What Is a Financial Planning Pyramid?

What Is a Financial Planning Pyramid? – SmartAsset

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Setting priorities in the process of creating a solid financial position can be challenging. The financial planning pyramid provides a visual explanation and reminder to help people make the right moves at the right time. It aims to keep people from taking inappropriate risk by gauging the relationship between risk and reward. The pyramid also takes into consideration the element of time as a person makes progress towards his or her financial goals. It is a simple way to suggest how much of a person’s assets he or she should commit to different investments and other financial products.

Deciding how to allocate your financial assets and when to do so is something a financial advisor can offer invaluable advice on. 

Levels of a Financial Planning Pyramid

There’s no single version of the financial planning pyramid. Some varieties have just a few levels and others have several. Some describe a wide variety of specific investments, asset classes and financial products and others just a handful of broad categories.

A core element of all versions of the pyramid is that the least risky financial moves are at the bottom, while the riskiest ones are at the top. The width of the pyramid at the level where a financial product appears suggests how important it is and how much of a person’s assets should be committed to it.

Here are levels of the financial planning pyramid:

Level 1 – The lowest level is the widest, which indicates its importance and where it should be in terms of priorities. It is also the least risky and, in fact, focuses on reducing financial risk. This level includes automobile, home, life, health, disability and liability insurance.

Level 2 – Once the first level is addressed, people can concern themselves with the second level. This level is focused on emergency savings. It includes money put into safe investments such as federally insured bank checking and savings accounts, certificates of deposit and government bonds.

Level 3 – The third level consists of savings and investment vehicles that may pay better interest rates than the very safe ones in the second level, at the cost of somewhat greater risk. They include money market accounts and high-grade municipal and corporate bonds and bond funds.

Level 4 – At the fourth level investments in equities begin to appear. These take the form of balanced mutual funds and high-grade shares of preferred stock and convertible bonds.

Level 5 – The fifth level consists of shares of blue-chip public companies as well as investments in growth-oriented mutual funds and real estate.

Level 6 – The sixth level represents investments in collectibles, speculative stocks and lower-grade bonds and mutual funds.

Level 7 – At the very top of the pyramid is a narrow wedge representing the small amount of assets that may be prudently committed to highly speculative investments. These could include commodities, over-the-counter penny stocks and the like.

Key Concepts

The main idea of the financial pyramid that the width of pyramid at a given level expresses how much a person might wisely commit to the investments in that level. That is, more of a portfolio should ordinarily be invested in blue chip common stocks than speculative penny stocks. Time is also a factor. This means people are advised take care of the risk-management tools in the first level before starting to build emergency savings or begin investing in the stock market.

Different investors have different situations, which can affect the pyramid. For instance, a person in the middle of his or her career may be more heavily invested in growth mutual funds than someone approaching retirement, who would likely emphasize safety of principal with investments in high-grade bond funds.

Some versions of the financial planning pyramid have an even lower level. This may include the creation of a financial plan. Another item sometimes included as part of the lowest level is a budget that aims to make sure a person has cash left at the end of the month to stock an emergency fund and, ultimately, invest.

While financial products at the bottom of the pyramid are lower risk than those on higher levels, there is no risk-free investment. Even government bonds may generate a negative return in terms of buying power if the return does not keep up with inflation. There is also a risk of paying insurance premiums without ever making a claim on the coverage benefits.

Bottom Line

The financial planning pyramid is a road map to help people decide where to put their emphasis today in preparing to reach their ultimate financial goals. It is a reminder of the relationship between higher risk and higher reward, and helps to ensure that people have the building blocks of a solid financial foundation in place before chasing better returns with riskier investments. While financial products at the bottom of the pyramid are lower risk than those on higher levels, there is no riskless investment. Even government bonds may generate a negative return in terms of buying power if the return does not keep up with inflation. There is also a risk of paying insurance premiums without ever making a claim on the coverage benefits.

