Think twice about the inheritance you leave behind
We frequently come across a situation where clients try to sort out their children’s bequests through life insurance, while other fixed assets (such as a farm or a company) are transferred while the testator is still alive. This strategy is popular among farmers where the son becomes the farmer and the daughters need to be compensated for the fact that they won’t inherit the farm.
Here is an explanation using a recent scenario we came across:
A broker suggests that a client take out R20 million worth of life insurance to solve his inheritance problem.
The policy details are as follows:
- Age of insured life currently = 63
- Life cover = R20 million
- Premium = R18 655 per month
- Cover growth = 7% per year
- Premium escalation = unknown, age related
If the company or farm is currently making good profits, the paperwork usually gets done because a quick calculation says that you must pay R18 655 pm for 89 years before you can reach the amount of R20 million. Unfortunately, things aren’t as simple!
If we could assume that this person is a healthy, non-smoker and lives a stress-free life, is it unreasonable to expect him to comfortably reach the age of 84 years? I suspect not. If so, his situation will look as follows.
- Cover amount at age 84 = R82,8 million (R24,3 million in today’s purchasing power, if inflation is 6%)
- Monthly premium = R370 133 (about R109 000 in today’s purchasing power).
Over the previous 21 years his pay-out has increased with 21.5% (in real terms) while his premiums increased by 484%! At this stage his premium growth is also around 16.5% per annum.
The complications with this plan:
- There comes a point where the premiums simply aren’t sustainable. A portion of the cover amount or, in extreme cases, the whole policy is cancelled or lapsed.
- The values for these policies are largely thumb sucked and usually isn’t in line with the value of the farm or company that is to be inherited. This often leads to great unhappiness and conflict within a family.
The fact that the father is unable to take out policies to the value of the farm is understandable. Let’s say the land and equipment is worth R50 million, it would be unjust (and unaffordable!) to take out a R50 million policy for every daughter just because the son inherits the farm.
He merely inherits the rights to an asset (not R50 million in cash) and in fact only gets a job out of the deal. However, this reasoning is flawed, because the value of what the son inherits (even if he never sold the farm) is the future profits that those assets will or could generate.
For example: If a farm delivers an average after-tax profit of R1 million per annum for 25 years and the annual profit keeps rising by 6% (from the point where the son takes over at age 40 and until he reaches 65 and hands over the reigns again), the value of that alone is R19.9 million (discount rate of 8% used). Then we have not yet placed a value on the farm or equipment itself.
- The father, and often the mother as well, will have to pass away before the daughters can inherit a cent. This is increasingly problematic since people tend to live longer. If both parents or even just one of them lives up to their 90s, the daughters will possibly only inherit after age 60.
At this age the inheritance won’t make much of a difference to the course of their lives.
- Bequests to your daughters is not exempt from estate duty and therefore the net pay-outs of the policies would only be between 75% and 80% of the amount for which your life is insured.
- These plans don’t make provision for circumstances where a farm (usually the premium payer) goes through a cash flow crisis or is completely or partially declared insolvent and must be sold.
I have seen very few of these plans where everyone is satisfied with the outcome or the expected outcome. I can also say with certainty that it’s not any of these parents’ intention to be unfair or to cause conflict between their children. Unfortunately, this is often how things unintentionally play out with this type of planning.
Is this (life insurance) the only answer to a fair inheritance? Or is it a “simple” solution that, by chance, happens to profit the person who has proposed it handsomely?
Don’t get me wrong: Life insurance is still indispensable to cover the cost of death (such as estate duty, executor’s fees and, in some cases, mortgage bonds). In my opinion there are more meaningful solutions, of which some options might require a complete mind shift. If I look at the unplanned outcomes of this insurance plan, I would advise that you and your adviser spend more time investigating the alternatives.
Andró Griessel is a certified financial planner and the managing director of ProVérte Wealth & Risk Management.
Follow him on Twitter @Andro720911. He writes twice a month for Netwerk24.
Although all possible care was taken in the drafting of this document, the factual correctness of the information contained herein cannot be guaranteed. This document does not constitute advice and anyone planning on taking any financial action based on this document, is strongly advised to first consult with their personal financial advisor. ProVérte Wealth & Risk Management is an authorised financial service provider with FSP no. 5966.