What Does Insurance Do?

An interesting question and if you ask 50 people, I doubt you will get 50 coherent answers. Maybe not 20. People often own insurance because they think they are supposed to, or because their spouse thinks they are supposed to, or because the government requires it, (car insurance) or because the bank requires it (fire insurance.)

While these may be true, and the motivator, for many, it is possible to rationally decide to buy insurance because it has value to you.

People usually think about insurance in two ways:

  1. Insurance protects wealth that exists. The fire insurance, the lawsuit for negligent driving, the all-peril loss of your 40 carat diamond, your errors and omissions coverage. or,
  2. Insurance creates wealth where none exists. Typically life insurance although some make the case for critical illness or disability income insurance.

While these are a little true they are very limiting.

First of all, 2) is almost always not the case. Life and other like forms of insurance protect an intangible asset. Your career value, the ability to earn income. Just because you cannot sell it to someone else does not alter its nature as wealth. Later on, these forms of insurance protect the wealth you have from being used to pay debts or taxes or medical bills.

So most simply, insurance protects wealth from loss. More true, but still not the complete reason that people should own insurance. Besides most people will not buy the proper insurance for that reason. It has no feelings attached.

With life insurance, there is nothing in it for them. It is like betting against the home team. There is a loss no matter the outcome. If the home team wins, (live a long time) then I lose the premiums. If I collect the benefit, I died.

Most people do not own life insurance for what it is. Actually that would be an odd reason to own anything. Value is in use.

Salespeople usually suggest that people own it for what it does. Create liquidity, protect assets from forced sale, liquidate actual and implied liabilities and in some cases a way to accumulate wealth. Again limiting although possible to explain.

People should not own insurance only for what it is, that is just silly, or only for what it does, that is just the adult decision. People should own insurance because it allows them to do things they can do only if they have it. It offers them choices previously unavailable.

For example, suppose I owe the government $2 million upon my death. I could own some assets specifically for this liability. Those assets have limits, principally they must be liquid and secure. That is a very restrictive start. They cannot be business assets because those are neither liquid nor secure. They cannot be things like development properties or personal real estate. Again not predictable enough. The limitations dominate.

Suppose instead, I set aside $1million in a secure and somewhat liquid account to pay premiums on a $2 million life insurance policy. Maybe even buy an annuity. Now my tax liability is liquidated, whenever I may die, and I have $1 million in my hand to do with as I please. Maybe educate grandchildren, or payoff mortgages, or make down-payments, or buy a nice Hennessey Venom GT Spyder like Steven Tyler’s, or invest in a very speculative, completely illiquid investment, like a farm 5 miles out of town. Maybe some seed money for the kid’s business or a nice condo in the Caribbean.

No matter my tastes, the insurance allows me to do something I could not have done without it.

With insurance done right and for the right reasons, the home team always wins.

Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. don.s@protectorsgroup.com

What Price Is Right?

“The question of whether investors would buy mutual funds if they knew the true cost — and at what point the cost is too much — is moving to the forefront of a raging debate.” is the lead to a story by Barbara Schecter in Financial Post 25 April 2013.

There is a followup on the 27th. Where’s the Transparency? authored by actuary Fred Vettese. The implication is that fees are too high and deferred sales charges and the misalignment of purposes harm the client.

By way of disclosure, I am financially indifferent to this issue, at least as an adviser. I have almost no funds under management and have not sold a new one in the last 6 years.

Are fees too high? Are clients badly served under the current system? Interesting questions but neither article provides the answer. A good answer is deeper. Fees are too high if the value received in exchange for the fees is too little. Until you know both parts there is nothing to talk about.

Management Expense Ratio (MER) is not “cost.” MER is price. Cost includes price as one its components, but it includes other things like risk, convenience, time, information and more. Price as a proxy for cost misleads.

Choosing the lowest MER price is not smart if by paying less you get less, and worse don’t know what was given up. It is the factory-second parachute problem. Would you buy such a parachute for half price without asking why it is cheaper?

Cost is what you give up and value is what you get back. To be fair they must balance.

You cannot have a reasonable discussion, transparent or not, without considering what you get in return for what you give up. There is a material cost to do it yourself and to paying an unknown hourly rate to use skilled people to help balance your portfolio as suggested by Mr. Vetesse.

Ms. Schecter quotes Ermanno Pascutto, executive director of the Canadian Foundation for the Advancement of Investors Rights (FAIR). “Investors do not comprehend the impact of fees on their investments.” True! Absolutely and irrefutably true. To be fair, they do not comprehend the impact of having no fees and no advice, either.

