After a brief getaway to visit my siblings—a yearly tradition we began after losing our mom—I’m back this week with a couple of topics I’d like to delve into. The first topic revolves around my perspective on managing finances and how they contribute to a secure and fulfilling life. The second topic involves exploring the concept of “mitigating risk” (or “indemnifying risk” as I will refer to it here) and its relevance to the previous discussion.
To be clear, your “full life” likely looks nothing like mine beyond the broad strokes. It is important to understand what “full life” means to you in order to have a basis for what that means as regards to finances. Wanting to be free to vacation or to pursue hobbies or volunteer work may result in very different long-term money needs. Also, how soon you want to make those things happen (and even a desire to have leisure while working, by way of work/life balance) are factors. However, coupled with the specifics of YOUR full life are some basics – Maslow’s hierarchy of needs: (https://en.wikipedia.org/wiki/Maslow%27s_hierarchy_of_needs):
The bottom strata are those basic needs that, unfortunately, many struggle to achieve. As noted in an earlier post, housing costs are increasingly an issue – both for availability and affordability. Recent inflation reminds us that costs generally rise (and, relative to deflation, this is not necessarily a bad thing – but it stretches our income nonetheless). In many cases, the next strata can also cause hardship if there is illness or accident along life’s path. This BLOG is about ways to manage those issues so that you have the ability to pursue the strata above – where that full life is realized.
Rather than recreate the wheel, here are a couple of posts I encountered recently and that I believe provide sound advice. the first is from New Trader U and talks about the discipline necessary to successfully save and invest for the future:
The second address ways to keep the money you have been earning and is from Bankrate via Yahoo finance:
Please take some time to look over these articles before continuing, as I will refer to them throughout the rest of this post.
Now we turn our attention to the concept of “indemnifying risk. First, some definitions for how I will use this project management conceptual framework:
Risk – The potential for financial drain resulting from an action or external cause
Risk avoidance/limitation/mitigation – Evaluating and implementing ways to avoid or reduce the impact of a risk on your bottom line
Risk indemnification – Ways to address the risk that remains once you’ve done the above (indemnifying residual risk)
Consider an example unrelated to finance to demonstrate the general concepts. Suppose I need to attend a customer meeting in a neighboring town tomorrow at 9 a.m. This town is roughly a 3-hour drive away, but traffic can be unpredictable, potentially extending the journey to 5 hours. The primary risk is not arriving on time for the meeting, which is undesirable. Upon evaluating the risk, I identify several mitigation options: 1) I could wake up at 2 a.m. to drive early, avoiding heavy traffic, but this entails waiting nearby for the meeting to start while risking fatigue, which could affect my performance; 2) I could travel this afternoon and stay overnight at a hotel near the meeting location, an option that is costly in terms of both time and money; or 3) I could contact the customer to discuss rescheduling the meeting to a later time, allowing more travel time without disrupting my sleep schedule or incurring hotel expenses.
In the above, what is missing is risk indemnification. The three options presented are all mitigation strategies, but there remains a residual risk of not attending the meeting – however small. Say I had an accident along the way, for instance. This could entail a whole new set of risk evaluations, depending on the impact to transportation and my health, and result in my missing the meeting… The residual risk of one strategy over another may be different but no mitigation will completely eliminate all risk. So, how can we indemnify the residual risk? Well, the tradition (though a stretch for this example) means is to insure against the remaining risk by shifting the impact and cost to another entity (for a fee). This is what we do when we buy insurance. If I have a car accident and am insured, I have shifted to risk of the cost of that accident to the insurer (less my deductible – itself a residual risk that I have to plan for through savings) in exchange for my payment of premiums to the insurer. However, as in this case, the analysis may not present a good or necessary way to indemnify the residual risk. After all, I’m not likely to buy an insurance product for the financial impact (if any) of missing the meeting and the residual risk may be small enough that I assess it to be worth leaving uncovered (I, or someone, can call the customer, should I be unable to make the meeting and reschedule at whatever impact that may have on relationship and schedule outside of the meeting, itself).
As it relates to our financial view, these concepts can be leveraged in similar fashion – and traditional insurance products are often – but not always – my recommendation. Let’s look at the big three items: Earning, Spending, and Saving.
At a high level, Earning covers our ability to make money through our abilities and labor as well as the ability of the money we save to produce earning. Spending covers all aspects of our consumption and includes everything from the cost of food and shelter to the cost to maintain or increase our education and knowledge (and that of those we care for). The savings part has a number of components and must address several – often competing – needs, including having the money to spend on higher education, retirement, those residual risks that we have assessed as “self-covered” (like the house or car damage deductibles), and plans we make for that full life (like vacation travel).
In the coming weeks, I will address each of these aspects in detail, but I will close out today’s entry with a (mostly) non-insurance example of what I mean when I talk about indemnifying risk. When we look at our strategies for saving for and living in retirement, I have often seen articles that discuss when the best time to take Social Security might be. Some tell us that early is better and most say to wait. Several discuss the nuances of own versus spousal benefits and how to assess the efficacy of certain claiming strategies available to surviving spouses (which will be the subject of a future post). Rarely do I see a discussion of taking these payments from the perspective of the risk of outliving your money. To my thinking, looking at Social Security as an element of savings is flawed. We pay in sure, and the average person (me included) thinks we are entitled to “get our money back”. Lately, I have been thinking about it differently. If I have planned for the future in a way that allows me to delay drawing until I reach 70 years old, the amount I will draw at that time will have increased by 8% per year for each delayed year after age 62, furthermore, the larger check will be the starting point for yearly cost of living increases, which help maintain the buying power of that larger sum into the future. This creates a stream of income that I can’t outlive – a way to view the delay as a means to indemnify the risk of not having enough savings to cover a long life. Sure, the potential is there that I could pass on before ever drawing a penny, but that won’t matter to me, now, will it? (I know, many folks have intentions to leave a legacy for their heirs and this strategy would erode their savings in the event of premature death, but it would actually benefit that strategy should they live long and prosper – with all credit to Mr. Spock). Thinking of this delay as similar to paying home or auto insurance premiums is a good way to see the benefit. We pay those costs with no intention of every needing the insurance payout, but we recognize the benefit of that cost to mitigate risk.)
I’m thrilled to kick this off and delighted to see the initial comments, even if they’re mostly from friends for now. Feel free to reach out if you’d like to see more on any related topics—your feedback is always welcome!
Kevin