Personal Financial Planning: PART 1 – Risk Management

Since this blog is a diary about my advocacy for financial literacy and freedom, I thought I’d begin with personal financial planning- what it is and why it is important. In its simplest definition, to be financially free is to have money working for you and not you working for money. It is about leveraging your financial know-how and assets to get the best monetary return so you can live the life you want. In starting one’s journey towards financial freedom, it is crucial to have an awareness of where he is financially, where he wants to go and how to get there.

Let’s break it down: Personal means it is customized according to an individual’s needs and goals. Financial, pertains to money matters. Planning is the process of goal-setting, creating and implementing an action plan. Combining all these, personal financial planning is the process of creating and implementing a customized plan around your needs and wants which require money.

Why do we need it? We have INFINITE NEEDS & WANTS, yet everything about us is FINITE. We have a limited paycheck, which is exhausted from payday to payday. The number of years we work is also limited, putting a cap on our earning potential and income source. For those who have planned for their retirement, who have worked in companies or countries with a good pension plan, it is a welcome reprieve from at least forty years of back-breaking work. The rest dread it because no work means no pay. Our body is also limited. Over time our body deteriorates as part of a natural process or hastened by one’s lifestyle. We cannot stop growing old, and of course death is inevitable.

In the Philippines (based on Sunlife’s It’s time findings), out of one hundred people who retire, only two are financially independent. The rest depend on relatives (45%), charity (30%), while the remaining (22%) continue to work beyond the age of sixty years old. This is a very sad reality given that our country is dominated by a working population rather than an entrepreneurial one. It underlies the fact that while most of us have worked for more than half of our lives and spent much of our waking hours preparing for work and ensuring we deliver what our bosses want and paid us for, we are not prepared to deal with our own retirement. That the past forty years of labor only resulted in improving the bottom line of our employer, and not ours. That’s why we need to have a financial plan, because these numbers can be turned around.

A good personal financial plan contains these elements: risk management, wealth accumulation, and wealth preservation. I will discuss each of these in detail. Instead of merely looking at it as a pyramid, think of it as a financial house, with risk management at the base, followed by wealth accumulation, and wealth preservation at the top.

pyramid

  1. RISK MANAGEMENT

Risk management, also known as income protection is at the base of financial planning because this is where everyone should start. To be financially secure, you must protect your income, which is the same as protecting yourself. Why? YOU are your greatest asset. Do you think that if Warren Buffett lost all his fortune and went bankrupt, he’d remain poor? Eventually he’d get it back over a few years, because his knowledge and skills are his best assets. The rich know this, so do businesses. Airlines manage risk by hedging oil prices. They buy contracts that let them buy oil, their biggest variable expense, at a fixed cost, so that if the world’s oil prices skyrocket, they can buy it at a lower price. On a personal level, the biggest expenses are those which not only eat up your savings / income but also those that prevent you from earning, like illness or a disability. This brings us to our next point. More than education and skills, your income potential can only go as far as your health can take you. Ever seen highly-paid individuals (CEO’s, athletes) who are sickly? Not really, because income is based on performance, which depends on one’s health.

We have to manage risk because it is real and present, because there are so many things outside our level of influence and control. On a macro level, we cannot predict when the next depression will be, when outbreaks will appear, or when wars will break. On a personal level, we can’t say for certain our how day tomorrow will go, what’s going to happen to us in the next five or ten years, how and when we’re going to die. Though we cannot predict the future, we can at least prepare and mitigate its impact. The financial risk that we’re trying to mitigate is the loss of income.

What happens if you don’t manage risk and have a rocky foundation on your financial house? As a fairy tale goes, the straw house which the pigs built was huffed and puffed easily when the wolf came. But when they built it on bricks, no matter how much the wolf huffed and puffed, the three little pigs were safe. The wolves in our financial journey are the natural (earthquakes, storms, eruptions, etc) and personal (accidents, sickness, job loss, death) calamities which are beyond our control. Yet, there are also financial traps we create ourselves: when we live beyond our means, when we enter into a new business without studying the market, or when we put our money in dubious sources and expect unrealistic returns (Ponzi scheme) or when we simply let greed and pride take over, that’s when the financial base crumbles. To manage risk, we need to secure our money and investments, create a savings plan, build an emergency fund, and reduce our debts.

Life insurance and health plans are the key instruments for securing income and wealth. Life insurance protects our family from income loss and enables your family to continue to LIVE, even if something happens to the breadwinner. To understand what income loss is, simply look at your monthly expenses and your liquid assets such as bank deposits and money-market instruments. Sum up your liquid assets and divide that by the monthly expenses. Say you have P500,000 thousand pesos of liquid assets and P50,000 monthly expenses. This means that your family can live comfortably for ten months, before they run out of money. At the eleventh month, they might have to sell the house, rent an apartment and use the proceeds from the sale of house to finance their living expenses. Ultimately, life insurance is a security blanket that provides an income stream to the grieving family, so that they can continue on LIVING. This is a MUST for every father and mother who wants to protect their family so that their children wouldn’t suffer because they didn’t plan for the UNEXPECTED. Single individuals also require minimum cover for life insurance so that if something happens to them, if they die or get disabled, their family wouldn’t be burdened.

Health plans pay for the high cost of hospital bills/ operations from dreaded illnesses. In the Philippines, heart attack, stroke, and cancer are the leading causes of death.   Five Filipinos die of cancer every hour. Two hundred seventy six Filipinos (yes in the Philippines) die from a fatal heart attack every day. When one gets diagnosed with a major illness, their first priority should be their health, how to get better and the treatments available and not how to pay for their medical bills, which could balloon to hundreds of thousands or even millions, depending on the severity. Skipping the base and proceeding directly to wealth accumulation leads to trouble since this means that when disaster strikes, you tap into your investments / properties. It would be good if the market was up and you sold your investments at a gain, but what if the market is down? You will be selling your investments at a loss just to pay for medical bills, just because you need it now and can’t wait for the market to take its natural course. Thus, health and disability plans, insure and secure your investments, so that you can use them for the purpose you originally intended for them (as your retirement money or a trip abroad or as education fund ).

We also need to have a savings plan because this instills discipline and also creates an awareness of our attitude towards money. Do you have the mindset of a consumer or an investor? Do you let your money go or do you let it grow? Instead of treating money as a means of exchange that allows you to buy your needs and wants, treat money as a seed, which you can grow and multiply. When you’re single, you have minimal expenses and can set aside more for investments. That’s why it’s best to start saving and investing early, because time and compounding allows you to build passive income. When you’re married and building a family, it’s best to have a savings plan that the couple agrees and will be committed to. After all, you wouldn’t want to save and invest, only for your spouse to spend it right? Both of you should CHOOSE and COMMIT.

We also need to have an emergency fund which will be used during short-term emergencies like calamities or short-term job loss or illness. The recommended emergency fund is 3-6 months of your monthly income, which should allow you to live comfortably for the same period when ever emergencies strike. When this is used up, build an emergency fund once again.

Lastly, we also need to eliminate credit card debts because of the high interest payments. When your credit card bills have piled up, settle them with your savings so that your future income stream goes to your savings and not debt servicing. To kickstart eliminating your credit card debt:  add up your latest credit card balances and settle the card with the largest outstanding amount. Ask your bank to reduce your interest rate. Even a little interest rate reduction helps, especially if your outstanding debt is already more than twice your monthly income. If you have a deck of credit cards, cut them up and leave one only for emergencies, preferably, the one with the lowest interest rate and credit limit. Commit.  Always remind yourself the high cost of not saving and investing today.

In summary, risk management is where everyone should start in their financial journey. We have already established why it’s important and the tools we can use to achieve this – life insurance, health plans, savings plan, emergency fund, and debt elimination. I will discuss the other two components in more details in the next article.

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