While there is plenty of talk about “the fees are too high”, there is none about what they should be. In the Post stories there are references to what the fees are in other countries. Comparison to American costs is misleading. American costs are not 1% lower. Americans calculate their cost ratio differently. See how here.

Costs of any kind affect an investor adversely. Greatest value for a given cost, and given value for the lowest cost are the desired analysis conditions. Neither article addresses that. Implicitly, they assume there is a way to get something for nothing and you can if you ignore these:

  • Successful investing is not a skill-free zone. Investment selection, whether it is to buy, to keep or to sell, is an expensively acquired ability. Could you organize a tax-efficient fund? Likely not.
  • Even if people could handle the technicality, it is not easy. There is much more to it, like managing emotions. Urgency hurts you. Fear and greed are bad for yield.
  • Do-it-yourself is not a time saver. Include research and skill building efforts in the time. Spending 4 hours a week on your investments will do an incomplete job, and save some fees. Will the saving be worth as much as spending the same 200 hours per year doing what you are good at doing? Not likely.
  • Successful investing is technical and burdened with paperwork. You will love keeping track of the cost base for taxes, reporting interest, dividends, foreign income and all of that, tracking trades, checking the prices and quantities. Mr. Vettese did not mention that his pension clients already incur those costs and you probably do not. Not quite the same thing.
  • Estimate risk. Risk is defended by information. You have less than you need. News versus fundamentals is like weather versus climate. It means little.
  • Do you really think that spending a few hours a week will let you compete successfully with a Harvard MBA with 10 years experience, working 70 hours a week and having access to information you do not even know exists?
  • Who is your devil’s advocate and are they cost free? Charlie Munger sometime says to Warren Buffet, “Have you lost your mind?” Who is your Charlie Munger?
  • Who checks? You are not objective enough.

Deferred sales charges (DSC) are certainly abused, but on the other hand, for investors with little money, it is the only way to get attention. It is uneconomic for an adviser to deal with an account under $100,000. (Two of the big bank-owned investment companies in Canada have stopped recently.) Front end costs are material. If you want a plan before deciding on a portfolio, you need to decide how to pay for it. DSC’s let an adviser get involved in a businesslike way.

Beyond $250,000 it is usually fair to say that there is no place for a DSC.

The world works like this. Good, Complete, Cheap. PICK ANY TWO. Ongoing, excellent advice and service is not cheap. If you want service and skill, the price must be acceptable to both you and the adviser.

Will regulation help? Regulators normally add cost but little value. Instead, investors should select advisers for competence and service. Few can judge. Designations don’t help much. Investors need to learn fundamental things and many investors can not. With regulation, they may think that they need not care.

Just as wise investors avoid incompetent advisers, wise advisers should avoid incompetent clients or even competent ones with unreasonable expectations. They are trouble.

There is a cost to do something and there is a cost to do nothing. If you think doing nothing costs nothing you are delusional. Regulation won’t fix that reality. Personally I would rather pay a little too much for something that works, than pay too little for something that might not. Take a look at an older article. Cheap is Too Expensive.

At the root is a failure to communicate. There are two possible approaches to clear it up:

  1. Industry, demonstrate your value proposition. As it is, critics who do not understand, or intentionally ignore that, can argue price without a comparison to value.
  2. Investors, if fund managers and their advisers charge too much, buy shares in mutual fund companies instead of their funds.

TINSTAAFL

Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. don.s@protectorsgroup.com

The Swiss Army Knife

In 1891, Carl Elsener, a master cutler in the Swiss village of Ibach, invented a most innovative object – The “SWISS ARMY KNIFE”.

You would be hard pressed to find someone who does not know about these.   The New York Museum of Modern Art and the State Museum for Applied Art in Munich have both selected it for their collection of design excellence.  Despite its excellence, the SWISS ARMY KNIFE has an obvious flaw. It is good at doing 33 things, but it is not the best at doing any one of them.

A Swiss Army Knife is most valuable when you do not know exactly what problem you will face.

In cases where you do know what problem to solve, single purpose tools will always solve the problem better.  A green Robertson screwdriver is an extremely poor pair of scissors but it is peerless at driving #6 Robertson screws.

People need to address this specialized versus multipurpose decision when looking at achieving financial goals.

You know some problems in advance.  The clear ones include the need for income in the event of illness or injury, the need for liquidity, the need to resolve debt or tax obligations on death.  You should use special purpose tools to resolve these.  If you need income, buy an income tool.  If you need capital, buy a capital tool.  You will always get better value.

