Protect - A Building Block of Financial Independence by the Cashflow Cop

FI Building Blocks:

Introduction

The third Building Block to FI is to Protect. If you have come here without reading the first and second steps, then go back to the FI Building Block: Earn and go forward from there.

As a Police Officer, I am used to managing risk and we are taught to have multiple contingency plans. In other words, what’s your backup plan for your backup plan? The last thing you want to do is to make good progress towards financial independence only for it to come crashing to a halt, or worse, shot back to square one because something unexpected happens. Unfortunate events in life such as losing your job and a sudden long-term family illness cannot only drastically increase your stress levels, but could seriously scupper your plans for FI. There are a number of ways to mitigate against some of these risks.

The Emergency Fund

Have an emergency fund which would cover all your expenses for six months or longer. This will give you an invaluable safety net if say your household income drops unexpectedly, or if there is a surprise expense such as a roof to repair. The reason why I recommend six months or more is because anything less will not give you the headspace you need. For example, can you really secure a new job within three months of losing your job? What happens if one disaster occurs after another, not giving you time to rebuild the small emergency fund you had? You might be able to find a job quickly and fix the roof at the same time, but the extra time really makes a difference and places less pressure on you and your family in an already stressful situation.

The money that is saved needs to be liquid (easily accessible). There is no point having an emergency fund if you need weeks or months of notice before you can get the money. Most of the time, having money easily accessible means you will be getting little to no return on it. Putting the money into the stock market means taking the risk that if you needed it, you may sell at a loss. There are ways to manage this so that you can still get some return on your money by incorporating a heavier mix of bonds in your portfolio, but for now, just think of the emergency fund as cash in the bank. Finally, you really do need an emergency fund before you start tackling any debt for the same principle. By paying off your debt, that money is gone and cannot be reclaimed in an emergency. You don’t want to be making really good progress on tackling your debt only to go back into debt because of an emergency!

Insurance

There are some in the FI community who are against insurance. Their reasonings are many, but from what I understand, it stems from the value in self-insuring and the poor value certain policies provide. That is, having a sufficient emergency fund which makes insurance pointless and a waste of money. Also, is the insurance you take out really worth the paper it is written on with all its clauses, terms and conditions? Of course, you will hear stories about a person not getting their insurance payout. The media is biased towards bad news. The reality is that most insurance claims are paid out because the policies were set up correctly and bought for the right reasons. Just make sure you read the contract and policy documents as boring as it may be. I think in certain circumstances, insurance is worth getting, but only you can decide for yourself.

Just take a moment to consider the size of the emergency needed if you or your partner suffers a critical illness so you can no longer work. Or, I dread to think, you or your partner die and you have children to bring up. Unless you win the lottery or have a substantial inheritance, such life events will mean you’ll have to work much longer than you intended to. This is where insurance can be beneficial. Yes, insurance can be expensive and the chances are, you won’t have to claim. In fact, you hope you’d never need to claim. However, in the event you do, you will be glad you had insurance in place.

Before I go through some of the main possible insurance products out there, you need to check if your employer already offers you insurance. This can save you money. However, you also need to consider that once you leave the company, the insurance may well cease. As a result, if you were to take out insurance once you have left your job, you will be older and so it will cost you more. This is why, in certain circumstances, it may make sense to take out your own insurance policy as well as having the company one. For Police Officers, at least for my Force, I have Life and Critical Illness Cover which I have also extended to my wife. However, as soon as I leave the Force, the cover stops. There is no way for me to offer to pay to continue with the cover because it is only open to serving Police Officers. I would need to take out a new cover, which by then would cost substantially more than if I took out an extra separate cover now.

Life Insurance

This type of insurance pays out in the event the person insured dies. You can go for a term level policy which pays out a set amount if you die within a certain period of time for a set premium. There are increasing term policies which increase the potential payout each year in line with inflation. However, your premiums will go up by at least the same percentage. There are decreasing term policies, which are usually taken out with a mortgage. This is when the life insurance pays out just enough to pay for the outstanding balance of your mortgage.

Once you have decided on the type of policy you want: 1) Term Level; 2) Increasing Term; and 3) Decreasing Term, you then need to decide on how long you would like the insurance to run for. The longer the term, the more expensive it is because as you get older, the chances of you dying increases due to ill health.

Unless you are choosing a decreasing term policy to cover a mortgage, you will then need to decide how much you want to be insured for. This is the amount that will be paid out. There is no set rule to decide on this. You need to decide for yourself what amount would help your family get through what would be an already difficult time. The last thing they want to worry about is money. As a start, it could be: 1) enough to pay off all your debts including your mortgage; 2) sufficient money to cover all living expenses for x number of years, or 3) money which would allow your family complete your family’s FI Plan.

By the way, there is also something called whole-life policies, but I personally find them poor value for money. They are designed to last your entire life, so are guaranteed to payout (we are all guaranteed to die). As a result, the premiums you pay will be much higher to take into account that the policy has to pay out at some point in the future. I see this type of policy as more of a savings account which provides a very poor return unless you die young. For me, the policies are not worth the money and are very expensive.

When taking out an insurance policy, there are so many add-ons. These include:

Indexation – this is when you choose to have the amount of cover increase every year based on inflation. This will ensure that in say 20 years time, the value of your life cover does not erode due to possible increased living costs. However, by choosing this option, your premiums will increase by at least the same percentage as your cover increases. From what I have found, your premiums will actually increase a few percent above inflation. Over time, this is a lot of money. It is another example of the finance sector taking advantage of the compounding effect. There is nothing wrong with that, but Cashflow Cop is here to show you how you can make the magic of compounding work for you as well. I am personally not a fan of indexation. Having said that, the main advantage is that the increased cover you get is based on your health at the time you took out the policy. In other words, you are getting increasing amounts of cover without further medical underwriting. Any life policy with an indexation option is also called an ‘increasing term’ policy.

