3. Not belonging to a medical scheme
Too many young and fit people think that they do not need to belong to a medical scheme. They argue that they will pay more in premiums than they will receive in benefits.
They have a point. According to research by Discovery Health Medical Scheme, if you live to 90 years, 62 percent of the total amount you will spend on medical treatment during your lifetime will be spent after the age of 60, and 58 percent will be spent after the age of 85. The average value of the claims submitted by Discovery Health members in the 50-plus age bracket is greater than the average value of the claims submitted by members of all age groups combined.
But there are two problems with not joining a medical scheme when you are younger:
• You could develop a severe medical condition, such as contracting a debilitating illness, or be seriously injured in a motor vehicle accident; and
• You will pay penalties if you join a medical scheme only when you are older.
• Medical costs
The costs of medical care could ruin you financially. Discovery Health, the biggest open medical scheme in South Africa with more than two million members and dependants, receives between two and three motor accident benefit claims a year for every 1 000 members, Alain Peddle, the scheme’s head of research and development, says.
The average cost of hospitalisation is R30 000, with about 50 percent of that added on for fees for professional services, such as radiology, pathology or specialists, he says.
As with most forms of insurance, the average cost is not the most revealing. Discovery Health’s top five motor accident-related claims for July to December last year were: R1.65 million, R1.1 million, R900 000, R752 000 and R646 000. (These costs are for hospitalisation only and exclude professional fees.)
Besides motor accidents, the following examples of the average high-cost claims submitted to Discovery Health last year show that medical care is not cheap: burns with skin grafts, R129 000; skull, spine, hip and major limb operations, R289 000; liver transplant, R590 000; and a heart/lung transplant, R646 000. (Again, these figures exclude professional fees.)
Peddle says the costs of follow-up treatment can vary widely, but, to take a liver transplant as an example, a transplant without complications will cost between R6 000 and R12 000 a month for medication, pathology and consultations. The costs may be significantly higher should complications arise – for example, the organ is rejected or infections occur.
Peddle says it is highly dangerous for the young and healthy to believe that they do not need to belong to a medical scheme.
“In fact, many of the most expensive claims we receive are for members under the age of 35 who have sustained significant trauma.
“Very few individuals are wealthy enough to self-fund their medical costs.”
Peddle also warns: “People who choose to self-fund run the risk of being denied treatment [at a private hospital] if the condition is not clearly a life-threatening emergency. In any case, private hospitals will transfer patients, once stabilised, [to a state hospital] if funds are not available.”
You cannot be refused membership of an open medical scheme, but you may be subject to two major penalties if you join a scheme without having belonged to any scheme previously, or after a certain break in membership. The penalties are:
• Waiting periods, during which you pay contributions without being entitled to full benefits. The waiting periods are:
* A general waiting period of up to three months.
* A waiting period of up to 12 months for any specific illness or condition. Schemes apply this waiting period to pre-existing conditions in particular. This waiting period would also apply for a maximum of nine months if you join a medical scheme when you are already pregnant.
You cannot buy out of any waiting period. You cannot remain a member of one medical scheme and join another at the same time in order to enjoy cover while you sit out the waiting period on the scheme you have joined.
• Late-joiner penalties. If you have not been a member of any scheme and you join a scheme after the age of 35, penalty fees can be applied.
The penalties are on a sliding scale based on your age. The longer you wait before you join a medical scheme, the higher the penalties. If you were previously a member of a scheme, any years of membership will be subtracted from your current age to determine the age band and resulting penalty rate. In other words, age at application minus years of creditable coverage.
You could end up paying 75 percent more than other members are paying for the same benefits.
The purpose of the penalties is to discourage young and healthy people from delaying joining a medical scheme until they are unhealthy, thereby placing excessive financial pressure on a scheme.
Peddle says there were 3.3 million principle medical scheme members, with 4.4 million dependants, as at December 2008 (the figures are from the Council for Medical Schemes’s most recent annual report). Discovery Health has estimated that there may be up to two million relatively affluent people who could afford to belong to a medical scheme but who choose to self-fund instead.
