Financial Independence: Lighting the FIRE for the next generation (1)

lifefinance
December 27, 2022
3
Insurance, Investing, Personal Finance, Property, Saving

It was the best of times and the worst of times to reach Financial Independence and Early Retirement (FIRE) over the past few years. Best of times, because the gains in equity investments up to 2021 meant that many people could reach their FIRE goal earlier than expected. Worst of times, because the subsequent fall in both equity and bond investments in 2022 has meant that early retirees are facing a sharp fall in portfolio values just upon retirement. Which is exactly what sequence of returns risk is.

Even for those whose retirements are not at risk, the recent past is instructive with regards to investing for FIRE. At the very least, the assumptions from the past decade (the period when FIRE has become mainstream) need to be rethought and reconsidered. If you can do it all over again, what will you do, or not do? If you can pass some inspiration to the next generation looking for financial independence, how will you light their FIRE?

Lighting the FIRE for the next generation

Inspiring financial independence in the next generation is probably not contentious. More often, parents have agonised over more often is whether they should provide more than enough for their children, not just for their childhood, but also beyond that in the form of connections, gifts and inheritances. Many, especially those who attain FIRE without such advantages, believe that they need to set an example of working hard for their kids, and hence delay retirement despite being financial independent until their children have gone to college or even later. But others believe in setting up their children so that they can be free of financial constraints and can pursue their passions and aspirations.

Financial independence and FIRE for the next generation

Whatever the motivation, we can probably agree that parents have a duty to pass on whatever knowledge they can to their children. And perhaps even a helping hand, in the form of a loan, a guarantee, a fallback, or even just a place to stay, should they require it. So, how would we lay the groundwork for financial independence for the next generation? How would we do it ourselves, if we could start all over again?

Getting the Basics of Personal Finance Right

Let’s start right at the beginning of anyone’s personal finance journey. How do we help our children get the basics right, right from the start? To be honest, the next generation are much luckier, with a lot of the advice now having gone mainstream and being easily available from the web and other sources without having to pay someone to learn about it. The main pillars of personal finance we often hear about, for young people starting off, are:

Emergency funds
Insurance
Savings and investments
Getting on the property ladder
Debt

Let’s take a look at these in order.

1. Emergency Funds: Save to invest rather than putting into savings deposits

The first piece of advice any young adult usually gets, is to save a portion of their monthly pay check, and accumulate at least 6 months of expenses as an “emergency fund”. The idea behind this is to have some funds on hand should there be an emergency. For example, an illness which requires taking time off from work. Or unemployment, which can last anything up to 6 months. The emergency fund is to be kept in liquid assets, such as savings deposits, which can be withdrawn at a moment’s notice.

However, keeping an emergency fund of 6 months or more of expenses comes with the attendant sacrifices. For example, this means that you cannot invest this in more illiquid assets which have higher returns. So this delays the start of your investment journey by anything from a few months to years. Or precluding you from putting aside money needed later for an important payment or purchase, such as the downpayment for a property purchase. How can we do better?

For a start, we should recognise that having an emergency fund is basically self insurance (as we discuss here). And this is precisely what a household unit, or a family, can help with. After all, back in prehistory, people starting living together in order to pool resources and to insure one another. Think of the hunter-gatherers and the farmers ensuring their families get fed no matter whether game was scarce or harvests were poor. And by definition, FIRE’d parents will have plenty of liquid financial assets in their portfolios which they can easily liquidate to help meet the costs of an emergency!

So, the first thing financial independent parents can do for their kids is to help insure them for emergences. And allow your young adults to get started on their investing journey at an earlier age. While ultimately the investments made at an earlier age may not matter too much in the grand scheme of things (while we all know about benefits of time in the market, the amounts available at a younger age are usually too small to make a significant difference in the end results over 30 or 40 years of investing), it is more about learning to invest and putting money at risk for higher returns.

Help your children to self-insure, instead of them having to save hard for an emergency fund, and get them started on other aspects of savings and investing earlier.

2. Insurance: Do not over insure!

Almost without fail, a young adult gets approached by a friend working as a Financial Advisor or as an Insurance Agent very early on. Usually, there will be a persuasive sales pitch about ensuring their loved ones are well provided for should anything (touch wood) happen to them. After which a relatively expensive whole life and/or critical illness and/or investment linked policy is recommended. And almost invariably, the young adult is saddled with a high monthly burden of making payments to service these plans. Money which can be much better applied to taking the initial steps in financial independence.

a) Hospitalisation and Surgical insurance

Of course, some forms of insurance are useful. For example, health and surgical insurance is probably the most useful of all. So much so that everybody is almost always covered for it either by their employers, or through the national system of Medishield Life. And hence there is really no need to go overboard in obtaining additional cover for this. After all, hospitalisation statistics show that the overwhelming majority of the warded patients are not young adults, but the elderly. But other forms of insurance may not be quite as useful.

