Making Order Out of Your Tail Risks

People seem to clamor for some kind of order in their life. They search for a set of clearly defined rules to follow to produce desirable outcomes. This desire for order may partially explain the wild success of Jordan Peterson’s 12 Rules for Life and his follow-up Beyond Order, which brought us 12 more rules. Admiral William McRaven was ushered into fame with the Make Your Bed speech he gave at the University of Texas graduation ceremony. This speech elucidated the profound impact that living by a set of “simple” rules can have.

 Now, these rules can be broadly applied, or they can be applied with specificity. One rule that brought order to the chaos of mathematics was the order of operations. Many of my contemporaries will either delightfully or fearfully recall PEMDAS being hammered into our minds with silly phrases like Please Excuse My Dear Aunt Sally. We were forced, as middle schoolers grappling with our first introduction to multi-step equations, to memorize these rules. We were made to fear a scenario in an apocalyptic future where all calculators, computers and other mathematical aids were no longer available. We could be assailed at any moment by a shadowy figure demanding we solve such an equation with nothing more than our wits. So the proper order has remained tattooed on our minds. A similar tale can be told about properly ordering the planets in our solar system with phrases like My Very Educated Mother Just Served Us Nine Pizzas.

When it comes to personal finance, which I would argue is more important than multi-step equations and the order of the planets, we have a few examples of organizations making attempts to bring order to this chaos. Ramsey Solutions is perhaps most famous for their disdain for debt, but another well-known bit of content they have produced are the 7 Baby Steps for personal finances. The Money Guy, a popular personal finance personality, has his Financial Order of Operations. These are both fine places to start, but I have my own biases, perceptions and expertise that I have used to create my own order of operations.

Which operations should you address first? From my work as a retirement planner and my formal training for my Master of Science, Personal Financial Planning, my CFP, and my CFA, I would argue one should start with mitigating tail risks.

For those in the accumulation stage of life--those working, earning an income, saving, and investing--tail risks are those things that can prematurely end your ability to earn an income and accumulate savings. These would be things like uninsured major medical events, uninsured disability, and premature death.

No financial plan or system of budgeting, saving, and investing, however carefully constructed, is likely to survive one of these events. For a single individual with no dependents, life insurance is the one area where coverage is not necessary. Medical coverage and disability coverage are vital.

For major medical coverage, disability coverage, and, premature death coverage (for those of us with dependents), it is easy to get distracted by the wrong variable: the probability or likelihood of an event occurring. The probability of a major medical event, a disabling event, or premature death is generally low for young, otherwise healthy, individuals. But this isn’t the appropriate way to assess your need for coverage. We must consider severity.

           However improbable one of these events are, if they do arise, the financial impact can be permanently crippling. A stay in the ICU without medical coverage can wipe out a career’s worth of savings and investing overnight. The same can be said for an uninsured disabling event precluding a person from returning to their job or losing their ability to earn an income entirely. These events must be carefully considered because they have the potential to wipe a person out entirely. As retired race car driver Rick Mears put it: To finish first, you must first finish.

           The first step in my financial order of operations is to establish the appropriate level of insurance coverage in the areas that could damage a financial plan permanently and irreparably. The level of coverage required will vary widely from person to person. For those who have insurance coverage through their employer, call your benefits department and do not leave the call until you understand your coverage.

Medical coverage is, even for the savviest individual (and exceptionally so for Texas A&M educated people like me), extremely complicated. You want to discuss your coverage, your HSA or FSA options (if applicable), your deductible, your copay, and your maximum out of pocket limit as a starting point. This should be done with a specialist in your benefits department.

Disability coverage is similarly complicated. Make sure you understand if your policy is an own occupation, any occupation, or a hybrid policy. Make sure you understand if you have coverage for long-term disabilities, short-term disabilities, or both. Find out what proportion of your income will be replaced, or what the monthly benefit amount will be, and if these benefits will be received tax free or if they will be taxable. Ask about the length of the elimination period ( the length of time you must go without receiving any benefits), and recall, the first check will arrive 30 days after the END of the elimination period. This conversation should be had with a specialist in the benefits department or at the insurance company you have chosen.

The first order of business for constructing a financial plan is properly insuring these tail events. If you have any questions about how tail events might affect your financial future, give me a call.

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