How to Buy Life Insurance

How to buy life insurance

Choosing the right type of life insurance policy and its death benefit can be confusing. Not too long ago, I published a guest post from Baruch Silverman of The Smart Investor on the different types of life insurance. In this post, you’ll learn how to buy life insurance.  Specifically, I’ll help you evaluate which, if any, of those types of policies fit your situation and how to select your death benefit.

Why are You Buying It?

The first thing you want to consider is why you are buying life insurance. Three common purposes are:

  • the death benefit.
  • the investment returns.
  • sheltering gifts to your heirs from income taxes.

Death Benefit

If your primary purpose for purchasing life insurance is the death benefit, you’ll want to focus on term and whole life insurance.

Investment Portfolio

Some people use life insurance similar to other financial securities (such as stocks and bonds). Variable life and universal life have investment components to them. In simplified terms, the total amount you pay as premium for these types of life insurance is split between the amount to cover the cost of a whole life policy and the excess which can be invested. As such, the life insurer doesn’t invest the portion of premium related to the death benefit.  Further, the life insurer reduces the excess to cover its expenses, a risk charge and its profit margin before investing it.

Variable and universal life policies include the cost of whole life insurance.  Thus, only people who want the coverage provided by whole life insurance might consider using life insurance as part of their investment portfolio. Even then, the returns may not be as high as other investment vehicles with similar risk because of the additional costs charged by the life insurer.

Tax Shelter

Sheltering gifts to your heirs from income taxes only applies to the very wealthy (those who have more than $11 million in assets). I’m assuming that the vast majority of my readers aren’t in this situation, so won’t address it here.

Other Considerations

All types of life insurance can have an indirect impact on your investment portfolio. If you purchase life insurance in an amount that will cover your dependents’ basic living expenses, it allows you the option to invest your portfolio in riskier assets in anticipation of getting higher returns. That is, the death benefit itself could be considered a low-risk investment.  It reduces your overall portfolio risk when added to the other assets you own.

Do I Need Life Insurance?

Some people don’t need the death benefit from life insurance. In that case, it doesn’t make sense to buy life insurance as an investment security either. In the last section of this post, I provide the details of estimating your target death benefit. People whose target death benefit is zero are those who don’t need life insurance.   Briefly, characteristics of people who have a target death benefit of zero are:

  • Their available assets are more than their debts. Available assets exclude any illiquid assets (such as any real estate or personal property they own), savings for their dependents’ retirement (but not their retirement as they don’t need retirement savings after you die), emergency savings and any savings designated for large purchases.
  • They have enough money to cover their dependents’ education expenses.
  • Their dependents can support themselves on their existing income plus your available assets, including being able to make debt payments as they are due or after using available assets to pay off any debts.
  • They have enough money to pay any end-of-life expenses related to their death.

If you aren’t sure if you meet these criteria, keep reading!

Term vs. Whole

If  you’ve decided that you are buying life insurance for the death benefit, you need to decide whether term life or whole life insurance will better meet your needs. The primary differences between the two options are the length of time you need the insurance and the cost.

Term Life

If you think you will need life insurance for a limited period of time, term life insurance is likely better for you. For example, you might have dependents who aren’t currently able to cover their living expenses and the cost of any debt.  In that case, you might want to buy life insurance that will pay off your debts and support your dependents until they are independent.  If your needs change, many insurers will let you convert a term life insurance policy to a whole life policy without having to provide medical information or have a physical, one or both of which are often pre-requisites for purchasing whole life insurance.

Term life premiums are constant over the term of any policy you purchase. However, if you buy a policy when you are older, the premium will be higher than if you buy the same policy when you are younger.

Whole Life

If you think you will need life insurance for your entire life, whole life insurance is likely better for you. For example, if you have a spouse or disabled children who will never be able to support themselves, whole life insurance could supplement your savings to help make sure they are able to live more comfortably, regardless of when you die.

In addition to the death benefit, whole life insurance gives you the option to borrow money. As you pay premium, life insurers designate a portion of your premium as the cash value. The cash value is always owned by the insurance company, but you are able to borrow an amount up to the cash value at any time without prior approval, any collateral or impact on your credit score. The interest rates on cash-value loans are less than many other sources, particularly credit cards. If you die before the loan is re-paid, the amount of the loan will be deducted from your death benefit.

Cost Comparison

Whole life insurance is much more expensive than term life when you are young, but eventually becomes less expensive.

Probability of Dying

The graph below provides some initial insights into the difference in cost between whole life and term life, as it shows the probability that you will die at each age. I calculated the values based on 2016 data from the Social Security web site.

Probability of dying for each year of age

Not surprisingly, the probability you will die increases at each age. If you buy whole life insurance, it will cover the entire portion of the graph from your current age until you die. As such, there is a 100% probability that the life insurer will pay your death benefit (assuming you continue to pay your premiums). It is just a question of when.

If you buy a 20-year term policy and you are 30 years old, only the deaths that occur in the portion of the graph below highlighted in green would be covered. That is, you will receive the death benefit if you die between ages 30 and 50 and will get nothing if you die after age 50.

Same line graph with blue shading from ages 30-50

The probability you will die is much smaller in this narrow window than the 100% probability you will die at some point.

Present Value of the Death Benefit

There are many factors that determine the premium for term life and whole life insurance policies, but the most important component relates to the death benefit. Actuaries (who help price life insurance) usually base the portion of premium related to the death benefit as the present value of the death benefit expected to be paid, on average, in each year.

One-Year Term Policy

The chart below shows the present value for $1 of death benefit for several sample policies. For illustration only, I have calculated the present values using a 3% interest rate and the probabilities of dying from the charts above.

Present value of death benefit divided by death benefit at each of ages 25, 35, 50

The easiest way to see the impact of the increasing probability of dying is to look at the present value of the death benefit for a 1-Year Term Life policy. You can see it increases from almost zero (actually $0.0015 per dollar of death benefit) at age 25 to $0.042 per dollar of death benefit at age 70 which corresponds exactly to the increase in the probability of dying at each age.

Policies with Longer Terms

There are also increases in the present value of the death benefit for the Whole Life and 20-Year Term Life policies as the age you first start buying the policy increases.

You can also see that the present value of the death benefit at age 25 for the Whole Life policy is much, much larger than the present value for either of the two term life policies. This relationship corresponds to the graphs above which compared the probability of dying in a 20-year period as compared to the 100% probability that you will die at some point.

The difference between the Whole Life and 20-Year Term Life policies is fairly small at age 70, because there is a high probability that you will die between age 70 and 90 – the period covered by the 20-Year Term Life policy. In fact, almost 80% of people age 70 will die during the 20-Year Term Life policy period.  As such, the present value of the death benefit for a 20-Year Term Life policy at age 70 is very roughly 80% of the present value of the death benefit for a Whole Life policy.

Annual Premium

The insurance company collects premium over the full life of the insurance policy to cover the present value of the death benefit. That is, you don’t pay all of your premium to the insurance company in one lump sum, but rather on an annual or monthly basis.