If you know the problem, then “Swiss-Army-Knife-Like” financial tools provide weaker  answers.  No mutual fund can guarantee retirement income as well as an annuity.  Similarly, no annuity can provide accessible capital at some future undetermined time as well as a mutual fund.

Nothing is cheaper than using life insurance to pay the inevitable estate costs and income taxes.

Special purpose tools solve specific problems most efficiently.  When the problem or opportunity has not yet become clear or may change in the future, a multipurpose tool will be advantageous.  However, watch for changes that will render it less efficient.

If you can clearly define the problem or opportunity, you should find a specific financial tool to resolve it.

Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. don.s@protectorsgroup.com

Complicate Your Investments. Here’s How.

You can make investing complicated and not very successful . You can do it with an ignore list and a focus list.

Ignore

  • Volatility
  • Liquidity
  • Income taxes
  • Transaction costs
  • Time
  • Leverage effects

Focus On

  • Rate of return
  • Relative rate of return
  • Publicity regarding your investment

I will guarantee bad results if you do all of these.

Instead, think about buying businesses not stock. Good businesses may not always reflect their value in the stock price, but over time, they tend to move toward higher value and better dividends.

I noticed recently that Bill Gates’ investment management firm holds a large stake in John Deere. Interesting. The company is a dominant one in its field (pun intended,) and has been so for more than 140 years. It pays a comfortable dividend and it does not seem to be under attack from other well financed and innovative competitors. Nice deal. No drama.

Drama is the hard thing to avoid. For some people the drama is the part of the investment they seek. I suppose most tax shelters and initial public offerings would be difficult without this aspect. If you invest for excitement and social status you are in trouble. You will have given up other values to get these. There is nothing free in the investment world. If you get more of one thing, you gave up something else to get it.

Private equity is the most difficult. Everyone wants in on the ground floor of a successful business. It is not that easy.

Even professionally managed venture capital firms, exposed to well understood and rational projects, analyzed by people with years of experience and superior skills, lose their money more often than they make money. 4 times as often! The expectation of success with your idea for a better dog harness or an ipad app or a Tanzanian theme restaurant are in the 1 in 100 range if I am being generous. More likely in the 1 in infinity range.

There was an interesting piece in USAToday which dealt with why athletes go broke. They point out three reasons.

  1. They invest in private equity deals,
  2. They buy real estate,
  3. They spend too much.

You knew about the third one.

Better to invest in boring businesses with a track record, competent managers, and a transparent, liquid market. It will not be as exciting to talk about at the bar at the golf club but it will generate more net worth.

If you change the ignore list to focus and the focus list to ignore, you will be okay. You can buy a nice trip or a new car (with cash) to impress the folks at the club.

Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. don.s@protectorsgroup.com

Insurance Poor??

Somebody is always insurance poor.

It could be your future self or estate who is insurance poor because the claim received for your death or disability is too small.   Alternatively, it could be your present self who has to come up with the premium each month.

People tend to get his wrong because they don’t analyze the problem very well.  The present self uses hyperbolic discounting to estimate the value of the future benefit.  The current premium seems to be worth more, so the present self feels hard done by if they pay.

There are many excuses that help justify the behaviour.

My favourite, “Every morning I get up and say, ‘Good thing I didn’t buy insurance yesterday, because I didn’t need it,’  I have been right way more often than I have been wrong”  The future self is going to lose big while the present self wins small.

I would be willing to wager that the Harvard Business School does not teach their MBA students that win small / lose big is a good strategy.

Some people don’t like life insurance because, “It is like betting against the home team.”

True in a way, but again the present self is putting their feelings in opposition to the needs of the future self.  The reality is that the present self could afford the loss of the premiums and the future self cannot afford the absence of the claim.  Clearly one or the other is going to lose.  Support the one with the bigger loss.

You can be insurance poor but only if you have covered risks that don’t exist, have failed to cover risks that do exist, have mismatched the product and the problem, or if you have covered things that are certain to happen.

In the last case, you are paying the claim plus the insurer’s overhead.  Think $0 deductible dental plans.  The claim is certain, the premium will be more than the claim because the insurer has overhead to recover and a profit to make.  For a single person, a deductible results in a premium reduction that is greater than the amount of a small deductible.

Talk to a professional, they can help you sort out the real issues.

Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. don.s@protectorsgroup.com

Dividing Assets in Divorce

Deciding how to split assets is more than just dividing the values on paper.   People often make the mistake of believing that dividing everything in half is the simplest and fairest way of handling things.  This is not necessarily true.  People need to pay attention to the decisions they make about dividing property  and consider the long term  consequences.

