Markets tumble, interest rates spiral, motor cars are stolen ... it seems that our financial well-being is at the mercy of forces beyond our control. But as damaging as unforeseen events can be, our own bad choices are often an even bigger threat to our finances. We show you how to avoid 10 all-too-common mistakes.
“The fault, dear Brutus, is not in our stars, but in ourselves, that we are underlings,” Cassius says in William Shakespeare’s Julius Caesar. One interpretation of these lines is that it is not fate that creates misfortune but the weakness of human behaviour. And this is true when it comes to our finances. Many people would be decidedly more financially secure if they followed the basic rules of financial planning. Even though the best-laid plans are buffeted by external shocks, such as the stock market crash in September 2008, the most costly mistakes are of our own making.
Obviously, there is little that the widows and orphans who were the victims of the diabolical actions of J Arthur Brown and his cronies at Fidentia could have done to halt the alleged misappropriation and gross mismanagement of their money.
However, when fate does intervene, as in the 2008 market meltdown, more often than not it is not the actual event, which you cannot control, that causes long-term financial distress but how you react to it.
The importance of how we react to financial events, actual and perceived, is now so well recognised that the science of behavioural finance has come into its own as a field of study.
But most of the time, there is not much that behavioural science can really teach us. The common financial mistakes made by individuals, even financial experts, have been known for years. As political philosopher Karl Marx famously said: “History repeats itself, first as tragedy, second as farce.”
Take, for example, the people who have fallen foul of what has become known as the Tannenbaum Ponzi scam. It is tragic that so much money was lost in yet another contrived investment scheme. But when you consider that many of those who were taken for a ride include senior South African executives, it is in fact farcical.
Acts of omission (such as not having sufficient life assurance) can be as damaging to your finances as acts of commission (such as investing in a scam).
This article describes some of the most common, and potentially the most expensive and tragic, financial mistakes you can make. Even worse, making some of these fundamental mistakes is likely to seriously undermine the financial security of your dependants, possibly for generations. Ensure you do not lose money by making these big, bad choices.
1. Not planning for the unexpected
Most South Africans die before they reach the age of 50. That’s quite a scary statistic! The main reason is Aids and related diseases, but our roads, violent crime and a multitude of other accidents and diseases also claim an inordinate number of lives and leave many people permanently disabled.
It is imperative that you buy risk life assurance if you have dependants but do not have sufficient savings to provide for them should you become disabled or die prematurely. Life assurance that provides benefits on death will ensure that your dependants can maintain their standard of living. And it is even more important to have assurance against being left disabled by either an illness or an unexpected event.
Apart from not encumbering yourself with debt, risk life assurance should be number one on your list of financial priorities.
Despite the risks that each one of us faces every day, research by True South Actuaries & Consultants in 2008 showed that the vast majority of South Africans are under-insured against death and disability. The research found that the average household earns R60 000 a year (R5 000 a month) and should have been insured against death by an average of between R431 000 (if your dependants tightened their belts and did away with all luxuries) and R531 000 (if you wanted to preserve your dependants’ standard of living). These were the lump sum amounts that would be needed to generate a monthly income to sustain your dependants financially.
But actual life cover averaged a mere R239 000. So, if you are Mr or Ms Average and are the main breadwinner in your family, and if you die or are disabled today, your family would have to cut its living standards by up to half.
It would cost the average household between R1 330 and R2 322 a year to raise its life cover to the ideal level. The total amount that South Africans would have to spend to be properly assured is R34 billion. Their cover is about R10 000 billion short (or R5 600 billion if their dependants tighten their belts).
To have sufficient life assurance to maintain your current standard of living, you should be paying premiums of about 3.9 percent of what you spend every month on living expenses (or 2.2 percent to meet a belt-tightening budget). Again, this is if you are Mr or Ms Average.
The simple calculation for risk life assurance is: your current and future liabilities, less how much you have (your assets), less your current assurance. Most people’s future liabilities are likely to be as high as between 15 and 20 times their current annual income. Obviously, the calculation is affected by the number of dependants you have and the period for which they will depend financially on you.
You may be lucky enough to belong to an occupational retirement fund that provides group risk assurance. But John Anderson, the head of national consulting strategy at Alexander Forbes, says that most group life assurance is insufficient to meet the needs of members. Most group life assurance schemes provide what he calls core cover, leaving a significant gap in what you will need. Core cover is normally based on a multiple of your annual pensionable salary and not your actual needs.
Research by Alexander Forbes shows that 65 percent of retirement funds provide a group risk benefit multiple of up to four times a member’s pensionable income. The average is three times.
Anderson says the research shows that the benefits paid to the dependants of 80 percent of fund members are, on average, more than 50 percent less than what they require.
Group risk cover based on a multiple of salary does not take account of all the important factors that must be considered when buying assurance. These factors include your age, how many dependants you have and their ages, your state of health, how much you have saved and how much debt you have.
The main reason most group schemes offer only core cover is historic. When most retirement funds were defined benefit schemes, if you died before retirement age, the benefit paid to your dependants was based on a pension that was calculated as if you had reached retirement age. In most cases, the benefit was paid as a monthly pension that increased over time to take account, at least partially, of inflation. The pension was topped up with a lump sum of about twice the member’s annual salary, paid from group life assurance.
But then came the big switch to defined contribution funds, where you take the risk that you will have sufficient money on which to retire; only the contributions you and your employer make are defined, not the final pension. If you die before retirement, your dependants receive only your accumulated savings plus any group life assurance. So the younger you are or the shorter your period of membership of the fund, the less your dependants will receive in accumulated benefits if you die prematurely.
