Unravelling the Social Security Tax

As many as two thirds of South Africans reach retirement age with little or no funded pension benefit. To address the situation, government is proposing comprehensive changes to the social security and retirement industry. The objective is to redress the current situation which forces retirement savers into two distinct groups and continues to reinforce the divide between the country’s first and second economies.

On the one hand, some 13 500 private pension funds provide cover to more than seven million lives. Members of these funds are usually higher income earners, who receive proportionally more tax incentives to save than lower income individuals.

On the other hand, South Africa’s poor rely on a social old age grant, capped at R870 per month for the 2007/2008 tax year. Recipients of this grant are means tested to determine whether or not they qualify. The means test is a process that effectively punishes low income earners for saving.

A social(ist) solution

Social security and retirement reforms will be introduced to plug the gap which exists between South Africa’s rich and poor – and to provide basic retirement, unemployment, death and disability benefits. Reforms will be funded through contributions to a national social security fund which will be implemented by way of a multi-pillar system of mandatory contributions.

The first pillar of this system remains the state social grant assistance programme. Grants will still be funded by government to provide a safety net against poverty in old age. Government is likely to extend the cover offered by the current social old age pension to include all South Africans over the age of 65. The additional R4 billion per annum required to fund this proposal will have to come from government revenue.

Mandatory contributions

Additional funds to be applied to basic retirement, unemployment, death and disability benefits will be secured through mandatory retirement contributions by employed individuals. Government has proposed three contribution categories.

In the first category, workers will pay a mandatory contribution to a national social security fund up to an agreed earnings threshold. Government’s intention is to close the wide gap between the current old age pension grant and private pensions. The level of this threshold is not finalised, but could be in the region of R60 000 per annum.

To prevent job losses and economic hardship for low income earners, government will spend between R20 and R30 billion per year on subsidies to low income earners. Once again, the exact structure has not been finalised. Examples tabled in the 2007 Budget Review suggest a maximum R5 000 subsidy on annual salaries up to R15 000 and a subsidy of R7 500 less one-sixth of the annual salary for those earning between R15 000 and R45 000.

Further mandatory contributions

The second category will apply to individuals earning more than the earnings threshold. These income earners will have to make further mandatory contributions to a private occupational or individual retirement fund.

Finally, high and middle income earners will be able to make additional voluntary contributions to private retirement funds.

Impact on the financial adviser

Retirement fund reforms will not replace the requirement for independent retirement savings, nor the roll played by the financial adviser in guiding individual investors. What will change is the nature of the advice given. Advisers will have to take into account the amount of funds being contributed by each client to the mandatory Social Security Fund. They will then have to advise the client on appropriate levels of additional retirement funding through the voluntary contribution channel.

Tax issues

Government has made limited proposals on the tax treatment of retirement contributions. There is a definite move toward an expenditure tax model – confirmed by the recent abolishment of retirement fund tax.

Other recent moves include the increase in the lump-sum tax free withdrawal amount from R120 000 to R300 000 and a change in the allowable withdrawal from living annuities. The maximum limit for such withdrawals has been lowered from 20% to 17.5% per annum.

Where contributions to private funds are concerned, tax incentives will apply only to a certain upper threshold. Beyond this threshold, incentive for retirement saving is likely to fall away.
This means that for higher income earners, financial advisers may be less concerned with tax efficiencies than with the destination of retirement savings. One possible outcome will be a move from the traditional savings vehicles such as listed property funds or fixed property investments and unit trusts.

Some tough questions have to be answered

How government will address the needs of individuals who have never contributed to the social security system? It will be years before the national Social Security Fund will be self-sufficient – and years before the first contributors to this scheme will receive the intended benefits. Does government propose to eradicate poverty by simply extending the coverage of the social old age pension in the interim?

A second question relates to how government will minimise the impact on the existing pension and retirement fund industry. It is inevitable that many of the country’s 13 500 pension schemes will fall by the wayside in a drive to reduce administrative costs.

Although the basic framework for government’s new social security system has already been decided, it remains for government, industry and various other stakeholders to thrash out the regulations, laws and percentages that will make the system work.