A single lump sum benefit to cover all a client’s requirements in the event of their death is often not the optimal solution. In this article, we explore a better solution.
One of the foundations of a good financial plan is ensuring that you have adequate cover in place to provide for those left behind in the event of your death. To address these various needs, a financial needs analysis (FNA) should be completed. This useful tool ensures that all primary needs in the event of your death are captured and valued appropriately. The result of an FNA typically yields a one-time lump sum amount recommended as a death benefit.
This approach is appropriate for the once-off costs that are incurred at death – mainly estate duty, executor’s fees and taxes like capital gains tax. With the correct inputs, an FNA can accurately calculate these costs and propose an appropriate lump sum benefit to match.
However, a lump sum benefit is less appropriate where the life insured wants to leave an inheritance to their beneficiaries. Many clients, when asked how they envision this, express it as “I want to leave my child R10 000 per month, escalating by inflation, until their twenty-fourth birthday,” for example. The FNA will convert this income need into an equivalent lump sum amount.
Using a lump sum benefit to meet an income need introduces several complications into the financial plan.
Lump sum challenges
Firstly, the calculation of a lump sum requires assumptions about investment returns, inflation rates, and the beneficiary’s lifespan. The result is very sensitive to the assumptions used – small changes to the assumptions often lead to very different answers which is a risk left to the beneficiary. You can use prudent assumptions in the FNA, but this then means that the amount of life cover proposed is expected to be more than is required. Many clients have a set budget for risk and investment benefits, and higher premiums for life cover may reduce what they are able to save for retirement. In a country where only 6% of South Africans are on track to retire comfortably*, it is important to make sure that we are saving as much for retirement as possible.
Secondly, many beneficiaries lack the financial knowledge or the discipline to manage a large lump sum intended to provide an income. On receipt of the lump sum, they may make large purchases, such as buying a new car, reducing the lump sum and leaving less for ongoing income needs assumed in the FNA.
Lastly, even if the amount of lump sum life cover calculated is sufficient to provide an income should the client pass away now, the projected benefit amount will diverge from the need it is intended to meet over time. Life cover is almost always sold with automatic benefit increases that apply on each policy anniversary, which means that the benefit amount grows over time. This is appropriate for the lump sum needs mentioned earlier – it makes sense that over time, the net asset value of your estate will grow, which means you will need more cover for these needs. However, the amount required to provide an income to your beneficiaries typically does the opposite; the older the life insured is on the day they die, the smaller the amount that needs to be left as an inheritance. A child who is two years old requires a much larger amount to cover an income until their 24th birthday than one who is eighteen.
Clients who take the full amount suggested by the FNA often end up with more cover than necessary if death occurs years after policy commencement. In our experience, many clients cannot afford the amount of life cover suggested by the FNA and then opt to take less cover, leaving them with less cover than they need. Because estate duty, executor’s fees and any taxes must be paid in full before an inheritance can be left, beneficiaries bear the full cost of this shortfall.
Addressing the challenges
In recent years, some of the South African life insurers have made benefits that pay an income on death available on their products, in addition to the traditional lump sum benefit. A Life Income benefit, which pays an income on death, addresses all the above problems. With Life Income, no assumptions need to be made to convert an income need to a lump sum amount – the life insured can choose a benefit that matches their stated need exactly. Beneficiaries don’t have to manage the funds to ensure they receive the intended income. Finally, a Life Income benefit matches the projected need over time, offering equivalent cover to a lump sum benefit at a considerably cheaper premium.
Consider a 38-year-old man who has two children aged four and one. He wants to leave each of them with R10 000 per month, escalating at inflation, until their twenty-fourth birthday. An FNA would calculate a lump sum need of R3.7 million, costing R743.39** per month. Alternatively, two income-based benefits that pay an income that exactly matches the income he wants to leave his children would cost R538.94** per month – a 28% saving.
Further to this, the Life Lump Sum solution would add R3.7 million to the life insured’s estate, while the two Life Income benefits would add R2.95 million, which further adds to the overall cost efficiency of the income solution.
While lump sum benefits are the traditional approach to meeting death needs, financial advisers can provide their clients with materially better cover at a more affordable premium, by distinguishing between income and lump sum needs. This approach ensures that clients receive the right mix of benefits, tailored to meet their specific requirements.
*10X Investments Retirement Reality Report 2023
**Bidvest Life new business rates as at September 2024