Summary/TL;DR
A plan to protect your income and assets from the unexpected is just as important as your plan to grow them. Sufficient cash reserves, life and disability insurance, and liability insurance are key components to a robust financial defense.
Introduction
Your asset and income protection form the foundation of your overall financial plan. Those who dismiss the importance of the (admittedly boring) basics such as building an emergency fund/cash reserve and obtaining sufficient life, long-term disability, and liability insurance coverage, will fall much further behind in their goals than their peers who don’t.
In today’s post, I discuss the three most important pieces of a robust protection plan that, when properly implemented, will serve as a springboard for sustainable and long-term financial success.
Emergency Funds/Cash Reserves
No matter what your circumstances are, a strong cash reserve is essential. It’s purposes are many fold - paying the deductible on an insurance claim, smoothing out temporary and unforeseen fluctuations in your cash flow, or replacing income during a season of unemployment.
The “right amount” to keep on hand is different for everyone. You don’t want to keep such a small balance that you’re exposed to risk, but you also don’t want to keep such a large balance that you’re crowding out your other goals and missing out on investment gains. In general you’ll need 3-6 months of living expenses plus insurance deductibles on homeowner’s, auto, and health insurance. Here are some rules of thumb for how much to keep in your cash reserve:
Single, no dependents: 3 months of living expenses + insurance deductibles
Married with children: 6 months of living expenses + insurance deductibles
Married without children:
Single income household: 6 months of living expenses + insurance deductibles
Dual income household: 3 months of living expenses + insurance deductibles
Business owners: Depending on your industry and the consistency and reliability of your revenue streams, you might need anywhere from 3-12 months of living expenses + insurance deductibles. Obviously, the more unpredictable your cash flow is, the more your cash reserve should be.
When you first sit down and figure out how much your cash reserve can be, it can prove to be intimidating. The thought of saving tens of thousands-of-thousands of dollars before getting to focus on your other goals isn’t fun for anybody. For this reason, I encourage people to segment their cash reserve into equal parts and prioritize each segment within the rest of their savings goals.
For example, if I have a $40,000 cash reserve goal, then the first $10,000 is my highest savings priority. Every dollar I save needs to be sent to my cash reserve until this first checkpoint is reached. Beyond this, many of my other saving goals take priority and could look like this:
Cash reserve up to $10,000
Contribute up to match in 401(k)
Cash reserve up to $20,000
Hit my target savings amounts for my children’s 529 savings plans
Maximize Roth IRA
Cash reserve up to $30,000
Maximize 401(k)
Other goals (if applicable)
Cash reserve up to $40,000
Cash reserves are best split between a savings account and higher yield cash equivalents such as money market mutual funds or high yield savings accounts (HYSAs).
This way, if a small amount of cash is needed right away it can be transferred to your checking account immediately. Everything else is earning a more respectable amount of interest in safe and highly liquid vehicles that can be transferred to your savings account within 1-2 business days. Certificates of deposit (CDs) are not an ideal place to store cash reserves.
Life & Disability Insurance
Most individuals have life and disability insurance through their employers and (mistakenly) believe that they are sufficiently covered. This puts them and their families at huge risk in the event of a catastrophe. Life insurance is essential for protecting your business partners, spouse, children, or other dependents who would struggle after your passing. Disability insurance will protect your income (personal and business) if you experience an illness or accident that prevents you from working.
Like cash reserves, the precise amount of life and disability insurance that you need is unique to you. I always encourage against “rules of thumb” with insurance and working with a planner to help you determine how much you actually need.
Those in the financial services industry understand all-too-well that not all life insurance is created equal. Here’s all that I have to say on this topic for today’s post. Life insurance is not an investment. It is not a tax haven. And it is not a retirement account. Anyone trying to sell you life insurance on these pretenses is up to no good. If what you need is true life insurance – death benefit to provide your family with essential assets that they would otherwise be deprived of in the event of your death – then you need term insurance. Period.
When it comes to purchasing life and disability insurance, your employer’s coverage is often the best place to begin. If your budget allows, however, I almost always recommend purchasing individually owned policies that will follow you from job to job.
Liability Insurance
The last, and unfortunately commonly overlooked, essential piece to a strong asset protection plan is umbrella liability insurance. This covers you in the event that you are sued and integrates with the liability insurance within your homeowner’s and auto policies. It also provides more comprehensive coverage than your homeowner’s and auto insurance.
At net worth levels above $1M, this becomes essential. Fortunately, it is some of the least expensive insurance you can buy, with a $1M policy costing around $200-400 annually. Umbrella insurance is sold in increments of $1M, and its best practice to regularly purchase more as your wealth increases over time.
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