Unless you die during the policy term of the Term Life policy, you will pay premium for more years under a Whole Life policy than under a Term Life policy. Therefore, the differences you see above are larger than the differences in premium payments.

Illustration

The chart below shows the annualized amount of the loss costs. That is, I divided the present values of the death benefits by the average number of years an insured is expected to pay their premium. For example, for the 20-Year Term Life policy, the denominator was calculated as the sum of the probabilities that the insured would be alive in each of the 20 years and therefore able to pay his or her premium.

Approximate loss cost per year per dollar of death benefit at ages 25, 35, 50 and 70

Although these relationships are not precise, they are roughly representative of the differences in annual premium you might pay for the different types of policies at different ages. At age 25, the annual cost of a Whole Life policy in this illustration is roughly three times the cost of either of the Term Life policies. By age 70, the annual cost of a Whole Life policy is less than the cost of 20-Year Term Life policy because, while the present value of the death benefit isn’t all that different between the two policies, people who buy Whole Life policies make more premium payments, on average.

Reality vs. Illustration

It is important to understand that I prepared these examples as illustrations to help you understand the differences between Whole Life and Term Life insurance premiums. In practice, life insurers use different tables showing the probability of dying and different interest rates than I used for illustration, as well as using more sophisticated methods for calculating the present value of the death benefit and including provisions for expenses, risk and profit.

In practice, I’ve seen estimates that Whole Life annual premiums are anywhere from three to fifteen times more than Term Life premium at young ages. As you are looking at your options, you’ll want to get several premium quotes, as they vary widely depending on your age, location, gender, health and many other factors.

How Much to Buy

As with any financial decision, there are two conflicting factors that will influence the amount of the death benefit you buy on a life insurance policy – your budget and your financial needs. In the section, I will talk about how to estimate the best (i.e., target) death benefit for your situation. Once you’ve selected an amount, you can get quotes from several insurers to see whether the premium for that death benefit will fit in your budget or whether you will need to find the best balance between premium affordability and death benefit for you.

Rules of Thumb

Not surprisingly, there are some rules of thumb for guiding your selection of a death benefit. Some of the ones I’ve heard are:

  • Three to five times your salary
  • Ten times your total earned income (i.e., salary, value of benefits and bonus)
  • Ten times your total earned income plus $100,000 per child for college

Rules of thumb like these can provide some insights, but they, by definition, can’t take into account your personal circumstances.

Tailored Approach

A better approach for selecting a death benefit is to analyze your own finances and goals for buying life insurance.   I suggest calculating your target death benefit as the total of the amounts needed to meet your goals, considering the following components.

Debt

If you have debt, you’ll want to consider whether your dependents will be able to continue to make the payments on the debt out of their own income. For example, if your spouse’s earned income is high enough to continue to make your mortgage payments, along with all of the other expenses he or she will need to cover if you die, then you might not need to include the remaining principal on your mortgage as a component of your target death benefit. On the other hand, if you are concerned about your dependents’ ability to continue payments on any debt, you’ll want to include the outstanding principal on those debts as a component of your target death benefit. I’ll define this amount as “Debt Principal to be Pre-Paid.”

Final Expenses

When you die, your dependents will incur some one-time expenses. These expenses can include your funeral or memorial costs and professional expenses to settle your estate. I’ll call the amount of these expenses, “Final Expenses.”

Net Future Living Expenses

The next component of your target death benefit calculation is the amount you need to cover your dependents’ future living expenses.

Current Expenses

Start with your household’s total expenses from your budget. This amount will include monthly expenses for everyone in your household, the amounts you are setting aside each month for your designated savings and any amounts you are setting aside for your spouse’s retirement. To be clear, it will exclude any amounts you are saving for your own retirement.

You can eliminate any monthly expenses or amounts for designated savings for things that are only for your benefit. For example, if you spend enough money on clothes for your job to include it in your budget, you can eliminate those expenses. Similarly, you can also eliminate any expenses related to a vehicle that only you drive or designated savings to replace it.

Earned Income

You then need to calculate your dependents’ monthly earned income. This amount may be calculated in two parts – current monthly earned income and future monthly earned income. For example, your spouse may currently work part time as you are relying primarily on your income for support. If you die, your spouse may be able to work full time to increase his or her earned income. Alternately, your spouse may need some education (discussed below) to get the qualifications needed for his or her desired profession.

Extra Expenses

Next, you’ll need to calculate the amount of any expenses that your household will have because of any changes in your spouse’s availability to provide household services. For example, your spouse may work part-time while your children are in school and provide childcare after school. If your spouse starts working full time after your death, you will need to add after-school care expenses to your budget.

Time Periods

The last factor that goes into this calculation is the length of time until you think your dependents will become self-sufficient. For children, you might assume that they will become independent after they turn 18 or graduate from college. The ability of your spouse to become self-sufficient will be a function of his or her skills, education and/or need for more education and household responsibilities (e.g., childcare or elder care).

I suggest splitting the calculation of this component of your death benefit into three time periods – short-term, medium-term and long-term. For each time period, you’ll calculate your net living expenses as expenses minus income. For any periods for which income is more than expenses, set the difference to zero.

  1. Short term – During this time period, you’ll use your current monthly expenses, excluding your personal expenses, and your dependents’ current monthly earned income.
  2. Medium term – During this time period, you’ll use your current monthly expenses with adjustments for extra expenses for services currently provided by your spouse and your dependents’ future monthly earned income.
  3. Long term – During this time period, you’ll assume that your children (other than those who will always be dependent on you for care) are self-sufficient, so can eliminate all expenses related to children and their care from your expenses. You’ll use your spouse’s future monthly earned income. In many households, income in this period will exceed expenses so there may not be a need for death benefits to cover expenses in this period.

You also need to estimate how many months each of these three time periods will last.

Net Future Living Expenses

Your Net Future Living Expense amount for each time period is calculated as the number of months it will last multiplied by monthly net living expense amount. You can then calculate your total Net Future Living Expenses as the sum of the three amounts you calculated for the three time periods.

For those of you who like to see formulas instead of words, you will calculate:

  1. Short-term Net Expenses = Greater of 0 and Current Expenses – Current Income
  2. Medium-term Net Expenses = Greater of 0 and Current Expenses + Extra Expenses – Future Income
  3. Long-term Net Expenses = Greater of 0 and Future Expenses – Future Income
  4. Net Future Living Expenses = (number of months in short-term period x Short-term Net Expenses) + (number of months in medium-term period x Medium-term Net Expenses) + (number of months in long-term period x Long-term Net Expenses)

You could refine this amount by considering inflation and investment returns. Depending on your investment strategy and the time until the funds are used, your investment returns, on average, can be more than inflation. As a conservative first approximation, I suggest using the total without adjustment for inflation and investment returns.

