In the simplest terms, financial planning is about the question that all of us should be thinking: "Will I have enough?"
The answer to that question requires a fair amount of information-gathering in four areas: What you own, what you owe, your income and your expenses. My experience suggests that few people really have a handle on this. So until you get a grip on where you are today, it's quite difficult to make a plan to get you where you hope to be tomorrow. (For related reading, see: Evaluating Your Personal Financial Statement.)
Determining How Much You Spend
Three of the four parts of the equation are usually easy enough to figure out. The hitch, however, is on the expense side. More often than not, the task of coming up with reasonable numbers for a couple dozen or more key expense categories is a trip into the unknown. You probably won't have much difficulty pinpointing the cost of things like cable TV and heating but do you really know what you've been spending on gasoline and groceries? Probably not. How about gifts, clothing or eating out? (For related reading, see: 6 Habits That Will Make You Broke.)
Still, let's assume that you have somehow managed to put together a budget and identified your assets and your liabilities. If everything remains constant from now until some day in the distant future, the task would be close to a no-brainer.
How Income and Expenses Change
But things change. When you plug in numbers, they will almost always change over time. And when you retire, your income will shift from employment earnings to such things as earnings on investments, pensions, and social security. With the exception of fixed-interest securities, the probability is that your returns on investments will vary from year to year. Pensions (if you are fortunate enough to have one) usually remain constant, though a few have built-in cost-of-living adjustments. Social Security is still around, but its future is anything but certain. (For related reading, see: Managing Income During Retirement.)
The expense side of the equation is also murky. Although we'd all like to think that we'll be around for a long time, it's essential to prepare for changes in expenses upon retirement as well as changes in expenses when there is only one surviving spouse. Add to that the occasions when there is an unusual expense, perhaps a new roof or a new car. Or for younger families, the cost of educating children. Shocking as it may be, the probable cost of educating today's newborns could be $500,000 or more. For these kinds of things, you can't just wing it. Planning for children's education needs attention on day one.
Along the way, there will often be such nonrecurring items as inheritances or perhaps funds from the sale of a larger home when downsizing. Whatever the case, the point is that a proper financial plan must be a dynamic instrument. It's something that needs to be reviewed regularly and modified as your situation changes.
For all plans, the bottom line is that either you will have enough to continue living in your hoped-for lifestyle or you will have to work longer, spend less or increase the return on your investments. The earlier you address these issues, the more likely it is that you will have enough. (For more from this author, see: Investors: Don't Let Fees Reduce Your Returns.)