We’ve discussed retirement saving at some length. But when we’re young, we have other long-term financial goals too. Where do buying a home and insuring one’s life fit in?
We have so many demands on our resources that it’s very difficult to find additional money to save for retirement. Two of the most fundamental demands come from the desire to own a home, and to buy life insurance so that our dependents aren’t left in the lurch if we pass away at a relatively young age. In this post let’s (briefly) discuss both of those competing desires.
First, buying a home. Typically that requires a lump sum as a down payment, plus taking out a loan (called a mortgage) for the rest of the cost of the home. That loan in turn requires monthly payments to pay it off along with the interest charged on it. Is it worthwhile? More worthwhile than saving for retirement? Those are questions to which the answers are personal rather than absolutely right or wrong.
I’ve seen a quotation to the effect that we’re born short a home, implying that we don’t feel complete until we own the roof over our head. (Though if we buy more than one, any additional real estate is just another investment rather than bringing emotional satisfaction.) Whether the quotation is accurate or not, it reflects a strong emotional need, and for many people that’s a good enough reason to place buying a home at the top of the list.
Emotional fulfillment is a valid reason for spending – a topic I plan to enlarge upon in a future post. The thing is to pay a rational price for the home, rather than one inflated by our emotional satisfaction.
A home is usually considered a growth asset, rather than a safety-oriented one. It isn’t difficult to see that it isn’t a form of fixed income asset, since it doesn’t come with a series of pre-specified income payments that we receive. Rather, it’s a kind of asset that we hope will grow in value as our economy grows. But we shouldn’t expect its growth to be commensurate with the long-term return on equities, because a home effectively pays us dividends by saving us rental payments, and it’s the total real estate return (growth in property value plus rent saved) that would be more comparable with equity returns.
Two more comments on your home as an asset.
One is that it isn’t a diversified asset, like an equity index. It’s a single very specific holding in your portfolio. So it’s not unreasonable to expect its investment performance to vary widely from that of a diversified equity index or even a diversified portfolio of real estate holdings.
The other is that, regardless of any emotional fulfillment it may bring you, your home is also an expensive asset, and if (as it generally does) it reduces your ability to contribute to your pension pot, it may be an asset that you need to sell in order to be able to stop working. If so, it does double duty, as part of your pension pot too. We’ll examine your options at that time in a future post.
Now let’s look at life insurance. Why would you need it? In fact, why would you need any form of insurance at all? (Your home, your car, your life, whatever.) It’s because the future is uncertain, and there are some outcomes that can leave us (or our survivors) financially badly off; and even if we can’t completely avoid those uncertainties, we’d like to do something about the negative financial impact if one of those bad events occurs.
There’s a quick commonsense sort of way to think about such events, shown in the table below. This considers future risks in two ways. One way is: how likely is the risk to happen? Is there a high probability that it will occur, or is the probability low? The other way is: how big a financial impact will it have, if it occurs? A high or a low impact?
Risks and financial impacts
|High probability||Low probability|
|High impact||Budget for the expense||Pool risk; buy insurance|
|Low impact||Budget for the expense||Accept disruption|
Here’s what the table says. If there’s a good chance (a high probability) that the event will happen, build the impact into your budget. Don’t let it surprise you. After all, it is likely to happen. In the unlikely event that it doesn’t happen, that’ll be a pleasant financial surprise for you.
How about an event that’s unlikely to happen, but if it does, the impact will be small? Typically, that’s not worth bothering about. Even if it does happen, it won’t disrupt your financial situation much, because its impact is small. You may even have a small reserve for these unexpected events.
Now look at that box that represents something unlikely to happen (low probability), but if it does, it’ll have a big impact. That’s the situation you want to avoid, and that’s when insurance is generally indicated. I talked about risk pooling in Post #20. But even if you didn’t read it, it’s something you probably already do, whether you realize it or not.
For example, fire insurance for our homes. According to statistics available on the internet, the chance that a person’s home will catch fire in any given year is far less than 1%. But if there is a fire, it can do enormous damage. So we pool our risk exposure with others by buying a fire insurance policy. The premium (apart from the insurance company’s loadings) is essentially the product of the probability of occurrence and the likely financial impact. And commonly, the product is a small number. So the premium tends to be small and acceptable, and if we don’t have a claim, that’s just fine.
Now apply that principle to your life. The chance of passing away in any given year is small, while we’re working: it doesn’t reach 1% until we’re close to retirement. But if we have dependents, the loss of working income if we do pass away can be devastating. So a logical step would be to consider buying term insurance that replaces the lost income, the term ending when work is projected to end. And since the lost income declines by one year’s worth every year, a logical consideration might be what’s called a “decreasing term insurance,” where the amount paid on passing away is very large if that event happens when we’re young and declines to zero at the projected retirement age.
Of course there are many other considerations involving life insurance, which potentially has uses beyond the replacement of working income. But I’ll leave those for the experts to explain, particularly since some considerations depend on taxation, which varies from one country to another.
A home, if bought at a rational price, satisfies many potential needs: a roof over your head, emotional fulfillment, retirement savings. Decreasing term insurance can inexpensively hedge the chance that an early passing away deprives your dependents of the work income you would otherwise have earned.
I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.