Lay the foundation for building wealth by: (a) maintaining an emergency cash reserve of three to six months living expenses; (b) having health, disability, and (perhaps) life insurance; (c) buying plenty of liability insurance coverage for your cars and home; (d) after your wealth has grown, getting an umbrella policy and perhaps a long term care policy; (d) marshaling your assets by organizing your financial records and claiming all the financial resources you’re entitled to; and (e) preparing for the possibility of your mental incapacitation by giving a trusted person a power of attorney to manage you financial affairs if you can’t. Also, try to take care of your health.
Laying the Foundation
In order to have a sound financial plan, you need a solid foundation. The foundation should be the same regardless of which investment plan you choose. We outline below the elements of a solid financial foundation.
Have an Emergency Cash Reserve
It’s important to have a cash reserve of three to six months living expenses. It serves as a buffer against the downsides of life—a layoff, an illness or injury, or another Hurricane Katrina. How would the cash reserve work? Let’s take a family with monthly living expenses of $4,000. The recommended cash reserve would be somewhere between $12,000 and $24,000. That may seem like a whale of a lot of cash to have sitting around. But it gives you peace of mind that your finances won't be abruptly upended when bad things happen. To paraphrase Longfellow, into every life some rain shall fall. A cash reserve saves you from borrowing--highly undersirable if you've just lost the ability to repay the loan--or selling retirement assets to cover current living expenses, which can wreck your long retirement term plans. Don’t use your emergency fund to pay for a fancy lifestyle. That undermines the purpose of having an emergency fund.
The emergency fund should be kept in a safe place, like a money market fund, or a credit union or bank money market account. Money market funds that invest only in U.S. Treasury securities are safe and their interest may not be taxed by your state (although it is taxed federally), which means that their returns are actually pretty competitive after taxes. Other money market funds are only slightly less safe, and tend to pay competitive rates. Credit union money market accounts sometimes pay fairly competitive interest rates, as do some online banks. Bank money market accounts usually pay less than competitive interest rates, but are otherwise suitable places for the emergency cash reserve. Bank and credit union accounts will be federally insured up to $100,000 per customer per institution, so they are also safe.
Protect Against Personal Risks
As we discussed in our section on personal risks, it is important to have insurance coverage for a variety of risks.
Health Insurance
Health insurance is critically important. If you have a major illness or injury, not only will you be unable to work, but you will also rack up big medical bills. If you don’t have health insurance, your debts will balloon while your income grinds to a halt. Health insurance will usually absorb most of the costs of a major medical crisis. These bills can greatly exceed your lost income, so controlling your medical costs through insurance coverage is essential. Having health insurance also makes it easier to obtain quality medical care as and when you need it. (Try getting admitted to a hospital emergency room without an insurance card—it ain’t easy.) Many, and perhaps most, people have at least one significant medical crisis during their working years. Health insurance will help you get through the crisis and back on your feet.
Disability insurance is an important part of your financial foundation. Disability can be a temporary, as well as permanent, problem, and occurs perhaps more often than people realize. Some people are unable to work for a period of a year or two or three, but then recover enough to resume working. Other disabilities are permanent. Disabilities, like illnesses, increase your expenses (with medical bills) while cutting off your earning power. Disability insurance provides income while you are unable to work—not as much as you were making, but maybe enough to cover basic living expenses. Thus, it helps to keep you away from your retirement assets.
Life insurance protects not you, but those you care about, in case something happens to you. If you have dependents, it can provide the equivalent of your earning power after you are gone. If you have no dependents, life insurance isn’t necessary (and don’t let an insurance agent tell you anything different). But if your demise would leave a spouse and/or kids in dire straits, and you don’t otherwise have substantial financial resources, buy some life insurance. How much you should buy depends on what other resources you have. If you already have significant assets, a smaller amount of life insurance may suffice. If you have few financial resources and a host of expenses, buying enough life insurance to equal 6, 8, 10 or more times your annual income might make sense (depending how many kids you have, how old they are, whether your spouse will stay home with the kids, how much of the expected college costs you want to cover, etc.).
Buy term life coverage. It’s simple to understand, which makes comparison shopping easier. Other kinds of life insurance, such as whole life, universal life, and so on and so forth, are rather complex financial instruments, where the true costs and rates of return can be elusive. Ordinary investors should avoid them.
Long term care insurance covers costs of long term health care. Long term care coverage is primarily for the elderly. It includes coverage for in-home care and assisted living facilities, which Medicare covers only on a limited basis or not at all. So this kind of coverage can help you afford these types of care if you don't have other assets. Long term care insurance also covers nursing home care. While Medicaid also covers nursing home costs, you'd have to spend down your assets first before you could qualify for Medicaid. Thus, long term care insurance serves as an estate planning measure, protecting your assets from being dramatically reduced if you need long term care. In this way, it benefits your spouse and other heirs.
