When drawing up your financial plan and choosing life assurance products, you should work out how much life and disability cover you need. It is imperative you do this so that your dependants are not left with an income shortfall should you die or become disabled. There are various factors you have to take into account when doing these calculations.
Taking an educated guess is not the right way to go about calculating the amount of life and disability cover you need. It is in your interests to consult a financial planner, who can help you do the calculations and ensure that your life and disability cover needs are met within the context of a holistic financial plan.
Your financial planner should also take into account the effects of income tax, because this will have an effect on your cash flow and returns in the long run. Ian Beere, the 2007 Financial Planner of the Year and a partner at Netto Financial Services, says you should reassess your life assurance regularly so that you take into account changes in your financial circumstances, such as those that result from the birth of a child, a job promotion or divorce.
Beere says you should keep in mind that the purpose of life cover is to fill a hole, not build a mountain. “You should have sufficient life assurance for your family to maintain their standard of living when you die, but life assurance should not be about making your family rich,” he says.
Life assurance comes at a cost and should be in place to protect and provide for your dependants. “Therefore, if your children have grown up and become financially independent, you should reassess your life assurance requirements,” Beere says.
Also, as your net wealth increases over time, your life cover should decrease. Instead of paying for life cover you don’t need, you can put your money to better use by investing it for your retirement or paying off debt. Similarly, as your retirement savings increase as you get closer to retirement, your need for disability assurance will decrease.
Beere says if you have children and your spouse does not work, you should consider buying life and disability cover for your non-working spouse because you may be faced with high childcare costs if she dies or becomes disabled while the children are still minors.
DOING THE SUMS
Here are the steps you should take to work out your life assurance needs:
- Work out the monthly income your family will need after you die or the monthly income you and your family will need should you become disabled and become unable to work. The income they require should exclude your mortgage bond, vehicle and other debt repayments because you should provide money in the form of credit life assurance or other savings to settle these liabilities in the event of your death.
- Beere says you should work out your family’s required income for two phases (if your spouse works, this will be the shortfall in his or her income);
- While your children are dependent on your surviving partners; and
- The remainder of your partner’s life from the time your children leave home.
Based on the monthly income required for those two phases, you must work out how much you need to invest to provide that income. For example, in today’s rands (2008), your family will require a basic capital amount of about R5.2 million to provide them with a pre-tax income of R20 000 a month for 16 years (requirement for phase one), followed by R15 000 a month for 40 years (phase two). If you want to do a rough and ready calculation, the rule of thumb is that you require R1 million in life cover for every R4 000 in monthly income you want to provide for your dependants. So, if you want to provide your dependants with a pre-tax income of R16 000 a month, you will require life cover of about R4 million.
- Calculate your total debt. Your family should be able to settle all your debts after you die – this will include your mortgage bond, your car finance and any accounts you may have. If you have credit life insurance for any of these debts, that debt amount can be excluded from your life assurance calculations.
- Bear in mind that your family could be faced with a high healthcare bill if you die after a prolonged illness. Your family will also have to pay for your funeral. Funeral costs have risen dramatically in recent years and most funeral parlours demand payment upfront. You could include funds for your funeral in your life assurance or you could take out a separate funeral policy. You also need to take into account possible costs, such as capital gains tax (CGT), estate duty and executor fees.
- CGT. When you die, the capital gains on your assets, except those left to your surviving spouse, will attract CGT. To calculate these gains, the taxman will determine the value of an asset in the year of your death and deduct the base cost (the cost to you of acquiring the asset or the value of the asset when CGT was introduced in October 2001). Assets let to a surviving spouse are exempt from CGT and so is the first R120 000 of any gains in the year of your death and the first R1.5 million in gains made on a primary residence.
- Estate duty. Your estate will pay estate duty at 20% on the assets in your estate. However, any assets left to a surviving spouse, including a common law spouse, are not dutiable. The first R3.5 million in your estate is exempt from estate duty.
- Executor’s fees. Executors usually charge 3.5% of the gross value of the assets in your estate plus VAT, which amounts to 3.99% of your estate unless you have negotiated a better rate with your executors. However, if you have nominated your spouse as your executor, he or she is unlikely to charge executor’s fees, Beere says. You need to ensure there are sufficient funds in your estate to cover these expenses and provide adequately for your dependants. If there is a shortfall of funds in your estate to meet these costs, the executor may have to sell some of your assets, such as shares or your primary residence. Although these forced sales can generate the necessary cash, the selling price may be well below market value, resulting in a capital loss for your family.
- Take into account your group life cover with your employer. You can find out what your group life cover is by speaking to either your company’s human resources department or the principal officer of your retirement fund. Once you subtract your group life cover from the amount you have calculated already, the remaining amount is the amount of life assurance you will need.
CALCULATING YOUR DISABILITY COVER
Once you have calculated how much life cover you will need, you will have done most of the work required to calculate your disability cover, Ian Beere says. It is important to remember that disability cover comes in two forms:
- A disability pension, which is paid every month until you are able to return to work or the day you retire, whichever comes first. This type of disability cover is called income protection.
- A lump sum benefit, which is paid in cash if you are assessed as being permanently disabled.
It is usually good to have both of these benefits, but the amount of each will depend on the circumstances. “You should remember that there may be limits to how much disability cover you can buy in some cases,” Beere says.
- This article was first published in Personal Finance newspaper on 4 October 2008.