Life is an adventure full of twists and turns, and learning to navigate it can take a lifetime. Unfortunately, that’s a little too late. That’s why planning early for your financial future is so important. Where to begin though? Read our article about the hierarchy of needs to learn more.
Think about mountain climbers. They don’t start climbing the mountain then decide they need more equipment, nor do they get equipment then think about how to use it. They consider the challenges and risks they’ll need to overcome to reach the summit, then decide what equipment is necessary to achieve their goal.
Financial Hierarchy of Needs
So what challenges do you face climbing the mountain of life? A good way to visualize it is by applying Maslow’s Hierarchy of Needs*. Maslow divided all human needs into a hierarchy in which the base levels must be fulfilled before a higher level need is relevant. As an example, if you’re hungry and don’t have any food, you’re not likely to be thinking about what car you want to buy. You can use this as a road map to plan out your needs throughout life, then decide what tools can help you get there.
The first level in Maslow’s Hierarchy are physiological needs. These are the basics of survival such as food, sleep, clothing, and shelter. Meeting these needs are the first priority to ensure that a person can continue living at all. This step is straightforward, but it’s not always easy. At this stage it’s hard to think beyond putting food on the table.
Safety and Security
Assuming you’re still alive, have food, clothing, shelter, (and at least a bit of sleep!), the next priority is to ensure safety and security. In Canada, the government does a lot to try to ensure these needs are met through a justice system and universal health care.
However, not all aspects of safety and security are addressed by the government. For example, one major dental procedure can present a financial challenge, so having some form of supplementary health insurance is important. This coverage is often supplied by employers in the form of a group benefits package. If your employer doesn’t provide any benefits though, or if your benefits are limited, it may be worth considering purchasing your own supplementary health insurance coverage.
Thankfully at this point you have a job that pays the bills, keeps food on the table, and you likely have coverage for basic health care costs. But what if something happens to you that leaves you unable to work? How would you continue to pay the bills and feed yourself? A major part of providing security is ensuring that you’ll be able to continue fulfilling your physiological needs, even in the case of an accident or illness.
Having a rainy day fund set aside is one idea, however it’s difficult to save enough to compensate for a lost career. Living Benefits coverage can play an important role protecting against the unexpected by providing a safety net that can pay a portion of your normal salary in the event of a long term disability or providing a lump sum benefit in the case of a critical illness.
Love and Belonging
Now that your basics needs are met and you’ve found a way to secure those needs, at this point in your life you may have started a family or be planning to. That’s great news, but ensuring your family is protected long-term gets a bit more complicated. You’ll likely want to start saving money for your kids to go to university or college, pay for their extracurricular activities… and possibly some therapy for yourself!
Term Life Insurance
One of the scariest questions you may face is, what would your family do if something happened to you? How would they continue putting food on the table? Or pay for post-secondary education? Life insurance is a great solution to hedge this risk. And the best part is, since the likelihood of you dying at a young age is low, term insurance can be relatively inexpensive. As an example, if you’re 30 years old with a newborn child and decide that your family would need $500,000 to support themselves if you died, you may only be paying a few hundred dollars a year to provide that amount of coverage for 20 years (until you’re 50). This is a simple and inexpensive way to provide security for your family in the early years. It’s important to note though, that because the risk of you dying increases dramatically as you age, renewing that same policy at age 50 will also be significantly more expensive. As a result, term life insurance is best used only as a short term solution.
Permanent Life Insurance
Another option is a permanent life insurance policy. As the name implies, instead of lasting only a set number of years, these policies last your entire life. They tend to cost a bit more because, unlike term insurance for which the insurance company rarely has to pay out, the company always pays eventually with permanent insurance, provided you keep your policy in force. Some newer forms of hybrid policies also provide more flexibility by building up a guaranteed cash surrender value. As an example, if you paid premiums for 20 years into one of these policies, and then decided you no longer needed life insurance, you could surrender the policy and potentially get back some or all the premiums you paid. Not such a bad deal.
Once you’ve got your family secured and are on a good trajectory, you’ll likely begin focusing more on who you are, what you’ve done, and what you hope to achieve in your life. At this stage, your higher needs are for respect from others, and more importantly, respecting yourself.
As an example, are you proud of your career? Do others look up to you as a role model? And what is it you hope to achieve in your life? These are difficult questions, so don’t despair if you don’t know the answers. Achieving these kinds of goals may require greater amounts of capital and thus more sophisticated planning. Some people may decide they don’t like what they do for a living and decide to turn their lifelong hobby into a business. This can be a very exciting time, but figuring out how to fund a new venture is rarely simple.
Investing in a TFSA
Your best bet is to start planning for this time well ahead. This can take the form of investing in a TFSA which can be drawn down without incurring any new tax on your investment income. Keep in mind that there are limits on how much you can invest in a TFSA each year.
Investing in Life Insurance
Another less frequently considered option is permanent life insurance. It sounds counter-intuitive, but because insurance can build a cash surrender value (CSV), it can actually be used as collateral for a loan. Hybrid Life insurance in particular is well suited to this as it generates CSV faster than traditional products. This can be a very effective way to fund a new business, or an expansion of an existing one. The best part is you still maintain your insurance coverage. In the case of a tragedy, your insurance death benefit can pay off the loan and the remainder still goes to your beneficiary.
The highest tier in Maslow’s hierarchy of needs is self-actualization, when you are committed to fulfilling your ultimate potential. This can include mastering a talent or skill, becoming a central figure in your community, or leaving a legacy for future generations. At this stage there are three primary considerations from a financial perspective: retirement, your estate, and your legacy.
Preparing for retirement can take many forms depending on your career or business. Some people may rely on a pension while others will have invested in an RRSP or TFSA that they intend to dip into. Again, another often overlooked option is using the cash surrender value of life insurance as collateral for a loan that can be used for retirement planning. Exempt life insurance policies are not subject to tax on the investment income earned within the policy unless it is withdrawn by the policy owner. In addition to this benefit, newer hybrid policies also offer guaranteed cash surrender value and investment options, that can guarantee a return for life.
The second consideration is your estate. Life insurance is a clear and effective strategy for maintaining the wealth passed to your spouse, children, or estate. The reason why this is so effective is because when you pass away you are deemed to dispose of your assets which can result in an income tax liability. This can significantly impact the value of your estate. On the other hand life insurance death benefits (including any value in the policy’s fund) are received by a beneficiary on a tax free basis.
The third consideration is the legacy you leave after you pass away. Beyond the assets that you pass to your spouse or children, you may hope to have a lasting positive impact on the world. One of the most common ways of doing this is by donating to a charity. Did you know that you can name a charity as the beneficiary of a life insurance policy? Some people, as an example, will purchase a permanent life insurance policy when they’re young to ensure their family has security, but as they age and their children become successful, they find they no longer need the same amount of coverage. At that point they might choose to change the beneficiary from their spouse or children to a charity.
*Maslow, A. H. (1943). A theory of human motivation. Psychological Review, 50(4), 370-396