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The development of a financial plan involves many assumptions. Some relate to average rates of return for asset classes, others pertain to such things as inflation rates and living costs.
For those in the preretirement phase there is also the timeframe over which investments will be made before retirement and then, in most cases, consumed post retirement.
Using these assumptions, a planner can identify a ''wealth target''. This can be defined as the future lump sum that must be accumulated by retirement to enable the individual (or family) to enjoy the quality of life, and length of retirement, they aspire to. As you would guess, this figure is different for everyone. It is critical that the assumptions used in this calculation of the wealth target are carefully considered, as relatively small changes can have a significant impact on the final figure.
There is, however, one assumption that is sometimes not properly questioned. What would happen if you were not able to make those current and future savings because of death or disability?
Yes, the difference between achieving an average annual return of 5% or 7% is significant, but its relative impact is dwarfed by the possibility of not being able to make savings at all.
It is here that the statistics are a little sobering. In New Zealand, of 100 men over the age of 30 around 12 will die before age 65 (1). The stats are better for women, but the number is still 10 out of 100.
Disability figures in New Zealand are a little harder to find. But based on American statistics (2), a typical male, non-smoker, who leads a healthy lifestyle has a 21% chance of becoming disabled for three months or longer during his working life. There is also a 38% chance that the disability will last five years or longer.
In New Zealand, some of this financial risk is reduced by the existence of ACC, but perhaps not as much as you might think.
On average only 30% to 35% of disabilities are caused by accidents and ACC does have limits to its cover. The ACC also supports you until you can return to ''a job'', not necessarily your current role and earnings potential.
Many people get confused by the mathematics of calculating the right level of insurance cover for their circumstances. This is where it is helpful to understand the concept of a wealth target and how this figure relates to your insurance needs.
If premature death occurs, then life insurance proceeds can effectively mimic the accumulated savings that would have otherwise occurred during that person's working life effectively ''fast forwarding'' the family to their agreed ''wealth target''.
Disability and Income Protection insurance can support the family and help maintain a savings programme.
Critical Care (Trauma) cover can provide a lump sum to reduce debt or cover unexpected expenses like child care and time away from home, or specific medical treatment or non-funded medications.
However, it is important to get the balance right. Your current income needs to cover current living costs, saving for retirement and insurance. It is easy to focus too much on just one area and there is natural tension between paying insurance premiums and saving for your future.
I recommend that your risk management programme should be considered in conjunction with building wealth to get this balance right. Your personal insurance programme should be reviewed periodically. As you repay debt, and accumulate investments, your need for life cover will generally reduce.
Over time, the dollars that were previously directed towards insurance premiums could be redirected to an investment programme.
Personal risk advice is complicated and is a specialist skill in its own right. It is for this reason that I personally don't provide advice in this area but refer clients to qualified specialists.
Insurance sometimes gets a ''bad rap'' from the general public. However, over the years, I have worked with enough widows and widowers to acutely understand that when disaster does strike, a well-considered personal risk programme makes a world of difference to those left behind.
(1)NZ Life Tables 2005-07, Statistics New Zealand
(2)USA Council for Disability Awareness. Personal Disability Quotient (PDQ) calculator
-Peter Ashworth is a principal of New Zealand Funds Management Ltd, and is an authorised financial adviser based in Dunedin. The opinions expressed in this column are his own and not necessarily that of his employer. His disclosure statements are available on request and free of charge.