This article first appeared in Personal Finance Magazine, 4th quarter 2017
You might think it takes a lot of luck to achieve financial security and a comfortable lifestyle, but luck is only an opportunity, not an end in itself. Even lottery winners quite often end up broke within a few years.
In most circumstances, the state of your finances is the total of your attitude to money multiplied by the information and advice you seek and act upon, compounded by your self-discipline.
To compile a list (in no particular order) of the worst mistakes known to financial advisers, Personal Finance consulted three people who work with people and their money decisions every single day: Sue Torr, the managing director of Crue Invest, a financial planning consultancy in Cape Town; Peter Hewett, the 2014 Financial Planner of the Year and managing director of Hewett Wealth in Johannesburg; and Gareth Leonard, a wealth manager at Netto Invest, also in Cape Town.
The mistakes they dreaded most were:
1. Not protecting your greatest asset No, not your home or car, but your ability to generate an income. Lose that, and you may not be able to meet your current living expenses, let alone save for your retirement, says Torr.
“Until you have accumulated sufficient assets, the importance of an income protection benefit cannot be overstated. You might think the chances of becoming completely disabled are slim, but the truth is that an income protection benefit is designed to protect you in the event of a temporary disability too.”
Torr cites the example of a photographer client who injured his arm in an accident and was unable to work for three months. He depended on his disability insurance for the three months, which also cushioned the financial impact of having to take on an assistant to help him when he did work again.
Leonard adds that people struggle to imagine disability or an early death. Although you may lead your life cautiously, you can’t afford to discount the risk of being harmed by someone else’s recklessness. You should take out both life cover and disability cover as soon as you have dependants who rely on your income, he says.
And what about the work of the stay-at-home spouse? “If a stay-at-home mom died, or was disabled or fell ill, there would be financial implications for the breadwinner, such as the need to hire additional domestic help and arrange transport for the children,” says Torr. “Together with your financial planner, you need to assess the economic value that the stay-at-home spouse contributes to the household and insure it accordingly.”
2. Drafting an inactionable will The pitfalls of will-writing are many and varied, even when everything is done by the book and the result is valid in all technical and legal respects. Without advice from an expert, you might not think through the long-term implications of the provisions you make, or take into account that circumstances change for your heirs, and that estate duty and capital gains tax will take its toll on your estate.
If you make unrealistic bequests, your will may be inactionable, which can cause enormous inconvenience, hardship and expense. Torr cites the example of a divorced mother of three young children who was forced to contest her late ex-husband’s will. Although he had provided generously for various people, he had overestimated his net worth and failed to take into account that his ex-wife would have a substantial claim against the estate for the maintenance of his children.
“Winding up his estate is now going to take much longer than it should,” says Sue, “and there is a huge amount of feuding going on among all the parties.”
Hewett says there is a widespread perception that a will is unnecessary until you have accumulated significant assets, despite the serious consequences of dying intestate (without a will). Intestate succession can be a disaster for beneficiaries, resulting in, for example, the forced division of assets between your spouse and your children, or minor beneficiaries’ inheritances being controlled by the state-run Guardian’s Fund, instead of someone you trust.
3. Investing too conservatively Leonard says being too conservative in your investment strategy can severely deplete the potential of your retirement savings.
“There is a great deal of comfort in not having the capital value of your investment moving up or down on a daily basis, but, without a certain amount of risk, returns that could have been achieved are missed out on, resulting in a smaller retirement fund at retirement age,” he says.
Retirement projections show that you need to save more to compensate for low returns on investment, leaving you less disposable income every month during your working life.
He points out that conservative investments are also potentially less tax-efficient, because they make more use of cash and bonds, which earn interest and result in an income tax liability once interest exceeds the annual exemption level: R23 800 under the age of 65, or R34 500 at age 65 and older.
4. Spending too much on a wedding One of the worst mistakes a couple can make, says Torr, is to go into debt to pay for a dream wedding. Expectations and costs have soared into the stratosphere, and couples are starting their married lives at an enormous disadvantage, she says.
A total bill of R250 000 is not unusual, but that’s the equivalent of a 10-percent deposit on a R2.5-million home. Save for the wedding, choose a more cost-effective option, restrict numbers to close friends and family, but, whatever you do, do not risk being burdened with debt when you start married life, says Torr.
5. Succumbing to greed and fear When it comes to investing, greed and fear are particularly dangerous emotions, says Torr. “The fear of missing out on a ‘sure-thing’ investment and the desire to have more (even when you have enough) can cause investors to make unwise investment decisions,” she says.
“When times are tough, particularly, people tend to look for alternative sources of income, and the risk increases of being taken in by a pyramid or Ponzi scheme and sustaining massive financial losses. Although we like to believe that it is only ignorant people who fall for pyramid schemes (multi-level marketing) and ‘exclusive investment clubs’, this is not the case at all.”
She cites the example of a group of Cape Town doctors and specialists who were recently scammed out of R30 million by a con-artist purporting to run an exclusive investment portfolio for doctors only.
Hewett provides some basic considerations when an investment opportunity comes your way:
If it offers far higher returns than any other similar investment, it is very likely that the underlying risk is much higher;
A guarantee is only as good as the underlying guarantor, and in many instances may be completely valueless; and
If a stranger had found a way of making an inordinate amount of money, why would he share the opportunity with you?
Check the following before contemplating any offer:
The public profile and reputation of the company involved;
Whether the company marketing the product is registered with the Financial Services Board;
Whether the individual marketing the product is employed by the company, and his or her licensing qualifications and background; and
Whether the proposed product benefits and returns seem reasonable relative to other similar products in the market.
