Personal risks can wreck your financial plans. Job loss, injury, illness, disability, death, personal liability and property damage can throw a wrench in your financial plans. Protect yourself against these risks.
To soften the financial impact of job loss, illness, or injury, have an emergency cash fund. The emergency fund should be separate from your regular checking account and should hold enough cash for 3 to 6 months of living expenses. When times are hard, cash is king.
If you lose your job, negotiate for termination benefits. These can include your salary (as much as you can negotiate), earned and expected bonuses, accrued vacation and sick days, continuation of health (and dental) insurance, stock options and restricted stock, assistance finding another job, and your employer’s agreement not to contest your right to unemployment compensation. You’re entitled to the money in your 401(k) account, except possibly for matching funds provided by your employer if you haven’t had the job long enough. You may or may not get all these benefits, but it doesn’t hurt to ask. If you are represented by a union, consult with the union about your termination rights.
Collect unemployment compensation. Unemployment compensation payments will reduce your dependence on your termination benefits and savings. You may be required to look for a job while getting these benefits. But that’s good for your retirement plan anyway. Unemployed people won’t have a rosy retirement.
Insure your risks. Health insurance, disability insurance, life insurance and homeowner’s or renter’s insurance are important. An umbrella policy may be a good idea if you have a significant net worth. Think about long term care insurance, especially if you expect to be well off later in life. However, stay away from limited scope insurance.
The world, as we all know, is a dangerous place. Managing risk is an important life skill. People manage risk all the time. Driving a car is one of the most common risk management activities. You monitor the road for careless drivers, potholes, deer, snow, ice, rain, and other problems, and try to avoid accidents. Playing sports also involves risk management—you want to win but you also try to avoid injury.
Financial planning includes management of a variety of risks. Planning for your financial security doesn’t consist only of increasing one’s assets. You should also avoid or reduce risks that can damage or destroy your financial security.
These risks fall into two categories: risks to you as a person and risks to your wealth. Examples of the first include job loss, injury, illness, disability, and death. These risks impair your ability to earn money. Examples of the second risk category include investment loss from market fluctuations, credit risk, fraud, inappropriate investments (such as lack of diversification or unsuitability), legal liability and damage to one’s property. These risks damage your net worth. We discuss personal risks here, along with legal liability and damage to one’s property. Investment risk--a world unto itself--is discussed in the next section.
If a personal risk materializes, the cost could be tens of thousands or even hundreds of thousands of dollars. Take a look at the cost of just one night in a hospital. You could take a trip to Europe for that much money. Without protection (such as health insurance), your finances could be wrecked by a health problem.
Dealing with Personal Risks
The personal risks you commonly face include job loss, injury, illness, disability, and death. Your assets could be endangered by legal liability imposed on you or by damage to your property. A large pool of savings softens the impact of all of these risks. However, since most people won’t have that large pool of money, except possibly when they retire, they have to handle these risks differently.
Maintain an Emergency Cash Fund
Job loss happens. Having an emergency cash fund with enough money to cover 3 to 6 months of expenses is an important way to soften the impact. Termination benefits and workers compensation can provide a bit of a cushion, but it’s a thin, hard cushion. An emergency fund allows you to keep going without having to draw down retirement assets like the money in your 401(k) or IRA accounts, or to reach into the equity in your home. That way, you have a chance of preserving your retirement savings even though you are temporarily out of work.
The emergency cash fund should not be in your regular checking account, but in a separate account that is safely invested. Good places for the emergency cash fund would include bank or credit union money market accounts (the credit union is likely to pay higher interest rates), or a money market mutual fund (especially one that invests only in U.S. Treasury securities). The emergency fund would be helpful not only if you lose your job, but also if you are injured, fall ill or become disabled.
Negotiate the best termination benefits you can get. If you lose your job, try to get: (a) as many weeks or months of salary as possible for termination pay; (b) payment of any bonuses, awards or commissions you’ve earned or accrued, or which you can reasonably expect; (c) payment for accrued vacation and sick days; (d) continuation of health insurance benefits (remember that you have COBRA rights to retain your employer’s health insurance for 18 months even if your employer doesn’t offer anything else, although you’ll have to pay separately for the coverage); (e) continuation of other insurance benefits, such as dental coverage or life insurance; (f) a written statement of the balance in your 401(k) account and any other retirement accounts you might have with the employer, such as an employee stock option plan (the assets in these accounts are yours--except possibly for matching funds from your employer if you haven’t had the job all that long--and you don’t have to negotiate for them; but you should make sure you know how much you have); (g) your right to retain any stock options, restricted stock and similar incentive compensation benefits that you have received, earned or are entitled to; (h) your right to retain any employer provided equipment, such as a laptop computer, if this equipment is important to you; (i) the employer’s agreement not to contest your claim for unemployment compensation (if the circumstances are such that you’d qualify for unemployment comp); (j) your employer’s agreement to give you a good reference (or at least a neutral reference such as only a confirmation of dates of employment and positions held); and (k) assistance from an employer provided outplacement or headhunter firm. Your ability to obtain these benefits will depend on the circumstances of the situation, but they are something for you to think about. If you are represented by a union, consult with the union about your termination rights.
