The importance of mitigating risk when planning for retirement

There are a number of risks that investors face on the path to accumulating sufficient retirement assets. From one’s first pay cheque to the date of formal retirement, it is likely that life will not follow a predictable trajectory, but will rather involve a series of curveballs, missteps and errors. In addition to investing enough to ensure that one is able to retire comfortably, effective planning should include identifying potential risks to your retirement funding and putting appropriate mechanisms in place to mitigate these risks.

During your pre-retirement years, also known as the ‘accumulation phase’, your ability to consistently generate an income over a long period of time is the mechanism upon which your future wealth will be built. Any interruption to your earnings – whether temporary or permanent – will compromise your investment potential, and as such, loss of earnings is a risk that can, and should, be mitigated against. One of the most effective ways of mitigating against this risk is by taking out disability insurance, either in the form of an income protection benefit, lump sum disability, or a combination of both, depending on your specific circumstances. It is worth noting that when applying for any form of disability insurance through a reputable insurer, your application will be subject to medical underwriting. As such, it is advisable to apply for disability cover while you are young, healthy, and insurable. Many disabling illnesses are a function of aging, so securing disability insurance when you have a greater chance of a favourable underwriting outcome is important. Once you suffer from any pre-existing conditions and/or illnesses, your application may be underwritten to exclude certain benefits or conditions which, in turn can adversely affect you at claims stage.

Income protection cover, which is an occupation-based benefit, is an excellent way to protect your earnings into the future should you become either temporary or permanently disabled. Albeit fairly expensive cover, an income protector is a great way to ensure that you can cover your future living costs if your illness or disability renders you incapable of generating an income. In general, when taking out an income protector, you will have the option of protecting between 75% and 100% of your income, depending on your needs up until your desired retirement age, but generally not past age 70. For those engaging in unorthodox or high-risk occupations, securing an income protection benefit may be somewhat difficult, although there are a handful of insurers who have started catering for this market. While an income protector is a great way to ensure that you can cover your future living costs should you be unable to earn an income, many people fail to take into consideration how they will continue funding for their retirement if they lose their income, which is why creating a disability scenario in your retirement plan is of paramount importance. If you are disabled before you have managed to amass your wealth, you will need to make provision for a capital amount that can be invested and set aside for your retirement, which is what lump sum disability cover can help you to achieve.

When determining the most appropriate level of lump sum disability cover you would require in order to fund for your retirement should you become disabled, you and your advisor will need to ensure that the underlying assumptions used in capitalising your future income needs are realistic for your circumstances. Specifically, assumptions regarding likely investment returns, inflation and life expectancy need to be carefully considered and stress-tested. Determining your future income needs, particularly if you are relatively young, can be particularly tricky, but it is always advisable to err on the side of caution when agreeing on the underlying assumptions. remember, while your premiums towards your capital disability cover are not tax deductible, you will not be taxed on the payout.

Most importantly, full disclosure on your insurance application form is critical to ensure that your claim is not rejected at claims stage. Remember, even a seemingly small non-disclosure which has no relation to one’s disability can result in your claim being rejected on the basis that you did not provide the insurer with all necessary information required to assess the risk that you present to them and underwrite that risk accordingly.

Should you become disabled, either through accident or illness, and your lump sum claim is paid out, you will need to invest the proceeds of your claim appropriately in line with your investment horizon. If you’re disabled early on in your career, you will naturally have a longer investment horizon which may allow you to invest your capital in higher risk assets at the outset and then reduce your investment risk as your approach retirement. On the other hand, if you become disabled closer to your planned retirement age, you may need to take a more conservative investment approach with your capital. Either way, continually reviewing your disability cover is key to ensuring that the quantum and type of cover you have in place remains appropriate to the life stage you are in. Before you have amassed any wealth, it is likely you will need a sizable quantum of disability cover, whereas as your net wealth increases you may be able to trim back the quantum of lump sum cover as your ability to self-fund your future income improves.

Whereas disability insurance can be used to protect your future retirement, life cover can be effectively used to protect your spouse or partner’s retirement in the event of your premature death. While you and your spouse are still building up your retirement nest egg, it may be appropriate to take out sufficient cover on your life to ensure that your spouse is able to enjoy a comfortable retirement in the event of your passing. If you make your spouse the beneficiary of the policy, the proceeds will be paid directly to him/her in the event of your death, although the value of the proceeds will be considered deemed property in your estate and therefore subject to estate duty. In terms of section 4(q) of the Estate Duty Act, the value of all property which accrues to one’s surviving spouse is deductible from the gross estate of the deceased, and this includes the proceeds of any domestic life policy where the surviving spouse is the named beneficiary. The proceeds of such a policy are paid directly to the surviving spouse and therefore do not attract estate duty nor executor’s fees. The definition of ‘spouse’ in the context of section 4(q) includes a permanent life partner, and not only a legal spouse in terms of the Marriage Act or the Civil Union Act.

Once again, as your personal circumstances change over time and as you move through life’s various stages, it is important to review the quantum and purpose of the life cover you have in place. As your net worth increases over time you may be able to reduce your life cover accordingly, and redirect any saved premiums towards achieving other financial goals.

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