Is the retirement annuity back in vogue?

Gareth Stokes, FAnews Online Editor

What is the best financial instrument for retirement savings? Long-term savers traditionally make use of retirement products such as pension funds, provident funds and retirement annuities (RAs) to reach their goals. They also make use of endowments, unit trusts or direct equity and property investments. For many years the debate around life investment products was whether the lacklustre annual returns warranted the exorbitant fees and deductions.

In recent years consumer journalists have repeatedly castigated life companies for churning investments, enticing savers with inflated returns and misappropriating interest earned on investors’ funds. Savers were particularly affected by poor surrender values on early policy terminations. The situation resulted in a memorandum of understanding (MOU) between life companies (then represented by the Life Offices’ Association) and the Finance Minister as to the treatment of RA fund member policies and other savings products offered by the long-term insurance industry. The agreement – more often referred to as the Statement of Intent (SOI) – was concluded in December 2005.

Revisiting the SOI

The SOI set out minimum standards for surrenders and early terminations across a range of life savings products, including retirement annuities (whether with or without life cover), endowments, whole life business (where the products primarily have a savings purpose) and reversionary bonus business. Future premium cessation would require LOA members to voluntarily credit to the affected policy as follows:

1. Each RA fund member policy with the value of at least 70% of the investment account of the policy at the date immediately preceding the premium cessation;

2. Each endowment policy which is made paid-up or subject to a premium reduction (i.e. policies still on the books of the insurer), with the value of at least 70% of the investment account of the policy at the date immediately preceding the premium cessation;

3. Each endowment policy that does not remain on the books of the insurer (i.e. a policy that is surrendered or lapsed) with the value of at least 60% of the investment account of the policy at the date immediately preceding the premium cessation;

4. Each qualifying whole life policy, as identified in accordance with paragraph 2.2.3, with an equivalent value as referred to in paragraphs 4.7.2 and 4.7.3 above; and

5. Each reversionary bonus policy, with an equivalent value as referred to in paragraph 4.7.2 and 4.7.3

The SOI called on life companies to view the above as the minimum standards to apply to early termination values. It also set out appropriate compensation for early termination and surrenders prior to the SOI effective date. The LOA, National Treasury and FSB undertook to implement appropriate measures to make these minimum standards binding on all members of the long-term insurance industry over time.

Stick with new generation products

The negative press mentioned earlier dissuaded many South Africans from sticking with their RA investments, and no doubt caused some residual damage to national savings in the process. Now that life insurance companies have implemented minimum termination guidelines and taken steps towards more cost effective and transparent savings products, retirement annuities – especially ‘new generation’ annuities – are back in favour. Why should you consider retirement annuities as a long-term savings tool?

Metz Press’ Paying Less Tax Made Simple series notes that “RA funds were introduced to South Africa in 1960 to give self-employed taxpayers the opportunity to make provision for retirement while enjoying tax benefits similar to those available to pension fund members.” As corporate South Africa moves to the ‘cost to company’ remuneration model the tax benefit of a RA is one of its major draws. If you’re not contributing to a company pension arrangement then you can claim up to 15% of your non-pensionable income (pursuant to certain conditions) as a tax deduction. To maximise your tax benefit you should purchase a RA with the full 15%.

Allowing for a 30% marginal tax rate this means every R1 000 invested in a RA costs only R 700! And a net return of 5% translates to a 50% return on investment! Any minor disappointments in long-term annual returns are offset by the higher capital amount. This ‘calculation’ is clearly not acceptable for the industry when publishing returns, but it certainly reflects the impact on a taxpayer using the product its full potential.

What about excessive fees?

Volumes have been written about excessive fees charged on life savings products, including sales commissions and ongoing administration charges. One of our readers recently offered this RA motivation gem: “An RA is insurance against being penniless when you are too old to earn an income!” He argued that the RA  remains the safest policy you can purchase – protected from creditors when disaster strikes – and from the member until a pre-determined retirement date. Considering these benefits a 5% charge on premium can be considered cheap!

The RA is just one of many financial instruments you can purchase to prepare for retirement. Individual savers should consult frequently with their financial advisers to invest in products appropriate for their long-term needs.

Editor’s thoughts: All else being equal the RA seems a sensible primary savings mechanism for the self-employed and for those whose companies make inadequate retirement provisions for them. Are you happy with the costs levied on and returns generated by so-called new generation retirement annuities? Add your comments below, or send them to gareth@fanews.co.za