Some people try to negotiate for a temporary continuation of employment while they search for a new job, in the belief that it’s easier to find work if you are employed. Others ask for the use of an office and telephone line at the old employer’s office while they search for a job, to maintain the appearance of being employed. You may want to consider these possibilities. But don’t lie to a prospective employer about your actual employment situation.
Carefully read anything your employer asks you to sign in connection with your termination. Almost always, an employer offering termination benefits will ask you to waive your rights to sue for discrimination, wrongful discharge and other potential legal claims, and perhaps other legal rights (such as your right to stay in your employer's health insurance plan under COBRA). If you’re seriously considering a lawsuit, don’t sign anything even if that means losing some of the termination benefits. You should be able to use COBRA rights to maintain your health insurance (unless you’ve engaged in “gross misconduct”). If you sign a document that waives your COBRA rights, you can still revoke that waiver for a limited period of time (which should be at least 60 days after your regular employee health insurance coverage ends). The assets in your 401(k) or other retirement accounts are yours in any event (except possible for employer matching funds if you haven't held the job that long), so you don’t have to waive any rights to get them.
Take Advantage of Unemployment Compensation
Apply for unemployment compensation if you qualify. Unemployment comp is a form of insurance meant to assist people who lose their jobs under a variety of circumstances. The benefits aren’t great and you usually are required to look for a new job. But drawing unemployment comp reduces the extent to which you have to tap into your own savings. And finding a new job will be good for your retirement plan.
If given a choice between changing a diaper and thinking about insurance, a lot of people would grab the kid and head for the nursery. As a matter of one's priorities in life, this is understandable. But you should spend at least a little time making sure you have the right insurance coverages.
We hardly need to emphasize the importance of health insurance. The system of payment for medical care in America receives more attention than almost any other domestic public policy issue, and many millions of words have been devoted to the subject. We’ll just summarize the crucial points.
First, if you can get access to a group policy, do so because group policies tend to be cheaper. That usually means finding employment. Consider staying employed in order to have subsidized health insurance even if you otherwise think you can retire. Buying health insurance on your own can be shockingly expensive. You can enroll inMedicare at age 65 but you likely would be saddled with very high health insurance costs if you retire at an earlier age without retiree health benefits. Lengthening your working years makes it easier to get health insurance, enhances your ability to save for a comfortable retirement and increases your Social Security benefits.
If you are uninsured, buy health insurance if at all possible. Health care expenses may be the most common reason people file bankruptcy, so without insurance, your finances could be wrecked by a medical problem. If you’re leaving an employer with group health insurance, use your COBRA rights to maintain coverage for up to 18 months (and longer if you’re disabled), unless you have a better alternative. A few states have programs to provide insurance to those who might otherwise be uninsurable. Check with your state government.
Health Savings Accounts are part of a new kind of health insurance policy called a High Deductible Health Plan. High deductible plans require you to pay the full costs of your health care up to a limit usually of a few thousand dollars. After that, the plan begins to pay benefits (although you may still have co-pays). You can set up a Health Savings Account (HSA), and deposit pre-tax dollars into this account to cover the first few thousands of dollars of expenses. Some employers might also make contributions to employee HSAs. You take a tax deduction for the contributions you make to the HSA (up to a limit, which in 2007 is $2,850 for individuals and $5,650 for families; if you are 55 or older, you can make an additional "catch up" contribution of $800). Thus, the HSA provides a tax shelter as long as you use the money for medical expenses. The amounts in the HSA need not be spent within any particular time. You can carry over unspent amounts from one year to the next. The money in the HSA is placed in an account at a bank, credit union, or other financial institution, and bears interest.