The problem is that when most retirement funds converted from defined benefit to defined contribution schemes, group life assurance was not altered to make good the potential shortfall, particularly for younger members. At best, many schemes simply increased the group life benefit cover from two to three times annual pensionable salary. Some retirement funds, now realising the potential problem, are revising their group life assurance (see “How wide is your group cover safety net?”).
Anderson says it is vital that you approach a financial adviser, who will calculate how much risk assurance you should have based on your circumstances. You should compare this amount with your existing risk assurance and identify any shortfall.
If your total risk assurance plus your savings from all sources are not sufficient to provide a lump sum of at least 10 times your current annual income, you need to increase your risk assurance urgently.
The 10 times figure is a conservative rule of thumb; the more realistic amount is likely to be closer to between 15 and 20 times your annual income, depending on how many dependants you have and how long they will be dependent on you.
Give your dependants their due
You should Do the following to make sure that your dependants receive their benefits:
• Have a valid will. There is little point in planning for your dependants’ financial well-being if you do not leave instructions on how they should be provided for after your death.
The Fiduciary Institute of South Africa (Fisa) estimates that only 10 percent of the population has a will. Fisa executive member Graham McPherson says there are fewer than five million registered wills in South Africa. The number of valid wills may be even lower, because many people have more than one will.
Of all reported adult deaths, about 70 percent involve estates worth less than R125 000. These estates do not require an executor and are disposed of in terms of the Administration of Deceased Estates Act. The remaining 30 percent of adult deaths involve estates worth more than R125 000, for which the Master of the High Court requires the appointment of an executor.
• Name a beneficiary of an individual life assurance policy, whether it is a risk or an investment policy. This will ensure that the benefits are paid to your dependants without delay (they will not have to wait for your estate to be wound up). Furthermore, executor’s fees of up to 3.5 percent (plus VAT) will not be levied on the payout.
• Never provide a life assurance company with misleading information, such as concealing your poor state of health or that you engage in a risky hobby, in an attempt to reduce your premiums. If the life company finds out that you have provided false or misleading information (either by commission or omission), it will repudiate a claim and your dependants could face destitution.
2. Not having short-term insurance
People who do not have insurance or who are under-insured tend to think they are their own risk managers and that they will be able to pay for any lost or damaged property out of their own pockets. But you cannot know to what extent a road accident or the loss of your property will affect you financially.
The Automobile Association says that “getting into our cars every morning remains one of the most dangerous activities we do on a daily basis”. It says that in most parts of the world your chances of being involved in a motor vehicle accident are one in 5 000 accidents. In South Africa, it is one in 10.
According to Refilwe Moletsane, the deputy chief executive of the South African Insurance Association, as many as 6.4 million of the 8.5 million vehicles on our roads could be uninsured. This means that not only will the uninsured find it very difficult to replace their own vehicles, but it is unlikely that they will be able to pay for repairs to another vehicle should they cause an accident. Moletsane says it costs on average between R25 000 and R30 000 to repair a vehicle.
Ian Kirk, the chief executive of Santam, the country’s largest short-term insurance company, provides an example of how a vehicle accident can affect your finances: “If you have no insurance and crash into a Porsche, the person whose property you damage has the right to sue you in your personal capacity, which could turn out to be financially crippling. Apart from the repair costs, for which you will be personally responsible, there are other costs involved, such as loss of earnings, and pain and suffering, which could also cost you dearly.”
In addition, short-term insurance provides support in terms of qualified legal advice when it comes to liability claims, so you save on legal costs.
Kirk says that last year Santam, and the short-term insurance industry in general, experienced a considerable increase in the frequency and the cost of claims. Weather-related incidents were the main contributors to property claims. Theft, lightning and fire were the main reasons for household contents claims.
Trends in claim patterns last year show that there was a 22-percent chance of a person submitting a motor vehicle-related claim, with the claim amount averaging R12 500. For household contents, one out of eight people lodged a claim that averaged R9 500. These figures indicate that it is financially prudent to have adequate insurance rather than to attempt to cover losses out-of-pocket as they arise.
But having insurance does not mean that you do not need to take a hand in managing your risk, thereby reducing your costs.
Kirk says Santam helps its clients to take charge of their insurance cover by alerting them to the risks to which they are exposed. He says this puts them in a position to exercise greater control over their exposure to risks and ultimately to reduce them.
“Many people are unaware of the safety and security risks associated with their own homes, or whether they are over- or under-insured. By conducting a risk assessment, clients will better understand and therefore manage the risks they face,” he says.
Taking precautions, such as having a proper security system installed at your home, can reduce the probability of a claim. The more claims can be reduced, the lower the premiums.
Kirk warns that poor attention to detail could find you out of pocket when it comes to short-term insurance claims. You should update your policies from time to time, at least every year, to ensure that your insurance cover remains adequate.
He says research shows that up to 40 percent of people with short-term insurance are under-insured by up to 45 percent.
“Clients often forget to inform insurers about changed circumstances and the accumulation of new possessions. Unfortunately, they only realise the impact of this when they have a claim,” Kirk says.
• Always provide full details and the correct valuations of the items you insure. If you under-insure, an insurance company will reduce your claim by the proportion by which you are under-insured.
• Read the policy document, particularly the section on exclusions. For example, if you cause an accident and you had smooth tyres on your car or you were over the blood-alcohol limit, it is unlikely that an insurance company will meet your claim. Some policy conditions are more obscure, such as ensuring that your roof is in sound condition.