Getting the balance between death benefit contributions and retirement right

29 February 2012 Alexander Forbes Financial Services (Pty) Limited, Michael Prinsloo, Head: Best Practice, Research and Product Development

A person’s most valuable asset as they start out on life’s journey is their human capital - represented by their ability to learn, earn and accumulate other assets. Since everyone runs the risk of dying before these notional human assets are converted int

Yet, equally, those who survive into their sixties, realising the full potential of their human capital, also run a risk “of not having saved sufficiently to sustain themselves in retirement” says Michael Prinsloo, Head: Best Practice, Research and Product Development, Alexander Forbes Financial Services.

In an ideal world, to protect their human capital, people would match their death and disability benefit structures with their real and constantly changing needs. Done correctly, this would allow South Africans to cover their liabilities in the event of their dying before they had the chance to translate their human capital into accumulated assets or savings. This would also provide a more efficient allocation of their income between insurance and savings, for life’s crucial needs, like homes and education, or for retirement.

The reality, however, is that many South Africans either waste a significant portion of their income and forfeit years of savings and investment returns by over-insuring and not saving enough for retirement or, more likely, failing to protect their human capital by being under-insured. In both cases they fail to match their death benefit contributions to their real risk profiles.

In short, most South Africans “over-insure when it is not required during periods of low liability, or do the opposite and under-insure, by sticking to flat structures and failing to adequately protect their human capital wealth at those times in their lives when they are carrying large liabilities” says Prinsloo.

For example, a single 24 year old starting out on her first job with no dependents and little debt, requires very little life cover. “Taking out the minimum death benefit cover and instead investing a higher portion of income in retirement savings would make sense at this stage in life” says Prinsloo.

The same person 10 years later, now married with two young children and a mortgage, has three dependents; two of them requiring up to 20 years support and education, the third potentially a lifetime of support.

At this stage it makes sense to increase the death benefit cover to try and meet these additional liabilities. Since at this stage there is often huge pressure on disposable income it is also usually necessary to decrease the amount contributed to savings or retirement provisions each month in order to increase the life cover. Over time, once the children have left home and the house is paid off, lower death benefit cover would again be sufficient – and savings and retirement contributions could again increase.

None of this thinking is new and with a competent financial advisor it is not very hard to achieve. Yet relatively few people make the effort to appoint or consult a financial advisor, even though in some instances their advice is free, for example, where an employer makes a financial adviser available to employees.

“However, the bulk of the population are not aware of the need for, or able to afford, this advice in their personal capacity” says Prinsloo.

In order to address this lack of knowledge as well as the low rate at which South Africans seek financial advice, some time ago the industry developed age-banded death benefit and life stage investment structures.

Age-banded death benefit structures typically provide a different multiple of salary death benefit cover depending on one’s age in, say, five year age bands. Life stage investment structures typically de-risk the investment portfolio as the member approaches retirement age, looking to protect accumulated capital.

While life stage investment portfolios have become fairly common in institutional pension funds, the same is not true of death benefit structures. Both those structures allowing individual member risk choice and age-banded death benefits have suffered limited take-up by funds – “possibly due to the pressure of trying to keep retirement savings at a certain level” says Prinsloo.

Certainly a more intelligent way of striking a balance between covering liability in the event of death, while maximising savings and retirement contributions when liabilities decrease, is to vary the allocation of contributions between either death or retirement cover in accordance with how a person’s responsibilities, debt and ability to save change throughout their lives.

Yet research shows that most death benefit structures in the employee benefits industry are fixed at all ages. Even worse, these fixed structures have in most cases not changed for over ten years - and typically set at levels which do not meet member needs. For example, almost 80% of members’ death benefits only meet half their liability need.

Instead, “varying the allocation between death benefits and savings or retirement contributions by adopting a lifecycle driven approach can significantly improve individual member outcomes” explains Prinsloo.

The important part is to ensure that varying the allocation of contributions takes place automatically - and that this automatic allocation is applicable to most members by making it the default position. While from time to time individuals may wish to opt out of defaults, which can often be accommodated to some degree, research shows that that most people remain in sufficiently strong defaults – whether these are investment life stages, risk benefit structures or any other type of default benefit structure for that matter.

“The theory is that with enough people in age–based, lifecycle-linked contribution and benefit structures more South Africans will be better prepared for retirement as well as adequately covered for their real liabilities in the event of death before retirement” says Prinsloo.

Since a lifecycle-linked death benefit and retirement structure is age-based it inevitably generalises. While certainly better than a fixed structure focused on the average member receiving, say, three times annual salary on death regardless of liability, the lifecycle-linked death benefit structure assumes a liability profile based on “what most people are doing, and what their responsibilities are at each stage of their lives” says Prinsloo.

An age-banded lifecycle death benefit and retirement structure is obviously less effective where a person’s lifestyle choices differ from the average; by not getting married, choosing not to have children, inheriting an estate, or becoming the breadwinner to a much larger extended family, for example. Under these circumstances the best option remains managing the balance between your death benefit cover and your retirement contributions yourself. This is best achieved by consulting and appointing a qualified financial planner to advise you throughout your life - “and where possible making use of any flexibility provided by employee benefit schemes to customise contributions and cover based on individual needs” advises Prinsloo.

Finally, in the absence of access to a qualified financial planner, Prinsloo believes that the next best option is to “contribute to a lifecycle-linked death benefit and retirement structure automatically allocating contributions between covering liabilities in the event of death and investing sufficiently for retirement - at each age of your life”.

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