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Your most important asset

Is a large pot of money really better than a monthly income?

Consider this picture: A 43-year-old man – in seemingly perfect health – sits on a couch in his living room with his wife and daughter. “Gary can get R2 million in life cover and R1 million in disability cover for just R700 a month,” the advertisement reads.

Or this one: A provident fund member, highly upset about a government plan to enforce the compulsory annuitisation of two-thirds of his fund benefit at retirement instead of allowing him to take all the funds in cash at retirement.

There is something about a large sum of money that gets people much more excited than the idea of a steady monthly income.

So entrenched is this concept, that it is frequently cited in songs, game shows or literature. The “pot of gold at the end of the rainbow” and “Who wants to be a millionaire?” come to mind. 

Why do investors favour a lump sum?

It may be because “wealth” is generally associated with a lot of assets or a large pool of money.

Unfortunately, most people struggle to manage a significant pot of money – particularly if they need to live off it for a long time.

As the former chief executive of a large asset manager succinctly puts it: “Most mere mortals are used to a monthly income. Large capital amounts get us all confused.”

Human beings overestimate the value of a lump sum, adds Brad Toerien, CEO of FMI.

Research it recently conducted suggests that if offered a choice of R1 million or a guaranteed income of R10 000 a month for the rest of their lives, most people will prefer R1 million, even though the second option is worth significantly more.

The preference for a lump sum may also be because financial planning has historically been done this way and that people prefer to have access to a large pot of money.

“But in reality, what we work for is a lifestyle and to protect that you need a regular stream of income,” he says.

The preference for lump sum benefits – in retirement and with regard to injury, illness or death – may also be related to a distrust of institutions.

People may argue that if the money is in their bank account, it is theirs to use as they see fit, but if a financial institution or government has to provide them with an income, their fortunes are in a third party’s hands.

Apart from the behavioural issues related to a lump sum and people’s tendency to spend a large part of their pot quite quickly, it can also be difficult to determine how much money someone would need to provide a continuous future income. Assuming Gary from the ad died soon, would R2 million be enough to settle his debts and still provide enough of an income to cover his family’s monthly living expenses?

And then there is also the inflationary impact to keep in mind…

Lump sum vs regular income

From a financial planning perspective, there has been a growing realisation that people’s greatest asset is their ability to earn an income throughout their lifetime.

While most defined contribution funds lack a clear income-goal focus for individual members, commentators are increasingly highlighting the need to focus on income instead of a pot of money during planning.

In a recent Moneyweb article, US Nobel Prize winner and retirement specialist Professor Robert Merton, argued that retirement funds should use an income measure to tell members how they were doing on their way to retirement, instead of just reporting what the current fund value (lump sum) is.

Merton said it was much easier for people to relate to an indication that if they currently earned R10 000 a month and continued saving for retirement the way they do, they would only get an estimated income of R2 000 a month in retirement after inflation was taken into account.

While there is value in receiving a lump sum – which could be used to settle debts or to pay for a wheelchair or home improvements or a funeral depending on the circumstances – it is of much less value if it will largely be depleted to pay for these expenses and there is no on-going future income stream.

It is perhaps time to question whether it is appropriate to place so much emphasis on saving towards a large pot of money at retirement or the importance of taking up a large lump sum death, critical illness or disability benefit.

While there is undoubtedly value in all of these lump sum benefits (people will surely be better off having a lump sum retirement or risk benefit than not having it), the value of a lump sum is significantly impeded if investors don’t also have the ability to earn a monthly income in line with their living standards. First, solve for income…

Which bodes the question: Should the focus not be shifting towards financial planning that ensures investors can replace their monthly income from today until the day they die (and thereafter if they have dependents) and that it can be adjusted in line with inflation instead of just targeting a seemingly large pot of money at some point in future?

Investors may just get to the end of the rainbow, only to realise the pot of gold will not be covering their expenses for long.

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COMMENTS   17

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I’d take the R1 million too, and invest it. It will take just over 8 years to get to R1 million from the R10 000pm and by then inflation would have eroded it somewhat and keep eroding it going forward until it is near worthless, even if I had invested it all every month, I think it will be hard to catch up with the lump sum.

You have a point but the average earner won’t think like this

And especially your Provident Fund Member. He will buy 2 taxis, a v8 for himself and a large screen plasma tv.
Then join the queue for a social grant – and get one.

Your calculation is the wrong way round, supersunbird, and does not take the present value of the future income stream into consideration. The present value of both is the only basis upon which you can compare the two options. Even if the R10,000 per month does not increase by the inflation rate every year, you only need to survive 11 years for the monthly income to be better than the lump sum, assuming an inflation rate of 6% per annum.
While I agree with the general trend of the article, it is not a question of the one or the other that will be best for everyone. If you are disciplined and have good investment knowledge or access to a well qualified and reliable planner, the lump sum may very well be better for you. The average salary earner may be better of with an income for life.