Education

There are two types of education expenses that you might want to include in your target death benefit calculation:

  1. The portion of the cost of education for your children that you want to provide. Some people suggest $100,000 per child for college. This amount may or may not be the right amount depending on how much you expect your children to contribute to their educations, how many years of college education you want to support and what type of school they attend. Prestigious colleges can cost as much as $75,000 to $80,000 a year currently (2020), while in-state tuition (assuming your children live at home while attending college) can cost as little as $15,000 a year in some states. Other children may not go to college or may attend a trade school.
  2. The cost of any education your spouse needs or wants to allow him or her to work in a profession he or she enjoys and allows him or her to earn enough money to increase his or her independence.

Target Death Benefit Calculation

You can now calculate your target death benefit as follows:

Debt Principal to be Pre-Paid

Plus        Final Expenses

Plus        Net Future Living Expenses

Minus   Savings in excess of your real estate and personal property assets, emergency fund, designated savings and spouse’s retirement savings

Plus        Education Expenses

Minus   Amounts in existing college funds

Minus   Any amounts included in your Net Future Living Expenses designated for college

If you are single with no debt, this amount could be zero indicating that you might not need to buy life insurance. If you are married with no children, don’t have a lot of debt and have a spouse who can increase income or decrease expenses to be self-sufficient fairly quickly, you may need only a small death benefit. At the other extreme, if you have several children and a spouse who won’t be able to be financially independent for many years or ever, your target death benefit could exceed $1 million.   As you can see, the specifics of your financial situation are very important to setting a target death benefit and a rule of thumb may not work for you.

Do I Need a Financial Planner?

Do I Need a Financial Planner?

Creating your own financial plan can be a daunting task. If you aren’t sure where to get started or have a plan but want to improve it, a financial planner might be able to help. I’ve never used a financial planner, so I interviewed two friends who use a planner and Graeme Hughes[1], The Money Geek, to get their insights and perspectives.

In this post, I’ll first distinguish financial planners from other types of financial advisors. The rest of the post provides responses to questions asked by a few of my readers to help you with the following:

  • Figure out whether and how a financial planner can help you.
  • Prepare for your first meeting with a financial planner.
  • Understand the process for developing a financial plan and the deliverables.
  • Select a financial planner who meets your needs.

Financial Planners vs Other Financial Advisors

There are many types of advisors who can help you with your finances. In this post, I’ll focus on professionals who provide financial planning services. These professionals can be independent advisors, work for firms that perform solely financial planning services or can be employed by mutual fund companies, stock brokerage firms (e.g., Schwab or Morgan Stanley), other financial institutions (e.g., Ameriprise) or other types of firms (e.g., accounting firms). Most of these financial planners provide a brand range of services intended to assist you in creating a sound financial plan and attaining your financial goals.

Types of Other Financial Advisors

There are many other types of financial advisors, some of whom may be called financial planners, who specialize in segments of your financial plan. Examples of these advisors include:

  • Insurance agents who can assist you in finding the best insurance policies to meet your needs. Some insurance agents specialize in just property & casualty lines (such as residences, cars or umbrella policies) or health or life insurance or annuities, while others can assist with several or all types of personal insurance.
  • Stock brokers who provide advice about specific companies or financial instruments in which you might want to invest.
  • Money managers who make decisions about what to buy and sell in your portfolio and execute the transactions.
  • Debt consultants or consolidators who can help you find the best strategy for paying off your debts.
  • Tax accountants and tax lawyers who can provide advice about your tax situation and how it might impact your financial decisions. Tax accountants can also prepare your tax returns.

What’s Best for You

You’ll want to choose an advisor who has the right expertise to address your questions. If you want help with your overall financial plan, a financial planner is best. If you go to an advisor with a narrower focus in that situation, you might not get the best information for your overall financial health. For example, an insurance agent who specializes in life insurance and annuities would be less likely to focus on non-insurance savings mechanisms, such as 401k’s or exchange-traded funds, than a financial planner with a broader area of expertise.

To be clear, all of these types of advisors can be very valuable in refining your financial plan, but you’ll want to make sure you have the right expectations about their expertise. In fact, your financial planner may refer you to one or more of these consultants on a specific aspect of your financial plan.

What Services do Financial Planners Provide?

The primary service provided by a financial planner is the development of a sound financial plan. This process can include assistance with setting financial goals, budgeting, estate planning, retirement planning, selection of insurance coverages and investment strategies.

The specific services provided will be tailored to your needs. If you are just getting started, the financial planner may focus on identifying goals and creating a budget. If you already have a financial plan and want increased comfort that you will meet your goals, these services could be as sophisticated as statistical (Monte Carlo) modeling of your future financial situations under a wide range of assumptions regarding future investment returns.

As part of or before your first meeting, a good financial planner will ask about the current status of your finances and what your goals are for deliverables to make sure the planner helps you in a way that makes sense for you.

Do I Need a Financial Planner?

Using a financial planner is a matter of personal preference. I’ve never used one, but my background as an actuary and working with the finance and risk management departments of insurance companies has given me the confidence to go it alone. However, most people can benefit from good advice. As Graeme says, though, “You only need to be careful not to pay for more than you need.” His thoughts about the services you might want to use by age are:

  • A young person starting out might get counseling on budgeting, savings strategies, how much to save, and which tax-advantaged accounts to use.
  • Middle-aged individuals with more substantial savings ($100K+) might want to get an assessment of where they stand for retirement and how much to save to meet their retirement income goals, considering all of the resources at their disposal.
  • Pre-retirees (5-10 years out) will want to have a comprehensive plan to ensure they have adequately covered all likely scenarios, so they can be confident in their retirement plans before pulling the plug on work.

If you have enough assets for it to matter and aren’t highly confident you are on track to meet your goals or you suspect there are gaps in your knowledge, a professional financial planner can help.

For a different perspective on using a financial planner, check out this article from Schwab that I happened to read as I was writing this post.

What Will I Get?

Primary Deliverable

The most important deliverable from a financial planner is a financial plan. Depending on where you are in the process of managing your finances, it will include some or all of the following items:

  • Your financial goals
  • A statement of your current financial position (assets and debt)
  • A budget
  • Your savings strategies and actions, including
    • Short-term savings
    • Designated savings
    • Retirement savings, sometimes including investment advice
  • A plan for re-paying your current debt
  • Guidance about the types and amounts of insurance to buy, along with descriptions of your current policies
  • A brief description of your income tax situation
  • Guidance on what needs to be done to ensure that the legal documents are in place in case you become incapacitated or die

Other Deliverables

In addition, financial planners can provide longer term projections that show estimates of the growth in your income, assets (from investment returns and additions to savings) and expenses. These types of projections can provide insights about your ability to retire when and in the style you want.

Another benefit of working with a financial planner is that you can get referrals to other advisors and can become aware of other financial resources to help with different aspects of your financial life. For example, most financial planners do not draft legal documents, such as wills, trust agreements or powers of attorney. Many financial planners, though, have worked with lawyers who have this expertise and can provide you with a referral.