High deductible plans are the product of government policy intended to motivate subscribers to spend health dollars carefully and shop for lower cost care. That’s why you pay the first few thousands of dollars of expenses. Proponents argue that this should result in wiser and less expensive consumer choices, thereby resulting in a more efficient and less expensive health care system. Should you have an HSA? Consider the following points:
1. How does the high deductible health plan’s coverage and service compare with traditional plans? The most important consideration in choosing health insurance is the insurance part of it, not the tax savings or investment earnings. Make sure you have solid coverage of your health risks. Do you like the health plan’s coverage and does the health plan provide good service? Most individuals won’t get more in tax savings than about $1,000 to $1,200 a year, and families in higher tax brackets might save around $2,000 a year. These tax savings can be lost very quickly if the health plan’s coverage is less comprehensive than a traditional plan. A major medical crisis can cost hundreds of thousands of dollars, and holes in your insurance coverage can mean hefty out of pocket expenses for you. If you have such a crisis (and remember that just about everyone eventually gets sick or has an accident), a health insurance plan with comprehensive coverage and good service is worth far more than one that offers some tax savings. Look closely at the scope of the coverage of the high deductible plan, and try to gather information about how satisfied current subscribers are with the plan's health coverage.
2. Does the high deductible plan really save you any money? Remember that you must pay the first few thousand dollars of health expenses each year. Even though the HSA allows you to use pre-tax dollars to pay these expenses, pre-tax dollars still cost you money. If your combined state and federal income taxes are a third of your pre-tax income, 67% of the first few thousand dollars of expenses are effectively an aftertax expense for you. Contrast that with a traditional fee-for-services health care plan, where the plan often starts to pay benefits after an initial deductible of some hundreds of dollars. Some health maintenance organizations (although not all) may impose even less out of pocket cost (although it may significantly limit your choice of physicians). Depending on your health care needs, a high deductible health care plan may cost you more money, out of pocket, than other plans.
Even though high deductible plans offer tax savings, their monthly premiums can’t be deducted. Oddly, their premiums can sometimes even be higher than the premiums for traditional plans. (One of the federal government’s 2007 health insurance plans for employees and retirees has higher premiums for its high deductible option than its standard payment for services option.) Premiums are only one cost item, of course. To calculate your total costs, you would have to look at deductibles, co-pays, and scope of coverage, and how they would all work together in light of your health care needs. Factor in all these considerations, along with the tax benefits, before you make a choice.
3. HSAs have an exit strategy problem. Money in an HSA that is withdrawn for any purpose other than paying medical expenses will be subject to state and federal income tax and a 10% penalty. If you are 65 or older, you won’t have pay the 10% penalty on HSA money withdrawn for any purpose other than medical expenses, but you will have to pay income taxes. So if you don’t use the money in the HSA for medical expenses, it can be costly to withdraw, especially if you are younger than 65.
4. Are you making a good investment with an HSA? Many HSAs are with banks or credit unions, which are likely to provide returns that are lower than what you would get if you invested in the stock markets. Assume you have $500 left over each year in an HSA, and it pays interest at 3% per year (balances smaller than a few thousand dollars might earn even less; banks are not generous with interest rates on deposits). After 30 years, you will have about $24,300. This money could be used tax free for medical expenses, but would be subject to income taxes if used for any other purpose (and a 10% penalty if you are under 65).
On the other hand, assume you are in the 25% federal and 6% state tax brackets, and save the after tax equivalent of $500 per year (which would be $345). You put it in a mutual fund that invests in the stock markets as a whole (such as a broadly based index fund), getting average annual returns of 7% (which is about the historical average for the stock markets for the last 100 years). After 30 years, you’d have about $26,000, all of which has already been taxed and can be used for anything (including caviar, champagne, golf, luxury cruises, and shoes, along with medical expenses) without penalty or further taxes. Considering the exit strategy problems of using the $24,300 in the HSA for anything other than medical expenses, you’d be better off doing the simple thing and saving the after-tax money in a low cost mutual fund that invests in the stock markets as a whole.
4. Who benefits from HSAs? The people most likely to benefit from an HSA account are those in relatively good health who have low medical expenses. They can pay for their expenses with pre-tax dollars, and amounts they don’t use can be invested for the future. Over time, they may accumulate a potentially significant pool of pre-tax dollars to cover medical expenses in their later years. Also, beginning in 2007, people who have an existing IRA can make a one-time transfer of money from the IRA into an HSA. This would be a way to rapidly build up the amount of money you could use tax-free to cover medical expenses, and is particularly useful for older people with an existing IRA that holds some money they don’t need for living expenses. However, you need to subscribe to a high-deductible health plan or have an existing HSA to pull this maneuver. If you are enrolled in Medicare, you cannot subscribe to a high-deductible health plan, so you are out of luck, unless you happen to have an HSA from the past. Regardless of circumstance, you should, in the first instance, evaluate whether the high-deductible plan is the right plan for you from a health insurance standpoint.
