I am always a positive person and encourage other people to always think positively about their goals, dreams and aspirations.
However, it is also important from time to time to be realistic and acknowledge that sometimes there are unexpected negative events whereby ‘bad things happen to good people’ as the saying goes. And that part of organising and optimising your finances should also incorporate mitigating the possibility of bad things happening.
It is nearly impossible to mitigate the possibility of every possible eventuality and I do not have the ability to see into the future and neither do you, but you should consider how you might mitigate what I would call ‘known unknowns’.
Those things might include:
• Unexpected capital expenditure which cannot be met out of regular cashflow – an example might be an unexpected repaid bill for you car that isn’t covered within warranty
• Loss of or interruption in regular cashflow or income – this could be through loss of current job role, changing job role, delay of payment
• Significant decline in the value of invested assets within pensions or investments – this could be due to a decline in financial markets generally or specific holdings
• Chronic ill health preventing you from working and generating sufficient regular cashflow for a prolonged period, but not necessarily immediately threatening to life.
• Serious Ill Health or Death – unfortunately at present we are all mortal and I’m sure most of us either know directly or indirectly someone who has been impacted by a serious illness which has impacted their life significantly.
So what can you do to mitigate some of these ‘known unknowns’?
Essentially you have three Choices:
1. Do nothing – run the risk of these things happening and make no provision at all. For life’s great risk takers, those who are not ready/willing to take action and people who are blindly positive – the ones who say ‘that will never happen to me’. I would never advocate for taking this choice.
2. Self insure – set aside sufficient cash to be able to cover for that eventually. That might work for some things and not for others, but most people are not in the fortunate position to have sufficient assets that they can set enough cash aside without harming their future goals.
3. Insure – this is essentially exchanging the risk of this happening with an external party – an insurance provider. The exchange works in that you pay a premium to mitigate the risk, and then if the circumstance happens the insurance company provides the financial mitigation. The main risks to you here thereafter are in keeping up the premiums to continue to have the cover in place, as well as ensuring it is the correct type of insurance whether that be in payout period, amount or frequency.
So how should you be mitigating the ‘known unknowns’ given the three choices above? Let’s go through them …
Unexpected capital expenditure
For this one there is only really one realistic option – self insure with sufficient cash savings as a reserve or emergency fund.
The question really is how much to assign towards this.
A good guide here would equivalent to 3-6 months worth of your regular expenditure. In addition you could also think about the largest realistic one off unexpected cost you could expect or have had in the last the few years.
Interruption of cashflow
Again for this one there is only really one realistic option – to self insure with sufficient cash savings as a reserve or emergency fund.
The reserve or emergency fund can cover both of the previous elements, you may just want to consider increasing it slightly depending upon your view on the likelihood of them occurring. If you are self employed or work in a volatile sector you might want to have an increased level to others.
Decline in invested asset levels
The first thing to say here is that unless there is a realistic need to access these monies in the short to medium terms, lets say 3 years, and provided that your goals have not changed and your holdings are broadly well diversified or spread and allocated correctly to achieve your goals, then you may not need to do anything.
Essentially if it isn’t permanently broken then do you need to fix it.
Unfortunately, market declines are a feature and not a bug in the financial system with history as our guide here. It is simply a case of remaining patient.
A good way to think about this is to consider your investments like an artistic sculpture, whereby the more that you touch it, move it or use it, typically the more at risk of permanent damage it becomes.
Now if you are in the situation where asset levels have already declined and you are intending to access the monies in the short to medium term, then unfortunately the only mitigation you have is to delay or reduce those withdrawals to reduce the impact of them in the long term.
If you are in the situation whereby they have not declined but you are intending to make withdrawals, you should consider reducing the risk on the equivalent amount of monies you intend to withdrawal over the next few years, or even convert them to a cash reserve or emergency fund for your assets. This is where the expertise of a professional would be useful.
Chronic ill health
So this is the instance whereby you are unable to work for a prolonged period of time due to ill health, beyond the period whereby a reserve fund would be sufficient, but not necessarily life changing/threatening.
In this instance I would be advocating for insuring this known unknown. This is typically done by something which is called an income protection policy in the UK whereby in the event of a claim after an agreed deferment period a regular tax free income equivalent.
This is a type of cover which is often overlooked, but should really be considered before others.
After all, if there isn’t sufficient flows of money coming in then significant financial implications need to happen and quickly. Insuring this simply mitigates that from needing to happen.
Think of it like insuring a money printing machine or an ATM, but that you are that precious machine!
Serious ill health or death
In this instance I would again be advocating for insuring this known unknown.
In the circumstance of serious ill health this might be done by the income protection policy which I just outlined, and it could also be in the form of serious illness cover commonly known as critical illness cover, which pays out a lump sum in the event of diagnosis of a defined list of conditions. This lump sum could be used to repay debts such as mortgage, or to enable capital expenditure to enable costs for lifestyle adjustment or change.
In the circumstance of death, this is about ensuring financial security for people who are financially dependent upon you. This could be in two forms.
The first would be in the form of a life insurance policy, which would again pay out a lump sum in the event of death which would enable debts or loans to be repaid, make lifestyle changes or support cashflow for a period.
The second would be in the form of a family income benefit policy, which would pay out a tax free income for a defined period to loved ones to compensate for the potentially reduced cashflow they are experiencing.
With insurance policies there are two key things to add. Firstly to check that if you are an employee whether you have any provision provided via your employer. Secondly, that the level of cover required is sufficient to meet your needs, but is also relevant to your circumstances, which is known as insurable interest.
So there you have it, your guide to disaster planning and how to mitigate those known unknowns.
*Investments Carry Risk. Capital at Risk.
**Protection plans typically have no cash in value at any time and cover will cease at the end of the term. If premiums stop then cover will lapse’
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