The Department of Health’s low-income medical scheme investigation has indicated that a further seven to 10 million people could afford cost-effective or reduced medical scheme cover, possibly with some assistance from their employers.
4. Not saving
Most South Africans simply do not save. According to the Reserve Bank’s December 2009 quarterly report, gross savings by households as a percentage of gross domestic product increased marginally from 1.4 percent in the second quarter of last year to a still pathetically low 1.5 percent in the last quarter.
The Reserve Bank says the increase was not because people suddenly discovered the need to save but was a consequence of “tight economic conditions and stricter lending criteria on the part of banks”. And if it were not for compulsory savings, such as contributions to occupational retirement funds, the figure would probably be negative.
The biggest consequence of the low savings rate is that very few people can afford to maintain their standard of living in retirement, particularly because pensioners are living for longer, which means they need even more money in retirement than they did, say, 20 years ago.
On top of this, many people use debt to finance purchases, even of consumable goods or items that depreciate rapidly in value. This results in a downward spiral, because debt needs to be serviced with interest, which means there is even less potential for saving.
It is important to have savings to meet your:
• Short-term needs, such as to pay school fees or to replace a stove that has packed up. You should also aim to build up an emergency fund equal to about three times your monthly disposable (after-tax) income so that you have a financial cushion in a crisis, such as writing off your car or losing your job.
• Medium-term needs, such as a new vehicle or to put down a deposit on a home. You should aim to save a specific amount of money within a fixed period. Use any windfall, such as bonuses or tax refunds, to top up your savings.
• Long-term needs, which essentially mean retirement – without a doubt your biggest single savings requirement. As with risk life assurance, as a rough rule of thumb you should aim to have saved between 15 and 20 times your annual salary at retirement, depending on your age and number of dependants. For most people, this means you will have to save for at least 40 years, from your first pay cheque.
It is a long-term slog to achieve financial security in retirement and not many people attain it, because they do not stick to the basic rules.
When saving for retirement, your goal is to replace the income, or a percentage of the income, you are earning at retirement with an income from your savings. This is known as your net replacement ratio. For example, if you are earning R10 000 a month shortly before you retire, aiming for a net replacement ratio of 75 percent means that your pension on the date you retire will be R7 500 a month.
Anderson says that your ultimate retirement benefit will depend on the following:
Costs (expenses and life and disability assurance)
Portfolio in which you invest
Retirement age (years of membership of fund)
Losses due to non-preservation of savings
Annuity factor at retirement (cost of securing a pension)
Ideally, a retirement fund should aim to provide you with a net replacement ratio of between 75 and 80 percent after 35 to 40 years of membership. But Anderson says that most funds target between 60 and 75 percent because of lower expected investment returns and the increasing longevity of members who reach retirement.
To achieve these targeted net replacement ratios, the average contribution (employer plus employee) to a retirement fund in South Africa is 13 percent of pensionable income (after administration expenses and the cost of risk life assurance have been deducted). Anderson says this contribution rate is at the upper end of the rates considered reasonable by the World Bank, although it is likely that a higher contribution rate will be required in future, given expectations that investment returns will be lower and increased longevity. The government has set a contribution target of 12 percent of pensionable income in its retirement reform proposals.
The question arises why most people reach retirement with a net replacement ratio of only 28 percent. The main reasons are that people:
• Are not forced to save for retirement. Many employers do not have occupational retirement funds, and many contract workers, part-time workers, domestic workers, seasonal workers and self-employed people do not save for retirement through formal retirement-funding vehicles.
One of the aims of the government’s retirement reforms is to force every person in formal employment to save enough to provide a net replacement ratio of at least 40 percent.
• Save too little. Alexander Forbes says 17 percent of members of occupational retirement funds have contributions (employee and employer) of less than 10 percent of their pensionable income, while 40 percent have contributions lower than the 12 percent sought by the government in its reform proposals.
• Start saving too late, losing the advantages of compounded investment growth. Research by Alexander Forbes shows that most fund members retire with as few as five to 10 years of pensionable service; 12 percent retire with between 10 and 15 years; 14 percent with between 15 and 20 years; and only seven percent with between 35 and 40 years of pensionable service. On average, pensionable service of the last fund prior to retirement is 19.5 years for men and 15.8 years for woman.
