The definition of “Balance Sheet” is a financial statement that summarizes a company’s assets, liabilities and shareholders’ equity at a specific point in time. These three balance sheet segments give investors an idea as to what the company owns and owes, as well as the amount invested by the shareholders.
The balance sheet must follow the following formula:
Assets = Liabilities + Shareholders’ Equity
The Household Balance Sheet uses the Balance Sheet concept – it gives an overview at a point in time, but unlike a traditional balance sheet, looks at resources as a combination of assets and potential income to pay for goals, and goals, or future expenditures.
- Resources stated as “cash on hand” for financial accounts and Present Value for future resources.
- Goals, as stated as future expenditures, discounted back into the present.
- Resources not used to pay for goals, such as home that will not be sold, are not included.
On the right side are the future expenditures or goals. The Household Balance Sheet answers the question “Can I afford my goals?” by assessing goals discounted to the present across the three goal levels. These three goal levels, Necessary, Target and Aspirational are assessed in terms of how much funding is needed to accomplish goals at each level. Necessary goal amounts are funded ahead of Target amounts and Target amounts are incrementally funded ahead of Aspirational incremental amounts. In the case where the expenditure levels are the same, the entire funding of the goal is at the necessary level.
A helpful way to think of the priority levels is as three supermarket baskets where the Necessary basket contains the items which it is essential to fund, the Target contains the items in the necessary basket plus the additional costs to target, and the Aspirational basket contains the necessary items, the incremental target items and the additional “nice to haves.” That means if you have changes in the Necessary goal level, you could very well have larger changes in the household’s life plans as. Meanwhile, changes on the Aspirational goal level would result in only minor changes to the household’s life plans. With 3 goal levels, you can capture the household’s flexibility in accomplishing goals.
See an example of the John Smith Household below:
Why do we need three goal discount rates?
We thought you would ask that. Here is our answer: For every goal, there are many ways of achieving it. So when we do the analysis, all necessary goals get funding first, because they are the essential costs, then target, and thenaspirational goals. This allows the advisor to assign degrees of risk on how assets might be allocated. The Necessary goals, the essential goals, might have an asset model that would be considered conservative. The incremental target amount might have an asset model that yielded a higher return, and the aspirational goals might have an aggressive portfolio. As a financial advisor, think of necessary as a bare minimum—even for portfolio modeling purposes.
Necessary, Target and Aspirational goals can each have a unique goal discount rate, or could have the same discount rate.
Now let’s break it all down…
Necessary Goal Level:
Necessary goals are the essential or goals where risk needs to be contained. The Balance Sheet value represents the stream of necessary goals as present value, discounting the future expenditure flows using the necessary discount rate. This is the equivalent to the rate of return on a portfolio with after tax cash flows that provide the required cash flow with low risk. The current default discount rate used for the Necessary goal amounts is 3.2%, but you do have the option of entering a different rate for each plan. The default rate is derived from the expected return of a conservative portfolio with an 80% fixed income, 20% equity mix.
Target Goal Level:
The Target goal level allows for a little more risk on the incremental costs over the necessary goals, and the aspirational goal level allows for more risk on the aspirational incremental costs. In other words, for target goals, more risk can be taken, so the present value calculation uses a discount rate analogous to the expected return typical of a moderately risky portfolio. The default discount rate used for Target goal amounts is 5%, but once again, you have the option of entering a different rate for each plan. The default rate is derived from the expected return of a moderate portfolio with 50% equity, 50% fixed income mix.
Aspirational Goal Level:
For the Aspirational goal level, more risk can be considered. The expected return of a fairly aggressive portfolio is used as the discount rate. The current default discount rate used for the incremental Aspirational goal amounts is 6.8%, but you have the option of entering a different rate for each plan. The default rate is derived from the expected return of an aggressive portfolio with 80% equity, 20% fixed income mix.
On the other side of the balance sheet, you have your assets: resources. Resources are the assets and income the client expects to have and use to fund their future goals, this includes assets that the client currently owns and future income that the client expects to receive.
Anticipated benefits is any post-tax income stream from a benefit plan, such as Social Security, pensions, or annuities, that starts in a particular year and continues throughout the principal’s life
The Household Balance Sheet supports the following types of anticipated benefits that continue till end of life:
- Social Security
On the Household Balance Sheet, Anticipated Benefits are presented as present value.
Anticipated Savings is any pre- or after-tax income stream that the client expects to receive to fund goals. Examples include:
- Retirement or college savings (pre-tax savings)
- Monthly savings from employment (after taxes and monthly expenses)
- Rental income
- One-time income payment, such as an inheritance
- Annuities that have an end date
- Disability income
- College Savings
The Household Balance Sheet supports two different methods of showing savings:
- Retirement Contributions (i.e. pre- or post-tax contributions to retirement accounts)
- Other Savings (i.e. after tax income)
For the Household Balance Sheet, Anticipated Savings are discounted back to today’s dollars.
After-Tax and after-penalty fee
The balance sheet value of Retirement and Brokerage Accounts is less than the actual value by the amount of the deferred tax liabilities owed in the account. In other words, the Retirement and Brokerage account amounts reflect taxes and penalty fees. The Total Retirement Accounts and Total Brokerage Savings Accounts value gives you an overview of your client’s purchasing power.
Total Resources is the sum of Anticipated Benefits, Anticipated Savings, Retirement Accounts, and Brokerage Savings Accounts.
Does your client want to save for a boat? What about a new car or condo? Are they interested in acquiring real estate? Discuss these goals with your client and set incremental goal achievement rates as part of one of your goal scenario plans or overall life plan.
If you are still struggling, consider the area you are having the most difficulty with and do not hesitate to contact our support team: [email protected]