How Should I Prepare?

All financial planners have their own unique processes. As such, you’ll want to ask your planner the format of the information he or she would like to see. Many planners will provide you with a questionnaire and/or an information request to guide you through the process of compiling your information. Nonetheless, there are a number of fundamental pieces of information that every financial planner will request. They are your:

  • Assets, including retirement accounts
  • Liabilities
  • Income
  • Monthly expenses
  • Current or future defined benefit pension benefits
  • Financial goals
  • Values

Graeme was quite clear that the numerical values above should be firm, accurate numbers, not guesses. It will take some time to compile all of this information, but will ensure that you get the best service from your financial planner. He also added that you should “run away” from any planner who makes recommendations before obtaining this information.

What is the Process?

You are likely to meet with your financial planner once or twice to create or refine your financial plan initially. Some planners prefer to learn about your finances by reviewing documents and answers you provide to their questionnaires. Other planners prefer to have an introductory meeting to learn about you and your finances. In either case, the financial planner wants to learn your objectives and concerns, along with your family structure.

The financial planner will then assess your situation and goals, identify gaps and challenges, and determine the most appropriate strategy for ensuring your goals will be met. The planner will prepare a financial plan and an investment plan, including an asset allocation assessment for investments, and provide them to you in writing.

Your financial planner will then meet with you in person to present the plan and make recommendations. You and your planner will then identify the action items that come out of the plan and assign them to either you or the planner, depending on their nature and your planner’s areas of expertise.

How Often Should I Check Back In?

Financial planning is not a “one and done” exercise. You’ll want to track your progress against your plan and adjust it as necessary. Adjustments might be needed as there are changes in the economy and investing markets or changes in your personal life, such as marriage, a death in the family, children, or a change in your goals.

If both your life and the economy are fairly stable, once a year may be often enough to meet with your financial planner. More typically, you’ll want to check in with your financial planner twice a year. Of course, if you have any life changes, it will also be a good time to check in with your financial planner to see if any tweaks or more significant changes to your financial plan are indicated.

How are Financial Planners Paid?

There are a number of different ways in which financial planners are paid. Here are some of the more common options.

No Charge

If you use a financial planner at a brokerage firm or mutual fund company, you can often get some financial planning services at no charge. The more money you hold at the brokerage firm, the more services you can get at no charge.

Fixed Fees Per Service

Many independent financial planners will provide services on a fixed-fee basis. That is, they will charge you a fixed cost for each of the different aspects of your financial plan with which they provide assistance. Financial planners at brokerage firms also can charge fixed fees for services that are beyond those that are provided at no cost.

Commissions

Financial planners who also sell products, such as insurance or mutual funds, are often paid based on the products you purchase through them. For example, sellers of insurance are often paid 5% to 15% of the premium on the policies you purchase.

Percentage of Assets

Although it is more common with people who manage your money than with advisors who help you with your financial plan, some financial planners are paid as a percentage of the market value of your assets that they manage. This type of compensation is also common for financial planners who work for mutual fund companies.

What’s Best for You

When you get advice from a financial planner, you’ll want to understand the possible biases introduced by the form of their compensation. The vast majority of financial planners are ethical and are focused on your best interests. Nonetheless, you’ll want to be aware of the possibility that the solution proposed by a financial planner is potentially influenced by their compensation. As such, I suggest seeking financial planning advice from people who provide their services either at no charge to you or for a fixed fee.

How Do I Find the Financial Planner that is Best for Me?

One of the best ways to identify possible financial planners is to get recommendations from other financial professionals with whom you already have a relationship, such as an accountant or attorney. If you have friends who are particularly financially savvy, you might ask them for a recommendation. However, you are probably at least as skilled at selecting a financial planner as any friends who are in the same boat as you. And, you are a better judge of a good fit for you than anyone else. Also, I strongly recommend against using a family member as a financial planner. There are almost always too many emotions tied up in family relationships for a family member to be able to advise you on a subject that often requires difficult conversations, such as your finances.

Check their Qualifications

Once you have identified one or more possible financial planners, you’ll want to check their qualifications and whether they have been disciplined. In the US, the most common designation attained by professional financial planners is a Certified Financial Planner, though there are many other designations that indicate expertise, such as a Certified Financial Analyst or a Certified Public Accountant (CPA).

Once you’ve identified the candidates’ professional designations, you’ll want to check to see if there has been any disciplinary action against them. Disciplinary actions are all available on-line. Graeme’s words of wisdom are, “I don’t care how minor the infraction. I wouldn’t go near anyone who has been disciplined. It’s not hard to be an honest advisor, and I wouldn’t trust anyone who has failed at that.”

Interview a Few Financial Planners

You then want to interview the remaining candidates. Again, I’ll provide Graeme’s advice, as I think it is right on target.

  • Are they generous with their time?
  • Do they listen to you?
  • Do they listen to your spouse?
  • Are they genuinely curious about your situation and your plans and goals?
  • Do they ask questions?
  • Or, are they too quick to sell you something?

Your Final Selection

Look for a combination of training and experience. A financial planning designation should be a minimum, along with several years in the industry. They should also be able to refer you to current clients who can recommend their services.”

I suggest that you also think about whether you feel you can develop a good, long-term relationship with the potential advisor.  Also, consider whether they garnered your respect during the interview. Starting the process of financial planning on a shaky foundation will be unproductive at best.

[1] Graeme Hughes is an accredited Financial Planner with 23 years of experience in the financial services industry. During the course of his career he completed hundreds of financial plans and recommended and sold hundreds of millions of dollars of investment products.

A Man is Not a (Sound Financial) Plan

A man is not a (sound financial) plan

“A Man is Not a Plan!” It sounds like a very dated statement, but a guide on a recent trip I took told me about a conversation he had with one of his nieces about her finances.  They were talking about how she could improve her financial situation by building a sound financial plan. As they were talking, one of them came up with the slogan, “A Man is Not a Plan.” He suggested I use it as the title for one of my posts. So, here it is!

In this post, I will talk about the key components of a sound financial plan. A financial plan provides the structure to help you organize your financial information and decisions. I’ll provide brief explanations of the things to consider about each component, what you need to do and, for most of them, links to posts I’ve written that provide much more detail. I’ll also provide insights on how to know when you need help and who to contact.

Sound Financial Plan

A sound financial plan includes the following sections:

    • A list of your financial goals – In this section, you’ll want to identify your three to five most important financial goals.
    • A list of your current assets and liabilities (debts)
    • Your budget
    • Your savings and investment strategies to help you attain your goals, including
      • Short-term savings
      • Designated savings
      • Retirement savings
    • Desired use of debt, including re-payment of current debt
    • Your giving goals
    • Risk management strategy, i.e., types and amounts of insurance to buy
    • Understanding of your income tax situation
    • What you want to have happen to you and your assets when you become incapacitated or die and related documents

     

  • You will likely be most successful if you create a formal document with all of these components of a sound financial plan. You’ll want to review and update your financial plan at least every few years, but certainly any time you have a significant change in your finances (e.g., a significant change in wages) or are considering a significant financial decision (e.g., buying a house, getting married or having children). Of course, a less formal format is much better than no plan at all, so you should tailor your efforts to what will best help you attain your financial goals.

