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Financial Planning Value-add Examples

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Have you considered the long-term financial effects of investing in a fixed deposit vs a diversified portfolio, or the lumpsum you should withdraw from your retirement funds on retirement, or the estate planning implications around different investment products?
We unpack some frequently asked financial planning questions and scenarios using visual illustrations. These scenarios should provide food for thought around the many factors that should be considered when making supposedly simple investment or product decisions.

Investing in a fixed deposit only

An individual is selling his business for proceeds of R10million after tax. He would like to invest in a way that will provide him with a regular income for the rest of his life while keeping the capital accessible for emergencies or his dependants upon his death.

The individual asks if he should invest the full lump sum into a fixed deposit at a large South African bank, because banks offer a “risk-free” interest rate, and the capital is guaranteed to be paid back in 5 years’ time.

Looking at a picture of how the capital grows over the investor’s lifetime, without adjusting for inflation, we can see that the capital does not grow or decrease for the remainder of his life. This is because he places the capital into a fixed deposit every 5 years and receives his capital back at the end of each fixed term.

A chart showing the capital value R10mil invested at a fixed interest rate, with interest being paid out monthly

IMAGE 1: A chart showing the capital value R10mil invested at a fixed interest rate, with interest being paid out monthly

Consequently, the interest earned does not change for each 5 year period. The individual will earn monthly interest from the fixed deposit, at the rate agreed upon at the start of each 5 year period.

A chart showing the monthly interest earned over time, assuming no interest rate changes, not adjusting for inflation

IMAGE 2: A chart showing the monthly interest earned over time, assuming no interest rate changes, not adjusting for inflation

However, if we adjust these 2 pictures for inflation, we see a different outcome. Below we illustrate how the value of the R10million capital has decreased in buying power, by adjusting annually for inflation.

A chart showing the capital value of R10mil invested at a fixed interest rate, with interest being paid out monthly, with the capital value being adjusted for inflation

IMAGE 3: A chart showing the capital value of R10mil invested at a fixed interest rate, with interest being paid out monthly, with the capital value being adjusted for inflation to illustrate the true buying power of the future capital in today’s terms

In the same manner, the buying power of the monthly interest decreases annually as the cost of goods and services increases over time.

A chart showing the monthly interest earned over time, assuming no interest rate changes

IMAGE 4: A chart showing the monthly interest earned over time, assuming no interest rate changes, while adjusting for inflation to illustrate the true buying power of the income, in today’s terms

Tax on fixed deposits:

Fixed deposits or money market funds pay interest income to the investor. Interest income is considered taxable income and must be included in each individual’s tax assessment for the tax year. Individuals can earn interest up to R23,800 (under age 65) or R34,500 (over age 65) before tax becomes payable. However, interest income above these thresholds will become taxable and can result in the investor having to pay additional taxation to SARS.

Conclusion:
Fixed deposits and money market funds, while providing capital protection, do not provide the best long term outcome for several reasons. The first reason is that while earning a fixed interest may seem attractive, the fact that the interest income does not increase annually with inflation means that the buying power of the interest earned is decreasing in buying power. Secondly, fixed deposits are generally illiquid, and you may be penalised should you need to access your capital in an emergency. Thirdly, you cannot alter your income to match your actual living expenses. Finally, investing your capital in a South African bank deposit does not provide any diversification or offshore protection against a weakening Rand.

Investing in a diversified portfolio

We will now show the same individual’s financial position while assuming that he invests in a diversified investment portfolio instead of a fixed deposit.

The capital is invested into a diversified portfolio of unit trust funds. The portfolio holds 30% in local shares, 30% in global shares, 20% in bonds and 20% in cash instruments.

A chart showing the capital value of an investment portfolio growing over time, assuming the investor is drawing an income of 6% per year while increasing their income by inflation each year

IMAGE 5: A chart showing the capital value of an investment portfolio growing over time, assuming the investor is drawing an income of 6% per year while increasing their income by inflation each year

The investor can withdraw a monthly income from their investment portfolio and they can alter the income to match their living expenses. The lower the income drawn, the longer the capital will be expected to last, and vice versa.

A chart showing the value of monthly income withdrawn from the investment portfolio, increasing every year

IMAGE 6: A chart showing the value of monthly income withdrawn from the investment portfolio, increasing every year

If we adjust for inflation, you will see that the capital value of the portfolio decreases incrementally over time.

A chart illustrating the inflation-adjusted value of the capital invested over time

IMAGE 7: A chart illustrating the inflation-adjusted value of the capital invested over time

However, while the capital value may decrease in real terms over the very long term, the income withdrawn is being increased every year and hence the investor is maintaining their lifestyle and continuing to earn an income that is keeping up with the rising costs of goods and services.

A chart illustrating the inflation-adjusted income the investor is withdrawing, showing that the investor maintains the same purchasing power throughout his retirement

IMAGE 8: A chart illustrating the inflation-adjusted income the investor is withdrawing, showing that the investor maintains the same purchasing power throughout his retirement

Tax on unit trust funds:

Unit trust funds are usually more tax efficient than investing in bank products because the different assets in the portfolio are taxed in different ways. The growth earned over time will comprise capital gains, interest income, local dividends, and foreign dividends etc.

