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.