Waiver of Premium – this allows you to stop paying your insurance premium if you become seriously ill or disabled. In other words, you continue to be covered by the insurance even when you cannot work.

Guaranteed vs Reviewable Premiums – guaranteed premiums mean that the premium you pay will not change for the entire duration of policy (unless you select indexation). Reviewable premiums mean the insurance company reserves the right to review your policy every few years and adjusts the premiums you pay. Reviewable premiums tend to start off lower than guaranteed premiums but can increase significantly. It may be suited if you are currently very price sensitive but expect your income to rise significantly in the future.

Single Life vs Joint Life

A joint life policy is one policy which insures two lives, for example for yourself and your wife. However, this type of policy will only pay out once. So, in the event one of you dies, the policy pays out once and then terminates. When taking out single life policies, it means that each person being insured have their own policy. So, in the event your partner dies, the insurance pays out, but your life remains insured. This is perhaps useful if you have children. What I have found is that getting two single life policies works out just the same as a joint policy. On occasions, it has even been cheaper!

Critical Illness Cover

This is a type of insurance which pays out even when you do not die. It pays out when you fall very ill. What does very ill mean? They call is a critical illness. The list of critical illness changes quite regularly based on medical advances, but think of it as a very serious medical condition. An add-on you can have to this type of cover is called ‘Total and Permanent Disability’ cover. This means the insurance company will pay out if you are unable to work in an occupation which you are suited by training, education or experience.

Insurance Brokers Are a Rip-Off?

I used to think insurance brokers surely cannot work in your best interest. Surely, their interests are aligned to whoever provides the best commission. Whilst this can be true, it is up to you how you manage this relationship to your advantage. I went through I broker when we took out our insurances policies. I did my research and asked prospective brokers questions. If they stumbled on any of them, I knew they weren’t the broker for me. The terms above will hopefully give you a good head start. Remember that if you are interested in any of the add-ons, to ask about them. I found adding them on did not affect my premiums, but I had to ask about them and request the broker go back to the underwriter to add them on.

They can also secure deals even cheaper than going direct. That was very much the case with me. It was significantly cheaper, so much so the underwriter was surprised they offered me such a price. I negotiated hard! They can also liaise with underwriters directly to resolve any problems. If you find that you will be ‘rated’ (industry term for policies involving an individual with medical conditions requiring much higher premiums), your broker will explain everything to you and tweak your policy to make it affordable.

Finally, if your insurance broker does not talk about a Trust, then find another. Life insurance policies can be written into a Trust so that it remains outside your estate and so not be subject to inheritance tax calculations. A trust is treated as a separate legal entity. It is something I have done with all my insurance policies and is free to do with most big providers if you ask. This alone can potentially save your family thousands of pounds in tax. If you are a Police Officer, check that the life insurance you get as part of your Force is also placed into Trust. I checked with my Police Force and it is already written into Trust. However, with 43 different Police Forces in England and Wales, I don’t know if it would be the same for every single one.

Other Insurance

There are of course other insurances to consider. Some you have no choice in the matter, such car insurance if you own a car or building insurance if your home is mortgaged. There is also health insurance, albeit more relevant to American readers at the moment, but who knows what our beloved NHS will become in the future. Would we need pay extra taxes to fund it? Would we need to pay a subscription fee? Will we need to pay extra for non-emergency treatment? These are things I am considering as part of Our FI Plan. There is also income protection insurance. This is cover for if you can no longer work for a set period of time, such as being made redundant. I find the terms of these policies restrictive and with a sufficient emergency fund, I do not find a need for them.

Key Points:

Have an emergency fund of at least six months worth of expenses.
Protect your path to FI with insurance.
Understand how life insurance works.
Use a specialist broker.
Put any life insurance policies into Trust.

Insurance can be a very divisive topic in the FI community. I also don’t think it gets enough attention. I get it. Why would you pay a monthly premium for something which you may not need? It’s money down the drain. That money could be invested and help you reach FI sooner right?! I am not suggesting that you go out and over insure yourself. Instead, take a hard look at your situation (see FI Building Block: Budget) and decide how much risk you can accept, both psychologically and financially. I am asking you to consider all the insurance options and if it is not appropriate for you, simply rule it out and reassess in the future. Cashflow Cop is about having a grip on your finances and living intentionally.

Like I have said, everyone’s journey will be different. Although I already have life and critical illness as part of my job, I have chosen to take separate cover out in the event I decide to leave the Police. This locks in our premiums at an age when we are relatively healthy. Our life and critical illness policies will run all the way until we are over 65. For us, it is a peace of mind worth paying for. I know that should the worse happen, we will still reach FI. Why didn’t we opt for a term of 7 years, covering us up to when we hope to reach FI? Well, locking in our premiums for 35 years was worth it for us. The good thing about life insurance is that you can cancel it at any time. We could cancel it once we reach FI, but could let it run and potentially leave a bigger legacy for our children. If my mind is set on something, I want to make sure I have multiple plans in place to ensure I reach my goal. Statistically, I am unlikely to claim on these policies, so it is indeed throwing money away. However unlikely it is, the fact remains that it does happen. I see it every day in my job. What is your plan if it happens to you?

You’ve now learnt the basics of maximising your income, understanding your financial position and giving your finances adequate protection. Now, lets move onto learning how to make your money work for you: FI Building Block: Invest.