Financial Review – How Do You Plan Your Finances From an Impact Caused by A Shock Event Such As Covid-19?
Client: Should I be worried about Covid-19 to my financial plans?
Me: Yes, you should. In insurance terms, this is a financial critical illness. It is serious.
Client: Something like heart blockage and doing a balloon?
Me: No, more like a heart attack had already happened.
Client: But you’ve told me that with advanced medical science, many people can survive.
Me: Yes, but I’ve also told you that some people won’t and until it happens, we don’t know who is which.
Client: So how worried should I be?
2020 ushers in the beginning of a new decade and the year started with stock markets at an all-time high, optimistic economic projections and many sporting events such as the Olympic games to look forward to. In a few months, everything has changed due to Covid-19 and unfortunately, it was not for the better both economically and financially. The financial impact has already hit countries, businesses and individuals hard with the effects of a global shutdown expected to be felt for quite some time.
For many people’s personal financial plans, things are unlikely to be the same again as the impact is not something that a “6-months rainy fund” can negate. Whether you are an employee, an employer or an investor, it is inevitable that you would have suffered losses in one way or another through a loss in income, in revenue, in capital or worse, a combination of all.
Ideally, this is the time you will want and need to sit down with a trusted financial planner to review the financial impact caused by Covid-19 onto your personal financial plans. Yet, the reality is that many financial planners (myself included) are going through a crisis of this magnitude (or circuit breaker) for the first time and the usual financial review process of updating values and assessment of financial gaps may not suffice.
Do not start exercising during a heart attack. Start by surviving the heart attack.
While the extent of this crisis may be huge, it is still a crisis nonetheless and just as a rainbow inevitably follows a storm, a recovery will most certainly follow a crisis. In my opinion, we should be doing a financial review to prepare us to not only ride through the storm but also position us to benefit from the opportunities of the recovery.
A quick word on “Shock Events”. In financial planning (and retirement planning which I specialise in), shock events can be defined as unexpected events that put financial plans at risk by creating costly and unplanned financial burdens.
Here is a list of examples of “Shock Events”:
- Major home repairs/upgrades
- Major Dental expenses
- Significant out-of-pocket medical/prescription expenses
- Drop in home value of 25% or more
- Running out of assets
- Sudden loss in total value of savings of 25% or more
- Family emergency
- Death of a spouse
- Victimisation of scam/fraud
- Loss of home through foreclosure
- Divorce during retirement
- Loss of capacity
From this list, you can see how the possible financial impact from Covid-19 can result in one or several of the shock events occurring in people’s financial lives.
Financial Review for Shock Events
Here is my 3 part financial review process on how to review your finances from a major shock event like Covid-19 and I hope that it can serve as a foundational “thought process” for you to customise your own reviews. Remember, the key lies not in the style of the review; the key is to survive the present and be well positioned for the future.
1. Make a judgement call – 3 months, 1 year or longer?
Begin by confronting the brutal truth – how bad will it be for you? I recommend that you think about this in terms of how long (i.e. a time period measured in months) that you will suffer from a loss in income of 25% or more.
Will it be for 3 months, up to a year or more than a year?
If the impact is expected to be for a period of 3 months or less, the impact to your finances will not be significant and you will only need to make minor changes to adapt. Drawing down on some savings may be needed but overall, your strategy should be to adapt temporarily without the need to change any long term plans or commitments.
If the impact is expected to be for a period of more than 3 months to as long as a year such as being asked to go on indefinite no-pay leave or having to temporary suspend the operations of your negative cash flow business, you will have to be prepared to make adjustments to reduce costs and commitments to “ride through the storm”.
If the impact is expected to be for a period of more than a year such as being retrenched or permanently closing down your business with the expectation that your current skills set no longer has good market value, you will have to amend your financial plans and expectations.
Here is a summary of the “judgement call” review:
Click above image to enlarge
2. Get Clarity – How long can you last financially?
Once you’ve made your judgement call, you will need to get an updated picture of your financial position to work out your next steps. There are many things that you can review but for this purpose, you should be focused on your liquidity status – How long can you last financially?
There are 3 items to review to get a clear picture of your liquidity status:
A. Review your fixed expenses (Measured in Dollars)
Fixed expenses are the amount of money that you will need to have every month to pay for the “non-negotiables”. From my own experience and that of clients, the difficulty is in identifying if an expense is really “fixed”. There can be many “grey” items and I have been in enough financial planning discussions to know how tricky this discussion (even if it’s with yourself) can be. I once made a client upset when I suggested that a cup of Starbucks is not a necessary fixed expense in the morning!
One simple rule to help you evaluate if an item is a “fixed expense” is to ask yourself what will happen should you not have money to pay for that item? If you will resort to borrowing to pay for that item, then that will probably be a fixed expense item that you will need to budget for.