Assets differ in a number of ways.  Some are liquid like cash. Some assets like RRSP accounts are tax deferred. Some assets need to be valued in a specific manner according to family law rules and regulations. Investments may have a differ value after taking into account possible capital gains taxes.

Sometimes assets have an emotional connection that may have more worth more than the actual dollar value such as a house, business, or family heirloom.

Assets may have costs to consider.  A couple may have a $400,000 investment  account and a house worth $400,000 (mortgage free).  The assumption is that if one spouse takes the house and the other takes the cash, this results in an equal division.    Keeping the house has costs such as property taxes and upkeep and maintenance. The investment account will be growing over time earning interest. It may not seem quite the equal split over a period of  time.

Debts are also part of the division of marital property.  Allocating debts in divorce may mean paying them off, refinancing, or applying for new debt.  Different types of debt carry different fees, charge, penalties and terms.   Just because you have $10,000 left on your car loan and $10,000 credit card debt doesn’t mean that the car loan should go one spouse while the credit card debt goes to the other.

Divorce settlements are often agreed upon with limited insight into the long-term consequences.  As a result, settlements that seem to be fair and workable initially do not necessarily stand the test of time.  Therefore,  I would recommend the services of  a divorce financial planner  when working on your settlement  to show you  how decisions you make today will affect the rest of your life.

The Financial Concerns with “Grey” Divorce

Overall divorce rates have been dropping over the last couple of decades – with one notable exception. Divorce rates among  people now in the over-50 age group have nearly doubled over that same period.  Here are some financial concerns that couples in this situation should think about:

  1. Housing – Can you afford to continue living in the house you’re in. What’s the cost of moving?
  2.  Short  term & long term financial stability – Need to create a budget allowing for  changes in lifestyle which may include paying off debt and increasing savings
  3.  Lifestyle adjustment –  Older couples have less time to re-establish themselves financially.  You may be faced with liquidating assets to maintain lifestyle. You may face living on half of what you planned on for retirement.  Living longer and faced with the fear of  outliving savings
  4. Retirement funds – RRSPs/ LIRA accounts are divisible property.
  5. Company Pensions – They can be considered an Asset or Income.  New rules about valuing and dividing pensions in Ontario Jan 2012
  6.  Insurance  – You need to understand what you currently have.  Going forward as a single person, you’ll need to consider life, property/casualty, disability and critical illness insurance
  7.   Medical Benefits –  can you get continued coverage on your “ex’ plan.. who qualifies as “spouse”  How much will individual  “plan” cost.. is it worth it?
  8.   Account Beneficiaries – you need to consider who are current beneficiaries , if you want to change them and any tax implications in making those changes
  9.   Getting back into the workforce.. Hard for anyone  who’s been out of the workforce for a period of time to get back into the workforce
  10.   Changing your will –  you may have to look at beneficiary designations as well as who is your  Executor
  11.   Business – Your business may be your biggest  asset. What’s if really worth?

 It’s not easy to deal with the end of a marriage..especially  if you’ve been together for a long time.  I welcome you to visit Mutual Solutions    –  providing complete divorce solutions  if you are  considering ending a long term marriage. 

 

Who’s Handling the Family Finances?

I met with Amy (not her real name) the other day who told me she managed her finances perfectly well while she was single. Once she married, she agreed to let her husband handle the family finances. Now facing divorce, she found herself in financial difficulty because of her husband’s spending habits. She regretted not paying attention to the family finances  during their marriage and had to deal with  the added  guilt of not being aware of key financial information when the marriage finally ended.

When we marry, most coupled agree to a practical division of labour and responsibilities.  Each partner takes on specific “jobs” throughout the marriage. One may take out the garbage and handles the carpooling duties while the other spouse agrees to prepare meals and pays the bills. As we’re creatures of habit, we tend to keep those same “jobs” for our entire married life.  If it hasn’t been your “job” to deal with the finances, it is imperative that you stay in touch with the family finances regardless.

How do you do that?

You should attend meetings with accountants, financial planners, insurance agents to develop their own relationships with these key advisors. Too often I hear women say  “I ‘ve never even met the insurance agent” or “I’m finding it difficult to get information from the accountant since he and my spouse are old friends and golf together every weekend.”

You should look over monthly bank statements and credit card bills even if you are not the partner actually making the payments.

Pam (not her real name) found a lack of her own active credit history worked against her as she was offered high rate cards with small lines of credit when she applied for a card on her own after her husband left. You should be sure that the credit card you are using has been set up in your own name and not an account in your husband’s name with you being simply an authorized user. 

