What is financial protection?
Financial protection is the vital first step on your path to financial freedom that ensures your plan is built on solid foundations.
In 2018, FT Adviser referenced research by Royal London which found that of people with a mortgage:
- Nearly half had no life insurance.
- Over two thirds had no critical illness insurance.
- Four fifths had no income protection insurance
In other words, the vast majority of the population is just one incident away from financial disaster. If the main earner dies or becomes too sick to work, these families face a serious risk of financial hardship, falling behind on mortgage payments and even homelessness.
In his Bloomberg article ‘Bias, Blindness and How We Truly Think’, Nobel Prize winner Daniel Kahneman, one of the founding fathers of behavioural economics, noted that:
“Most of us view the world as more benign than it really is, our own attributes as more favourable than they truly are and the goals we adopt as more achievable than they are likely to be.”
In many ways this is a good thing, because without this inherent optimism, humans would not be prepared to take the many risks in science, business, and life which benefit society as a whole, with occasional disastrous consequences for individuals.
But optimism bias can be dangerous. Nowhere more so than in the area of financial protection, which is the area of personal finance most widely ignored by DIY financial planners.
Financial protection is the process of developing a comprehensive plan to ensure that your family’s finances are protected against the major risks of death, ill health, and being unable to work. It’s the first financial planning topic I cover in the family factor as without it your finances can go up in smoke at any moment, leading to significant hardship.
For senior professionals, the broad priority order is as follows:
If you die without a will then the laws of intestacy apply and half of any amount of your estate above £270,000 will not go to your spouse but directly to your children. The court will appoint a guardian for your children if you and your spouse die, and someone to oversee their financial affairs.
A simple will is straightforward to arrange. Most professionals will amass larger estates over time, and where there are minor children, you may want to consider using trusts to ensure that the right provision is made for your children. Trusts can ensure that proceeds from your estate, pensions and life insurance are managed together in a way that ensures the right provision is made for your children and they get their inheritance in the amounts, and at the times, you would wish. This is a specialist area requiring legal advice.
Death benefit nominations
Your company life insurance, any policies you’ve bought (perhaps with a mortgage) and any death benefits from you pension scheme have one thing in common: they all need you to fill out a form nominating your beneficiaries. If you haven’t done this recently, make sure you check that your current spouse or partner is named.
Life insurance pays out on your death — either a lump sum or a so-called ‘family benefit’ over a period of years. It is often bought alongside a mortgage. It can either be a policy that you buy each year (‘annual renewable’) or it can be a policy bought to cover a longer period of time (‘term assurance’) with premiums paid monthly. Some policies linked to mortgages reduce the cover over time (‘decreasing term assurance’) in line with the outstanding mortgage amount.
The amount of insurance you need depends on circumstances, whether both of you earn, and so on, but should generally at least cover paying off the mortgage on the death of you or your spouse to enable the significant change in lifestyle and working patterns that may be needed, particularly if you have children.
Income protection insurance
Many financial advisers say that this is the most underused but most important insurance. It provides you with an income, potentially until age 60 or 65, if you are unable to work for a period due to illness or injury. According to the Money Advice Service, each year one million people in the UK find themselves unable to work due to illness or injury. This is around ten times the number of working age people who die in the UK in any given year. Yet despite this, around three times as many people with a mortgage have life insurance as have income protection insurance.
Note that this is not the same thing as unemployment insurance (which has a bad reputation because of the number of restrictions policies contain on paying claims). Income protection only pays out if you are unable to work due to illness or injury. Imagine what would happen to your household finances if your major breadwinner were no longer able to earn. Such an event would destroy the financial security of most families and so this should be viewed as essential cover.
Everyone should have an emergency fund in cash (premium bonds, instant access account or similar) of at least three to six months’ basic expenditure. As many have found out during the COVID-19 crisis, even apparently secure employment can suddenly seem less so, and you don’t want to be forced to sell investments just as stock markets are tumbling. This is a form of self-insurance against unemployment, and much more effective than the often expensive and hard-to-claim unemployment insurance policies. Many income protection policies have a waiting period before the benefit starts to pay, so your emergency fund can cover this too.
Critical illness insurance
This will pay a lump sum on diagnosis of certain specified illnesses such as cancer, stroke or multiple sclerosis. It can be used to fund medical fees, nursing or temporary or permanent lifestyle changes. It should be viewed in conjunction with, in particular, income replacement insurance. Premiums can seem high, particularly at more advanced ages, reflecting the likelihood of claim.
As COVID-19 has shown, we have a brilliant National Health Service in the UK, particularly for emergency and acute care. But sometimes diagnosis and non-critical surgery is much quicker and more convenient if covered privately. For this reason, almost all professionals will have health insurance offered as a company insurance benefit, but make sure you have extended the cover to family, if that is an option. If you are approaching retirement, see if you can stay in your firm’s health insurance scheme on favourable group rates.
Lasting power of attorney
These vital documents enable trusted family members to manage your finances and make medical decisions on your behalf if you either temporarily or permanently do not have the capacity to do so. Without a lasting power of attorney, families must apply to the courts to manage a family member’s finances (for example, in the case of dementia) and have less influence over medical matters. This can create great distress at difficult times. Forms for putting in place lasting power of attorney can be found online. This can be done yourself, although we had our solicitors check them as part of a simple process while getting our wills done.
Financial protection is a complex area where it is well worth taking regulated financial advice from someone authorised by the Financial Conduct Authority to recommend specific products for your needs. There are specialist advisers that focus purely on protection.
A critical first step
A financial plan without protection is like a house built on sand. Inadequate insurance leaves many families one unlucky event away from severe financial hardship including loss of their home and in a worst case may leave dependent children entirely unprotected. Financial protection should be put in place before savings and investment.