The three tables highlight the consequences of how much you save, the number of years you save and the age at which you retire.
If, for example, you contribute 10 percent of your income to a retirement fund for 35 years but retire at the age of 55, you will receive an income (net replacement ratio) equal to about 39 percent of your final salary at retirement. However, if you save for 35 years but retire at 65, you will receive a pension equal to about 56 percent of your income.
The reason for the higher replacement ratio at 65 is that the older you are, the higher the pension from a guaranteed annuity, because the life assurance company expects that you will live for fewer years.
If you retire at 65, but have contributed 10 percent of your income to a retirement fund for 45 years, your replacement ratio jumps to 75 percent. And if you retire at 65 after having contributed a very unlikely 20 percent of your income for 45 years, you will receive 151 percent of your final salary as a pension.
Please note that these tables are merely a guide. Alexander Forbes has made numerous assumptions about the investment returns, interest rates and the inflation rate in doing these calculations. The figures can vary quite considerably, depending on the prevailing economic conditions.
• Do not preserve their retirement savings. Alexander Forbes’s research shows that the average employee will have seven jobs over a working life of 40 years. The average fund member is unlikely to preserve more than 30 percent of the value of his or her retirement savings when changing jobs. The level of preservation has been even less where individuals have been retrenched following the recent financial crisis, Anderson says.
If you leave a job and opt to take the savings you have accumulated in your employer’s occupational retirement scheme, you need to reinvest your savings to ensure you will be financially secure in retirement.
5. Not budgeting properly
Many people do not budget; they do not plan how they will spend their money. Or, if they do have a budget, it is simply a wish list without any foundation in reality. Then, when they arrive at the ATM, they are surprised to find that there is no more money to withdraw.
A proper budget requires a proposed spending programme for the month, an actual record of what was spent the previous month and on what, and an accounting of how and when money was under-spent or over-spent. The challenge is to ensure that you end the month with money in the bank, without having to borrow.
Two key elements of good budgeting are to provide for savings and the rapid repayment of debt. A proper budget will also separate non-discretionary spending, such as the repayment of debt, rent and transport, from discretionary spending, such as buying the latest hi-fi system.
A good budget will be conservative in assessing income (particularly where income is based on commission earnings or bonuses) and generous in assessing expenditure. Adopting this approach makes it more likely that you will get your budget right.
But even when people do budget properly, they still often get caught out, because they base their plans on the here and now; they do not take account of what may happen.
Nothing can throw out a budget more rapidly and significantly than when the unexpected happens. This could range from your refrigerator packing up, to having a serious motor vehicle accident or a burglary. Even when you are insured against loss, you will often find that the insurance payout will not cover your losses in full. You need to self-insure against unexpected events by building up a savings fund to cater for emergencies.
Interest rate cycles can also have a dramatic effect on your budget. For example, millions of mortgage bond holders with adjustable, or variable, rate home loans suddenly find themselves in financial trouble when interest rates are increased. Too often, the result is the loss of a home, particularly when the loan has been kept at its maximum to finance other expenses, often non-essentials, such as holidays.
To cope with interest rate hikes, you need to budget to pay off extra on your home loan, particularly when interest rates are low, so that you can avoid having to pay more when interest rates rise.
John Loos, the property strategist at First National Bank Home Loans, says currently there is a much lower risk that you face having your home repossessed, despite the high debt levels and poor savings rates. This lower risk can be attributed to a slowing inflation rate and the reduction in interest rates by four percentage points last year.
But Loos says there is a growing risk that you will get into serious financial difficulty, particularly once interest rates start to climb again, if you do not reduce your debt levels now.
According to the Reserve Bank’s December 2009 quarterly report, most categories of loans and advances continued to contract in the third quarter of last year. But home loans were the exception. The Reserve Bank says that over the 12 months to October last year, advances in mortgage bonds, which account for about 52 percent of the total loans to households, grew by 3.6 percent.
