When faced with the onerous task to plan for one’s financial needs there are multiple scenarios and requirements that come to mind. This confusion often leads to a point where hands are thrown into the air and all planning is halted and left to deal with on another day. Once this point is reached that “another day” rarely arrives…
Hopefully, I can simplify this and unpack basic financial planning in a few simple steps and hopefully, this will encourage some individuals out there to get into action!
People have different concerns and priorities in life and everyone’s situation is different. However, when it comes to financial planning there are generally three areas of concern namely:
- How much money do I need when I retire and am I making sufficient provision?
- What do I do if I lose my work due to an accident or sickness?
- How much life insurance, if any, do I need?
The most important requirement you need to determine at the start of your financial planning journey is how much income you and your family will require in the following scenarios:
- Monthly income needed should you retire today (ignore future income and expenses but deduct long term debt like bonds if they will be settled by retirement date);
- Monthly income needed today should you no longer be able to work due to illness or an injury; and
- Monthly income required today by your family should you pass away.
These are the three buckets that will form the core of your future financial planning. By knowing the answers to the three mentioned scenarios we can now start to plan for each event. At this point, I have ignored a fourth bucket namely provision for short, medium and long-term expenditure which will be a part of your investment strategy that I will deal with in a future article.
At this point, I would like to state that financial planning should be all-encompassing and take all your assets and sources of income into consideration. Too often insurance-related solutions are the only consideration to prepare for life’s events and other assets are ignored.
If you are asset rich you do not need life insurance unless your portfolio comprises mainly of fixed assets that can lead to a liquidity problem in your estate when you pass away. Insurance must only be taken for specific potential liabilities and must be specific and calculated. Ideally, you should have minimal life insurance and plentiful assets the day you die.
Life insurance and assets should be like a seesaw. At the start of your planning journey, you may require much more life insurance than at the end of your working life. As your assets grow life insurance should be reduced – liabilities should however always be covered especially if you have financial dependents. Those individuals who fail to accumulate sufficient assets may have to keep more life insurance to fulfil legacy wishes.
So how much is enough for each eventuality?
The required income scenarios that I referred to above can be dealt with in various ways namely:
- Investments that provide an income (interest, dividends);
- Property where rental income is derived;
- Retirement funding; and
- Life insurance.
By way of example let us consider a monthly income requirement of R40 000 per month in each of the three mentioned scenarios i.e., retirement, disability and death.
In this scenario, it is important to decide how important it is to leave a legacy. If the planner feels strongly about leaving their retirement funding as a legacy, a larger amount of funds will be required on the day they retire compared to the planner who is only concerned about receiving an income for the rest of their life without a legacy requirement. In general, if a person retires, we plan for a life expectancy up to age 100. In other words, a 35-year income period, unless there is a clear indication or instruction from the planner to reduce the planning term for medical or other reasons. If we now get down to the nitty-gritty the following will apply:
Considering that pension income must increase at least at the rate of inflation, then it is advisable to limit drawdown (income) to the following:
- Where legacy (transfer of capital to beneficiaries) is important, annual drawdown should be limited to around 3.5% of the capital value.
- Where legacy is less important, annual drawdown could be increased to 5% of the capital value.
In the above scenarios, you would therefore require:
- In the case of 1) R40 000 x 12 / 3.5% = R 13.7million capital
- In the case of 2) R40 000 x 12 / 5% = R 9.6 million capital
- The above figures are based on real-time (today’s value). Inflation must be taken into account to determine what the future income and capital requirements will be. That will ultimately determine how much you need to invest to reach your retirement goal. A simple rule to allow for future inflation of 5% per year is to double today’s required capital for every 15 years to retirement. In other words, in scenario 2) above and assuming you have 30 years left to your retirement date, the R9.6 million will change to R38.4 million required in 30 years. If retirement is planned within 15 years, the amount required will be R19.2 million. There are more scientific ways to calculate these requirements more accurately but in this case, I am trying to simplify the planning process to provide a picture that will still be pretty accurate.
- Drawdowns/income, as well as the future capital value, will be a function of investment returns. In future articles, I will elaborate on the importance of returns and the cost of conservatism. In short, the more conservative the investment portfolio is the higher the contribution amount will have to be, and the more capital will be required at the start of retirement. In my example above an investment return of 9% per year was assumed.
- If there are going to be alternative income sources at the point of retirement, the income amount must be subtracted from the required income to determine the required capital amount. For example, if the planner owns a rental property with a rental income of R10 000, then the required capital amount as in 2) above will be:
R40 000 – R10 000 = R30 000 x 12 / 5% = R 7 200 000 (or R 14 400 000 in 15 years). In a similar way, if it is the intention to sell a current rental property or any other asset at retirement, that amount must be deducted from the calculated capital requirement if you want to determine how much must be invested to reach your capital goal. For example: if you own a rental property worth R3 million and intend to sell it, the capital amount that you must save towards in 2) above will be:
R9.6 million – R3 million = R6.6 million (or R 13.2 million in 15 years).
