Assessing The Financial Needs Of Your Family
What should I consider when assessing the financial needs of my family when I die?
As Woody Allen wryly observed: “I’m not afraid of death; I just don’t want to be there when it happens”. Many people eventually reach a stage in their lives, usually quite late, where they require advice because they have realised the importance of planning ahead for this inevitable event.
Life and health insurance protection is the underpin of most good financial planning. These types of insurance can ensure that, if the worst should happen, the right amount of money will reach the right hands at the right time. Life insurance puts money in the hands of those who need it when a person dies. There are many reasons why this money might be needed, including paying off a mortgage (or other loan) if a borrower dies, protecting a family against the early death of a spouse, partner or parent (particularly important for people with financial responsibility for children), paying inheritance tax (IHT) or protecting a business against the financial consequences of the loss of its owner or a key employee.
The life assurance needed to cover a loan is relatively simple to assess. You need enough insurance for the amount of the loan and the cover should last for the time that the loan is outstanding. If you pay off some of the loan, you should be able to reduce the amount of cover earmarked for this purpose. But most people also need insurance cover to replace their income if they were to die. The same principles apply but the calculations are a little more complicated. For example, you decide you need life assurance cover to provide the school fees for a child who is now five and will probably be in school until she is 18. You should therefore first quantify the total amount of school fees that you would have to pay over the period and take out cover of this amount for the next 13 years.
The approach to insuring other needs is roughly the same. For example, you could calculate how much your family would need to cover the general household and other expenses and how long they would need the funds.
You can arrange for life cover to pay out a series of annual amounts over a set period, which is a simple approach to replacing an annual income. But most life cover pays out a lump sum. If you want a lump sum to provide £1,000 a year for 10 years, you would need life cover of about £10,000; if the income were needed for 20 years, you may need an amount slightly less than £20,000 as the invested sum may produce some growth or income.
It’s sometimes hard to work out how much life cover you would require overall for your family, because of the difficulties of assessing your family’s needs after one or both parents have died. Current levels of expenditure provide a good starting point for making these estimates, and then you would have to consider the other costs that might be involved, like childcare. It can be especially difficult to assess the potential financial impact of the death of a parent who spends most of their time looking after children and the household. A good starting point is to estimate the costs of buying in these services.
The best way to ensure that the proceeds of a life policy are paid to the people you intend to benefit is usually to arrange for the policy to be in a trust. The most appropriate type of trust is generally one that gives the trustees discretion or flexibility about how they distribute the benefits, but it’s a good idea to get advice about this. If you die, the policy proceeds will be paid to the trustees and then the beneficiaries – not into your estate. This arrangement should save inheritance tax and speed up the payment to the beneficiaries.
By contrast, the purpose of health insurance is to provide some money if you fall seriously ill or have an accident, potentially affecting you for many years. In this case, you would probably stop earning although your financial needs might well be greater than ever. The state benefits you would receive would be relatively low and unlikely to provide sufficient income to meet your needs, especially if you have substantial rent or mortgage payments to make. You might also need capital, for example to make adaptations to your home or to pay off loans or other liabilities. Virtually everyone who is working needs some kind of health insurance to provide financial protection if their earnings are affected by serious illness or disability. Even if you have no financial dependants, there’s a very strong chance that you will need health insurance.
Income protection – sometimes called permanent health insurance – pays a weekly or monthly income if you cannot work because of illness or disability. You may think you don’t need to worry about this kind of cover, but the fact is that, in the UK, there are over 11 million people with a limiting long term illness, impairment or disability and 1 in 7 working age adults suffer from a disability (Taxbriefs, May 2014). Some employers provide income protection insurance, but a very large number do not. It’s worth specifically checking the position with your employer. Income protection can appear relatively expensive, but can be very valuable if you fall seriously ill.
It is normally advisable for income protection insurance to be inflation-protected in two main ways. You should be able to increase the level of cover from time to time regardless of your state of health, or the cover should increase automatically in line with inflation or some fixed percentage. But it’s also important to make sure that the benefit payments themselves keep pace with inflation otherwise, if the benefit payments never increased after you fell ill and could not work, their real value would be gradually eroded over the years.
