146- Using the Power of Financial Guarantees
Updated: Jan 15
Did you know that affordable financial guarantees are available from credit worthy companies? They come in a variety of forms ranging from very specific products such as life insurance coverage, annuities, fire insurance on your dwelling, federal deposit insurance and range all the way to bank provided credit lines. These guarantees can be used to offset financial risks you face. Especially in light of the pandemic, having differing layers of protections in place can be an important element of your financial life. In today’s post, we will take a brief look at guarantees.
What are Guarantees?
Guarantees are legal agreements that one party promises the other that they will perform— a service, a financial transaction, or a certain action such as the replacement of a defective product—in exchange for buying their product even if they lose money on that performance. Manufacturers, banks, insurance companies, delivery services and other entities offer them. The federal government provides guarantees. One example is deposit insurance for the money you have in the bank. The good news is that guarantees are available, and they can provide you with significant benefits. The bad news is that many times they have a cost that can be significant. In my view, there are certain financial guarantees available in the FinancialVerse where the benefits significantly outweigh the costs.
You will see a barrage of articles in the financial media questioning the cost of having guarantees in place or if the company/person offering the guaranty will actually live up to their promise to perform. I am here to tell you that guarantees are for the most part very good if you select the right products and companies.
As an example, I think longevity risk is one risk you can minimize using guarantees. This is the risk of living too long and running out of cash. The ramifications of running out of money to live on in old age are horrible given your likely inability to go to back to work to support yourself. You don’t want to wear a chicken costume outside a restaurant, do you? Is there a guaranty you can purchase to protect you against this risk? How can you plan to minimize this risk? What is the cost of this guaranty?
To protect yourself against the risk of outliving your money or what is called longevity risk, you have several options:
Rely on family members or friends to get you the cash or caretaking help you need.
Rely on government programs such as Social Security retirement benefits, Medicare and Medicaid.
Purchase a private insurance product from a state-regulated life insurance company called an annuity that will guarantee that a certain amount will be paid to you for as long as you live.
Pay the costs out of your private savings.
For most people, private savings are not enough, as they do not have sufficient assets to assume the risk of having to pay for the costs themselves. Totally relying on Social Security’s retirement benefit is not enough, as it is designed to replace just 40 percent of preretirement income for most people. Getting cash from family and friends is possible, but the question arises: can you rely on them for as long as you live? Lastly, buying a lifetime income guaranty using an annuity can be a great solution to minimize the risk.
In its simplest form, to purchase this insurance product, which is called an income annuity, you pay a lump-sum premium to the life insurance company in exchange for the insurance company’s promise to pay you a certain amount each month or year for the rest of your life. How can the life insurance company make good on this promise? How are they able to do this for you when you can’t do it for yourself? The key is that the state-regulated insurance company has buying power to purchase higher-yielding assets than you can; they can provide this service for large numbers of people, some of whom will die in younger years, providing funds for those who live longer; and they have the technology and actuarial talent to manage the risk that you do not.
Guarantees are available in the market but they come with costs. They are not free. In some instances they are subsidized by the US government for the good of the economy. What they do provide are ways to minimize or eliminate risks from your financial journey. For some reason, you will not see much written in the financial media about the power of guarantees. Yet, the psychological solace you get with the knowledge money or a replacement product or service will be delivered in the future, when it is needed, is powerful and comforting. You should familiarize yourself with the guarantees that are available and how they can work to financially protect you and your household.
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