5. When in doubt, choose the health plan with the most comprehensive health insurance coverage. HSAs have the unfortunate characteristic of intermingling insurance with investment and tax considerations. The same can be said of whole life insurance, universal life insurance, variable life insurance and other complex life insurance policies that have confused consumers for years. The purpose of health insurance is to insure against health risks, and not to provide an investment opportunity or a tax advantage. If you focus on the investment opportunities or tax advantages of a health insurance plan, you might take your eye off the ball. You have plenty of sasving and investment options outside of HSAs, some of which are tax-advantaged (like 401(k)s and IRAs, etc.). When shopping for health insurance, look, first and foremost, for a plan with comprehensive health insurance coverage and good service. HSAs may or may not make sense as a government policy to promote economic efficiency and lower costs in health care. But you as a consumer should focus on how well you (and your family) are covered against health risks. If you need open heart surgery or the full-blown course of treatment for cancer (surgery, chemotherapy and radiation therapy), or your child is in a serious accident and needs months of therapy and rehabilitation, you won’t give a rat’s left ear about economic efficiency, comparison shopping, tax advantages or investment gains. You’ll only care about whether your health insurance covers you and your family every which way from sunrise to sunset.
Disability coverage is the most important insurance you haven’t heard much about. Disability affects many people during their working years. Some suffer permanent disabilities. Others suffer long term but temporary disabilities, which may last many months or even years, but turn out not to be permanent. Disability insurance policies provide income while the person is unable to work. They will replace only part of the person’s income, but the availability of these payments lessens the need for the disabled person to liquidate retirement assets such as 401(k) or IRA accounts, or tap into his or her home equity. It is particularly important for working parents to have disability coverage, since they need to provide for more than just themselves.
Disability policies are sometimes provided by employers. These will be group policies and often are available to employees free of charge without requiring a physical exam. Benefits may be taxable if the employer pays the premium. And you are likely to lose the coverage if you change jobs.
If you buy your own policy, the benefits may well not be taxable and you’ll be able to take the policy with you if you switch jobs. Unlike employer-sponsored policies, a private policy may require a physical exam (although private policies are sometimes sold through your workplace, and those may not require a physical exam).
When shopping for disability coverage, look closely at the policy’s definition of disability. Ideally, you should receive payments if you are unable to work in your chosen field or profession, and, indeed, in your chosen specialty within your field. Such coverage is more expensive, but also more meaningful. A policy that protects you only if you cannot perform any kind of work isn’t very good protection, even if it is cheaper.
Be sure to find out if the policy can be terminated or the premiums raised, and, if so, under what circumstances. Some policies may offer inflation protection or even benefits that compensate you for the inability to make contributions to retirement accounts because you weren’t working. Of course, these features will add to the cost of the policy.
The Social Security system provides payments to those who are disabled. However, qualifying for disability payments under Social Security is difficult and time consuming. If you do qualify, the payments are modest at best. If you have dependents, purchasing private disability insurance is a good idea.
Life insurance is the most important insurance coverage you’ve probably heard too much about. One can’t watch an hour of late night TV without a sales pitch from a sports figure of 40 years ago about the need to buy life insurance from the most prestigious company you never heard of. You can hardly spend fifteen minutes with a life insurance salesman without getting a deluge of incomprehensible verbiage about permanent, whole, universal, variable, and adjustable life insurance with moveable components, flashing lights, built-in video capability, and an assortment of other mystifying provisions that cost you money but may or may not provide you with benefits that are largely indeterminable anyway from the tortuous language of the policies.
If you are single and have no dependents, ignore the siren calls of life insurance agents. Whatever the reasons they inflict on you for buying life insurance, don’t consider it necessary (or even a good idea; it’s not). Save and invest the money you would otherwise pay in premiums.
If you have dependents, life insurance may be important because your premature death really messes up the plans you and your significant other may have for your lives, the young ones, and retirement. We say “may be” because the need for life insurance depends on what other assets and resources you have. If you have a substantial net worth and plenty of liquid assets, you may need little or no life insurance. On the other hand, if you have few assets, a mortgage, car loans, large credit card balances and mouths to feed, life insurance would be a good idea.
If you’re thinking of buying life insurance, keep it simple—buy term life coverage. Term policies are much easier to understand than other products offered by life insurance companies, and simplicity lets you make better decisions. Term policies can be relatively inexpensive if you're young and in good health. Other types of policies tend to be much more expensive; and can be so confusing that you can't figure out if you're getting good value.
