet their income projection,
assuming a two percent inflation rate both before and after
retirement, and an eight percent return on investments
12-55 before
retirement and seven percent during retirement?
Case Study Answer

Steps:
1. Calculate the shortfall.
2. Inflation-adjust the shortfall.
3. Calculate the real return and the
annuity.
4. Calculate the period payment

12-56
Case Study Answer

12-57
 Case Study Answer

1) Calculate the shortfall (all on a before-tax basis

as stated):
The shortfall is $67,500 – $25,000 = $42,500
before-tax.
2) Calculate the inflation-adjusted shortfall (end
mode):
The adjustment is PV = $42,500, I = 2%, N = 25,
FV = ? Factor = 1.641
Kevin and Whitney need $69,726 each year12-58 (you
can round to the closest dollar).
 Case Study Answer

3) Calculate the real return and annuity:

The real return is (1 + nominal return) / (1 + inflation) – 1, or
(1.07)/(1.02) – 1= 4.90%.
To calculate an annuity (remember you will want the
payments at the beginning of the period, use the begin
mode on your calculator)
To get an annuity of $69,726 for 30 years at a 4.90% return,
set PMT = $69,726,
N = 30, I = 4.90%, and solve for PV.
Kevin and Whitney need $1,137,074 to be available in 25
years to give them the annuity for 30 years. 12-59
 Case Study Answer

4) Calculate the period payment (use end

mode):
To get this future amount, set the FV =
$1,137,074, N = 25, I = 8%, and calculate the
PMT = ?
Kevin and Whitney need to save $15,554 each
year to meet their retirement goal.

12-60
End of Lecture

13-61
 FIN205 – Wealth Management

Topic 13- Estate Planning

 Learning Objectives

 Understand the importance and the

process of estate planning.
 Calculate and avoid estate taxes.

 Draft a will and understand its purpose in

estate planning.
 Avoid probate.

13-2
 Why Estate Planning?
WHAT IS ESTATE PLANNING?
‒ Estate planning is a definite plan for the
administration and disposition of one’s
property during one’s lifetime and at one’s
death
‒ Estate planning is an essential part of
retirement planning and has two
components
 Build your estate through savings,
investments, & insurance
 Transfer your estate as you wish at death

13-3
 Why Estate Planning?

 If married, include spouse and children in

estate planning process

 If unmarried, make sure beneficiaries have

information about your estate that they will
need

 Newer lifestyles means different challenges,

which means plan early and get expert help

13-4
 Why Estate Planning?
OPPORTUNITY COST OF RATIONALIZING
‒Many people give little or no thought to putting their
personal and financial affairs in order for
their families that survive them

‒Demands of daily living can keep people from thinking

about death

‒Plan while you are in good health

‒Estate planning is especially important for non-

traditional households

13-5
Estate Taxes

 Without a surviving spouse, a large

estate is subject to estate taxes

 Determining estate taxes

 Value of estate is the value of all
assets minus any liabilities minus
funeral and administrative expenses

13-6
 The Estate Planning Process

Step 1: Determine the Value of Your Estate

 Determine the value of your assets.

 Use the death benefit, not cash value, to

determine value of life insurance.
 Include employer-sponsored death benefits.

13-7
 The Estate Planning Process

Step 2: Choose Your Heirs and

Decide What They Receive
 Once you know what you have, you can
decide who’s going to get it.
 In addition to a spouse, consider the special
needs of your dependents.

13-8
 The Estate Planning Process

Step 3: Determine the Cash Needs of the Estate

 Before distributing property to heirs, must pay
medical costs, funeral expenses, legal fees,
outstanding debt, and taxes.
 Use liquid funds to cover tax needs.

13-9
 The Estate Planning Process

Step 4: Select and Implement Your

Estate Planning Techniques
 Decide which estate planning tools are
most appropriate to achieve your goals.
 You may need a will, a durable power of
attorney, joint ownership, trusts, life
insurance, and gifts.

13-10
 Estate Taxes – Malaysia &
US
There is no estate duty or inheritance tax in Malaysia
so unless the deceased died domiciled in a foreign
place, these taxes can be ignored.
United States
 In 2019, the first $11.4 million of an estate can be
distributed to children or others tax-free
 Beyond this limit, the federal estate tax rates on the
taxable part of the estate is 40% in 2019.

