By Fred Petrie
You don’t want insurance, but you have to buy it for your car, because Manitoba Public Insurance requires it. Your bank likely requires that you have insurance that covers your home mortgage. Your most important asset, the one that provides you with a car and a home, is your income.
The risks to your income need to be managed. An unexpected job may interrupt your cash flow, making car and mortgage payments, not to mention grocery purchases, difficult.
This risk is best managed by having three months’ worth of net income in liquid savings to help you over such a hump. Tax free savings accounts are a good choice for this “emergency fund”. Employment insurance is another mandatory insurance product and theoretically it’s there to replace employment income for a short period. But you need to have your own nest egg to manage any unexpected interruptions in or demands on your income.
Longer term risks to your ability to maintain your income, such as a disabling injury, can be insured against, often on a group basis at work.
Your income is going to cease when you die. Financial planning can provide for loved ones who were depending on your continued income. Unless you are already independently wealthy, life insurance is the most cost effective way to manage the risk of premature death.
The next risk to your income will be when you stop working, whether forced to retire by age or health or choosing to do so. You can manage this risk by having a pension plan, supplemented by an RRSP. Income from additional investments along with savings will replace some of your pay cheque so that you can maintain your lifestyle.
There are risks of other occurrences that will put additional demands on your income. We all know people who are battling cancer or some other debilitating disease. Life insurance doesn’t help in this situation so insurance companies offer critical illness coverage. Most advisors recommend having two years of net income available to provide capital for getting through a period of care-giving, interrupted income, or for health care across the border that medicare doesn’t cover.
We plan financially in order to have a happy retirement, to travel, to enjoy our grandchildren and for pursuits that we didn’t have time for during our working years. But active as you may be in your 60s and even 70s, you will age. The expense we rarely think about is long term care.
That cost can exceed our pension and savings. The risk of living so long that you outlive your savings is best managed by continuing to keep your financial plan up to date, with investment products such as annuities that are guaranteed for however long you live.
If we really do not want to spend heavily on insurance, what is our alternative? The best alternative is to accumulate sufficient wealth that we can cope with life’s events ourselves; we self-insure these risks. That is what we do when we build up a nest egg to cope with short term interruptions or unexpected demands on income. An emergency fund is the first step in planning financial independence.
We divert some of today’s cash flow into investments. But while our investments are growing to be enough to self-insure our risks, we have the challenge that most of our risks are now. For the 20 to 30 years it will take to accumulate financial independence, we manage these risks by insuring the gap.
The insurance industry has created a clever product called Universal Life that does wealth accumulation while insuring the gap. Traditional permanent insurance products combined savings with insurance cost, implying that building a savings base would reduce insurance requirements for making up the face value of the contract. Universal Life unbundles these components, while still offering the tax benefits of the traditional plan.
As the investment portion grows, the insurance cost declines, as a decreasing amount of insurance is needed to make up the face value of the policy. You have a wide range of investment choices: fixed income, bond funds, asset allocation, and choices can be varied through the years. With good planning, by the time you retire the UL contract will have obtained sufficient value that it will continue to grow and you can stop making deposits.
Like the short term nest egg, the asset will be there after you retire to self-insure the on-going risks to your income, whether to supplement to your pension, to meet the crisis of a critical illness or for long term care costs. And if you are so fortunate as to not need the funds for any of these risks, it can serve as your legacy in a family trust to help your great grandchildren’s futures!
Fred Petrie, of Navigator Services, provides financial planning for families and independent businesses. He can be reached at 204-298-2900 or by email at firstname.lastname@example.org.