    Budget

    A budget itemizes all of your sources of income and all of your expenses, including money you set aside for different types of savings. It provides the framework for all of your financial decisions. Do you need to change the balance between income and expenses to meet your goals? Can you make a big expenditure? How and what types of insurance can you afford? How much debt can you afford to re-pay?

    I think that a budget is the most important component of a sound financial plan and should be the first step you take. Everyone should have a good understanding of the amounts of their income and expenses to inform the rest of their financial decisions.  While some people will benefit from going through the full process of creating a budget and monitoring it, others can be a bit less detailed.

    In the text section of your financial plan, you’ll want to include a list of your financial goals as they relate to your budget and how you plan to implement them. You can include your actual budget in your financial plan itself or as a separate attachment.

    Savings

    I generally think of savings in three categories (four if you include setting aside money for your kids): emergency savings, designated savings and retirement savings. You will want to address each of these types of savings in your financial plan. The information you’ll want to include for each type of savings is:

    • How much you currently have saved.
    • The target amounts you’d like to have saved.
    • Your plan for meeting your targets.
    • For what you’ll use it.
    • How fast you’ll replenish it if you use it.
    • How much you need to include in your budget to meet your targets.
    • Your investing strategy.
    • A list of all financial accounts with location of securely stored access information.

    Emergency Savings

    Emergency savings is money you set aside for unexpected events. These events can include increased expenses such as the need to travel to visit an ailing relative or attend a funeral or a major repair to your residence. They also include unexpected decreases in income, such as the reduced hours, leaves of absence or lay-offs related to the coronavirus.

    The general rule of thumb is that a target amount for emergency savings is three to six months of expenses. I suggest keeping one month of expenses readily available in a checking or savings account that you can access immediately and the rest is an account you can access in a day or two, such as a money market account.

    Designated Savings

    Designated savings is money you set aside for planned large expenses or bills you don’t pay every month. Examples might include your car insurance if you pay it annually or semi-annually or money you save for a replacement for your car you are going to buy in a few years.

    To estimate how much you need to set aside for your designated savings each month, you’ll want to look at all costs that you don’t pay every month and figure out how often you pay them. You’ll want to set aside enough money each month to cover those bills when they come due. For example, if your car insurance bill is $1,200 every six months, you’ll want to put $200 in your designated savings in each month in which your insurance bill isn’t paid. You’ll then take $1,000 our of your designated savings and add $200 in each month it is due to pay the bill.

    Retirement Savings

    Saving for retirement is one of the largest expenses you’ll have during your working lifetime. There are many aspects of saving for retirement:

    • Understanding how much you will receive in retirement from government programs, such as Social Security in the US or the Canadian Pension Plan in Canada.
    • Setting your retirement savings goal.
    • Estimating how much you need to save each year to meet your retirement savings goal.
    • Deciding what are the best types of accounts in which to put your retirement savings – taxable, Roth (TFSA in Canada) or Traditional (RRSP in Canada).
    • Determining in what assets (bonds, stocks, mutual funds or ETFs, for example) to invest your retirement savings in light of your risk tolerance and diversification needs and how those choices affect your investment returns.

    Debt

    Debt can be used for any number of purchases, ranging from smaller items bought on credit cards to large items purchased with a loan, such as a home. Whether you have debt outstanding today, use credit cards regularly and/or are thinking of making a large purchase using debt, you’ll want to define your goals with respect to the use of debt.

    For example, do you want to never have any debt outstanding (i.e., never buy anything for which you can’t pay cash and pay your credit card bills in full every month)? Are you willing to take out a mortgage as long as you understand the terms and can afford the payments? Do you have a combination of a high enough income and small enough savings that you are willing to use debt to make large purchases other than your home? Do you have debts you want to pay off in a certain period of time?

    As you think about these questions, you’ll want to consider what debt is good for you and what debt might be problematic.  A sound financial plan includes a list of your debts, how much you owe for each one, your target for repaying them, and your strategy for using debt in the future.

    Credit Cards

    Credit cards are the most common form of debt. Your financial plan might include the number of credit cards you want to have and your goals for paying your credit card bills. As part of these goals, you might need to add a goal about spending, such as not buying anything you can’t afford to pay off in a certain period of time.

    Student Loans

    Many people have student loans with outstanding balances. In your financial plan, you’ll want to include your goal for paying off any student loans you have. Do you want to pay them off according to the original schedule? Are you behind on payments and have a goal for getting caught up? Do you want to pay off your student loans early?

    Car Loans

    In a perfect world, your car would last long enough that you could buy its replacement out of your designated savings. However, the world isn’t perfect and you may need to consider whether to take out a loan or lease a car. Your financial plan will include your strategy for ensuring that you always have a vehicle to drive. How often do you want to replace your car? What is your goal with respect to saving for the car, loans or leases? How much will it cost to maintain and repair your car?   Your budget will include the amounts needed to cover the up-front portion of the cost of a replacement car, any loan or lease payments and amounts to put in designated savings for maintenance and repairs.

    Mortgages

    Most homeowners borrow money to help pay for it As part of creating your financial plan, you might include your goal for home ownership. Are you happy as a renter for the foreseeable future or would you like to buy a house?

    If you want to buy a house either for the first time or a replacement for one you own, you then need to figure out how to pay for the house. How much can you save for a down payment? Can you set aside enough in designated savings each month to reach that goal? What is the price of a house that you can afford, after considering property taxes, insurance, repairs and maintenance?

    Once you have a mortgage, you’ll want to select a goal for paying it off. When a mortgage has a low enough interest rate, you might make the payments according to the loan agreement and no more. If it has a higher interest rate or you foresee that your ability to make mortgage payments might change before it is fully re-paid, you might want to make extra payments if you have money in your budget.

    Paying Off Debt

    If you have debt, you’ll want to include your goals and your strategy for paying it off in your financial plan. You’ll first want to figure out how much you can afford each month to use for paying off your debts. You can then compare that amount with the amount needed to meet your goals. If the former is less than the latter, you’ll need to either generate more income, reduce other expenses, put less money in savings or be willing to live with less aggressive goals. These decisions are challenging ones and are a combination of cost/benefit analyses and personal preference.

Giving Goals

Many people want to give to their community either by volunteering their time or donating money.  If you plan to give money or assets, you’ll first want to make sure that you can afford the donations by checking your budget and other financial goals.  It is also important to make sure that your donations are getting used in the way you intended, as not all charities are the same.  A Dime Saved provides many more insights about giving in her Guide to Giving to Charity.