13-11
 Estate vs Inhiretence Tax

 An estate tax is based on the overall

value of the estate and so the tax will be
collected only if the value exceeds the
estate tax exemption after applicable
deductions are applied.
 On the other hand, an inheritance tax will
only be collected if the estate passes to
someone who is subject to the
inheritance tax in the first place.
13-12
 Trusts, Gifts, and
Contributions
 These may help avoid estate taxes.The trusts are
established to effectively remove assets from
their owners' estates while they are alive so that,
on their death, tax does not apply.
 Trust: a legal document in which one person transfers assets
to another who manages them for designated beneficiaries
-Grantor: the person who creates a trust
-Trustee: the person or institution named in a trust to manage
the trust assets for the beneficiaries

13-13
 Gifts
You can give the following monetary amounts to each person and to as many
individuals as you want, without triggering the gift tax. The amount is indexed
from time to time for inflation. Annual gift tax exclusion 2019 -$15,000
In addition to the annual exclusion amounts, you also can give the following
without triggering the gift tax:
Charitable gifts.

Gifts to a spouse.

Gifts to a political organization for its use.

Gifts of educational expenses. These are unlimited as long as you make a

direct payment to the educational institution for tuition only. Books, supplies
and living expenses do not qualify.
 Gifts of medical expenses. These, too, are unlimited as long as they are
paid directly to the medical facility
13-14
 Trusts, Gifts, and
Contributions (cont'd)
 Living trust: a trust in which you assign the
management of your assets to a trustee while
you are living
 Revocable living trust: a living trust that can
be dissolved
 Irrevocable living trust: a living trust that
cannot be changed, although it can provide
income to the grantor

13-15
 Revocable trust:
• Also known as a living trust, a revocable trust can help assets
pass outside of probate, yet allows you to retain control of the
assets during your (the grantor’s) lifetime.
• It is flexible and can be dissolved at any time, should your
circumstances or intentions change.
• A revocable trust typically becomes irrevocable upon the death of the
grantor.
• You can name yourself trustee (or co-trustee) and retain ownership and
control over the trust, its terms and assets during your lifetime, but make
provisions for a successor trustee to manage them in the event of your
incapacity or death.
• Although a revocable trust may help avoid probate, it is
usually still subject to estate taxes. It also means that during
your lifetime, it is treated like any other asset you own.
13-16
 Irrevocable trust:
• An irrevocable trust typically transfers your assets out of your (the
grantor’s) estate and potentially out of reach of estate taxes and probate,
but cannot be altered by the grantor after it has been executed.

• Therefore, once you establish the trust, you will lose control over the
assets and you cannot change any terms or decide to dissolve the trust.

• An irrevocable trust is generally preferred over a revocable trust if your

primary aim is to reduce the amount subject to estate taxes by effectively
removing the trust assets from your estate.

• Also, since the assets have been transferred to the trust, you are relieved
of the tax liability on the income generated by the trust assets (although
distributions will typically have income tax consequences).

13-17
 Wills

 A legal document that describes how to

transfer your property to others.
 Designate:
 Beneficiaries – those who are willed
property.
 An executor – personal representative who
will carry out the will’s provisions.
 A guardian – who will care for children under
the age of 18.
13-18
 Types of Wills

•A SIMPLE WILL leaves everything to your spouse

•A TRADITIONAL MARITAL SHARE WILL leaves half to
spouse and half to children or heirs. Avoid probate
•An EXEMPTION TRUST WILL passes to your spouse
except for an amount equal to the exemption, which passes
into a trust. The trust can provide a lifelong income
•A STATED DOLLAR AMOUNT WILL
- Should use percentages, not actual dollar amounts

13-19
19-19
 Formats of Wills
 FORMATS OF WILLS
‒ Holographic will
o A will that you write, date and sign, entirely in your
handwriting
o May not be recognized in some states
‒ Formal will
o Usually prepared with attorney’s assistance
o You must sign & have two witnesses, neither of
whom can be beneficiaries (people named to
receive property
‒ Statutory will
o Type of formal will on a pre-printed form. Has rigid
provisions, may be not meet current laws, and may
be invalid if you change provisions
13-20
19-20
 Purpose of a Will

 Estate: the assets of a deceased person

after all debts are paid
 Estate planning: the act of planning for how
your wealth will be allocated on or before
your death
 Will: a legal request for how your estate
should be distributed upon your death. It can
also identify a preferred guardian for any
surviving children
13-21
 Purpose of a Will (cont'd)

 Reasons for having a will

 Ensures that your estate is distributed
as you desire
 Beneficiaries (heirs): the persons specified
in a will to receive a part of an estate
 Intestate: the condition of dying without a
will - Court appoints an administrator who
may not make the decisions you preferred

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 Purpose of a Will (cont'd)

 Creating a valid will

 Minimum age—18 or 21
 Mentally competent
 Not under undue influence of others
 Must be signed and dated
 2 or 3 witnesses who are not beneficiaries
 Attorney recommended
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 Purpose of a Will (cont'd)
 Key components of a will
 Distribution of the estate
• Details the distribution to the heirs, usually by
percentage

