Personal Finance (Sec. 4.4)

FUNDAMENTALS OF FINANCE

A Guide for Helping Professionals

Adam J. McKee


This work is licensed under an Open Educational Resource-Quality Master Source (OER-QMS) License.

Open Education Resource--Quality Master Source License


SECTION 4.4: CAPITAL PRESERVATION


What’s the worst thing that can happen? The answer, of course, is plenty, and almost all of it bad.

-Jim Cramer


It has often been repeated that “a penny saved is a penny earned.”  Even if the expression has become trite, there is a lot of truth to the sentiment.  Money is a finite resource, and if it is not protected it can quickly vanish.  Much of what I’ve said in this book has been about saving it and not wasting it frivolously.  Sometimes disasters happen.  Big ones.  The kind of things that can suck all of your wealth down a great big hole never to be seen again.  Your house can burn down and take all of your stuff with it.  You could wreck your car, or a tree could fall on it.  You could be in an accident and be hospitalized for months.  These things are pretty terrible to think about, but we should always be protected against such catastrophes as much as we can.

Rule:  Hope for the best, and plan for the worst.

Insurance

There are companies out there that will insure anything if you can pay them enough, but we’re not talking about the odd case of a major league pitcher insuring his pitching arm for millions of dollars.  We’re talking about the everyday variety.   The idea of insurance is to spread out great risk.  It is a way to pay a relatively small sum of money (your “premium”) to recover the money you lose if you damage your car, your home, or your health.  These premiums can add up to a staggering sum.  Insurance is necessary and prudent, but you must be prudent when selecting what to insure and a policy to insure it.

Always keep in mind that insurance companies are not helping you out in your time of need because they are just kind and generous folks.  They are businesses and that means that they exist to make money.  That’s not to say that insurance folks are bad people and that they don’t provide a useful service.  But since they are in the business to make money, you should be a value shopper and look for the best value you can find.  Often this means being very specific about the product you want and comparing prices for just that product.  Insurance agents love to upsell you on higher commission products just like used car dealers love to sell you those extended warranties that you’ll likely never use.

A critical aspect of any insurance policy is what is known as the deductible.  The deductible is a specified amount that you must pay before the insurance company will start paying.  If the loss is less than the deductible, then the insurance company pays nothing.  Obviously, if everything else was equal, you’d want a deductible of zero.  The reason most of us have insurance policies with a deductible is that insurance companies give you a discount if you retain some of the risks.  Let’s say you find an almost invisible rock peck in the paint on your car.  If it costs you nothing, you’ll likely take it to the body shop and get it touched up.  If you have to pay $500 to the body shop before the insurance “kicks in,” you are likely to ignore the small, barely noticeable imperfection.  As a general rule, then, the higher your deductible, the lower your premium.  Different insurance companies do things different ways; some require that the deductible is paid per incident, and others require that it be paid each calendar year that an incident occurs.

This differs by the type of insurance as well.  Deductibles for medical insurance are most commonly based on the calendar year, and automobile insurance is usually per incident.  This means that you’ll need to read each of your policies carefully so that you know exactly how they work before you need them.

As I write this, the fate of “Obamacare” is a hot political topic.  How healthcare is done in the United States is likely to change dramatically over the next four years.  As it stands now, you will most likely get health insurance through your job.  This is usually considered a benefit because your employer pays at least some of the premiums.  Spouses and children can be added at an extra cost, which is taken out of your paycheck.  If you are married with children, then you will want to get premium information from both of your jobs in all possible combinations of coverage.  Your objective is to get the best coverage with the least premium.  The quality of health insurance matters!  Medical insurance can have copays, coinsurance, and deductibles.  It can get really complicated really fast.  You have to struggle through the explanations of how your policies work.  If you take daily medications, for example, it may be worth paying a higher monthly premium for the spouse’s insurance that has the best copay on those medications.  This is really boring and tedious stuff, but it can save you thousands of dollars if you make the best decisions.

Because medical insurance can leave you hanging with a ton of extra expenses every year, some employers offer what is known as a Flexible Spending Account (FSA).  You can put around $2,500 dollars per year into this account, and it comes out of your check before taxes.  This saves you some money.  Read the prospectus carefully before enrolling in one of these plans.  Many of them keep any money you don’t spend!  One strategy is to contribute only what expenses you know for a fact that you will spend annually, such as maintenance medications.  Most insurance companies these days issue you a special credit card that your doctor’s office and pharmacy will be happy to accept.

If you purchase anything that is not allowed, you will be billed for the purchase amount by the insurance company, and you get in trouble with the IRS if you don’t pay up.  The bottom line is that FSA accounts are a good idea if you have predictable medical expenses and you use your FSA card to pay your copays at the time of service.  If you are healthy and do not have any predictable medical expenses, then the annoyance and risk of loss are just too great.  Many FSA accounts can be used to pay vision and dental expenses as well.  If you have no or bad vision or dental insurance, this may be a good alternative.  Be sure to read your plan carefully and talk with your provider before enrolling!