  • Insurance

    Protecting your assets through insurance is an important part of a sound financial plan. The most common types of insurance for individuals cover your vehicles, residence, personal liability, health and life. There are other types of insurance, such as disability, dental, vision, and accidental death & dismemberment, that are most often purchased through your employer but can also be purchased individually.

    As I told my kids, my recommendation is that you buy the highest limits on your insurance that you can afford and don’t buy insurance for things you can afford to lose. For example, if you can afford to pay up to $5,000 every time your home is damaged, you might select a $5,000 deductible on your homeowners policy. Alternately, if you can afford to replace your car if it is destroyed in an accident, you might not buy collision coverage at all. Otherwise, you might set lower deductibles as your goal.

    For each asset in your financial plan, including your life and health which can be considered future sources of income or services, you’ll want to select a strategy for managing the risks of damage to those assets or of liability as a result of having those assets.

    A financial plan includes a list of the types of policies you purchase, the specifics of the coverage provided and insurer, changes you’d like to make to your coverage and your strategy for insurance in the future. You’ll also want to attach copies of either just the declaration pages or your entire policies to your financial plan.

    Car Insurance

    Car insurance can provide coverage for damage to your car, to other vehicles involved in an accident you cause and injuries to anyone involved in an accident. The types of coverages available depend on the jurisdiction in which you live, as some jurisdictions rely on no-fault for determining who has to pay while others rely solely on tort liability.

    Homeowners Insurance

    Homeowners insurance (including renters or condo-owners insurance) provides coverage for damage to your residence (if you own it), damage to your belongings and many injuries to people visiting your residence.

    Umbrella Insurance

    One way to increase the limits of liability on your car and homeowners insurance is an umbrella insurance policy. An umbrella also provides protection against several other sources of personal liability. If you have money in your budget for additional insurance, you might consider purchasing an umbrella policy.

    Health Insurance

    Health insurance is likely to be one of your most expensive purchases, unless your employer pays a significant portion of the cost. Whether you are buying in the open market or through your employer, you are likely to have choices of health insurance plan. Selecting the health insurance plan that best meets your budget and goals can be challenging.

    Life Insurance

    There are many types of life insurance, including term and whole life. Some variations of whole life insurance provide you with options for investing in addition to the death benefit. Once you have compiled the other components of your financial plan, you’ll be better able to assess your need for life insurance. If you have no dependents and no debt, you might not need any. At the other extreme, if you have a lot of debt and one or more dependents, you might want to buy as much coverage as you can afford to ease their financial burden if you die. To learn more specifics about buying life insurance, you might review this post.

    Income Taxes

    Some of your financial decisions will depend on your income tax situation.

    • Do you want your investments to produce a lot of cash income which can increase your current income taxes or focus on appreciation which will usually defer your taxes until a later date?
    • Is a Roth (TFSA) or Traditional (RRSP) plan a better choice for your retirement savings?
    • Are you having too little or too much income taxes withheld from your paycheck?
    • Do you need to pay estimated income taxes?
    • How will buying a house, getting married or having children affect your income taxes?
    • Will moving to another state increase or reduce your income taxes?

     

  • As you consider these and other questions, you’ll want to outline at least a basic understanding of how Federal and local income taxes impact your different sources of income as part of creating a sound financial plan.

    Legal Documents

    Although it is hard to imagine when you are young, at some point in your life you may become incapacitated and will eventually die. There are a number of documents that you can use to ensure that your medical care and assets are managed according to your wishes. You can either include these documents as part of your financial plan or create a list of the documents, the date of the most recent version of each one and where they are located.

    Powers of Attorney

    There are two important types of powers of attorney – medical and financial.

  • A medical power of attorney appoints someone to be responsible for making your medical decisions if you are physically or mentally incapable of doing so. You can supplement a medical power of attorney with a medical directive that is presented to medical personnel before major surgery or by the person appointed to make medical decisions that dictates specifically what is to happen in certain situations.A financial power of attorney appoints someone to be responsible for your finances if you are physically or mentally incapacitated. The financial power of attorney can allow that person to do only a limited number of things, such as pay your bills, or can allow that person to do anything related to your finances.

    Trusts

    There are several forms of trusts that can be used to hold some or all of your assets to make the transition to your beneficiaries easier when you die. Trusts can also be used to hold money for your children either before or after you die. While I am familiar with some types of trusts, I don’t know enough to provide any guidance about them. If you are interested in them, I suggest you research them on line and/or contact a lawyer with expertise in trusts.

    Your Will

    If you die without a will, your state or provincial government will decide how your assets will be divided. In many jurisdictions, your spouse, if you have one, will get some or all of your assets. Your children or parents may also get some of your assets. Most people want more control over the disposition of their assets than is provided by the government.

  • A will is the legal document that allows you to make those specifications. Your will can also identify who will become legally responsible for your minor children or any adult children who are unable to take care of themselves. That responsibility can be split between responsibility for raising your children and responsibility for overseeing any money you leave either to their guardian(s) or for them.

    How to Know When You Need Help

    As you can see, there are a lot of components to a sound financial plan and many of them are interrelated. There are many resources available to help you develop and refine your plan. Many of those resources are free, such as the links to the articles I’ve published on relevant topics. There are also many other sources of information, including personal stories, on line.

    You can also get more personalized assistance. There are many types of financial advisors, a topic I’ll cover in a post soon. Many financial advisors provide a broad array of services, while others specialize in one or two aspects of your financial plan.

    Sources of Advice for a Sound Financial Plan

    The table below lists the types of obstacles you might be facing and the types of advisors that might be able to help you create a sound financial plan.

    ObstaclePossible Advisors
    I can’t figure out how to make a budget or how to set aside money for emergency or designated savings.Bookkeeper, accountant, financial planner
    I can’t make my budget balance.Bookkeeper, accountant, financial planner
    I have more debt that I can re-pay.Financial planner, debt counselor, debt consolidator
    I don’t know what insurance I should buy.Financial planner, insurance agent or, for employer-sponsored health insurance, your employer’s human resource department
    I’m not sure I’m saving enough for retirement.Financial planner
    I have questions about how to invest my savings, including whether I am diversified or need to re-balance my portfolio.Financial planner or stock broker
    I don’t understand how income taxes work.Accountant
    I need help with a Trust, Power of Attorney or Will.Wills & estates lawyer

    Clearly, a financial planner can help with many of these questions, but sometimes you’ll need an advisor with more in depth expertise on one aspect of your financial plan.

Don’t Panic! Just Plan It.

Don't Panic. Just Plan it.

Financial markets have been more turbulent in the past few weeks than has been seen in many years, probably more volatile than has happened since many of you started being financially aware. You may be wondering what actions you should take. With the sense of panic and urgency surrounding recent news, it often feels as if drastic action is necessary. If you have created financial plan, inaction may be the best strategy for you!

As indicated elsewhere on this blog, I do not have any professional designations that qualify me to provide professional advice. In addition, my comments are provided as generalities and may not apply to your specific situation. Please read the rest of this post with these thoughts in mind.

