How to build a financial safety net in five concrete steps

I often read the same question: how should I save? Where should I invest? Should I quit my job and launch this super cool business?

All of those are valid questions but they often lack context. The advice will not be the same whether you have saved £10,000 or £100,000. The advice might also be different depending on whether your pension contributions or medical insurance are tied to your employer.

This blog post is about financial survival. If you have invested most of your savings or have quit your job to pursue a business venture, and if things don’t work out, how do you recover? The answer is to build a safety net. If you have not built a safety net prior to making your big move, you may have a problem. You potentially have to start from scratch, re-make whatever you used to earn and compete with younger professionals who might have taken your old job while you were gone. Not fun.

I personally feel we tend to over-celebrate failure. Failure sucks. It is a setback. It is not the desired outcome. You might learn a few things along the way but more importantly, all your hard work did not pay off. The following steps are meant to soften the blow. None of those steps are ground-breaking. But combined, they form an extremely powerful financial safety net. Your entrepreneurial adventure may not work out the first time but it could the second time. This assumes that you are in a position to have a second chance and that you are not completely broke.

If I seem to address my advice to people who are about to make a big change of career that could seriously impair their financial viability, that’s because those are the people who probably need it most. Note however that the advice below can definitely be applied by anyone, including those who intend to stay in their job for the foreseeable future. This was actually my mindset when I came up with that step plan.

1. Pay-off your debt

Unless you are paying off a mortgage for your main home with a 3% interest rate, you should repay any debt you have as soon as possible. Repaying off debt has two main advantages. First, you free up cash flow for future investments. Second, you don’t owe anything to anybody, and that is a significant step. As a bonus, it may even improve your credit score for when you truly need debt such as to buy a house with a mortgage.

The highest types of debt to repay on the list are student loans and credit card debt. Student loans are the next financial bomb in the United States and have quickly grown in the United Kingdom. Credit card debt is acceptable if you pay the amount due in full every month. Subject to that condition, I don’t see significant issues using your credit card to amass airline points. But again, make sure you pay everything in full every month without fail. Similar to a credit card is any financing offered by retailers or tech companies to purchase a TV or the new iPhone. Even if you managed to obtain a 0% financing, this is not a great deal. Tech purchases tend to depreciate very quickly and by the time you have paid off the financing, the purchase is essentially worthless. If you can’t buy an iPhone or MacBook fully in cash, you cannot afford it. Period.

While rates are slowing going up in the United States and the United Kingdom, they remain historically very low. In other words, it is very hard to make money out of savings in the current environment. Paying off your debt should be your first financial move to build your safety net. If you don’t owe any money, nobody can come after you.

2. Buy medical insurance and additional covers for critical illnesses

Always make sure you have appropriate medical insurance. Sadly, relying exclusively on the NHS is not the best idea. It takes forever to see a doctor through the NHS. Sometimes, there is an emergency and one cannot wait. In such a case, you should be able to see a private doctor using a private medical insurance. Insurance will not pay for everything but it will prevent medical bills from bankrupting you.

I also strongly suggest that you subscribe to a critical illness cover. This type of insurance will pay you a tax-free lump sum if you are diagnosed with a specific medical condition. For instance, critical illness policies typically cover cancer, heart attacks, liver failure stroke, third-degree burns, etc. Your basic medical insurance will cover the bulk of the treatment costs. However, the lump sum from your critical illness cover comes handy to pay the non-insured portion of your treatment as well as ancillary medical devices required for your recovery at home. The lump sum can also serve as compensation for the temporary loss of income due to your inability to go to work, which is especially important if you are self-employed.

3. Build up your pension pot

If you are thinking of leaving your job, make sure you contribute as much as possible to your pension pot. This is especially true if your employer matches your employee contributions. Remember that contributing to your pension is tax-free money. For more details on how to contribute, check out this post here.

The failure of a significant investment or venture should not comprise your retirement plans. Under no circumstances should you “invest” or gamble with money meant for your retirement. A pension provider should be managing your pension contributions based on an appropriate risk profile. Once this is done, leave it and forget about it.

The idea is that you don’t start from scratch if your business or investment failed. If you contributed to a pension pot beside making your big move, you should have something to go back to. It might not be much but it is something. Besides health, which we discussed above, you should cover as many angles as you can for your retirement. Save aggressively to contribute to your pension.

I appreciate the advice here may seem harsh. After all, if you followed those three steps so far, you still haven’t saved a pound in your bank account. I cannot stress this point enough: saving for retirement is the easiest and most-efficient form of saving due to the tax relief. Also, if you are still unconvinced, think about this way for a second: if you think it is hard to find a job in your thirties, try finding one in your seventies with poor health.

4. Open an Individual Savings Account (ISA)

In the UK, the main tax-free savings account is the ISA. The account can hold cash or stock and shares. In both cases, the annual allowance is £20,000.

When you start saving, you should open an ISA account. The cash version is the easiest to start with. If you don’t mind taking more risks, the share and stock option has the potential to be more profitable in the long run but be mindful of the charges billed by some providers. If you intend to take the money out within the next five years, maybe opt for the cash version (i.e. saving for a downpayment to buy a house). If you are holding an ISA as a way to complement your pension pot – a valid choice – then opt for the share and stock option. Note that you can open more than one ISA account as long as you don’t breach the annual allowance. There a few types of ISAs such as the Lifetime ISA and the Help-to-Buy ISA. If this is your first savings account, I would opt for a straightforward cash ISA and then you can do some research to see what second ISA would be the most suited to your needs.

The reason to start with an ISA in lieu of another savings account is to take advantage of the tax-free allowance as soon as possible. Remember, you cannot carry-forward the £20,000 tax-free allowance from one year to another. If unused during the tax year, it is indefinitely lost. Therefore, the sooner you open an account, the quicker you can save and potentially maximize your savings until the cap.

My guidelines are simple: save as much as you can until you reach that £20,000 threshold.

5. Make a will

Making a will allows you to decide what happens to your money and possessions when you die. In the will, you can also foresee other situations such as who should take care of your children. Properly done, it will mitigate inheritance tax.

If you don’t have a will, then the law will say who gets what. Your spouse and children will usually be the main beneficiaries. If all is well, this may be a perfectly fine option. But if you have given a lot of money to one of your children and want to make his or her sibling whole at the time of your passing, then a will is probably a better idea. If you are divorced or own a business, then getting a will is also important.

I sometimes read that paying £150 plus VAT to a solicitor to draft a basic will is not cheap. It ’s not anything but remember that £150 is incredibly cheap if your descendants can avoid years of litigation with the State, HMRC or various third parties. When you are seeking to draft a will, please get it right. Hire a solicitor specialized in will-writing and don’t fall for some free will template found on Google.

Your descendants will save in taxes and avoid litigation. Where are you going to get such a return for a £150 investment?

 

Conclusion: None of the above will make you a millionaire. Few will even be in a position to complete all the steps listed above and that’s ok. Think about it: if you can save half of the pension and ISA allowances, you should be sitting on a neat £30,000 (the current pension allowance is £40,000 and the ISA allowance is £20,000). Even if you only achieve step 1, you will be in a significantly better financial position. If you managed to complete all steps, then congratulations, buying a house (maybe by using that cash ISA as a downpayment?) or venturing into riskier investments should now be your next priority.