Sunday, January 8, 2017

4 Keys to Winning the Financial Security Game

Depending on many factors that are usually somewhat out of one’s control, winning the Financial Security Game can either be a relatively easy process, or it can involve a significant amount of hard work, sacrifice and patience.   You can be lucky and marry someone with lots of money, inherit lots of money, discover a rich gold-mine in your back yard or win a Megabucks lottery.  Or, you can take the more traditional approach:  you can work for many years and prudently spend and save until you think you have accumulated enough assets to feel financially secure.

Generally, there are four keys to winning the financial security game:

  1. Accumulate your assets 
  2. Grow your assets 
  3. Protect your assets 
  4. Find the right balance between Trade-offs
This post will discuss, in general terms, how you can go about trying to win the Financial Security Game.  Unfortunately, since we don’t have the phone numbers of attractive and wealthy potential mates, locations of gold-mines or future winning lottery numbers, we will focus mostly on the more traditional approach to achieving financial security.

Accumulate Your Assets

The first step toward achieving financial security is to begin to accumulate assets.  Note that these should legally be your assets.  So, if you have married someone with lots of money or you expect to receive a large inheritance (or you expect to win the lottery), you should exercise some caution in your financial planning with respect to those assets until you actually have a legal right to them. 

As frequently noted in this website, the basic actuarial equation for determining how much you can afford to spend (a key determinant of financial security) depends on how much assets you accumulate. 

This equation can be stated as follows:

Where the items on the left-hand side of the equation are your assets and the items on the right-hand side are your spending liabilities. 

Generally, the traditional way to accumulate assets is to become gainfully employed and spend less than one’s employment income (save).  For younger individuals interested in becoming financially secure, this should be a high priority as the current value of their investments is likely to be fairly small and therefore their only significant asset to be tapped for future spending is going to be their future savings.

Grow and Protect Your Assets

Once you have accumulated some assets, your financial life becomes more complicated as you will now need to grow and protect those assets.  These two objectives can often be conflicting.   The following tables show financial priorities for growing and protecting assets for younger pre-retirees and for older retirees/near retirees. 

click to enlarge

click to enlarge

In developing these priority tables, we have assumed that younger pre-retirees will continue to grow and protect their assets until they decide that they have enough to retire.  Therefore, their top “asset growing” financial priorities will generally continue to be saving a significant portion of their employment income (inside employer sponsored plans or outside), earning Social Security benefits, earning pension benefits (if available) and investing accumulated assets.  While their focus is primarily on growing their assets, they must also be concerned with protecting the assets they have already accumulated and expected future income.  This is accomplished mostly through various types of insurance.  For example, life insurance or disability insurance can be very important for replacing future expected income for affected young families with children. 

As individuals get close to retirement or reach retirement, their financial priorities generally shift somewhat.  While they still must grow their assets (generally by investing them), they must also protect their (now presumably much more significant) assets to make sure that they last for the rest of their lives.  Therefore, they may choose to consult with an investment manager/Financial Advisor.   A good Financial Advisor will help them develop an investment plan (to continue growing assets) as well as a spending plan that meets their financial goals in retirement (which presumably includes not outliving assets).   In addition to possibly investing their assets more conservatively than younger individuals, retirees and near-retirees will generally select different forms of insurance than younger individuals to protect against relevant risks.

Of course, pre-retirees, retirees and their financial advisors can use our Actuarial Budget Calculators (ABC) to help develop savings strategies (generally for pre-retirees), spending strategies (generally for retirees) and for determining when they may have enough assets to afford to retire.  If you develop a spending/savings budget as an individual or as a couple, you might also want to develop separate “contingency” budget strategies based on alternative assumptions about the future, including assumptions that:

  • your current employment ceases,  
  • your significant other dies, 
  • you get divorced or 
  • one of you becomes disabled or requires long-term care,
You can also use the 5-year projection tabs to model the impact of variations in investment returns and spending.  This “contingency” modeling may be helpful in selecting types of insurance to protect your assets, deciding on an appropriate investment strategy or simply developing “what if” strategies for planning purposes.

Finding the Right Balance Between Trade-offs

Unless you are one of the extremely lucky few who suddenly comes across a big pile of money, it is not necessarily an easy task to win the Financial Security Game these days.  There are a lot of trade-offs involved and opportunities to make mistakes.  In addition to the trade-off whether to grow assets or to purchase insurance to protect your assets, you must choose how much you can afford to spend today vs. how much you will be able to spend in the future.  These decisions would be much easier to make if you could only predict your (and/or your significant other’s) future employment, lifetime, health, investment returns on your assets, inflation, inheritances, etc.  Unfortunately, we just don’t know what the future holds.  Therefore, we must make our best-estimate (or conservative) assumptions about what the future holds and be prepared when our assumptions inevitably turn out to be wrong.