6. Plundering retirement savings Perhaps the most common mistake of all, says Leonard, is failing to preserve your retirement savings when you change jobs. Who isn’t tempted to use the funds just this once, when there is a pressing need, such as replacing your car, fixing the roof, or taking the family on a well-earned holiday?
The problem with drawing the money and spending it is that it is not only the lump sum that is lost forever, but all the potential capital growth over the remaining years to retirement – and that can never be replaced.
Linked to this cardinal sin of money management is another one: failing to save for retirement early enough. Hewett says it is vital to contribute to your employer’s retirement scheme, or your own retirement annuity (RA), at the maximum affordable level (but no less than 15 percent of your salary a year) from receipt of your first pay cheque. “This way, you become immediately accustomed to having less disposable income and future increases in your savings, in line with your increasing income, will be easier to live with.” (See “Start saving early”, below.)
Torr points out that even the best intentions can be ruinous if they tempt you to dip into your retirement savings.
“You want to see your child receive a tertiary education, but remember that it is easy to borrow money to fund tuition. It is impossible to borrow money for your retirement. Before resorting to using your retirement savings, all other avenues need to be explored, including student loans, bursaries, scholarships, apprenticeships, online study and part-time study while holding a job (such as waitressing). Sacrificing your own resources to pay for your child’s tertiary education may seem admirable, but the long-term result could be that you become a financial burden on your adult child for the rest of your life.”
EXAMPLE: START SAVING EARLY
This example illustrates how early saving rewards the investor, compared with longer, later periods of saving. These three investors save R10 000 a year at different stages of their lives. An annual return of 10 percent and a retirement age of 65 is assumed.
Investor 1 invests R10 000 a year from age 25 to 35 (10 years only) and ends up with R3 059 084 at retirement.
Investor 2 invests R10 000 a year from age 35 to 65 (30 years) and ends up with R1 809 434 at retirement.
Investor 3 invests R10 000 a year from age 25 to 65 (40 years) and ends up with R4 868 518 at retirement.
In short, if you consistently contribute towards retirement savings throughout your entire career, you will be far more financially secure than someone who delays saving.
7. Not having adequate medical cover The cost of medical cover is increasing at an alarming rate, and this is unlikely to change in the era of the national health insurance scheme contemplated by the government. Consequently, says Hewett, many people never join a medical scheme, or terminate their membership, on the grounds of affordability, leaving themselves open to financial ruin in the event of a serious health condition or accident.
As an alternative to top-tier medical scheme cover, he suggests you could opt for one of the many hospital plans offered by reputable medical schemes, take into account the prescribed minimum benefits required by law and add so-called “gap cover”. That way, he says, you can achieve good cover at a reasonably affordable cost.
“It is important to obtain a detailed analysis of the various cover components, assess all the exclusions and claim limitations, and ensure that the provider is financially sound. There are a number of advisory practices and medical brokerages that offer this service,” says Hewett.
Torr adds that most gap cover policies are limited to 300 percent of medical scheme rates, and the premiums are very affordable – about R269 per family a month. Unless your surgeon and anaesthetist are contracted to a specific medical scheme’s network, they may charge in excess of 300 percent of the medical scheme rate.
“Even an operation as simple as a tonsillectomy or hernia operation can result in thousands of rands in out-of-pocket expenses,” she says. “Without a gap cover policy in place, many people are forced to take out a loan or deplete their emergency funding to cover their medical bills.”
8. Wasting an inheritance Most of us can imagine all too easily making this sorry financial misstep. Leonard puts it high on his list of horrors, having seen several people take an easy-come, easy-go approach to a windfall that could make all the difference to their long-term financial well-being.
“If you have not had to toil for something, you are, by default, more comfortable with losing it,” he says. “When it is used up on lifestyle costs and experiences, life returns to the way it was prior to inheriting, with little to show for it.
“On the other hand, the boost a windfall can give your retirement funding is significant. Suddenly, you have a great deal of money that is earning interest, dividends and capital growth every year, and compounding over time through reinvestment.”
9. Not using the tax-break on retirement funds Failing to take advantage of the 27.5-percent tax deduction on retirement fund contributions is a huge mistake that many people still make, says Torr. You can save either through increasing your contributions to an employer-sponsored fund or opening an RA fund.
“Many investors remain reluctant to use an RA because of the minimum withdrawal age of 55 and past experience of poor returns on insurance-based products,” Torr says. “However, new-generation RAs, invested on a unit trust platform, offer investors flexibility and transparency without any penalties or unnecessary fees. Investors should maximise their tax-free RA contributions, as the benefits of investing with tax-free money cannot be overstated.”
EXAMPLE: SAVING ON TAX
Torr provides an example of the effect on disposable income of investing in an RA before tax is deducted, assuming a salary of R30 000 a month.
Using after-tax money to save R3 000 a month: the tax on R30 000 is R5 927, resulting in take-home income of R24 073, from which you save R3 000, leaving you with R21 073.
Saving R4 000 into a retirement fund: your savings into the retirement fund are before tax, so you are taxed only on R26 000. The tax is R4 487, leaving you with R21 513.
In other words, using these assumptions, you can save an extra R1000 into a retirement fund than you can into after-tax savings and still come out with R440 more a month.
10. Owning a holiday home Although owning a holiday home can be a great investment, there are risks involved, including the value of this asset in your retirement plan. Torr points out that being forced to sell your holiday home during retirement to improve your cash flow could mean having to accept less than the optimum sale price.
She says she has personal knowledge of one area on the Cape coast where the value of properties has fallen dramatically over the past few years as the economy has stagnated.
“There are now more than 30 holiday homes for sale in this sleepy fishing village – many of them urgent. Homes are selling lock, stock and barrel for unbelievably low prices, simply because the sellers needed capital to fund their retirement.”