 Executor (personal representative):

the person designated in a will to execute
your instructions regarding the distribution
of your assets
• Collects debts owed to the estate, pays debts owed
by estate, and distributes proceeds of the estate
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Purpose of a Will (cont'd)

 Guardian
• Parents should name a person to be
responsible for caring for any dependent
children
 Signature
• Validates will
 Letter of last instruction
• Describes your wishes regarding funeral
arrangements and tells the location of any
key financial documents
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 Purpose of a Will (cont'd)

 Changing your will

 May be necessary if you move to a state with
different laws or if you marry or divorce
 Major changes may require a new will
 Codicil: a document that specifies changes
in an existing will - Appropriate for minor
revisions

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 Purpose of a Will (cont'd)

 Executing the will during probate

 Probate: a legal process that declares a will
valid and ensures the orderly distribution of
assets
 Executor files forms in probate court, provides
a copy of the will, a list of assets and liabilities
of deceased, pays debts and sells necessary
assets - Typically opens a bank account for
this purpose
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 Wills and Probate

 Probate validates the will.

 Probate court appoints an executor,
generally the one designated in the will.
 Once the assets have been distributed
and the taxes paid, a report is filed with
the court, and the estate is closed.

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 Wills and Probate

Advantage Disadvantages
 Validate the will – allow for  Numerous expenses –
challenges and make sure it legal fees, executor fees,
is the last will and testament court costs.
of the deceased.  Slow, time consuming
process, especially if there
are challenges or tax
problems.

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 Wills and Estate Planning

Why do you need a will?

A Will Can Without a Will

 Assure that a child with special
 The court will appoint a
needs is taken care of.
guardian for any children.
 Make sure property that isn’t co-
owned or in trusts is transferred  The court appoints an
according to your wishes. administrator to distribute
 Make special gifts or bequeaths. your assets.

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 Writing a Will

 Although handwritten and oral wills are

accepted, this is not a good idea.
 Have a lawyer draw up your will or review
it.
 Wills need to be signed and witnessed.

 Be sure to update it and store in a safe

place.

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 Contents of a Will

 A will should contain the following clauses:

 Introductory statement.
 Payment of debt and taxes clause.
 Disposition of property clause.
 Appointment clause.
 Common disaster clause.
 Attestation and witness clause.

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13-33
A Sample Will (cont’d)

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 Updating or Changing a Will
– The Codicil

 A codicil is an attachment to a will that alters

or amends a portion of the will.
 Make sure your will conforms to your present
situation.
 Substantial changes warrant a new will.

 A codicil should be drawn up by a lawyer,

witnessed, and attached to the will.

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Letter of Last Instructions

 A letter of last instructions is generally

written to the surviving spouse.
 It is not a legally binding document.

 It provides information and directions

with respect to the execution of the
will.

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Letter of Last Instructions

 The letter of last instructions may

contain:
 Location of the will, legal documents
 Location of financial assets
 Names of those to notify of the death
 Listing of personal property
 Funeral and burial instructions
 Organ donations

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 Selecting an Executor

 An executor has a dual role:

 Making sure your wishes are carried out.
 Managing your property until the estate is
passed on to your heirs.

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 Selecting an Executor

 The executor will:

 Deal with personal matters
 Pay taxes
 Manage the financial matters of the estate
 Distribute assets
 Make a final accounting to the courts

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 Other Aspects of Estate
Planning
 Living will: a legal document in which
individuals specify their preferences
if they become mentally or physically
disabled
 Power of attorney: a legal document
granting a person the power to make
specific decisions for you in the event that
you are incapable

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 Other Aspects of Estate
Planning (cont'd)
 Durable power of attorney for health care
(Health Care Proxy):
a legal document granting a person the power
to make specific health care decisions for you
Maintaining estate plan documents
 Need to be kept in a safe, convenient place
 Key individuals need to know where
they are kept

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Other Aspects of Estate
Planning (cont'd)
• Estate planning information
• Life insurance policies
• Retirement account information
• Home ownership and mortgage information
• Ownership of other real estate
• Personal property
• Personal loans

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Other Aspects of Estate
Planning (cont'd)
• Recent personal tax returns
• Bank account information
• Credit card debt information
• Ownership of businesses
• Personal legal documents
• Investment information

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 Invalidation of a Will

A will could be invalidated under the following

circumstances
 evidence suggesting lack of mental competence
when the will was written
 evidence of undue influence, or pressure, on the
individual to write the will with certain provisions
 provisions in the will that do not comply with the
law
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 Avoiding Probate

