How can you quantify smart financial advice? And more importantly, how can you, as a client of a financial planner, do so? An approach by data provider Morningstar is helping advisers put a value on their advice to you.
Last week’s column dealt with research by Morningstar research executives David Blanchett and Paul Kaplan, who found that what is known in the industry as “advice gamma” – the value that financial advisers can add to your long-term financial security – can add 29 percent to your accumulated savings.
Blanchett and Kaplan list five main elements that make up gamma. They are:
1. Total wealth framework in asset allocation. Anne Cabot-Alletzhauser, head of the Alexander Forbes Research Institute, explains this by saying that the asset allocation of your investments must be holistic. So when your adviser decides how much of your savings should be invested in the asset classes of shares, property, bonds and cash, he or she should take account, not only of how much money you have to invest now, but also your lifetime earnings potential.
She says this approach allows you and your adviser to think more effectively about your capacity for risk rather than just your appetite for risk. This means considering when you should be taking more or less investment risk to get to where you want to go over the long term – regardless of how you might feel about being a risk taker.
It is also about adopting a consistent approach to investment, with your adviser restraining you when you want to bet your all at the peak of equity markets and again when you want to run for the supposed cover of money market funds when markets collapse, as they did in 2008, to miss out on most of the recovery, Cabot-Alletzhauser says.
2. Tax efficiency. Each financial product has its own tax consequences. For example, financial adviser Janet Hugo says that when you are saving you get the best tax treatment by investing in retirement annuities. However, there are also very sound tax reasons why you should or should not invest in life assurance endowment policies, depending on things such as your marginal tax rate and estate planning needs.
As important is advice on the tax implications of the financial products you use to withdraw an income from your accumulated savings.
3. Dynamic income withdrawals. This simply means not running out of money before you die, or assessing the probability of running out of money before you die on an ongoing basis.
According to the Morningstar researchers, as a consequence of current ongoing low bond yields, the old rule that a pension drawdown rate on your capital should be limited to four percent a year has become a three-percent rule. That means, for every R1 million in your retirement savings, you should withdraw a pension of only R30 000 a year.
But Cabot-Alletzhauser says this is not a once-off decision. She says your pension withdrawal amount should be determined each year based on the ongoing likelihood of portfolio survivability and mortality experience.
In other words, you (and your adviser) should be considering the selection of the right asset allocation (and tax efficiency) and how many more years you are likely to live. This may mean your adviser telling you to cut down on your income when markets crash so that you do not dig into your capital at an accelerated rate.
4. Annuity allocation. Cabot-Alletzhauser says a study by Allianz Life shows that the two greatest fears of pensioners are death (39 percent) and outliving their retirement savings (61 percent). One way to reduce the risk of running out of money is your choice of annuity. With an investment-linked living annuity you take the chance that your money will last you for life. However, if you purchase a single-premium guaranteed annuity, you will receive a pension for life.
Hugo points out, however, that because interest rates, to which guaranteed annuities are linked, are likely to remain low over the long term, a guaranteed annuity will pay you a relatively low pension at present.
The answer lies in timing the purchase of a guaranteed annuity or using some of your retirement savings to purchase a guaranteed annuity that will provide a minimum pension for life and investing the rest in an illa. This is another issue where a financial adviser can add gamma.
5. Liability-driven asset allocation. This technique takes the asset allocation decision one step further by looking at your specific liabilities – namely, your future income needs rather than simply the returns on your capital.
In other words, what do you need to save and how much do you need in returns to meet your future needs (liabilities) – not “how rich can I get?”.
Cabot-Alletzhauser says this is a far more efficient, albeit complicated, way of assessing your financial needs.
It means that your adviser must take into account more than simply your needs in retirement. He or she must also look at your shorter-term needs, such as what assets and products, including risk life assurance, you need for the education of your children.
Cabot-Alletzhauser says that, to get it right, your asset allocation and your liabilities should be appropriate for your current and future liabilities, and should be constantly reassessed. This obviously requires skill.
Morningstar gamma researcher Blanchett says that all five elements and other advice requirements are interrelated. A simple example: should you keep apparently surplus capital to ensure your savings last until you die or should you donate some of it to your grandchildren for tax and estate planning reasons?
