The Power of Planning: Risk Management
Introduction
In my most recent blog, The Power of Planning: Saving for Retirement, I gave a broad overview of different investment account types and how they may be useful to your situation. As each person’s circumstances are unique, so are our recommendations for what types of investment accounts would be most effective for you.
I wanted to remind anyone reading that the goal of these blogs is to communicate the importance of creating a well-thought-out financial plan. Remember, investing is a piece of the overall puzzle that is financial planning. Investing helps you build wealth whereas financial planning helps ensure the wealth you are building can withstand the curveballs life throws your way.
With that in mind, I will resume this series by discussing risk management and how to navigate the unexpected in life. Spoiler alert: The best way to navigate the unexpected is to plan to protect yourself and your loved ones from it.
Insurance
There are various types of insurance products available, all of which offer protection against a specific risk. For the purposes of this blog, we are going to focus on the types of insurance that directly protect you from loss of income.
Disability Insurance
What happens financially if you become disabled? If you are unable to perform the duties of your job, you will not be paid for not completing your work. In harsh scenarios, you may lose your job entirely, thus losing your source of income.
Disability insurance pays you a fixed percentage of your salary during the time you are unable to work. How much of your salary you are able to collect depends on the type of policy as there are short-term disability and long-term disability policies. Policies for short-term disabilities often pay 40-50% of your missed salary while policies for long-term disabilities pay 60%+ of your salary. These policies may be a part of the benefits package provided by your employer, but they are also available for personal purchase as well.
Life Insurance
I think we all understand the varying levels of impact we face when losing a loved one. Since this is a financial planning blog, I will stick to covering the financial impacts of an unexpected and premature passing.
It goes without saying that a premature death results in a permanent loss of income as compared to a potential temporary loss with a disability. This is income that can no longer be used to pay the bills, support your current lifestyle, or invest into retirement accounts.
Life insurance can help shield your loved ones from the financial uncertainty of a passing. Proceeds from a life insurance policy are received tax-free and are often used to pay off liabilities and funeral costs. If there are leftover funds after bills and debts are taken care of, that money can be invested to help aid retirement or future education costs for children and grandchildren.
A sudden loss of a loved one is a horrible thing to endure, and the financial hardships that coincide make premature deaths much worse. In the event that catastrophe strikes, life insurance can provide financial security in an otherwise somber period.
Long-Term Care
Long-term care is provided to individuals who lose the function of at least two of their six activities of daily living (ADLs). The six ADLs are bathing, dressing, eating, transferring (moving around), toileting, and continence (controlling your bowels and bladder).
According to the United States Department of Health and Human Services, roughly 70% of adults who survive past the age of 65 will need long-term care at some point.. This care can be provided in a facility, or it can be provided at home by health care workers who visit on a regular basis.
Long-term care is typically quite expensive. Unfortunately, so is its insurance. If you can afford it, it may be wise to fund a policy during your working years so that your wealth is not eroded by nursing facility bills in retirement. Conveniently enough, there are certain cases where life insurance and long-term care insurance can be purchased together through one policy.
Estate Planning
Wills and Other Legal Documents
Do you know where your assets will be going after you pass away? Most people think they do, but they don’t actually understand how it works. Without the proper documentation in place, the courts can decide where your money goes. This may not be a huge issue if you are married as your spouse should receive your assets, but there’s a lot left up for debate if you are widowed or unmarried. Designating your heirs within a will can help the courts direct your assets where you want them to go one day.
A will can help with more than just directing your assets though. If something tragic happens to you, who will take care of your kids? I imagine most parents have had that conversation before, but if that is not a decision you’d like the legal system to make for you once you’re gone, you need to write it in your will rather than just talk about it.
A Power of Attorney (POA) can be assigned to a loved one who can help you make financial and medical decisions if you are no longer of sound mind. Advanced Medical Directives can be used to tell your POA and health care providers what level of care they should provide. These two documents can be rather helpful for individuals who can no longer make big decisions on their own.
Beneficiary Designations
A beneficiary designation, also referred to as a transfer on death (TOD) plan in some cases, is attached to investment accounts, annuities, life insurance policies, and bank accounts. These designations help both loved ones and financial institutions understand where your money needs to go in the event of death.
It is critical to understand that a beneficiary designation supersedes what is written in a will. For example, if your will says the money in your IRA will be given to your cousin but the beneficiary designation attached to your IRA lists your son as the primary beneficiary, your son will receive that money instead of your cousin. Naming a beneficiary also keeps an account from being reviewed by the courts, which is another reason why beneficiary designations must be kept up to date at all times.
Emergency Fund
Nobody hopes rainy days occur when you suddenly need a few hundred, or maybe a few thousand, dollars to pay for something like a car repair or a leaky roof. Alas, life happens.
An emergency fund can help mitigate the sudden impact of a bad event. The amount you need in your emergency fund depends on personal preference, although conventional financial wisdom suggests you should keep six to nine months of your living expenses saved up in the bank. That may be a lot of money sitting in cash to use for new brakes or a roofing repair, so some people instead keep a smaller amount like $10,000-$15,000 left untouched in a separate account.
The Bottom Line
Unforeseen events can arise at any time, and the severity of these events differs for each person. I believe it’s better to be proactive rather than reactive when it comes to dealing with sudden changes. The better you’re protected against life’s curveballs, the more secure you and your loved ones will be when those curveballs cross home plate.