 Probate is essential to validate your will and

ensure your provisions are carried out. It
can also be time consuming and expensive.
 It is a good idea to avoid probate, and the
simplest ways to do so include:
 Joint ownership
 Gifts
 Trusts
 Beneficiary Designations (Insurance & EPF)
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 Joint Ownership

 Jointly-owned assets transfer to the surviving

owner without probate.
 3 forms of joint ownership:
 Joint tenancy with rights of survivorship –
ownership passes to survivor, bypasses the will.
 Tenancy on common – deceased owner’s shares
go to estate.
 Community property – surviving spouse receives
½ of all property acquired during the marriage.
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 Trusts, Gifts, and
Contributions (cont'd)
 Gifts: a tax-free distribution of up to $13,000
per year from one person to another prior to
death
 Not subject to tax for the giver or the recipient

 Contributions to charitable organizations

 Not subject to estate taxes

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 Gifts

 Do not go through probate.

 Reduce taxable value of estate, allow you to
help heirs while you are alive.
 Are a good way to transfer property that
grows in value.
 Disadvantages include the fact that you may
need the assets or that they are squandered.
 No limits on gifts to a charity.

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 Unlimited Marital Deductions

 There is no limit to the size of estate

transfers between spouses on a tax-free
basis - Spouse must be U.S. citizen.
 Estates up to $2 million can be transferred
tax-free to any other beneficiary.

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 Trusts

A legal agreement that provides for the management and

control of assets by one party for the benefit of another.
Trusts avoid probate
3 parties to a trust:
Settlor(s): This is the person (or persons) who creates the trust. Grantor(s)
is a common synonym.
Trustee: A person (either an individual, a corporation or more than one of
either) who administers a trust &protect trust assets from unreasonable
loss for the trust's beneficiaries
Beneficiary: A beneficiary is anyone who receives benefits from any
assets the trust owns.

2-50
 Trusts

 A legal entity that holds and manages an asset for

another person.
 Is created when an individual, a grantor, transfers
property to a trustee for the benefit of one or more
beneficiaries.
 The trustee can be an individual, an investment firm,
or a bank.
 Any asset can be placed in a trust.
 Standard family trust (credit-shelter trust): a trust
established for children in a family
 Testamentary trust: a trust created by a will
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 Trusts

 Why use a trust?

 Trusts avoid probate.
 Trusts are more difficult to challenge in court.
 Trusts can reduce estate taxes.
 Trusts allow for professional management.
 Trusts can hold money for a child with special
needs or until a child reaches maturity.
 Trusts can ensure that children from a previous
marriage will receive an inheritance.
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 Living Trusts

Revocable Living Trusts Irrevocable Living Trusts

 Place assets in trust  Trust is permanent.
while alive, withdraw  It becomes a legal
them later if you wish. entity, paying taxes on
 You retain title and gains produced.
have control over  Not part of estate,
assets. bypasses probate, no
 No tax advantages. estate taxes.

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 Testamentary Trusts
 A testamentary trust is created by a will.
 It exists once probate has been completed.

 Common types:
 Standard Family Trusts – also known as A-
B Trusts, Credit-Shelter Trusts and Unified
Credit Trusts
 Qualified Terminable Interest Property Trust
(Q-TIP)
 Sprinkling Trusts

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 Testamentary Trusts

 Standard Family Trusts – reduce estate

taxes when one spouse dies before the
other.
 Assets go directly into the trust, no taxes are
imposed.
 Remaining spouse uses the assets, and upon
death, the assets go to the children tax-free.

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 Testamentary Trusts

 Qualified Terminable Interest Property

Trust – ability to direct income from the
trust to spouse, then upon spouse’s death,
to whomever is selected.
 This trust keeps the estate from getting into the
hands of your spouse’s future husband or wife,
assets go to the children.

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 Testamentary Trusts

 Sprinkling Trusts – distributes income

according to need rather than a pre-set
formula.
 Trustee uses discretion to distribute the income.
 Trustee “sprinkles” income to those who need
it.

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 Estate Planning
Checklist
 Do you and your family know…
 Location of your will, power of attorney, and living will?
 The name of your attorney and accountant?
 Where to find your letter of last instructions?
 Location of safety deposit box?
 Whereabouts of deeds and titles to property?
 Site of your investments?
 All account numbers?
 Last year’s income tax return?
 Pension and retirement benefits?

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 How Estate Planning Fits
Within Your Financial Plan
 Key decisions about estate planning
for your financial plan are:
 Should you create a will?
 Do you need to establish a trust?
 Should you create a living will or designate
an individual to have power of attorney?

13-59
13-60
 A Last Word on Estate
Planning

 Many put off estate planning because it

is complex and deals with death.
 Go to a professional – don’t do your own
estate planning.
 Make sure your family knows where your
estate planning documents are.

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End of Lecture 13

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