Does it make any sense to get a private Integrated Shield Plan to cover private hospitalisation costs? It depends really. Chances are, you won’t really benefit from the hospitalisation benefits. Why? It is a case of the Prisoners’ Dilemma. While only a third of the hospital beds in Singapore Class A wards at Restructured Hospitals, or in private hospitals, more than two-thirds of the population have an Intergated Shield Plan! Clearly, not all the Integrated Shield Plan policyholders are going to be staying in the class of ward they are entitled to. And in fact, this is what has been happening, as Integrated Shield Plan policyholders have been opting to stay at a lower class of wards (to save costs as well), and also giving up their expensive plans as they get older (which is precisely when they would need it most!).

However, even if you are resigned to the fact that you may never get to use an Integrated Plan for hospitalisation coverage, having access to private medial specialists under the insurer’s panel of specialists is still of value. As our population ages, stretching public healthcare resources, this access to private specialists would allow you to “jump the queue” to receive specialist medical care when the need arises. Fortunately, this is available even under the lowest tier of Integrated Plans, which makes it a cheap (especially when young) way to hedge against queues for specialist medical care!

Hospitalisation and Surgical insurance is critical, but everyone is covered either at their workplace or by Medishield Life. Private Integrated Plans are less useful for hospital coverage due to over-coverage among the population, but offer a cheap way to access specialist healthcare.

b) Life insurance

Life insurance is usually the “gateway” product through which more expensive and complicated insurance plans are upsold, so a young adult will need to be wary of this. At the end of the day, insurance is a hedge, and you should only hedge if you have a liability to cover. Ensuring your loved ones are taken care of should anything happen to you is laudable, but if your parents are financially independent, the truth is that you actually have no liability to cover. Just as you do not buy car insurance if you do not own a car, you do not need life insurance if you have no liabilities!

But should you consider your future liabilities as well? For example, it is not inconceivable that 5 or 10 years down the road, a young adult might want set up a family, and that would be having some abilities to protect or hedge against. Such arguments are obviously flawed, because no one can predict the future, and whether such liabilities actually come about. More curiously, life insurance in Singapore tends to be more expensive for the young (relative to their risk of death), than for those older, say around their early to mid 30s (see here). Again, the pricing of life insurance reinforces the point that the we should only get insurance as and when we really have liabilities to protect against!

c) Whole life and investment-linked insurance: Mixing investments with insurance

What is more pernicious in life insurance sales is the promotion of whole life policies, endowment policies and investment-linked policies. That is, life insurance with an element of savings or investments embedded in them. At the end of the day, insurance is merely a financial tool which we can use. And multi-use tools tend to perform poorly compared with tools which are designed for a specific purpose. So it is with whole life, endowment, and investment-linked insurance. They will almost certainly fare worse than tools designed for a specific purpose, like term life insurance, or investment funds and exchange traded funds.

The shortcomings of mixing investments with insurance are twofold:

Firstly, the returns on these policies tend to be lower than pure investment products, due to the layers of fees embedded (see here for a detailed analysis)
Secondly, the higher cost in terms of monthly payments to service these policies (because of the investment element) means that you will most likely end up underinsured relative to your liabilities

So, mixing investments with insurance is a lose-lose proposition!

Get term life insurance coverage only when you truly need it (e.g. when you start a family), and never, ever, mix insurance with investments!

d) Critical Illness Insurance

A relatively new form of insurance on offer nowadays and quickly gaining popularity is critical illness insurance. As the incidence of illnesses like cancer, stroke and heart disease increase, it appears to be a good idea to have some form of insurance payout which allows you to take a break from work to recuperate. The usual rules of thumb are to get covered anywhere between 1 to 5 years of income.

The downside to this is that critical illness insurance, especially for early stage illnesses and/or multiple claims, can be quite expensive and servicing sufficient coverage may create a dent in your savings and investment goals, leading to financial independence being deferred. Alternatively, you may end up choosing a lower amount of coverage. At the lower end of coverage, say about a year’s income replacement, this quantum of cover is similar to what an emergency fund will cover, and this may be something that is left to self-insurance through (financially independent) family resources instead.

Another aspect of critical illness coverage that is worth considering is the amount of coverage needed. Recovery from such illnesses will usually take longer if surgery is involved, and even among the frail, a person can be fully recovered in a year, if not less. Hence getting coverage for anything beyond a year of income may in fact be a “nice-to-have” rather than a “must-have”, in the case where self-insurance does not work.

Approach Critical Illness Insurance with caution. It is expensive and the usual recommended amount of coverage may be too high, and hence eat into financial resources which can be better used for investments.

What you can look forward to in the second part of this!

So far, we have covered the more “defensive” aspects of personal finance, rather than the aspects which can lead towards financial independence. But trying to cover all that, including: