Managing a windfall

A windfall, in personal finance, is defined as a significant amount of money that a person gets unexpectedly. Windfalls can come from inheritances; gifts; retirement lump sums; lottery winnings; insurance settlements; legal settlements; or sudden increases in income (e.g., bonus payments, stock options, ...). While not being external sources of new wealth, other common sources of receiving large lump sums include real estate sales, the sale of a business, or widowhood/divorce.

Windfalls can range in magnitude from small additions to an individual's wealth to large fortunes. This article intends to provide guidance to manage windfalls that are relatively large compared to one's income and assets, enough to entail significant lifestyle changes and the need for additional planning. Windfalls can mean huge changes in a recipient's life, psychology and emotions.

Impulse spending is a big factor explaining why windfalls can quickly vanish. This excess spending might be related to emotions, and pressure from family and friends. But a less obvious reason is a psychological factor or bias called mental accounting. It might be psychologically easier to buy a luxury car using a sudden windfall than to, say, prematurely withdraw from your Registered Retirement Savings Plan (RRSP), which is earmarked for retirement, to pay for that same car.

Managing a windfall to optimize its positive impact is a three-part process: (1) psychological adjustment, (2) establishing priorities, (3) long-term financial planning. This article addresses each step, and also a fourth and final step, monitoring progress and making necessary adjustments. It also covers the "lump sum versus annuity" decision that some windfall recipients can face.

Psychological adjustment period

Many people dream of winning the lottery, but getting a large windfall is not necessarily a positive experience, at least initially. Possible negative reactions include anxiety, paralysis, isolation, guilt, etc. There even is a psychological condition called the Sudden Wealth Syndrome. There is no shame in consulting a psychologist if warranted.

This adjustment period may last 6-12 months, but in some cases up to several years. Different sources of windfall, such as the death of a loved one, may have powerful emotional consequences that you should focus on addressing, while spending minimal time worrying about finances. Coming to terms with your emotions will allow you to make better financial decisions.

Avoid early mistakes

Stay calm, and don't make any hasty decisions. For example, don't:

• quit your job prematurely
• buy extravagantly priced automobiles or properties, or engage in other expensive consumption spending
• be too generous too quickly to family, friends, and charities
• move to a new city without thinking it through

Be on the alert for people who may be trying to exploit you or take advantage of your new wealth. It’s important to recognize that you can be a target for all kinds of financial schemes.

Tell as few people as possible. Unfortunately, even those close to you may become resentful or solicit you for gifts when they hear about your windfall. You can always tell people later on when you've had time to consider the effect that information may have on your relationships.

Set the windfall money aside

A typical initial recommendation is to place the windfall into a safe place such as a savings account or Guaranteed Investment Certificate (GIC), for months, or even for a year or more. Other options include money market funds, or treasury bills.

Look at tax consequences

Even if the general recommendation is to do nothing with the windfall money for months or even years, unfortunately the taxman will not wait. If you're not sure if your windfall has tax consequences, many tax professionals will be willing to give you a free consultation.

Pay back high-interest debt

If you have high-interest rate debt outstanding, such as credit card balances, you can pay this back quickly and save a significant amount in interest payments. For low-interest debts, you can probably deal with those after you've established your priorities.

Establishing priorities and getting educated

Prioritize goals

Think about long term goals. Here are some possible ideas:

• Retiring, either in the short or long term
• Cutting back hours at work, and/or dropping less desirable shifts/jobs
• Changing jobs or starting a business
• Going back to school
• Saving money for the benefit of a loved one
• Moving to another city, or country
• Paying off debts
• Purchasing real estate
• Traveling or taking up a new hobby
• Growing your family
• Donating to charity
• Volunteering your time

Even a very large windfall will likely not be enough to fully fund all or even most of these goals, so it's important to prioritize your goals, both in terms of overall priority, and the time it will take you to reach them. Many financial novices are surprised how little of a windfall they are actually able to spend immediately. For example, based on rules of thumb such as the 4% rule, a $1M windfall can only generate about $40,000 per year of sustainable income over the long run.

Get educated

Whether or not you are inclined to manage the money yourself, you will need at least the knowledge necessary to evaluate financial professionals. Educating yourself on personal finance and investing will likely be, by far, the most money you will ever "earn" per hour, if it makes the difference between lifelong prosperity and a fortune squandered within a few years.

Long-term planning

Financial planning is a long-term process of managing your finances so you can achieve your goals. Financial planning after receiving a windfall involves the following considerations:

• Larger amounts of money increase the relative importance of certain aspects, such as tax planning, tax-efficient investing, minimizing investment costs, and estate planning.
• The windfall recipient is often thrust into a situation where they're required to manage a large amount of money without having the necessary skills, knowledge, and experience.
• The consequences of financial mistakes are higher, in terms of absolute dollars.

DIY or advisor?

Depending on your financial experience, your personality and the amount of the windfall, hiring a financial advisor, especially one with planning credentials, may be useful. The idea is to at least get a financial plan together, perhaps working with a fee-only planner. You can then decide if you want to implement the plan yourself or continue to work with an advisor.

You can also get feedback on the Financial Wisdom Forum. Most forum members are not finance professionals, but many are nonetheless experienced investors.

