Financial Planning for Dummies – Part 2
The first article in the “financial planning for dummies” series identified the 5 most common risks people face, namely:
- Dying too soon and leaving debt or dependents.
- Living too long (insufficient funds on which to retire).
- Disability (over a short or extended period).
- Funds for short term emergencies.
This article looks at the first of these risks; Dying too soon!
The risk here is that of leaving debt and/or dependents with insufficient means to pay the debt or support themselves. Typical examples are that of a big home loan or a spouse with young children. In this case most people do not have sufficient assets or a wealthy family support network and opt to insure the risk. This means that they buy life insurance that will pay a pre-specified amount to their beneficiaries on their death. Life insurance is not an investment – it pays when you die! As such, it is my opinion that it should only be used to cover risks that you can not (or do not want to) take. No debt or dependents, sufficient cash/investment reserves, a big (wealthy) family support network or no estate duty problems and you probably don’t need any life cover.
How much is enough?
There is no right answer that applies to everyone and each situation is unique. R1 million might be more than sufficient for one person while R10 million may be too little for someone else. If the insurance is to provide for a spouse and dependents then it is reasonable to expect to be able to generate 5-6% as a sustainable (and increasing) income from the capital i.e. R1 million net could provide ±R50 000 to R60 000 (tax free) per annum.
Most people in formal employment and who belong to the company retirement fund will also most probably have some form of group life insurance. This is usually a multiple of the annual pensionable salary e.g. 3 or 4 times the persons pensionable salary and this needs to be factored into any calculations. Never ask an insurance salesperson if you need more life insurance – they are incentivized to sell insurance and it is highly unlikely that they would tell you that you don’t need any more cover. Rather, consult a financial planner for an informed opinion and be prepared to pay for the advice – it might cost a bit in the short term but could save you fortunes in the long run.
It is also essential to nominate (appoint) beneficiaries on all of your policies (and to make sure that any beneficiary nominations are still current) – not only does this avoid any confusion at your death, but it will also save you about 4% of the value of the policies. This is because while any proceeds from a policy still form part of your estate, those where beneficiaries have been nominated are not handled by the executors of the estate thus saving the executors fees on them.
Life insurance is also frequently used for business purposes. This is for things like Buy-and-Sell and Key Person policies where businesses need to ensure that there are sufficient funds at the death or disability of one or more of their key employees or in order to be able to replace them or to fulfill any contractual obligations that they may have.
Another frequent use of life insurance is to provide liquidity in an estate. Often when performing an estimate of the estate duty liability (effectively the amount of tax that will be paid by a deceased person’s estate) it is discovered that despite there being plenty of assets, there are no liquid assets which can be used to pay the estate duty. For instance an estate might consist solely of 3 properties which are being left to 3 dependents. This might mean that one or more of the properties would have to be sold in order to provide the liquidity to pay the estate duty. This is clearly unfair on one or more of the dependents and in these cases some people opt to take out life insurance in order to provide the liquidity in the estate at their death. If the life cover is to provide for estate duty liquidity then you will need to determine the quantum of the estate duty need in order to determine the amount of cover and you will also need to add ±25% of the value of the cover to compensate for extra estate duty on the cover.
Remember, financial planning is not only for the wealthy and super intelligent! Everyone should have a financial plan.
A financial plan should identify the potential impact of any of these areas (as well as any others) and should be designed to minimize its impact. It is about objective (measurable) advice that results in a plan to identify and manage current financial risks and achieve future financial needs and goals .
If you have concerns about your finances or financial positions, you should be speaking to your financial planner.