Blanchett, who was speaking at a Morningstar conference in July, is reported as saying that the gamma your adviser can add is not limited to the five main areas listed above. He says there could be as many as 119 more elements of advice that could improve your financial security if applied properly. These include advice on:
* Risk assurance. Assistance with buying the correct risk life assurance to cover you and your dependants in the case of disability or death.
* Estate planning. Finding the most tax-efficient and cost-effective way to hand on your wealth, particularly to your dependants.
* Debt management. This can range from keeping you out of debt to how deciding quickly you should pay off your home loan.
* Cash lump sums at retirement. This means calculating what cash lump sum you should take at retirement to take advantage of the lump-sum tax regime, or whether you should defer tax, while earning tax-free returns on the money, until a later stage when you draw it down as a pension.
* Joint and survivorship annuities. Deciding what proportion of a joint pension a surviving spouse should receive on the death of the other. (See “Pension reductions for surviving spouses”, below.)
Blanchett says there is a long list of areas where an adviser can add value, and in many cases it could be far greater than the additional 29 percent on your accumulated savings on retirement as suggested in the research.
Take, for example, an adviser who actively encourages a retirement fund member not to take a cash lump sum when changing jobs. That piece of advice could make the difference between a pension of 20 percent of your final pay cheque and the 75 percent that you may potentially receive by not cashing in the money.
The non-preservation of retirement benefits is consistently shown to be one of the main reasons the majority of members of retirement funds do not retire financially secure.
PENSION REDUCTIONS FOR SURVIVING SPOUSES
Have you planned for a reduction in your income when your partner dies? It is one of the things that need careful consideration when you retire, Niel Fourie, public policy actuary at the Actuarial Society of South Africa, says.
If you intend to retire as a couple with a regular pension payout from a single guaranteed life annuity, you will need to buy what is known as a “joint and survivorship” annuity. This means that the surviving spouse will continue receiving the annuity when one of you dies, but his or her income will be reduced by between 25 and 50 percent.
Fourie says this so-called “reduction factor” is a common feature of guaranteed annuities designed to pay an income until both partners in the relationship have died.
Unfortunately, he adds, not many consumers are aware of this reduction factor and therefore do not plan for it.
Some annuities allow you to choose the reduction factor, others do not, especially when it is set by the rules of a pension fund.
The reduction factor aims to enable a couple to receive a higher monthly guaranteed pension while both partners are still alive.
“The higher the reduction factor, the higher the guaranteed pension payout you will receive as a couple while both of you are alive. The lower the reduction factor, the lower the initial guaranteed pension. If you choose a reduction factor of, say, 25 percent when you buy the guaranteed annuity, you and your partner will receive a lower monthly income than if you choose a reduction factor of 50 percent. But when one of you dies, the surviving partner will receive a higher pension than if you had opted for the 50-percent reduction.”
In other words, Fourie says, “a higher pension will be paid to the surviving spouse when a lower reduction factor is chosen and vice versa.”
The thinking behind the reduction factor is that one person has lower day-to-day expenses than two people. But Fourie says that if you have not planned for this sudden reduction in pension, which leaves the surviving partner with considerably less money to cover monthly living expenses, the surviving partner may run into financial difficulties.
He says the reality is that while many expenses decrease when a spouse passes away, there are many, such as rent, that stay the same or even increase. This is why it is so important for both partners to jointly select the reduction factor and understand the long-term implications of the percentage chosen.
“Once you have agreed to the terms and conditions of the annuity, including the reduction factor, you cannot change your mind at a later stage,” Fourie says.
He says you must carefully consider the expenses that you will have to provide for during your retirement years as a couple and then possibly alone when one of you dies. And don’t forget to factor in inflation, particularly medical inflation.
Fourie says medical costs are a good example of an expense that often foils post-retirement budgets, no matter how carefully they are drawn up.
“Medical inflation has, on average, been three percent above normal inflation for the past 10 years. Considering that medical scheme contributions and medical expenses usually make up a large portion of pensioners’ budgets, unplanned-for increases and a sudden reduction in annuity payments on the death of a spouse can cause financial hardship,” he says.
Fourie says women tend to outlive men by five to 10 years, and the reduction in pension on the death of one partner generally has the biggest impact on women.
“That is why every woman needs to take an active interest in the couple’s retirement planning,” Fourie says.
(Article by Bruce Cameron)