- Income replacement in the event of injury or illness
The capital amount required to replace income will be age-dependent. In principle, income-disability planning ends at age 65 whereafter retirement planning kicks in. As previously mentioned, if you are asset rich then insurance is not required. This is however one area where income replacement cover makes absolute sense, especially for younger planners. When one starts working you are probably asset poor (unless you enjoy trust benefits or received a legacy bequeathment) with at least 40 years of working life ahead of you as well as another 30 years + of retirement life where you need an income/pension.
I am astounded how many young people take out life insurance as soon as they start working, yet they have no provision for disability-income protection. Statistics show that the odds of a 25-year-old becoming disabled is substantially higher than them dying.
Note to young individuals – Life insurance becomes important the day you have financial dependents, not before that. When I ask young planners why they have life insurance they state because they have debt. So what? If the credit provider did not request life insurance, it is their problem! Good luck to them trying to recover the debt from you if you die and debt cannot be inherited as many fear. [It is important to note that the debt could be taken from the estate provided there are assets and liquidity in the estate. In most cases, the indebted asset will be sold (like a vehicle) to settle the debt with the residue paid to the deceased estate account.]
The point I am trying to make is that priorities are often skewed. It is much more important for a young person to protect their income as opposed to protecting a creditor.
Income replacement cover becomes crucial the day you start working – this is the most important insurance that you must get in place as soon as possible. Fortunately, most employers have income replacement cover as a group risk-benefit for their employees. If you work for a company and they do not offer this benefit I urge you to speak to a financial advisor and get this cover in place as soon as possible. It is not an expensive cover considering the benefit that you receive.
- Income replacement cover pays out monthly in the event of an injury or illness that renders you either temporarily (up to two years) or permanently disabled.
- The income payout is inflation-linked ensuring that your income benefit or salary replacement increases over time.
- For the first two years, the benefit will pay the equivalent of 100% of your funding salary after which it will reduce to 75% of your funding salary. Payouts are tax-free.
- Contributions towards the policy must remain in place. This means that during the period that you receive the benefit, the contribution must still be paid. If you fail to pay the premium, the cover will cease meaning that you will lose your monthly income.
- The income benefit generally pays to age 65 although there are providers that pay for a longer period. It is important to note that you still need to make provisions for retirement during the period that you are unable to work. The last thing you want is to earn income up to age 65 while you were unfit to work and then retire with no funding.
- Monthly income required in the event of your death
The calculation for the amount required is pretty much the same as the calculation for retirement provision. The main difference in the planning process is that for retirement planning you plan around an investment strategy to reach a goal sometime in the future. With provision for death, we work in real-time and calculate the capital requirement assuming you pass away today. One must also add to the capital requirement the amount of outstanding debt (which will reduce the monthly income requirement if settled) and estate liquidity requirements. In many ways, this is the easiest phase of planning, and a very specific plan can be put in place.
Note of caution: Planning around capital and income required in the event of death must be done in conjunction with estate planning and your will. If your will stipulates certain bequeathments to beneficiaries and insufficient capital is available to settle debt, estate winding up costs and estate duty, assets will be sold to cover these costs. This can cause havoc leaving insufficient funds to provide the required income or capital for loved ones. The more assets one gathers the bigger the effect of CGT will be when winding up the estate. It is, therefore, crucial to continuously revisit the liquidity requirement within your estate.
By using the retirement calculation, the capital amount required for income in the event of death can be calculated. (The income requirement may reduce over time as children get older and become financially independent). Do the planning with the help of a long-term budget.
The simple formula to determine the amount of life cover required will therefore be as follows:
Capital for income provision + debt + estate winding-up costs + estate duty + CGT – liquid assets not linked to income – retirement proceeds (less tax). If this is too onerous use the following calculation: (Calculation for income provision + debt) x 120%.
The above is a very basic concept. Obviously, all situations vary substantially and factors like bequeathments to spouse which is free of estate duty, trusts, usufructs etc, all must be considered and should be done with the assistance of a CFP® before taking the plunge.
The important message that I hope I managed to get across is no matter how basic, please just start with a financial plan and get some risks cover and some funding in place for retirement. Your financial plan is a live document that continuously changes and evolves. Even if your initial plan is basic make sure it is cost-effective, adaptive and flexible enough to change without penalties as your financial life grows and gets more complicated.
Health warning: Be careful and avoid life insurance-linked investment products that tie you into lengthy investment terms with severe penalties when you want to change. The financial services industry has become much more dynamic with many cost-effective products and well qualified financial advisors. It pays to contract with an independent experienced CFP ®.
Readers are welcome to email or phone me should they wish to discuss the above mentioned in more detail.