Tips for Investing

  • If making and implementing a financial plan seems like a complicated challenge, consider working with an experienced financial advisor. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
  • Once you’ve decided to start investing your money, you’ll have to decide on an asset allocation that’s appropriate for your goals, age and risk tolerance. And unless you invest in a target date fund that automatically adjusts that asset allocation, you’ll have to rebalance your assets over the course of your investing time frame. That’s where a free, easy to use asset allocation calculator can be extremely helpful.

Photo credit: ©iStock.com/Gajus, ©iStock.com/FG Trade, ©iStock.com/howtogoto

Mark Henricks Mark Henricks has reported on personal finance, investing, retirement, entrepreneurship and other topics for more than 30 years. His freelance byline has appeared on CNBC.com and in The Wall Street Journal, The New York Times, The Washington Post, Kiplinger’s Personal Finance and other leading publications. Mark has written books including, “Not Just A Living: The Complete Guide to Creating a Business That Gives You A Life.” His favorite reporting is the kind that helps ordinary people increase their personal wealth and life satisfaction. A graduate of the University of Texas journalism program, he lives in Austin, Texas. In his spare time he enjoys reading, volunteering, performing in an acoustic music duo, whitewater kayaking, wilderness backpacking and competing in triathlons.
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An Introduction to the 401(k)

Before investing in a retirement plan it will be highly beneficial for employees to understand what’s a 401k and how it works for them. The traditional 401k is one which employers provide to their workers by taking some money out of each paycheck to contribute to their personal account. In addition, many participating employers also contribute money to the worker’s 401k plan, often matching the employee’s contribution. When employers match their employees’ contributions, this is called a matching 401k. The traditional 401k is a stock investment plan, which means the money invested in a 401k is used to buy a set of stocks for an investment portfolio. When an employee invests in a pre-tax 401k plan, they incur some tax benefits, which include not owing any Federal income taxes on income that is invested in the 401k. In addition, money is automatically added to the employee’s 401k account from each paycheck, so they aren’t required to take action to ensure contributions are properly made. The ultimate purpose of a 401k is that it is a pension plan, which means that it is income that workers set aside for their retirement years. The goal of a 401k is to ensure that retired people do not have to worry about making ends meet in their later years of life.

The term 401(k) refers to a pension and profit sharing plan that is based on a defined contribution system. It is named after a section in the IRS tax code which came into existence through the Revenue Act of 1978. Even though financial planners were aware of the new Revenue Code 401(k), it wasn’t until 1981 that the IRS explained the rules for taking advantage of the new system. In the beginning, few companies offered this benefit to their employees, but by 2005, the 401k defined contribution pension plan became the most common private-market retirement plan offered by employers in the United States. By that time, the total nationwide value of all 401k plans combined, reached over two trillion dollars.

A major part of knowing what is a 401k plan involves knowing how it is funded. Employees participating in a 401k plan typically choose their investment vehicles, or what they invest their 401k funds into. These investments usually mean stocks, but investment vehicles can also be bonds, mutual funds, exchange traded funds, or derivatives. When employers pay into to the plan, it is called a profit sharing plan. In this case, employees may or may not be required to match the employer’s contribution to their 401k plan. There are limits to how much employees and employers can contribute to a person’s 401k, however. According to IRS law, an employer can only contribute twenty-five percent of the employee’s yearly income. The individual, on the other hand, can contribute up to $50,000 of their annual income to their 401k as of 2012, or the equivalent of their yearly salary, if it is under $50,000.

While 401k account holders do not get assessed taxes for the income that they put into their 401k at the time of contribution, there are restrictions that apply. Withdrawing money from one’s 401k plan before the age of retirement incurs a tax penalty of ten percent. This can be waived under certain hardship-related situations. This includes the employee’s death or complete and life-long disability, or when they need the money to pay for certain qualified medical emergencies. Upon retirement, money withdrawn from one’s 401k plan is taxed as ordinary income.

By Kelly Anderson

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