How much term life coverage to buy? That depends on the other financial resources you have, whether or not your spouse or partner works (and would want to continue working in case something happens to you) and what standard of living you want your survivors to have. First consider what your survivors would get from Social Security (remember that minor children get Social Security benefits, as well as the surviving spouse, up to certain limits). Your annual statement from Social Security should give you an estimate of these benefits. Also, you can go to www.socialsecurity.gov, click on “Your Social Security Statement” and you’ll be taken to a page with links that gives you information about family benefits. Check with your employer to see if it provides any benefits in the event of your death (note to federal employees: this means you, since the federal government provides survivors of deceased employees with benefits under some circumstances). Then look at your investment assets and any other resources that may be available. When you’ve scoped out your financial wherewithal, decide what your goal is. If you want your spouse to stay home and take care of the kids, and get them through college, calculate how much money your survivors would need to live on and how much the kids would need for college. Then buy enough life insurance to give your survivors a pool of money that, in addition to your other resources, would be enough to cover these expenses.
On the other hand, maybe your spouse would want to continue working, and only wants enough life insurance coverage to pay for child care and college expenses. The amount of life insurance you’d need would probably be less than in the first instance.
A comparatively young parent without substantial financial resources may buy coverage equal to 6, 8, or more times his or her annual income. That’s probably suitable for a situation like the first scenario, where the couple wants the surviving spouse to stay home and care for the children full time. If the surviving spouse intends to work or if you have significant resources from other sources, less coverage may be needed. There is no fixed rule of thumb.
A relatively new kind of insurance policy covers the expenses of long term health care. Basically, long term care means things like assisted living facilities, nursing homes and in-home care and assistance. Long term care insurance is cheapest if you buy it at a young age—look for a policy where the premiums don’t rise as you get older. If you buy in your 20’s or 30’s, the cost can be in the hundreds of dollars a year, although the amount of the premium will depend to a large degree on the extent of the policy’s coverage (i.e., more coverage means higher premiums). If you buy in your 40’s, the cost can rise to the range of one to two thousand dollars a year, depending on the amount of coverage. If you wait until you’re 65, the cost can be several thousand dollars a year.
A fair number of people eventually need one or more kinds of long term care. Medicare provides some in-home care, as do many health insurance policies. If you’re broke, Medicaid covers nursing home care but not the cost of an assisted living facility. Assisted living is quite expensive, and long term care insurance can help you cover its expenses. Otherwise you have to pay out of your own pocket.
Long term care insurance is in many ways an estate planning measure. If you have a significant net worth, or expect to have one, and want to protect it from the costs of long term care, buying long term care insurance is probably a good idea. While this kind of insurance has deductibles and other limitations, it can go a long way to preserving your assets. Long term care insurance rarely shows up on the radar screens of people in their 20’s and 30’s, but they are the ones who can purchase it most inexpensively. If you can lock in low premiums for life with decent coverage (i.e., coverage that will increase to compensate for inflation), this may be a good policy to buy even at a comparatively young age.
Beware of Limited Scope Insurance
You probably routinely receive junk mail offers of limited scope insurance. By limited scope, we mean policies for things like accidental death, cancer or other critical illnesses, credit-life, mortgage life or credit-disability. These policies tend to have a narrow scope, limited benefits, and sometimes many exclusions and limitations. Often, if you are well-insured with general health, life and disability policies, these limited scope offers are redundant or not cost effective. In general, focus on having good general insurance coverage and stay away from this limited scope stuff. Save the premium dollars for your retirement fund.
Cover Legal Liabilities: Auto Insurance, Homeowners Coverage, and Perhaps an Umbrella Policy.
Personal legal liability is another source of potential loss to your wealth. These are liabilities you might have to others. Perhaps the most common source of personal legal liabilities are accidents, especially car accidents. Accidents involving guests in your home can also result in legal liabilities. In some cases, these liabilities can be very substantial, involving hundreds of thousands, and even millions, of dollars. Every state requires that cars be insured to a minimum extent (but it ain’t much). Consider increasing your auto liability coverage up to $1 million. Most homeowners and many renters buy insurance to cover damage to their property and also personal liabilities they may have to others who visit their homes. This is another important protection against liability to others.
People with substantial net worths sometimes purchase so-called “umbrella” policies that provide additional protection on top of auto and homeowners insurance. If your net worth is in the high hundreds of thousands or more, think seriously about getting an umbrella policy of a few millions of dollars. In today’s litigious society, having a lot of coverage may pay off. Without liability insurance, years of financial planning and saving can be lost due to a single accident or other action.
Now, let's turn to investment risks.