Managing your personal finances is about more than just drawing up a budget and saving for a rainy day. It’s about achieving a balance between protecting your greatest asset (your income) while at the same time building your wealth.
It involves overcoming the need for instant gratification in order to achieve more sustainable goals. Effective financial planning seeks to distinguish between what you want now as opposed to what you want most and puts mechanisms in place to help you realise your goals.
The process involves understanding your personal concept of financial freedom and what it means for you. How much is enough? If you didn’t need to work, what would you do for the rest of your life? How do you combine payslip, passion and purpose?
Here are 8 definitive steps to help you start your financial planning journey the right way:
- Set goals
The first step is to set goals and objectives that are important to you. There is no one-size-fits-all, and every person’s goals and priorities are unique. To simplify the goal-setting process, it is often easier to separate your goals into different categories such as retirement goals, saving and investing objectives, risk protection goals and estate planning goals.
Do not let affordability, or lack thereof, put you off setting your goals. It goes without saying that at the outset of your career you will probably not be able to afford all the financial solutions that you require. Once you have established your goals, spend time prioritising them with a view to implementing them as and when your finances allow.
- Prepare a budget
Once you have reduced your goals to writing, the next step is to draw up a budget. Not all goals and objectives will be instantly achievable, and a budget will help you to manage cashflow, prioritise your goals and channel your money towards those goals that are really important to you.
- Protect your risk
Once you have analysed your goals in respect to your risk – taking into account what would happen in the event of your death, disability or ill-health – the next step is to consider suitable solutions. There are so many different insurance companies in South Africa and the choice can be overwhelming. Radio, TV, printed media and the internet are inundated with adverts for insurance companies offering discounted premiums, extra life cover and no underwriting.
Due to the complexities of insurance products, it is virtually impossible to make informed comparisons of benefits and costs. It is also difficult to assess the reputation of each life insurer in respect of claims-paying ability and administrative capability. A financial advisor plays an important role in analysing the insurance market on a regular basis and keeping abreast of product development. If you have a need for insurance cover, your financial advisor will prepare costings from at least three different insurance companies for you to consider. If he is independent, he will be free to advise you on the most appropriate and cost-effective solution for your needs with no incentive to do otherwise.
- Manage your debt
It is important to understand the difference between ‘good debt’ and ‘bad debt’ before embarking on a debt reduction strategy. Good debt, such as a low-interest student loan or home loan, is debt that is required in order to pay for big-ticket items that one would not otherwise be able to afford. Borrowing money to buy a modest home or to further your education is considered good debt.
However, debt that is incurred to purchase clothes, consumables and other goods and services is generally expensive debt (high interest) which is not sustainable in the long-term. If you have accumulated debt across a number of credit cards and shop accounts, it is strongly advised that you embark on a debt reduction strategy to eliminate your unsecured debt. While you are servicing high-interest, unsecured debt, it is almost impossible to start saving, build an emergency fund and invest for the long-term.
- Create an emergency fund
The next step is to create an emergency fund to protect yourself against unexpected, high-cost events. Inevitably, most people will find themselves in a position where they have to pay for something like a burst geyser, new tyres or an expensive vet bill. In the absence of an emergency fund, you might be forced to borrow money to pay for such an expense. This, in turn, creates a cycle of debt-dependency which is difficult to extricate oneself from.
Rather than borrowing money to pay for unforeseen expenses, it is advisable to set up an emergency fund to prepare for the rainy days. For most people, setting up an emergency fund takes time, especially if you have just embarked on your career. However, even setting aside R50 a month will help you in the long run. As a rule of thumb, it is advisable to keep the equivalent of three months’ salary in your emergency fund.
- Set up a retirement fund
Your future self will thank you if you start investing early on in your career. Given a longer investment timeline, the power of compound interest has more time to work its magic. Although you may not have any idea now at what age you wish to retire, or whether you ever intend to, long-term investing can bring you to a point of financial freedom which should be your ultimate goal.
Unit trust-based retirement annuities are a new generation of retirement annuities that offer investor flexibility, more transparency and greater cost-effectiveness. A retirement annuity (RA) is a very tax-efficient investment vehicle for your retirement that allows you to build capital during your working years so that you have enough money to enjoy the same standard of living when you retire, and it makes sense to maximise your RA contributions. Investors are permitted to invest up to 27.5% of their taxable income – less any amount that is being contributed towards a pension or provident fund – tax-free into an RA (up to a maximum of R350 000 per year).
Over and above the obvious advantage of investing with before-tax money, it is important to note that dividends tax and CGT are not charged on the investment returns achieved in an RA. Further, the money that you invest in an RA is deemed to fall outside of your estate and can therefore not be touched by creditors. It is also excluded from estate duty calculations.
- Draft a will
Regardless of your marital status, net worth or age, it is always advisable to have a will. There are a number of requirements that need to be met to ensure that your will is valid. If these requirements are not met, your will may be declared invalid and you will be deemed to have died intestate. We, therefore, caution you to avoid downloading will templates or attempting a DIY will.
Another document that you may wish to consider is a living will or advance directive. A living will is a declaration of your non-consent to artificial life support should you not be in a position to do so in person. Your living will not form part of your last will and testament, and we advise that you let your loved ones know if you have a living will in place.
- Invest surplus income
Once you have taken advantage of the tax deductions afforded by a retirement fund, such as an RA, it makes sense to invest any additional surplus income rather than leave it in a bank account. Vehicles that can be used for these purposes include tax-free savings accounts, endowments (for those in a tax bracket above 30%) and unit trusts. Unit trusts, or collective investments, are an excellent place to invest surplus income for growth.
There are currently around 1 300 registered unit trusts in South Africa with a whopping R2 trillion invested, and an independent advisor will be able to guide you through this process.
Time plays a hugely important role in determining the most appropriate portfolio for you. For instance, if you are planning to invest money for a two-year period as you save towards purchasing a property, you would need to select a low-risk fund such as money market or flexible income funds. If you are investing for a three- to five-year period, you might need a stable, moderate or conservative fund which has some share exposure but still holds a large portion in cash and other low-risk investments.
A five- to ten-year investment period might necessitate a balanced fund, whereas a longer-term investment – such as saving towards your newborn child’s tertiary education – you would want greater exposure to shares and property as you are able to tolerate more investment risk.