Once you know how much financial oxygen you will need minimally for each financial breath, you will need to review your lung capacity which brings me to the next review item.
B. Review your Basic Liquidity Ratio (Measured In Months)
The basic liquidity ratio measures your liquidity position over the short-term and is an indication of how long your cash assets can sustain your current financial needs without the need to draw down on other assets such as investments. This is commonly known as the “Rainy Day Fund”.
The formula for calculating the Basic Liquidity Ratio is:
Basic Liquidity Ratio = Total cash or cash equivalents / Monthly fixed expenses
For example, if you have cash savings of $100,000 and your monthly fixed expenses are $10,000, your Basic Liquidity Ratio is 10 months which means that should you lose your income, you have up to 10 months to find a new job without the need to resort to selling of assets or borrowing.
For cash or cash equivalents, you can consider sources of assets that you can withdraw for use within a week without any loss or significant loss of capital. You can consider current bank balances including fixed deposits, holdings in Singapore Savings Bonds, Money Market Unit Trusts…etc as cash or cash equivalents. CPF account balances may be considered if you have met the criteria for CPF withdrawal.
Your cash or cash equivalents are like your lung capacity. It should be able to provide enough oxygen for regular activities or even during strenuous exercises. However, no matter how long you can hold your breath or how strong your lungs are, you will still need oxygen tanks to supplement your needs when you are in unchartered waters which brings me to the next item.
C. Review your Standby Liquidity Ratio (Measured in Months)
The Standby Liquidity Ratio provides a deeper insight into your liquidity position and is an indication of how long your liquid investment assets can last when your cash assets are depleted.
The formula for calculating the Standby Liquidity Ratio is:
Standby Liquidity Ratio = Liquid Investment Assets / Monthly fixed expenses
“Liquid Investment Assets” are assets that can be sold off within a week for cash. Examples of “Liquid Investment Assets” are open-ended unit trusts, cash values in insurance policies and publicly traded bonds and shares. Investment assets such as properties, private businesses, art collections are generally excluded.
For example, if you have shares worth a total of $200,000 and your monthly fixed expenses are $10,000, your Standby Liquidity Ratio is 20 months.
An important note to make is that oftentimes, an urgent sale of assets may result in cashing out at a loss but that is what shock events do to financial plans – they create significant and permanent financial loss.
3. Inspect What You Expect – What is your net worth?
By now, you will have an estimation of how long you will be financially impacted by Covid-19 from making the judgement call and how long your assets (both cash and investments) can last from reviewing your liquidity ratios. The final step will be to do up a complete net worth statement.
A net worth statement is a snapshot of your current financial position and is a consolidation of all the financial decisions you’ve made. And, it includes both the good and the bad decisions. If you’ve made good investments decisions and made a lot of money, it will tell in the net worth statement. If you’ve made some terrible investment decisions and lost a lot of money, it will also tell in the net worth statement.
A properly created net worth statement is the most important tool to help you with sound decision making about the next steps to take.
Assuming that you have assessed that the negative impact on your income is expected to be for the next 6 months and you have a basic liquidity of 12 months, you are in a position to perhaps start investing and be well positioned for the eventual market recovery. Your net worth statement will provide you with the clues on how aggressively you can afford to invest.
On the other hand, assuming that the negative impact on your income is expected to be for more than a year and your total liquidity ratio (basic plus standby) is only 6 months, you will have to dive deeper into your financial situation to prevent a financial disaster from happening. Again, your net worth statement with provide you with the clues on how else you can “fill the holes”.
For a no-frills “pen and paper” version, you can use this version here.
You can also download this Personal Net Worth Review Tool (excel format) that I have designed to help you get an updated picture of your current financial position. Included in the tool is an auto-calculation feature of your liquidity ratios and I have kept the assets and liabilities fields “unlocked” to allow you to be able to customise the statement to your own unique situation.
(NOTE: Get our Personal Net Worth Review Tool (Excel Format) to help you get an updated picture of your current financial position. Get your review tool Here)
Interpretation, not Calculation.
If there is one positive that I believe we can take from the Covid-19 pandemic, it is that our collective “seriousness index” have risen. Many people are taking their health and hygiene more seriously, we are certainly taking our family’s well-being more seriously and perhaps, it is also an opportunity for us to take our financial planning more seriously than ever before.
Just like the wearing of masks may be the new normal, you should make managing your net worth statement a new normal.
One final note – the accuracy of the numbers in the net worth statement while important, is not what really matters. It is the interpretation of the numbers and the positive action that it leads to that will ultimately contribute to your financial well-being and success.
Good luck, have fun and make it a great habit to have!
Article by Lee Meng Choe
The writer is the Executive Director (Distribution) of GEN Financial Advisory