Long term care insurance is relatively inexpensive if purchased by those in their 20’s or 30’s (look for a policy that doesn't rate the premiums as you grow older). However, coverage gets progressively more expensive the later you buy. Those with little savings should take a pass on long term care insurance, unless they want coverage for assisted living facility expenses (most people don't end up in assisted living, but it's quite expensive if you do). Medicare and private health insurance cover in-home care to some degree, and Medicaid covers nursing home care. But those who have or expect to have significant savings may benefit from long term care insurance.
Even though this is primarily a financial website, we will take a quick detour into the world of health. Almost nothing can wreck your financial plans as badly as a major health problem or, even worse, your death. Medical expenses may be the most common reason for bankruptcy filings. You can recover from dumb investments, loss of your job, serial spending, and excessive use of debt if your health is good. But even the financially virtuous can lose everything with a major health problem. Taking care of your health is a very important way of protecting your financial future. Even if you have health insurance and disability coverage, they won’t replace income lost to a health problem dollar for dollar.
Eat a balanced diet. Hold on--we detest the FDA food pyramids as much as anyone and won’t give you any food police agitprop about eating five cups of rabbit food a day. A man’s cheeseburger is his banquet and everyone should have a banquet now and then. But loading up all day long on refined sugar, cholesterol, bleached flour, partially hydrogenated fat, salt, high fructose corn syrup, etc. only takes you down the road to bloat, flab, surreptitious trips to the extra large racks, fewer people checking you out, high blood pressure, diabetes and eventually heart attack alley. Your earning ability, among other things, could suffer.
Exercise—and that means more than your Spring and Fall semi-annual jog. Two or three times a week might do wonders. If you drink, drink in moderation. Don’t smoke, and stop if you do. Why enrich tobacco companies just so that you can heighten your risks of getting any number of horrific and painful illnesses, endure excruciating medical treatments, and then die prematurely? If you're having trouble quitting, go visit someone on home oxygen. After that, you'll be able to quit without any gum, patches, or whatever else.
Spend fifteen, twenty or thirty minutes each day relaxing. Do something that takes away your worries. Read a book, do a crossword puzzle, knit, pound the drums in your garage, or work on your ’67 Dodge Polara.
Prepare for Your Incapacitation
Consider giving a power of attorney for financial affairs to someone you trust to manage your assets in case you are incapacitated. A power of attorney for financial affairs allows the person you designate to keep your finances in order if you are incapacitated. Without a smooth transition in management, your finances could fall apart quickly. Who would pay the mortgage and utilities? Who would make financial arrangements for your medical care? Not all medical costs are covered by health insurance so someone needs to be able to write checks on your bank account. If you don’t designate someone to handle these matters, your family (or friends if you have no close family members) may have to go to court, which can be expensive and time consuming.
A power of attorney for financial matters becomes increasingly important as you get older and face increased risks of a stroke, heart attack or other major medical event. You can sign a power of attorney that becomes effective only if you become incapacitated (as certified by a licensed physician) or you can sign a “durable” power of attorney, which is effective immediately and continuously thereafter unless you revoke it. The advantage of the durable power is that no proof of your incapacity is required before the designated person can step in and take over. For an elderly person who is fading, but perhaps isn’t entirely incoherent, the durable power of attorney can make things much easier. For example, what if you are developing Alzheimer’s or some other form of dementia but are still partially functional? You may technically not be “incapacitated” but might have to move to an assisted living facility in order to be safe and well cared for. Who would manage your finances and ensure that the facility is paid? Who would sell your house if necessary to pay for your care? A durable power of attorney makes it easier for the transition in financial authority and responsibility to take place.
Of course, you should give a durable power of attorney (or any other power of attorney) only to someone you trust. There is a potential for abuse of such authority; embezzlement of funds by the designated person (legally called “attorney-in-fact”) sometimes occurs.
Persons who are designated attorneys-in-fact should understand that actually using a power of attorney may be more difficult than you’d expect. Banks and other financial institutions often don’t like to deal with a new person who isn’t the account holder, and may put obstacles in your path. You might have to provide medical proof of the account holder’s mental disabilities (such as a physician’s note), even if the power of attorney is durable. And you may have to negotiate your way through layers of management and into the bank’s legal department in a distant city. In extreme cases, you might have to take other steps—like going to court--if all else fails.
There are other ways of dealing with these problems. You could make the person you want to care for you a joint owner of all your assets. That automatically allows him or her to manage those assets in case you cannot. Giving someone else joint ownership requires a very high level of trust on your part, since the other co-owner could legally walk into your bank and take all of the money in your accounts. Another alternative might be to put your assets into a trust and make someone else a trustee. Again, your trustee should be someone you trust. You might want to consult with an attorney about these alternatives. The most important point is to think about how to deal with the problem of incapacitation.