Biggest Financial Risk from Recent News

I suspect that losing your job or losing business if you are self-employed is the biggest financial risk many of you face. Understanding your position within your company and how your company will be impacted by coronavirus, oil prices and other events will inform you as to the extent to which you face the risk of a lay-off or reduction in hours/salary.

If you think you might have a risk of a decrease in earned income, you’ll want to look into what options for income replacement are available to you, including state or federal unemployment programs, severance from your employers, among others. Another important step is to review your expenses so you know how you can reduce them to match your lowered income.  In addition, you’ll want to evaluate how long you can live before exhausting your emergency savings, with or without drastic reductions in your expenses. You may even want to start cutting expenses before your income is lowered and put the extra amount in your emergency savings.

Your Financial Plan & Recent News

In the rest of this post, I’ll look at the various components of a financial plan and provide my thoughts on how they might be impacted by the recent news and resulting volatility in financial markets. For more tips on how to handle financial turmoil, check out these mistakes to avoid.

Paid Time-Off Benefits/Disability Insurance

If you are unfortunate enough to get COVID-19 or are required to self-quarantine and can’t work from home, you may face a reduction in compensation. Your first line of defense is any sick time or paid time-off (PTO) provided by your employer. In most cases, your employer will cover 100% of your wages for up to the number of days, assuming you haven’t used them yet.

Once you have used all of your sick time/PTO, you may have coverage under short- or long-term disability insurance if provided by your employer or if you purchase it through your employer or on your own. Disability insurance generally pays between 2/3 and 100% of your wages while you are unable to work for certain causes, almost always including illness. It might be a good time to review your available sick time/PTO and disability insurance to understand what coverage you have.

Emergency Savings

Emergency savings is one of the most important components of a financial plan.  There are two aspects to your emergency savings that you’ll want to consider. The first is whether you have enough in your emergency savings.  The second is the risk that the value of the savings will go down due to financial market issues.

Do I Have Enough?

If you are laid off, have reduced hours or use up all, exhaust your sick time/PTO or get less than 100% of your wages replaced by disability insurance, you may have to tap into your emergency savings. The need to spend your emergency savings increases if you tend to spend most of your paycheck rather than divert a portion of it to savings.

I generally suggest one to six months of expenses as a target for the amount of emergency savings. In light of recent events and the increased risks lay-off and illness, I would focus on the higher end of that range or even longer. As you evaluate the likelihood you’ll be laid off, the chances you’ll be exposed to coronavirus and your propensity to get it, you’ll also want to consider whether you have enough in emergency savings to cover your expenses while your income is reduced or eliminated.

In certain situations, such as in response to the coronavirus, creditors will allow you to defer your payments.  You will then have the option as to whether to defer them or make those payments from your emergency savings./a>

Will it Lose Its Value?

I’ve suggested that you keep at least one month of expenses in emergency savings in a checking or savings account at a bank or similar financial institution. The monetary value of your emergency savings is pretty much risk-free, at least in the US. The only way you would lose any of these savings is if the financial institution were to go bankrupt. In the US, deposits in financial institutions are insured, generally up to $250,000 per person per financial institution, by the Federal Deposit Insurance Corporation (FDIC). For more specifics, see the FDIC web site. Similar protections may be available in other countries.

I’ve also suggested that you keep another two to five months of expenses in emergency savings in something only slightly less accessible, such as a money market account. There is slightly more risk that the value of a money market account will go down than a checking or savings account, but it is generally considered to be very small. Money market accounts are also insured by the FDIC. For more specifics, see this article on Investopedia.

As such, the recent volatility in financial markets are unlikely to require you to take action related to your existing emergency savings and could act as an opportunity to re-evaluate whether you have enough set aside for emergencies.

Short-Term Savings

Another component of a financial plan is short-term savings.  Short-term savings is money you set aside for a specific purpose. One purpose for short-term savings is expenses that don’t get paid every month, such as property taxes, homeowners insurance or car maintenance and repairs.   Another purpose for short-term savings is to cover the cost of larger purchases for which you might need to save for several years, such as a car or a down payment on a house.

Short-term savings are commonly held in money-market accounts, certificates of deposits (CDs) or very high quality, shorter term bonds, such as those issued by the US government. CDs and US government bonds held to maturity are generally considered to have very little risk. Their market values are unlikely to change much and the likelihood that the issuers will not re-pay the principal when due is small.

Thus, the recent volatility in financial markets is also unlikely to require you to take action related to your short-term savings.

Long-Term Savings

Savings for retirement and other long-term goals are key components of a financial plan.  If they are invested at all in any equity markets, your long-term savings have likely taken quite a beating. Rather than try to provide generic guidance on how to deal with the losses in your long-term savings, I’ll tell you how I’m thinking and what I’m doing about mine. By providing a concrete example, albeit one very different from most of your situations, my goal is to provide you with some valuable insights about the thought process.

Think about the Time Frame for My Long-Term Savings

As you may know, I’m retired and have just a little income from consulting. As such, my financial plan anticipates that I will live primarily off my investments and their returns. I have enough cash and bonds to cover my expenses for several years. As such, I’m not in a position that I absolutely have to liquidate any of my equity positions in less than three-to-four years.

For many of you, your most significant goal for long-term savings is likely retirement. As such, your time horizon for your long-term savings is longer than mine and you can withstand even more volatility. That is, you have a longer time for stock prices to recover to the recent highs and even higher.     In the final section of this post, I’ll talk about how long it has taken equity markets to recover from past “crashes” to help you get more perspective on this issue.

Know Your Investments

My view is that, if I wait long enough, the overall stock market will recover. It always has in the past. If it doesn’t, I suspect something cataclysmic will have happened and I will be focused on more important issues such as food, water and heat, than my long-term savings. For now, though, my view is that my investments in broad-based index funds are going to recover from the recent price drops though it may take a while and be a tough period until then. As such, I am not taking any action with respect to those securities. Once the stock market seems to settle down a bit (and possibly not until it starts going up for a while), I might invest a bit more of my cash to take advantage of the lower prices.

I have a handful of investments in stocks and bonds of individual companies. These positions have required a bit more thought on my part.   I already know the primary products and services of these companies and the key factors that drive profitability, as I identified these features before I purchased the stocks or bonds as part of my financial plan. I can now look at the forces driving the economic changes to evaluate how each of the companies might be impacted.

Example 1

I own some bonds that mature in two to three years in a large company that provides cellular phone service. As discussed in my post on bonds, as long as you hold bonds to maturity, the only risk you face is that the issuer will default (not make interest payments or re-pay the principal). With the reduction in travel and group meetings, I see an increased demand for technological communication solutions, such as cell phones. While the stock price of this company has gone down, I don’t see that its chance of going bankrupt has been affected adversely, so don’t plan to sell the bonds.

