Much has been written about the significant changes resulting from the new two-pot retirement fund system that went live on 1 September 2024.
The internet and social media are awash with flyers and brochures from retirement fund administrators and asset consultants about the core elements of the system and the rules around withdrawals from the savings component. Despite all this, we learned from our two-pot roadshow to financial advisors over the past few weeks that there are many subtle tax, advice and practical implications that go beyond the rules governing savings component withdrawals.
The two-pot regime – not replacing the current system but adding complexity
The roadshow made it clear that most financial advisors believe that the long-term financial planning implications of the two-pot regime on their client base would be limited. Most of them underestimated the extent to which the new regime would change every aspect of financial planning around major life events – even if the client does not intend to take any savings component withdrawals. Whether an individual is resigning from their job, getting a divorce, ceasing to be a tax resident or retiring – the two-pot regime touches clients’ lives in a meaningful way that requires careful analysis and tax planning by financial advisors.
Regularly cashing in the savings component: a serious long-term problem
Much of the two-pot focus has been on the rules for withdrawals from the savings component. While the new rules provide limited emergency access to retirement assets without members having to resign from their job, the long-term negative impact of continuous savings component withdrawals should not be underestimated. Here are some key considerations:
• Poor replacement ratio at retirement: The general rule of thumb for retirement savings is for an individual to save 15% of their gross salary over 40 years. By following this formula and investing in a typical balanced fund, members should achieve an income replacement ratio of around 65% to 75% at retirement. However, regularly withdrawing from their savings component effectively reduces their contribution to only 10% of their gross salary, resulting in a best-case scenario of a 50% replacement ratio at retirement.
• Loss of lump sums at retirement: Regularly drawing on the savings pot will leave fund members with little in their savings component at retirement. Consequently, they could have a limited retirement lump sum available, missing out on the favourable retirement lump sum tax table and tax-free amount (if not used previously).
• Income tax: Paying income tax on savings component withdrawals is expensive, especially for high-income earners in higher marginal income tax brackets.
It’s clear from the above that cashing in their savings component should be a last resort for retirement fund members who experience an emergency financial need – not one of their first options.
Should you change your clients’ investment strategies now that the two-pot system is in place?
The rationale behind this question appears sound:
• If the retirement component houses the fund member’s long-term portfolio, invest the whole retirement component in equities.
• If the savings component is supposed to be withdrawn frequently, invest it mostly in fixed income assets.
However, this is a situation where the intuitive option carries significant risk. Let’s investigate why you might not want to follow this strategy:
• Long-term asset allocation: Investing the member’s retirement component (66% of their total contribution) fully in SA and offshore equities and their savings component fully in cash and bonds will result in a lower equity exposure than the 75% retirement funds are allowed to hold. This will negatively impact the member’s investment return (potentially reducing long-term returns by almost 1% per annum – a significant cumulative impact over 30-40 years).
• Portfolio rebalances: Regular withdrawals from the savings component will necessitate regular portfolio rebalances to ensure the portfolio remains Regulation 28 compliant.
• Complexity: Investing the two components differently will dramatically increase the complexity and length of member statements, as every component will now have a different portfolio composition.
• Member behaviour: Investing the savings component in fixed income assets signals to investors that we expect them to regularly withdraw from the savings component. This contradicts our communication to clients to minimise savings component withdrawals as much as possible, and establish other forms of emergency cash pools to manage unexpected expenses.
Increased retirement savings over time – but not for everyone
There is evidence that the compulsory preservation of two-thirds of members’ retirement fund contributions under the new two-pot regime will be a powerful catalyst for the industry. Drawing on modelling done by the Actuarial Society of South Africa, we expect that the improved preservation characteristics of the two-pot system will signal a turnaround for what has been a shrinking SA retirement savings market over the past 15 years.
While this positive growth story is probably correct at an aggregate level, the impact of the two-pot regime on replacement ratios at retirement will differ for various member market segments. For example:
• Retirement annuity (RA) members: The ability to access one-third of contributions under the savings component for an RA increases the withdrawal access that these members have before retirement. This is likely to weaken the retirement outcomes for RA members in the new system unless advisors take active steps to discourage withdrawals or to increase contributions for these members.
• Younger employed members: Younger employed members of occupational retirement funds will no longer be able to withdraw their entire retirement benefit when changing employment. Instead, they will be forced to preserve two-thirds of their benefit for the future. These members should be dramatically better off under the new system, and they represent great early investment client relationships for financial advisors who are set up to deal with smaller preservation funds (less than R500 000 in value).
RAs: similar liquidity and tax benefits to company provident/pension funds
One of the upshots of the two-pot regime has been the alignment of the benefits for members of RAs, pension funds and provident funds. These three retirement products now offer:
• The same tax deductions at the contribution stage
• Identical emergency access from the savings components
• The same lump sum and tax treatment at retirement
Only time will tell how this will impact the relative market positions of different retirement products, but at least RA members are no longer at a disadvantage to members of occupational pension schemes. We are confident that these developments will see RAs assume a stronger role in the market for SMEs and professional firms, as well as industries with high staff turnover (like the IT and technology sector), where the overhead expenses of a company-sponsored scheme might be excessive.
The new two-pot regime represents one of the most important reforms to the South African retirement fund system over the past 30 years. There is no doubt that there are critically important longer-term implications and risks for fund members, and we encourage financial advisors to go beyond the operational matters and familiarise themselves with the longer-term business and financial planning implications of the changes.
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