On the other hand, if you invest the R1m offshore and the Rand goes Zimbabwe, you will be better off.

The answer to the headline: one’s education and qualification.

You say “….. offered a choice of R1 million or a guaranteed income of R10 000 a month for the rest of their lives, most people will prefer R1 million, even though the second option is worth significantly more”.

..???How can you say that it is worth significantly more?

1. Firstly, it depends on how long you live/expect to live after being given the choice.
2. Secondly, it depends on what return you can get on the R 1 million. If you are able to get more than 12% pa you are definitely better off with the R 1 million. If you are not, then contact me: benfieldian6@gmail.com, and I will tell you how you can. For the last 5 years I have averaged about 17-18% pa.

Most people are taught about money WRONGLY !! They are taught that your home is your best investment. A 1 million home will cost you R 2,159,342.
With most of the interest UPFRONT. So when you buy your second home you get to pay the first 5 years interest AGAIN !! Then saving in a bank is safe-WRONG!! Banks have not beat the REAL inflation % in over 20 years! Why save @ 5% and pay a bond @ 9%? Why save @ 5% and pay a car @ 14%?? Why save at 5% and pay credit cards @ 19%??? You pay huge interest to your bond then some commission broker sells you an Retirement Annuity (to lock your money for 35 years) and earn a pittance each month BUT I’m saving on tax, whilst paying HUGE INTEREST on the bond!! Ever have that feeling like you are not getting ahead Financially? YOU ARE NOT !! What you need is Financial Fitness !!

I think it’s not just a question of investment returns but of liquidity, so that
a) when trouble comes you can bank on your savings account to keep your creditors happy, or
b) when trouble comes you can bank on your RA to keep your creditors unhappy.

I’ll take the mil. Financial Fitness is great but I do like chocolates.

Indeed! Good luck to the bank on repossessing (it can’t) your RA when life (retrenchment or whatever) happens, while the home can easily be repossessed.

The time preference of money explains the spending and savings habits of people. It is a lifestyle choice. Some people are willing to give a limb later, in exchange for the opportunity to have a cupcake now. Lifestyle diseases, like type-2 diabetes, are increasing worldwide. More than 40% of deaths in South Africa can be ascribed to lifestyle choices. If a person prefers instant gratification to longevity, it will be impossible to motivate such a person to delay financial consumption in order to save.

The time preference of money also explains the so-called inequality in society. For the wealthier part of society, the generations before them had to invest time, effort and money. Socialism is a mental disease of instant gratification that motivates consumers to plunder savers. The members of the ANC and the EFF all suffer from this disease.

The problem with a fixed amount of R10,000 per month is that inflation will erode it over time. The decision to take the lump sum or the monthly income will also depend on your age at the time you have to make this decision. If you can invest the lump sum at 10% pa and inflation averages 5.5% pa you will run out of money after 11 years if you increase the income of R10,000 per month by inflation every year. If you take no annual increases the lump sum will still only last for 18 years at which time the R10,000 will still have the buying power of R4,000. In other words the monthly income is better even though inflation will erode it over time.

Inge, you sound like a very nice and intelligent young lady, As an old(er) man I hope, in this day of political correctness and the like, this statement does no label me a condescending, misogynist old fart. I am not a misogynist. Old fart? Some of my best friends call me worse!

Nevertheless, I am regularly disagreeing with you. How about an online debate, discussing why we differ on many of the issues you raise?

What is R10000 a month for life really worth in today’s money? That would depend on liver i.e. how long you have, the discount rate and the frequency of the interest payments. However, what is the present value of the income stream?

If we assume a discount rate of 8.71%, monthly payments and if we live forever the problem becomes that of the “consol” i.e. perpetual annuity. Simply the present value (PV) = 10000/(0.0871/12) = R1377727

If we live for 40 years: R1334917 (immortality is actually quite cheap).
If we live for 30 years: R1275762
If we live for 20 years: R1134868
If we live for 10 years: R799286.1

The break even point is about 15 years.

Richard where does the rate of 8.71% come from?

Long term bond rate

This article does not show any calculation of the time value of money. This no part of the argument is substantiated. Thus any conclusion one way or another, has no basis.

Lesson: DO the calculation, inclusive of inflation and interest rates, back to PV or DCF for cost of living.

“Most mere mortals are used to a monthly income. Large capital amounts get us all confused.” Any confused Lotto winners are welcome to contact me via the Moneyweb subscription desk for my assistance …

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