Example 2

One company whose stock I’ve owned for a very long time focuses on products used to test food safety. While the company’s stock price has dropped along with the broader market, I anticipate that people will have heightened awareness of all forms of ways of transmitting illness, including through food-borne bacteria and other pathogens. As such, I am not planning to sell this stock as the result of recent events.

Example 3

I own stock in an airline that operates primarily within North America. This one is a bit trickier. It looks like travel of all types is going to be down for a while. I’m sure that US domestic airline travel will be significantly impacted, but suspect it will not be affected as much as international or cruise ship travel. The reduction in revenue might be slightly offset by the lower cost of fuel, but that is probably not a huge benefit in the long term.

I’ve owned this company for so long that I still have a large capital gain and would have to pay tax on it if I sold the stock. At this point, I don’t think there is a high probability that this airline will go bankrupt (though I’m not an expert and could be wrong). I expect the price to drop more than the overall market average in the coming months, but also expect that it will recover. As such, I don’t plan to sell this stock solely because of recent events.   However, if this company had most of its revenue from operating cruise ships, was smaller, or had more foreign exposure, I would study its financials and business model in more detail to see if I thought it would be able to withstand the possibility of much lower demand for an extended period of time.

Summary

I have gone through similar thought processes for each of the companies in my portfolio to create my action plan. I will re-evaluate them as time passes and more information becomes available.

What We Can Learn from Past Crashes

Although every market cycle is different, I thought it might be insightful to provide information about previous market crashes. For this discussion, I am defining a market crash as a decrease in the price of the S&P 500 by more than 20% from its then most recent peak. I have identified 11 crashes using this definition, including the current one, over the time period from 1927 to March 14, 2020.

As you’ll see in the graphs below, the market crash starting at the peak in August 1929 is much different from most of the others. It took until 1956 before the S&P 500 reached its pre-crash level! Over the almost three years until the S&P 500 reached its low and then again during the recovery period (from the low until it reached its previous high), there were several crashes. I have counted this long cycle as a single crash, though it could be separated into several.

Magnitude of Previous Crashes

The table below shows the dates of the highest price of the S&P 500 before each of the 11 crashes since 1927.  It also shows the percentage decrease from the high to the low and the number of years from the high to the low.

Date of Market Peak

Price ChangeYears from High to Low

9/17/29

-86%2.7

8/3/56

-21%

1.2

12/13/61-28%

0.5

2/10/66-22%

0.7

12/2/68

-36%

1.5

1/12/73

-48%1.7

12/1/80

-27%1.7

8/26/87

-34%

0.3

3/27/00-49%

2.5

10/10/07-57%

1.4

2/20/20-27%

0.1

While they don’t happen all that often, this table confirms that the S&P 500 has suffered significant decreases in the past. What seems a bit different about the current crash is the speed at which prices have dropped from the market high reached just a few weeks ago. In the past, the average time from the market peak to the market bottom has been 1.4 years, but the range has been from 0.3 years to 2.7 years. While the 27% decrease in the S&P 500 from its peak on February 20, 2020 until March 14, 2020 is large and troubling, the average price change of 10 preceding crashes is -41% (-36% if the 1929 crash is excluded). As such, it isn’t unprecedented.

What Happened Next?

This table shows how long it took after each of the first 10 crashes for the S&P 500 to return to its previous peak. It also shows the average annualized return from the lowest price until it returned to its previous peak.

Date of Market Peak

Years from Low Back to PeakAnnualized Average Return During Recovery

9/17/29

22.29.3%

8/3/56

0.929.8%
12/13/611.2

31.7%

2/10/660.6

55.3%

12/2/681.8

28.3%

1/12/73

5.812.0%

12/1/80

0.2293.4%

8/26/87

1.6

28.1%

3/27/004.6

15.7%

10/10/074.1

22.9%

For example, it took 1.6 years after the market low price on December 4, 1987 (the low point of the cycle starting on August 26, 1987) for the S&P 500 to reach the same price it had on August 26, 1987. Over that 1.6-year period, the average annual return on an investment in the S&P 500 would have been 28%!

Because the values from the 1929 and 1980 cycles can distort the averages, I’ll look at the median values of these metrics. At the median, it took 1.7 years for the S&P 500 to reach its previous high with a median annualized average return of 28%.   There are obviously wide ranges about these metrics, but, excluding the 1929 crash, the S&P 500 never took more than 6 years to recover from its low. This time frame is important as you are thinking about the length of time until you might need to use your long-term savings.

After hitting bottom, the S&P 500 always had an average annual return of 12% or more over the recovery period, a fair amount higher than the overall annual average return on the S&P 500. Anyone who sold a position in the S&P 500 at any of the low points missed the opportunity to earn these higher-than-average returns – a reminder to not panic.

From Crash to Recovery

The graph below shows the ratios of the price of the S&P 500 to the price at the peak (day 0) over the 30 years after each of the first 10 market peaks in the tables above.

S&P 500 price changes for 20 years after crashes

The light blue line that stays at the bottom is the 1929 crash. As you can see, by 30 years later, the S&P 500 was only twice as high as it was at its pre-crash peak. For all of the other crashes, the S&P 500 was at least four times higher than at each pre-crash peak, even though in many cases there were subsequent crashes in the 30-year period.

To get a sense for how the current crash compares, the graph below shows the same information for only the first 100 days after each peak. The current crash is represented by the heavy red line.

S&P 500 price changes for 2 years after crashes

As indicated above, one of the unique characteristics about the current crash is that it occurred so quickly after the peak. The graph shows that the bright red line is much lower than any of the other lines on day 17. However, if you look at the light blue line (after the peak on September 17, 1929) and the brown line (after the peak on August 26, 1987), you can see that there were similarly rapid price decreases as occurred in the current crash, but they started a bit longer after their respective peaks.

Current Crash

We can’t know the path that the stock market will take going forward in the current cycle. It could halt its downward trend in a few days to a week and return to set new highs later this year. On the other hand, if other events occur in the future (such as the weather conditions that led to the dust bowl in the 1930s and World War II in the 1940s that exacerbated the banking issues that triggered the 1929 crash), it is possible stock prices could decline for many years and take a long time to recovery. Based on the patterns observed, this trend is less likely, but it is still a possibility.

As such, it is important as you consider your situation that you look at your investment horizon, your ability to live with further decreases in stock prices and your willingness to forego the opportunity to earn higher-than-average returns when the stock market returns to its pre-crash levels if you sell now, among other things.

Closing Thoughts

My goal in writing this post was to provide you with insights on how to view the disruptions in the economy and financial markets in recent weeks and plan your responses to them. My primary messages are:

  1. Don’t panic. While significant action may be the best course for your situation, do your best to make well-reasoned and not emotional decisions. Although you might want to sell your investments right away to avoid additional decreases in value, it isn’t the best strategy for everyone.
  2. Stick with (or make) a financial plan. Having a financial plan provides you with the ability to look at the impact of the uncertainties in financial markets and the overall economy on each aspect of your financial future separately, making the decision-making process a little easier.