Conclusion:
Investing into a diversified portfolio provides the investor with:
• Flexibility to withdraw more or less from their investment over time
• Adjust their spending to their investment growth
• Diversify their investments between different investment assets, including offshore assets
• Maintain the purchasing power of their income, by increasing their withdrawals at a rate that keeps pace with inflation

Consider your retirement lump sum carefully

A new retiree has R10m invested in retirement funds and R200,000 in savings. They do not have to pay off any debt.

The investor at first wants to withdraw a cash lump sum of R500,000 from their retirement fund, as they have not taken a retirement withdrawal beforehand.

Taking a lump sum of R500,000 from the retirement fund will leave the investor with a living annuity worth R9.5million and savings of R700,000. The investor elects to withdraw 5.5% from their living annuity and use the savings for excess expenses. As their budget is R40,000 per month, they use both their living annuity and savings to cover their expenses:

Living Annuity Income (before tax) R 43,858
Income Tax – R 8,624
Living Annuity Income (after tax) R 35,234
Additional Withdrawal from Savings R   4,766
TOTAL INCOME R 40,000

This method of drawing an income results in an effective monthly tax rate of 17.7%.

Using the additional savings to fund the deficit between the living annuity income and monthly expenses results in the investor’s savings of R700,000 being depleted at age 85. This is because there was not enough liquid capital made available at retirement.

 

A chart illustrating the investor’s financial position, assuming they split their income between their living annuity and savings. They deplete their liquid savings at age 85

Owing to the liquid savings being depleted at age 85, the investor must draw a larger portion of their income from their living annuity from age 85 onwards. However, the investor has reached the 17.5% income limit permitted by law. Therefore, the investor’s income will begin to decrease each year until the living annuity eventually runs to zero.

A chart illustrating how the investor’s income will start to decrease once they have depleted their liquid savings and reached the 17.5% living annuity income cap

IMAGE 10: A chart illustrating how the investor’s income will start to decrease once they have depleted their liquid savings and reached the 17.5% living annuity income cap

As an alternative financial plan, we model a scenario where the investor withdraws the full 1/3rd at retirement instead of just R500,000. This transaction will result in an immediate tax cost as a result of the withdrawal, however, the excess cash received can benefit the investor in the following ways:

  • The additional lump sum received can be invested to supplement the living annuity income
  • Because living annuity income is taxable, it is more tax efficient to withdraw a lower Rand value from the living annuity to reduce monthly tax

A chart showing that drawing a larger cash lump sum at retirement adds 5 years to the investor’s liquidity and an additional 1 year to how long their capital will last in retirement

IMAGE 11: A chart showing that drawing a larger cash lump sum at retirement adds 5 years to the investor’s liquidity and an additional 1 year to how long their capital will last in retirement

Conclusion:
This exercise illustrates the importance of considering one’s retirement decisions carefully before implementation. A retirement lump sum cannot be withdrawn after the retirement instruction has been executed by SARS, and hence one must be sure of their decision before going ahead with a retirement instruction. These decisions can have long-term implications on one’s financial position throughout retirement.

Understand the potential estate costs of your different investment vehicles

Different investment vehicles have different estate costs that apply on the death of the investor. An investor must work with a qualified financial planner to ensure that their beneficiary nominations and estate wishes are practical and efficient from an estate costs perspective.

As an example, an investor owns a living annuity and a unit trust portfolio. The investor is currently using his unit trust portfolio to pay for most expenses; however, he is in ill health and getting his affairs in order.

He has nominated his 3 children as the beneficiaries of his living annuity. They intend to draw the full living annuity as a cash lump sum on his death. This lump sum will be taxed as per the retirement lump sum tax table, and because he has drawn retirement lump sums previously, the expected tax rate the children will pay on the living annuity capital is 36%.

The unit trust portfolio does not have any beneficiaries nominated, as this is not allowed, and the value of the portfolio will fall into the investor’s estate on his passing. Because his total estate is less than R30million, the expected estate duty rate is 20% on death. The investor is unmarried and is allowed R3.5million in dutiable assets before any estate duty will apply.

Conclusion
Based on these facts, it will be much more tax efficient for the children to receive the bulk of their inheritance from the unit trust portfolio in the estate, rather than the living annuity. This is because the difference in estate taxes on the two investments is as much as 16% (36% on the living annuity versus 20% estate duty on the unit trust account). Therefore, it would be advisable for the investor to use his living annuity to fund his living expenses as far as possible, rather than leaving the living annuity untouched for the children to inherit.

The value of a professional financial planning practice

Studies have shown that a qualified financial planner can add significant value that extends far beyond the ongoing management of an investment portfolio. Our investment team is qualified to handle all aspects of an investor’s financial journey, ranging from investment management, tax planning, product structuring and estate planning.

The scenarios above represent examples of the complexity and detailed modeling that should be involved in key investment and retirement decisions. A small decision such as deciding between contributing to a retirement annuity or a tax-free investment can have a long-term effect on your financial position.

We believe that each individual’s financial plan should be personalised and created together with a financial planner to set out the investor’s financial roadmap and optimise their outcome.

Here is a summary of our financial planning process that you can follow to start your financial plan today:

Financial Planning Process

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