Spending

Budgeting can be a useful exercise regardless of wealth levels. Consider both the up-front and ongoing costs of purchases. For example, windfall recipients often do not consider the ongoing costs associated with expensive properties (property tax, maintenance, utilities, cleaning) or vehicles (fuel, insurance, maintenance, storage for the winter, etc.), which can be substantial.

Resist the temptation to spend a significant portion of a windfall on short-term consumption spending. The enjoyment you'll get from investing and spending the windfall over a long period of time, and the comfort from having financial security, will likely far outweigh that from any consumer purchases.

Investments

Investing capital, and earning a good rate of return for an appropriate level of risk, is an essential component of almost all financial plans. See the following articles:

• Getting started
• Asset classes
• Asset allocation
• Portfolio design and construction
• Rebalancing

Windfall recipients should be especially cautious with high-risk and complicated investments (private equity, hedge funds, startup companies, etc.). Windfall recipients are also often the targets of bad investments, or scams, so limiting investments to diversified funds from respectable institutions reduces this risk.

Debts

Main articles: Managing debt and Paying down loans versus investing

Medium- and high-interest debts, such as credit card debts, should be paid off quickly. Most windfall recipients should prioritize eliminating all debts, even low-interest ones, because the balance versus investing favors paying down debts more strongly than for more normal investors. Similarly, windfall recipients should probably avoid taking on new debts (for example, a large mortgage on an expensive new home), because servicing that debt will require good financial behavior over a much longer period of time, with many more opportunities for mistakes.

Insurance

A sudden change in wealth require reviewing your insurance needs. You may need more of certain types of insurance, like liability coverage. Consider umbrella liability insurance for example.

Yet you may need less of other types, perhaps including life insurance, disability insurance, and long term care insurance, if your heirs/you can maintain their/your standard of living in the event that you die or get injured.

You might also want to rise your deductibles on auto insurance and home insurance if you can afford to self-insure for higher amounts.

Emergency fund

Main article: Emergency fund

You may want to increase the amount of your cash reserves, a.k.a. your emergency fund.

Giving

Main article: Charity selection

Charitable giving can be a meaningful part of a financial plan. Especially if your windfall is large enough to at least cover your basic needs for the rest of your life, strongly consider at least some charitable giving.

Consider giving money to family or friends (to whom you would leave assets in your will) during your lifetime.

But remember to take care of yourself first: giving should be prioritized against other goals and included in a comprehensive plan.

Estate planning

Main article: Estate planning

Estate planning is the branch of financial planning dealing with preparing for one's own death and the associated distribution of assets, and also planning for one's own incapacity.

Getting a large windfall might require you to revise your last will and testament and other aspects of estate planning.

Monitor progress and make necessary adjustments

Once per year, check your your progress toward your goals, and consider the following checks and adjustments:

• Check your actual spending against your planned budget. The tendency to gradually increase your spending is known as lifestyle creep. If you find your actual spending significantly exceeds your plan, evaluate the reasons why, and either reduce spending on the items that provide the least value, or adjust your financial plan to include higher spending. Raising your spending could delay or prevent you from reaching certain financial goals.
• Monitor the performance of your investments and rebalance as necessary. Avoid any temptation to panic-sell either at market highs or lows. Stay the course.
• Reevaluate your insurance needs, and shop around with other insurance companies to make sure you are getting the lowest rates on policies, especially if your situation has changed significantly.

Every few years:

• Stay up-to-date on changes in tax laws, and change tax strategy if necessary.
• Reevaluate your estate plan. Beneficiaries may need to be changed, new trusts may need to be created, or old trusts may no longer be necessary. Estate tax laws also change frequently, so changes may be needed.

Avoid the temptation to tinker with your plan and investments unnecessarily. Hot new investments often get covered by the press and on social media, usually after their price has been run up on speculation.

Lump sum vs. annuity

The choice of a lump sum or a stream of payments (an annuity in the most general sense) can be a complex one with many influencing factors, such as your financial goals, expected investment performance, taxes, inflation protection, life expectancy, estate planning goals, financial health of the annuity provider, and others. If you are at all unsure of the best course of action, a consultation with a fee-only financial planner could be very valuable. However, most windfall recipients should lean strongly toward choosing the annuity, for these reasons:

• The windfall is much less likely to be squandered: a lump sum can be squandered by just one bad financial decision, whereas squandering an annuity would require a series of many bad choices, and not learning from prior mistakes.
• The most common reason to choose a lump sum is the expectation of a higher rate of return than the effective rate of return of the annuity. However, most windfall recipients are investment novices who are less likely to reliably generate high returns from their investments. This makes the guaranteed payments of the annuity more attractive in comparison.
• Windfall recipients have less need to earn a high return, so the guaranteed return of the annuity is more likely to be adequate to support a comfortable lifestyle.

See also

• Managing a windfall, Bogleheads wiki

Further reading

• Financial Wisdom Forum topic: "Investing a windfall."
• Financial Wisdom Forum topic: "Windfall - what to do?"

External links

• Financial Consumer Agency of Canada, Receiving a large amount of money
• GetSmartAboutMoney, Inheriting money, "Investing inherited money can help you reach your financial goals, but using it wisely starts with a solid plan"
• What should you do with a windfall?, Morningstar.ca