Critical illness insurance pays a lump sum if you are diagnosed as suffering from a specified illness. The advantage of critical illness insurance is the benefit is paid shortly after diagnosis of the illness, without any significant delay – unlike the waiting period of income protection. It’s also in the form of a lump sum that can allow you to make rapid adjustments to your lifestyle and pay off loans. People often take out critical illness insurance to cover a mortgage or other loan. Because you are more likely to have a critical illness than die, it’s more expensive than life insurance, but this reflects the likelihood of needing to claim on the policy.
The final area to consider is medical insurance. These are policies that help you to afford the cost of private medical treatment. Private medical insurance (PMI) pays for private health treatment, whereas health cash plans pay for everyday health costs, typically 75% – 100% of costs for dentistry, optical and consultation costs, plus a small sum for each day spent in hospital. Insurers are constantly looking at new ways to meet people’s needs, such as through life insurance that includes critical illness and/or income protection insurance, which may be cheaper. It’s important to look at your options and seek the assistance of a trusted advisor.
I want a better return on my money than I currently get at my bank and building society but am nervous of investing in the stock market. Is it worth the risk?
Probably the question I get asked the most often! Evidence shows that holding your nerve during stormy market conditions can pay dividends for investors in the long run. In 2013 – long before the latest bout of stock market turmoil – a team of behavioural economists at Barclays produced a paper with a highly intriguing title: Overcoming the cost of being human. The thesis argued that investors are their own worst enemy when they allow emotions to get the better of their reasoning. People often make less than they should from investments by buying or selling at the wrong times. In fact, they often make avoidable and unnecessary losses when they become panicked and reverse investment decisions prematurely.
It is part of our genetic make-up to react quickly to fear, which is why so many investors, having bought the right funds for the long term in a period of calm, then sell them at the first sign of market turmoil. It can happen to anyone. During the opening weeks of 2016, when a market meltdown came out of a clear blue sky, it made even hardened market professionals take decisions based on fear rather than logic. However, all the statistics of long term trends show that if we could curb our fear, we would be much better off.
The Barclays paper contains a heat map of movements in the MSCI World Index of 24 developed world stock markets for the 40-year period from 1970 to 2010 – the index is a proxy for a geographically diversified share portfolio. This analysis shows that four-fifths of all losses are incurred by investors with a holding period of less than five years. However, investors who were willing to ride out initial volatility and hold on for 12 years made a profit, whether they bought originally at a market peak or a market trough. Trying to time the market, by buying in troughs and selling at peaks, has little long-term value because the highs and lows become less relevant with the passing of time. Periods of market turmoil – such as the 1987 crash, or Black Wednesday in 1992 barely show up on a chart of long-term trends.
Three of the recognised global authorities on long-term investment returns are London Business School academics Elroy Dimson, Paul Marsh and Mike Staunton. They compile what is known as the DMS database1, published every year by the Credit Suisse Research Institute. The message of their work is that the essentials of success are to hold for the long run and have a diversified portfolio. There are, however, no absolute guarantees. Hence the key question: when talking about the long term, how long do we mean?
The Credit Suisse study helps here. It shows that in the UK, from 1900 to 2015, shares returned an average of 5.4% per annum, while bonds delivered 1.7% and cash 1%. However, it also underlines that there can be periods of underperformance, like the one we are currently living through.
Few investors like periods of volatility and where investor behaviour may have caused light ripples in the markets 30 years ago, now it can create tidal waves around the world as innovation and advances in global technology have a much quicker effect.
We may not like volatile markets but in truth we have to learn to live with them. History is firmly on our side in suggesting that the stock market should be home for a reasonable proportion of our money. Coping with volatility is the price we have to pay for the prospect of good long-term returns. Patient investors, with a diversified portfolio of assets, should be able to ride out the volatile storm.
Please bear in mind equities do not have the security of capital which is characteristic of a deposit with a bank or building society, as the value and income may fall as well as rise.
1 Credit Suisse Global Investment Returns Sourcebook, 2016
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