Protect Yourself Against the Claims of Others with Liability Insurance
Another part of the foundation for building wealth is protecting yourself against legal claims by other persons that could significantly impair your wealth. Liability insurance is the principal way of covering these risks. For example, if you are at fault in an automobile accident and are sued, insurance coverage may save you from having to pay injured persons from your own funds. If you don’t have insurance, you might have to pay over a large amount of your net worth to resolve the lawsuit. That could blow up your retirement plan in an instant.
Insurance against the claims of others includes automobile policies, homeowner policies and umbrella policies. State law generally requires you to maintain a minimum amount of liability coverage on your car. Buy well above the minimum. A million dollars of liability coverage is not too much, given today’s litigious society. Getting substantial property damage coverage on your auto policy—perhaps $100,000—is also advisable if you live in or drive in high income areas. Many luxury cars today retail close to or even above $100,000, and it would be a good idea to have enough coverage to cover a claim for one of these vehicles.
Homeowner’s and renter's coverage protects you against claims of others if they are injured while in your home. Again, a sizeable amount of liability coverage--$300,000, for example—is not overdoing it. Also, make sure a homeowner's policy limits for property damage reflect the current value of your house (not the land, just the house, because the policy covers damage to the house). If the property damage limit is less than the value of your house, you might have to spend a lot of your own money to get your house repaired or rebuilt.
If you are in an area where the house could be flooded, think carefully about whether or not to buy flood insurance. Flooding could occur if the local sewer system backs up into your basement. You don’t need to live next to the levees in New Orleans to have a flooding problem.
Finally, an umbrella policy might be worthwhile if you have a significant net worth. This policy would provide further protection against liability claims on top of automobile and homeowner’s policies. An umbrella policy can give you additional protection reaching into the millions. A few extra million dollars of liability coverage isn’t a bad idea if you have $500,000 or $1,000,000 in savings that could be lost in a lawsuit.
A person with a modest net worth should get substantial automobile and homeowner’s coverage. An umbrella policy isn’t necessary until one has accumulated a fair amount of money. Sure, the prospect of paying more insurance premiums isn't appealing; welcome to the world of the prosperous.
Make sure you have all your property and other financial resources. The first step is to organize your financial records so that you, and anyone who might take care of your affairs if you’re incapacitated, can figure out what you’ve got, where it is, and how much there is. Even if your records are mostly electronic, have a paper document stored in a secure place that lists your accounts, the account numbers, your creditors, any passwords needed to access your electronic records, and the locations of physical assets like safe deposit boxes and real estate other than your home. If your records are all electronic and only you know the passwords, your finances could effectively be lost in cyber space if you are incapacitated or pass away.
Keep the most recent statement you got from Social Security. While Social Security doesn't provide that much money, it will be a crucial part of the foundation of your retirement.
If your assets are invested in a lot of different places and ways—such as a dozen financial institutions—consider consolidating them. You should never put all your money in one bank or financial services firm. What if they have a computer glitch and your accounts disappear from their records for a while? Or someone steals your identity and empties out your accounts? If you divide your assets among two to four organizations, it’s hard for you to lose everything. But having money scattered among a lot of places complicates the management and diversification of your investments.
Also make sure you’ve claimed all the assets to which you are entitled. As odd as it may seem, there are billions of dollars of unclaimed assets waiting for their rightful owners. These include old bank accounts, unclaimed inheritances, unclaimed tax refunds, and other property. Much of it is held by state treasurers, and you can start to search for any unclaimed property that might belong to you by going to www.unclaimed.org., which is maintained by an association of state treasurers. The IRS website, www.irs.gov, allows you to check on the status of a refund through the “Where’s my refund” feature on the front page of the website (on the left). While finding buried treasure this way isn’t likely, you never know until you try.
Another question to think about is whether you might have pension rights from a company that you worked for years ago. For example, if you worked 10 or 15 years for the same company when you first entered the work force, and the company had a pension plan, you might have “vested” in that plan, even though you changed jobs later on. Check with that old employer to find out. If the old employer no longer exists, try to find out if it was acquired by another company or if it went out of business. The acquiring company may be able to help you with pension information. If your employer went out of business, its pension plan may have been taken over by the Pension Benefit Guaranty Corp. Check at www.pbgc.gov/workers-retirees/find-your-pension-plan/content/page676.html to see if this is the case. Another resource is the missing persons search feature provided by the Pension Benefit Guaranty Corp. (https://search.pbgc.gov/mp/), which can also help you determine if you have a pension claim. Also check at the nonprofit Pension Rights Center’s website (www.pensionrights.org.) for a list of pension counseling centers located in various states--they may be able to help you.
If you might have an account in a former employer’s 401(k) plan, but aren’t sure what happened to it, check with the former employer. If you can’t find the former employer, the plan may have been terminated. Check with the U.S. Department of Labor Employee Benefits Security Administration at www.dol.gov/ebsa. You can search for abandoned 401(k) plans at www.askebsa.dol.gov/AbandonedPlanSearch/.
Now, let’s turn to our Model Financial Plans.