When developing your personal financial plan you should always remember the importance of risk management. How can we define the risk in this case? It is any contingency that may affect the success of our planning. That is, within personal finances we must take into account the risks faced by our Human Capital and Financial Capital in each stage of our life. In the present article I will explain with examples how this works in two key stages of our life: Accumulation and Retirement. To do this, we will use a hypothetical example: Juan is a 40 year old person, with a monthly gross salary of S /. 10,000 and a savings rate of 10%. Currently Juan is married and has two children (6 and 4 years old).
Accumulation Stage (25-65 years)
In this stage, the risk is mainly focused on Human Capital, which is the capital that allows us to generate the savings capacity, and with that, to grow our Financial Capital. These risks can be divided into two: (i) risk of not generating enough income; and (ii) risk of dying or becoming disabled.
Let’s see the first risk. Is Juan’s 10% savings enough? Empirically, savings rates in countries such as the US do not exceed 10%, while theoretically it is said that this rate should be at 30%. As a general rule I advise you to save between 5% and 20% of gross income. To understand the risk of not saving enough, we tear down a very popular myth: “You must start saving when you are financially mature”. False. The younger, the less responsibilities, therefore, the greater the possibility of saving. And not only that, but the younger we begin to save, the greater the accumulation of our wealth because the investment period is longer. Let’s see two cases for John’s example. The results in both cases speak for themselves.
• Case 1: Assuming a constant income level from the beginning of his working life (25 years), Juan’s savings will allow him to accumulate a Financial Capital of S /. 1.6 million at age 65. This will be equivalent to an income during the retirement phase close to nine thousand soles per month.
• Case 2: Same assumptions, but Juan starts saving at 40 years old. At 65, Juan will have a Financial Capital of S /. 625 thousand, which will allow her to have an average income of S / 3,500 per month during her retirement.
The younger we start saving, the better we can face periods of uncertain income, such as unemployment. This in turn will reduce the risk that our Financial Capital can not accumulate enough for our retirement stage.
However, perhaps the greatest risk in our professional stage is Death. Although nobody likes to talk about this issue, we must be clear that our capacity to generate income will be valid as long as we have life. In case of death or disability, this ability disappears, and compromises the wealth of our family. This is where the concept of Life Insurance appears within risk management.
Here it is opportune to demolish another myth: “The older you are, the greater must be the coverage of your life insurance”. False. Life insurance covers our Human Capital, therefore, its relevance as a risk mitigator will depend on the value of Human Capital. This type of insurance only applies to the accumulation stage, so it does not make sense to keep it after retirement (at this stage the financial capital covers the contingency of death).
Let’s see an example associated with Case 1. If Juan dies at age 40, his family would receive a Financial Capital slightly lower than S /. 1.0 million, which should subsist the 25 years that were left Juan work, and also finance the retirement of the spouse (assuming they have the same age). What happens if Juan dies at 64? The family would have a financial capital close to S /. 1.6 million, it being quite probable that the responsibility of the widow for her two children is minimal (her children would be 30 and 28 years old). That is, the amount of life insurance must be greater, as the person is younger, and must be reduced (until disappear) as the person approaches his retirement. This also applies in the case of disability insurance (total or partial).
Although at this stage there are several risks involved, I want to focus on the longevity risk, which measures the possibility of living too many years and thus leave our assets in zero. Recall that at this stage, Juan will have two sources of income: (i) the retirement pension (Human Capital); and (ii) the income generated by the investments of the Financial Capital (estimated at S /. 1.6 million for Case 1).
The longevity risk is minimized with insurance products that offer perpetual annuities from initial capital. In our example, Juan’s coverage decision can be limited in two extreme cases: (i) desire to enjoy as much as possible until the last day (I protect my consumption); or (ii) desire to maximize the capital that he will leave to his heirs (I protect my legacy).
For the first case, Juan should have part (or all) of his estate and deliver it to an insurance company to provide annuities until his death (life annuity). In the second case, Juan would have part of his income for consumption and keep the balance capitalized (income scheduled), knowing that upon his death, this fund will belong to his heirs (without insurance intervention).
While there are no magic recipes, on average it is convenient to have a mix of programmed income and annuity, either one after the other, or both in parallel. In Peru, one option is to use the pension fund (Human Capital) under the figure of Temporary Income with Deferred Life Annuity (mix of both income) and use the Financial Capital as surplus for non-regular consumption. In this case, the Financial Capital would act as Juan’s legacy.
Risk management is vital within a personal financial plan. This management involves, among other aspects, the management of insurance as a cover for Human Capital. To the extent that Human Capital is responsible for Financial Capital, it is essential to view insurance management (coverage) as an investment and not as an expense.
Although in Peru the offer of insurance does not cover the wide spectrum of particular cases, there are many recognized international companies that offer these products at competitive prices in a personalized way. For this, it is very important that they look for professional advisers within the management of patrimonies, especially those people who have high assets.