Couples should keep three bank accounts (his, hers and ours) and maintain separate credit cards.

Couples are divorcing at later ages.  Many married women don’t make retirement savings a priority. If your husband is the main wage earner, you  trust him to save for  your retirement.  Clare (not her real name) assumed the Spousal RRSP her husband set up belonged to him and not her and wasn’t clear that he hadn’t been adding to her Spousal RRSP for awhile.  You need to understand that once you’re on your own, you need to make saving for retirement a priority.

Looking over a spouse’s shoulder from time to time is important even if you trust they’re doing a good job.

My divorce will cost what?

I was recently at a lunch meeting with other divorce professionals… and the topic of costs of divorce came up. We all face the “what do you charge and how much will it cost question” that all potential clients ask.  People facing divorce all have some preconceived ideas based on a friend’s experience, hearsay, media reports etc. Most people believe their own situation is not a complicated one and should fit in the “average cost range”.   As experienced professionals, we know that few divorcing clients fit the “average model” and the “cheapest price’ may not be that cheap in the long run. You only have one chance at a settlement which will affect you for the rest of your life. You want to be sure to get it right.

So how do divorce costs pile up?

The choice you make in how you will arrive at a settlement agreement directly affects the cost.

A do-it-yourself scenario where you work everything out between yourselves may be very effective and least costly but may best work in situations where there are no children, few assets and fewer complications.

Mediation allows couples to come up and come to agreement mainly on their own with a mediator who facilitates with the couple in reaching an agreement. Couples share the cost of the mediator. Each spouse in turn may have their own lawyer providing independent legal advice as required.

Collaborative Practice involves clients each with their own lawyer and the possible involvement of other professionals such as family specialists and financial specialists all working together to reach an enduring settlement.   A Collaborative divorce is a holistic approach where each professional charges at their own rate and divorcing couples have control over how much involvement from each professional there may be depending on their own  unique needs.

Traditional litigation can be costly if negotiations fail and end up in court.  Trial costs can be  enormous.

Legal fees represent only part of the costs. Other factors can impact the total cost of your divorce, such as:

  • The nature and complexity of the couples’ situation itself.
  • Your lack of financial knowledge or familiarity with your own finances
  • The need for involving other professionals to assist with valuations of such things as home, other properties, pensions, businesses,  stock options, tracing assets.
  • Your emotional state which may affect the duration and cost the time involved in reaching a settlement
  • Your decision to fire lawyers or lawyer’s decision to fire you.

The “what ifs” are the most painful and avoidable elements in divorce everyone should face head on. You should embrace the opportunity to pay for this knowledge to have peace of mind post-divorce. A divorce financial planner is the expert you want and need during divorce to make strategic recommendations in a cost-efficient manner no matter what method you choose to deal with your divorce.

The expertise of divorce financial planners is essential during divorce: To help budget for this process; source funds to pay for the divorce; educate clients and professionals about complex financial issues; analyze choices with greater expertise and less expensively than lawyers; produce precise analysis for desired outcomes; and provide financial counseling to clients post divorce. This is what you get when you pay for it!

Top of Form

 

Dis-Orientation: Back to School and Divorce

Traditionally, autumn is a boom season for divorce, particularly for couples, who wait out the summer at the cottage before returning home to cut their marital ties. Many couples considering splitting decide to wait until after the holidays to break the news to their children. How are these parents going to approach their separation or divorce – and how will it affect their children?  
Obviously school-year separations can be difficult for school-age children. Parents need to bend over backwards to minimize the changes and transitions in their child’s life so as to keep school-related schedules, after-school activities, playtime with friends and other routines as much the same as possible.  

Parents with university aged children face the additional burden of having kids who are moving away from home.  The added stress of dealing with ever increasing tuition costs and related school expenses makes divorce at this stage more complex.

As couples work through their separation agreement, they should be aware of the many financial issues that affect them and their children beyond the traditional items of child support.

They should be considering such things as:

  • Is there enough savings set aside for tuition and room& board expenses
  • How will any shortfall be funded by each parent?
  • Who manages any RESP plan set up for the student?
  • What additional expenses will students/parents incur as a result of parents living apart
  • Who will benefit from any tuition tax credit available to transfer to a parent

Sending kids off to university is an exciting and challenging time for both students and parents alike.  Dealing with divorce at this stage in your family’s life adds additional challenges.   If you need help sorting through the financial issues around these issues, we may be in the position to help.