Life Insurance

The big idea of life insurance is to protect your loved ones against the loss of income that occurs if you die and your paycheck stops coming.  That’s it. Period.  Don’t let an insurance salesman convince you of anything else.  All sorts of strange things are sold by insurance companies that masquerade as investment vehicles.  Anything called an “investment policy” is something to be avoided.  What you want is good old, cost-efficient “term” insurance.  Term insurance has no bells and whistles, and your rate is guaranteed for a specific period of time (the “term”).  Insurance companies love to sell you annuities.  Think of an annuity as being something like a corporate bond, but with big fees and commissions attached to it.  If you want bond exposure, then buy bonds.  Don’t buy overpriced insurance dressed up as an investment.

If you are a young parent with young children, term life insurance is cheap.  You should purchase enough to pay all of your joint debt and replace your income for around 20 years.  The odds are that this means having between $500K and $800K.  The idea is that your surviving spouse can raise the kids without you on that just as they could with you (financially speaking of course!)  There is no point in getting crazy and buying any more than that.  As the years go by, you can subtract your retirement account value–which is usually paid as a death benefit to your next of kin if you die–from the amount of insurance you need.  As your insurance terms expire, you can usually dramatically reduce your death benefit.  This is a very good thing, because the older you get, the more insurance costs.  When you get retirement age, insurance is phenomenally expensive and you will not even need it.

Many employers give you some life insurance as a benefit to working for them.  These policies are often for one year’s salary.  For example, if you make $40,000 per year, then your employer may give you $40,000 in life insurance as part of the job.  Many employers allow you to buy multiples of that amount for a very reasonable price.  For example, my employer gives me one year’s salary and allows me to buy another 5 years out of my paycheck.  If you have young children at home and don’t already have a sizable savings/retirement account, you need a lot more.  Max out the work insurance, then buy a term life policy for the balance of the 20 years.  In my case (if I was just starting my career), I’d need to buy an additional 14 years’ salary worth of insurance.  Since my retirement account is 15 years old and all of my children are near adulthood, I need far less life insurance.  That’s great for me since I’m getting to the age where any life insurance is expensive.  Now that I’ve said all that, do your own research and decide which strategy you like best.  I tend to err on the side of leaving your family more money that many financial advisors suggest.

Some employers also offer an “accidental death” insurance for next to nothing.  Statistically speaking, if you die in your early twenties, it will most likely be from accidental causes rather than “natural” causes.  If you like the idea of having this cheap insurance there, then it is probably not a bad idea to buy it.  Just keep in mind that it only pays off in the case of an accidental death; you cannot use it in your minimum insurance needs calculations.  Think if the accidental death policy as your way of sending your spouse on a nice vacation in the Bahamas to get over the tragedy of your passing.

If you do not have dependents, then buying life insurance is stupid.  Put Uncle Bob as the beneficiary on the one year’s salary worth of insurance your job gives you and let that do it.  If you can’t get insurance through work, all you need is a “burial policy.”  Insurance salespeople make it seem downright irresponsible to not buy a huge policy.  Base your numbers on the lost income that you need to replace.  If no one depends on your income, then you are wasting your money.

Disability Insurance

If you go to Bankruptcy court and observe the folks sitting around waiting for their case to be heard, 1 out of every 4 are there because of disability.  Banks take houses from people that cannot pay because of a disability more often than they do from people that die.  Maybe that is because more people have life insurance than do disability insurance.  You absolutely must have both!  The big idea of disability insurance is to protect you and your family financially if you cannot work.  Because of the huge array of things that can prevent you from working, everyone is at risk of becoming disabled.  Many employers offer this type of policy to employees at a very reasonable price.  Be sure to take advantage of this!

If you are shopping for a disability policy outside of work, there are a couple of things that you want to look at that are unique to this type of insurance.  The first is how they define disability.  You’ll want to make sure what types of disabilities are covered by the policy, and whether you can accept the risk that those limits create.  Rather than having a deductible like car insurance, most disability insurance has what is called an “elimination period.”  These periods, which range from a month to a couple of years, are how long you must wait before the insurance benefit starts to pay.  Make sure your emergency fund and your elimination period are aligned such that you’ll have an uninterrupted income.

The final thing you’ll want to know about a policy before you buy it is the benefits period.  This is how long you get the benefit.  For some policies, you only get benefits for a matter of months.  Some extend into several years.  The most expensive ones will last until you reach retirement age.  Of course, if you recover from your inability to work, the insurance company will stop paying.

Perhaps the biggest reason people make the tragic mistake of not buying disability insurance is that they think the government provides benefits for disabled persons.  This is true to a certain extent, but unfortunately, that extent is not enough to live on comfortably.  There are other limits as well.  Government disability insurance is provided by the Social Security Administration under the Social Security Disability Insurance (SSDI) program.  To be eligible at all, you have to have worked a number of years and paid into social security.  To receive this benefit, you must be totally disabled.  This means that if you can do pretty much any job under the sun–not just your job that you are trained for–then you are not eligible.  Even if you are eligible, the benefits are not very good.  The absolute maximum you can get as of this writing is $26,000 per year, or around $2,170 a month.  Another factor is that getting on SSDI is notoriously difficult because of the government’s efforts to prevent fraud.  Conventional wisdom says that you will be denied the first time you apply no matter what.  Since the disability insurance companies do not want to pay you, they will do a lot to help you get on SSDI.  This is arguably worth the monthly premium if you ever need the assistance!

