Creating a Financial Safety Net Is 50% Insurance and 50% Asset Creation
By Kristopher Meuwissen
We all know that protecting your income is important. You have been told a thousand times that you need to make sure that you have enough in case you can’t work anymore. So naturally people think that when I talk to them about income protection, I’m talking to them about insurance.
Well, they are only half right. There are two ways that you can protect yourself in the event of unplanned illness, injury or death.
The first is to pass on the risk to an insurance company which is the most common type. This includes personal insurance covers such as Life, Total Disability, Trauma and Income Protection. These covers range in cost, definition and quality. They can be owned individually, by superannuation or by a company (see our article that explains the difference between different covers).
The second way is to ‘self-insure’. Simply put, you have enough income-generating assets that it no longer matters if you work any longer.
So when you speak to a financial adviser about creating a financial safety net and they don’t mention asset creation, you need to get a second opinion.
The ultimate aim in self-insurance is to have an income coming in from one or more assets, which can support you or replace your employment income. Examples of these may be investment properties that yield rent, or owning businesses (shares) that pay you dividends from profits. You may already own this style of assets and not be aware that they could grow into assets large and stable enough to provide you an income.
This is the fundamental basis of superannuation in particular – the government forces you to put aside enough assets to fund you during retirement. But for most people, super alone isn’t going to be enough, and you’re also going to have to wait until your 65+ to get it.
People have said to me in the past, “Kris, if I saved all of the money that I have spent on insurance, I would have thousands by now”, and for the most part they are correct, but part of the problem is that they are too exposed to risk at that point to not have insurance.
The reason is simple, you will be in a better financial position if you do so. You will have more assets and you will spend less money on insurance.
To understand that reason though, you need to be aware of two things.
The first is compound interest and the effect it has on your investments, and the second is how insurance is priced.
When you take compounding interest into effect, you can have a relatively small investment grow incredibly well over time. For example, if you have a $5,000 investment at 30 and you add $10,000 a year to it which grows at 8% per annum, you will have just under $500,000 by the time you are 50 years old (see figure below).
Now, take this information into account alongside the fact that insurance is price by occupation, gender but most importantly, age. What that means is a 50-year-old is almost guaranteed to be paying more for insurance than a 30 year old.
The traditional idea with insurance is that you won’t need as much as you get older because you will have paid off your mortgage and you won’t have as many dependants in the house, but times have changed.
More and more Australians are entering into 30 year loan terms in their 40s (and the cost of housing has ballooned dramatically) and many households are having kids later and later which is meaning that people are holding onto their insurance later due to necessity of liabilities and dependants.
By having a risk strategy that includes wealth creation, you should be able to reduce your insurance costs and generate an income from your investments precisely when insurance costs become extra expensive.
Keep in mind that it is a sliding scale, and the more assets you have, the less cover you will require. But the opposite is also true. The less assets you have, the more insurance cover is required.
There are so many ways that you can build your assets. Beware the ‘get rich quick’ schemes and the “I bought 5 properties in 5 years, let me show you how” spruikers. No matter what your circumstances are, it is important that you consider the following:
Protecting yourself and your family financially is a touch more complex than calling an insurer you see on the TV and getting some quick life cover. Your considerations need to expand beyond the traditional methods of risk planning.
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