The Financial Hierarchy: A Roadmap to Stability, Growth, and Legacy
One of the greatest discoveries on my financial journey was uncovering the concept of the financial hierarchy. This tool has shaped the way I think, speak, and act regarding money. It’s a practical framework that helps you decide what to do with money once you earn it.
I’ve always believed that what you do with your money is more important than how much you make. That being said, making more money is undoubtedly a key to financial success and is highly encouraged. But the way you allocate, protect, and grow your money determines whether you achieve lasting financial freedom.
The financial hierarchy resembles Maslow's hierarchy of needs but is focused on financial priorities. Imagine a pyramid where each layer represents a critical financial step. Like a building, the strength of the pyramid lies in its base. If you invert it, it becomes easier to tip over. By tackling each layer of the hierarchy in order, you ensure stability and resilience in your financial life.
Let’s dive into the financial pyramid and explore each layer in detail.
The Financial Pyramid: A Visual Framework
Security and Protection
Debt Elimination
Asset Accumulation
Wealth Distribution
1. Security and Protection: Laying the Foundation
At the base of the pyramid lies security and protection. This foundational layer includes everything you need to shield yourself and your family from financial ruin in case of emergencies or life’s uncertainties.
Insurance: Protecting Your Income and Family
Your ability to earn an income is your greatest asset, and insurance is how you protect it. Investments will help you achieve your financial goals and insurance will help protect you along the way to ensure you get there. There are four main types of insurance to consider:
Life Insurance: If anyone depends on your income, life insurance is essential. Ideally, you should have term life insurance coverage equal to 20 years of your income (adjusted based on your situation). Even if no one depends on your income, permanent life insurance can at least cover funeral expenses and final costs.
Critical Illness Insurance: Provides a lump-sum payment if you're diagnosed with a specified illness, such as cancer or a heart attack. This money can cover treatment costs or help you take time off work.
Disability Insurance: Replaces a portion of your income if you’re unable to work due to injury or illness.
Health Insurance: Covers medical, dental, and vision expenses, helping you avoid large out-of-pocket costs.
Living benefits, such as critical illness and disability insurance, are especially vital. Without these, a sudden health crisis could derail your ability to earn and lead to financial hardship.
Estate Planning: Wills and Power of Attorney
Creating a will ensures that your assets are distributed according to your wishes rather than being decided by the government. Without one, family members are often left guessing, which can lead to conflicts, delays, and unnecessary legal costs. A power of attorney is equally important, as it allows someone you trust to manage your financial and healthcare decisions if you’re incapacitated.
Emergency Fund
An emergency fund acts as your financial buffer. Aim to save 3-6 months’ worth of living expenses in a liquid and accessible account. This prevents you from relying on debt in times of unexpected expenses, such as job loss or car repairs.
2. Debt Elimination: Breaking Free from Financial Burdens
Debt elimination is the next critical step after establishing security and protection. Carrying high-interest debt, such as credit card balances, can make it difficult to progress financially. Here’s how to tackle it:
The Debt Snowball Method: Pay off your smallest debts first to gain momentum and motivation.
The Debt Avalanche Method: Focus on debts with the highest interest rates to save money over time.
Balancing debt repayment with maintaining your emergency fund is crucial. While aggressively paying off debt may seem appealing, an unexpected expense without a safety net can force you to rely on the same debt vehicles, keeping you trapped in a vicious cycle.
3. Asset Accumulation: Growing Your Wealth
Once you’ve secured your foundation and reduced debt, you can focus on growing your wealth. Asset accumulation involves strategic investing to outpace inflation, in tax friendly environments, and achieve financial goals.
Tax-Free Accounts
Tax-Free Savings Account (TFSA): Contributions grow tax-free, and withdrawals are not taxed.
First Home Savings Account (FHSA): Combines the benefits of a TFSA and RRSP to help you save for your first home.
Principal Residence: Profits from the sale of your home are generally exempt from capital gains tax.
Tax-Deferred Accounts
Registered Retirement Savings Plan (RRSP): Contributions are tax-deductible, and investments grow tax-deferred until withdrawal.
Registered Education Savings Plan (RESP): Helps save for a child’s education, with government grants and tax-deferred growth.
Non-Registered Investments
After maximising tax-advantaged accounts, you can explore non-registered investments. These accounts don’t have contribution limits, but earnings are taxable. Working with a financial advisor can help you structure investments to minimise taxes.
The cash accumulation in a permanent life insurance policy can also be used as a tax free or tax deferred investment vehicle, depending on how it’s structured and how you use it.
4. Wealth Distribution: Leaving a Legacy
The final layer of the financial hierarchy focuses on wealth distribution, ensuring your hard-earned money benefits your loved ones and chosen causes after your passing. Proper planning in this area is often overlooked, but it’s critical for preserving your wealth.
The Importance of Wealth Distribution
Without a solid wealth distribution plan, a significant portion of your estate could go to taxes instead of your heirs. For instance:
If you own a large estate or investments, capital gains taxes may erode your wealth upon transfer.
Without a will, the government decides how your assets are divided, which may not align with your wishes.
Strategies for Wealth Distribution
Life Insurance: A permanent life insurance policy can provide a tax-free death benefit to your beneficiaries, covering estate taxes and leaving a legacy.
Trusts: Setting up a trust allows you to specify how and when your assets are distributed, protecting heirs from mismanaging their inheritance.
Gifting While Alive: Giving money or assets during your lifetime can reduce the taxable value of your estate and allow you to witness the benefits of your generosity.
The Impact of Poor Planning
Failure to plan for wealth distribution can lead to:
Higher Taxes: Without strategies like trusts or insurance, your estate could face steep tax bills.
Family Conflict: Ambiguities in asset distribution often cause disputes among heirs.
Delayed Transfers: Probate can significantly delay the distribution of assets, causing financial strain on your loved ones.
The Role of Financial Professionals
Navigating the financial hierarchy can be overwhelming, but you don’t have to do it alone. A strong financial team can guide you through each step:
Financial Advisor: Helps you create and execute a personalised plan.
Accountant: Optimises your tax strategy.
Estate Planning Attorney: Ensures your wealth distribution plan aligns with your goals.
Conclusion: Building Your Financial Pyramid
The financial hierarchy offers a clear path to achieving stability, growth, and legacy. By addressing each layer—starting with security and protection and progressing to wealth distribution—you can build a financial future that supports your goals and safeguards your loved ones.
Remember, the strength of your financial plan lies in its foundation. Start by protecting what you have, eliminate financial burdens, grow your wealth wisely, and ensure your legacy is preserved for future generations. With proper planning and professional guidance, you can achieve lasting financial freedom.
If you’re interested in how your current plan lines up with the financial hierarchy, we are here to help. Book a call with us and let’s have a look at your journey.