Homeowner’s Insurance

If you own a home, the odds are that it will be the biggest investment of your life.  (I hope that when you retire your 401k is much more valuable than your house!)  Houses can burn down, get flooded, fall down in an earthquake, get struck by lightning, and trees can fall on them.  Lots of bad stuff can potentially damage and destroy a house.  You’d be pretty stupid to own something as valuable as a house and not have insurance on it.  Most people take their entire working life to pay for a house, and banks and mortgage companies will insist that you provide proof of insurance.  So, most folks that own a house have insurance.  There are a lot of things you’ll want to look at before settling on a policy.  The bank only cares that their investment is covered in case of a loss.  That doesn’t mean that a particular policy is great for you and your family!  Many policies do not cover particular types of damage, such as earthquakes and floods.  Be sure to read the fine print before you buy.  The government makes you sign a paper when a policy doesn’t cover some kinds of damage; be sure to read all of those notices carefully before you sign them and forget that you did.

One of the biggest mistakes you can make is buying homeowners insurance that doesn’t adequately cover your other property that you keep inside the house.  Your home is very valuable, but so is everything else you own!  Insurance folks refer to the value of the property that will be replaced when a home is destroyed as “contents insurance.”  Contents insurance has a lot of rules as to what it covers; jewelry, furs, and guns are commonly not covered at all.  You will want to add special “riders” if you are a jewelry collector or a gun nut.  Outbuildings are another concern.  If you have a storage shed, for example, that you keep a lot of expensive tools in, you’ll need to talk to your agent about how to cover that.  Be sure that you are getting “replacement value” and not “fair market value” for your contents!  Replacement value means that you get enough money to buy all of your stuff back from a store.  Fair market value means what you could get for all of your stuff at a garage sale or selling it all on eBay.

Automobile Insurance

American’s have a love affair with vehicles.  They are usually far more than just a way to get from Point A to Point B.  Most of us spend a ridiculous amount of money on cars.  Car insurance protects your investment in case you damage the car, another driver damages the car, or an “act of God” (for some reason, insurance companies blame hail storms and falling trees on God) damages the car.  Most of us have some form of auto insurance because almost every state requires you to have liability insurance to get on the road, and if you don’t carry “proof of insurance” you can get a big, fat ticket.  You can get insurance with a lot of bells and whistles, but what you really care about are the liability amounts (which are usually set by state law), and the comprehensive and collision insurance.

Automobile insurance prices vary a crazy amount from person to person and from company to company.  It really pays to shop around and get quotes.  You’ll want to do this every time your policy is set to be renewed.  You can spend an incredible amount of money to get car insurance if you are considered to be in a high-risk category by the insurance companies.  The biggest risk is someone convicted of driving under the influence of drugs or alcohol.  Drunk driving is obviously stupid, the fines are immense, and the fine is nothing compared to what your insurance will cost you until the conviction drops off your driving record a decade later.

Other risk factors include your sex, your age, and your driving history.  To get the best price on insurance, you want to be an older female with a perfect driving record (no moving violation tickets) and no auto insurance claims and a great credit score.  The most expensive insurance premiums are awarded to young males with lots of tickets and insurance claims and bad credit scores.  Obviously, you can’t change your age or gender, but you can drive carefully, avoid tickets, take a driver’s education course while you are still in high school, and getting good grades if you are still in school.  If you have more than one vehicle, you can often get a multi-car discount, as well as insuring more than one family member with the same company.  Insurance companies that cover cars, houses, and people will often give you some pretty big discounts when you “bundle.”  If you are getting quotes anyway, consider asking for a “bundle” quote for your life insurance, auto insurance, and homeowners insurance.

If you do not own your home but rent or lease it, then you may want to consider renter’s insurance.  Renter’s insurance is similar to homeowners insurance except that the part that actually covers the cost of the house is taken out.  This means that renter’s policies are usually cheap.  The price varies widely, so shop around for these as well.  You can often get discounts for bundling your renter’s insurance with other policies, such as your car insurance.

Saving Money on Insurance

If you have a family, insurance can be a huge chunk of your monthly bills.  Because insurance comes out as a payroll deduction or an automatic electronic payment (you get a discount for that!), we rarely ever think about it.  This is one place where the average family could save a lot of money if they take the time to evaluate their insurance every six months or so.  Look for discounts; let your agent know that you are unhappy with your premiums and are shopping around.  They’ll get motivated to help you find every discount possible then!  You can also get a better deal if you pay for the entire policy period up front.  Most insurance companies charge you a fee to let you do monthly payments.  Recently, some companies have started waiving the fees if you do automatic online payments.  Be sure to investigate all of the fees and discounts you can get, and do it on a regular basis.  It certainly isn’t fun, but if it can save you several hundred or even thousand dollars per year, then it’s a good use of your time!

References and Further Reading

To find out more about SSDI and how it works, visit the Social Security website at the following link:

https://www.ssa.gov/disability/


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