The bank says the growth in mortgage advances was supported, in part, by a slight improvement in housing affordability stemming from lower interest rates, and by banks easing their lending criteria through lower deposit requirements.
You should budget to pay off any loan as soon as you can, and then use the money that you would have used to pay off debt to save for clearly identified medium- to long-term goals.
You will save a whack by paying more than the minimum on your home loan every month. Say you borrow R2 million over 20 years at 11 percent interest. Your monthly repayments will be R20 644, and you will pay a total of R2 954 504 in interest. Assuming you have a loan that equalled the full purchase price of your home, the property will have cost you R4.95 million by the time you have paid it off.
If you reduce the repayment period to 15 years, your monthly repayments will rise to R22 732. But the total amount of interest you pay will drop to R2 091 749, with your home costing you R4 091 749 by the time you pay it off; a saving of R862 755.
6. Living off credit
If you cannot meet your regular monthly payments from your income and are using credit cards to fulfil your financial obligations, you are mortgaging your future by accumulating high-interest, hard-to-repay credit card debt.
Striving to keep up with the proverbial Joneses is one of the biggest reasons we do not achieve our legitimate financial objectives. The Jones syndrome is the cause of excessive debt and minimal saving. In brief, we have become a wants-driven society rather than a needs-driven society.
There is nothing wrong with wanting to own a Ferrari. But there is something wrong with it if you have to borrow excessive amounts of money, and if you do not consider the cost of all the add-ons, from interest on a loan to the various financing costs, including insurance – and, most importantly, the impact the purchase will have on your overall financial plan.
If you stick to a properly constructed financial plan rather than installing, say, a swimming pool just because the Joneses had one built in the new year, you will in the end have a lot more money than the Jones family.
Debt can be divided into two broad categories: good debt and bad debt. Good debt is borrowing money to buy something that in all probability will increase in value. The best example is property, which over time has risen in value. Bad debt is borrowing money to buy something that loses value. And the quicker it losses value, the worse that debt is.
However, even bad debt is sometimes necessary. For example, a car may be essential for you to get to work or even to do your job if you are, for example, a sales executive. So although the car will decrease in value, you need it to generate an income. But then the trick is:
• To borrow as little as possible (by buying a VW Golf instead of a Mercedes AMG convertible); and
• To keep the vehicle as long as possible. Very few people realise that replacing a vehicle every few years is an easy way to sustain poverty. The new car may impress the neighbours, but the finance costs will chew up your ability to offload debt, save money and receive a discount for paying cash.
If over, say, a 48-year period, you buy a vehicle once every six years instead of every four years, you will buy eight new vehicles instead of 12. The two-year difference could enable you to save a couple of million rand more for your retirement, depending on the type of vehicle, the interest and other costs you pay on any loans, and the investment returns you could earn.
People who use their home loans to finance debt to purchase items that lose value are playing with fire, particularly when they use the loan to buy a motor vehicle and then repay the amount over the full term of the home loan. If you do this a number of times over the life of the bond, you could end up paying off a number of vehicles at the same time.
If you borrow vast amounts of money to live the high life, it will catch up with you, particularly when interest rates increase. This is why every responsible financial adviser will tell you to save at least 10 percent (preferably 20 percent) of your income, to keep debt to a minimum and to build up an emergency fund equal to three months of your after-tax income.
Elias Masilela, the chairman of the South African Savings Institute, says the main reasons you should avoid debt and save are:
• You improve your bargaining power when you can pay cash;
• You do not have to take on expensive debt to finance ad hoc expenses, such as furniture or a car;
• You are better placed to withstand financial shocks, such as replacing a faulty stove or paying for a funeral;
• You will have spare cash to invest, which will further improve your financial well-being over the long term; and
• You will not be caught out when interest rates rise, leaving you exposed to crises such as the repossession of your home or car.
The main reason many people get into financial trouble is because they do not manage credit and store card debt properly. They “max the plastic”, use the plastic for impulse buying, have too many credit and store cards, and repay the minimum amount due every month. They pay excessive rates of interest (ranging from 18 to 25 percent a year for some budget purchases). And if their debt gets out of hand, they will require debt counselling, which itself costs money.