(As published in Lifestyles 55+ March 2013)
Last month we set out the key to financial success – making sure your income over time will exceed your expenditures. Financial planning should be pretty straight forward – except for Mr. Murphy. His law says that what can go wrong will go wrong, at the worst possible time. So no matter what you do to ensure your income exceeds your expenditures, Mr. Murphy will be doing everything possible to mess you up. First you draft your financial plan, say a multi-year budget, with defined goals towards your ultimate objective of financial independence. The next stage of your financial planning is risk management.
What is your biggest asset? No, it is not your house or cottage or even your investment portfolio. Your most important asset is the present value of your future income. The value we place on a business is based on its net revenue. If we value a stock based on its Price/Earnings ratio, even at a conservative ten times, that means an income of $100,000 a year (expected to continue) is then valued at $1,000,000. Similarly, a young professional netting $100,000 has an income asset worth a million dollars. The second phase of your financial planning is to identify the risks to your income asset and, depending on the needs that that future income must meet, manage those risks through insurance.
Step one is to identify everything that could possibly go wrong. Then make contingency plans, first, to reduce the risk of that event occurring, and second, to mitigate the impact should the risk occur. Let’s start with income. Until you have grown your wealth to meet your income needs, you will likely be making most of your income from selling your labour. The first risk is if the current purchaser of your labour decides not to buy it anymore – fired, laid-off, redundancy – the result is the same: no deposit to your bank account. But your expenditures, many already committed on the expectation of that future income, will continue. Suddenly you are on the wrong side of the income-expenditure equation. To manage this risk you can reduce the probability of its occurrence. You work hard and keep your boss happy and you upgrade your qualifications. Nevertheless, your company gets taken over and you become redundant. Mitigation of the loss of income will start with government employment insurance. Being a competent financial planner, you will already have a three to six month emergency fund (likely in TFSAs for tax benefits) that will meet your short term expenditure obligations, like rent and groceries. Now if you were also proactive in your management of this risk you would have been networking and have new job offers coming in before you can call EI about your overdue claim.
The biggest risk to your income asset is premature death. If you are single, with no obligations, the expenditures that your income stream had planned to meet will also cease – so there may be no need for insurance to mitigate the impact. But if you have taken on obligations for expenditures that will continue after you: a partner, children, a home with a mortgage, other debts, care-giving and education, these will extend well into the future. You can then insure your life for sufficient capital to generate the income to meet these future obligations. Fortunately, the risk of this event occurring is minimal which means that life insurance is an affordable risk management tool.
A higher probability risk to your income stream is a disabling injury or illness. A combination of government programs and employer group insurance may be sufficient. If not, you might consider additional disability coverage for specific obligations, such as making your mortgage payments. These are examples of three risk management strategies for short, long or medium term risks.
What are some risks to the expenditure side of your financial plan? One immediate and on-going risk is temptation. We are bombarded daily about the latest bell or whistle we just must have. But you have identified this risk, and developed the discipline to minimize the occurrences. But no one is perfect. Mitigation would require reconciling your unplanned purchase to the budget that you carefully prepared and track every month. You just need to identify what you are going to give up to pay for what you purchased in a weak moment.
But some risk events will have impacts beyond what we can cope with. One example is the costs of a critical illness. Costs may include treatment not covered by medicare, a desire by one spouse to take time off work to care for a critically ill partner, or simply to pay for some big ticket items on your bucket list. You can look into transferring at least some of the risk mitigation to someone else. There are actually companies which are willing to assume some of your risk, who will make up the wealth needed to mitigate the impact of such a risk occurring. Who are these angels of mercy? They are called insurance companies. We may avoid them, perhaps due to pushy salespeople who make us feel bad about not protecting our loved ones. Don’t. Do your own financial planning, and your own risk management. Then decide what part of the risk you cannot afford to self-insure. Find an insurance agent who is a risk manager to help you find the best financial product to meet the need – and only that need – of the risk you decide to insure.