Why retirement annuities still make sense?
South Africa’s retirement landscape is slowly evolving. One of the main trends in recent years has been the consolidation of the traditional employer-sponsored retirement fund space, which according to the Financial Services Board (FSB) has shrunk from 13,000-plus funds to around 3,500 funds today. Unfortunately for savers it appears the “save costs by consolidating” motivation has morphed into one of “consolidating to avoid rising costs”! Increasing compliance requirements, most notably those introduced by the 1 July 2011 changes to Regulation 28, make it more necessary than ever for pension funds to appoint professional trustees and advisers to make fund administration and investment decisions.
“The rule of thumb for retiring independently is that you will need a capital sum of 15 to 20 times your final annual pre-tax income,” says Jeanette Marais, director of distribution and client services at Allan Gray. “This will give you an income equal to about 70% of your income at a retirement age of 65 – assuming you buy a conventional annuity with 5% escalation at retirement.” Pension funds are supposed to provide adequate capital upon retirement for the retiree to “buy” a sustainable inflation-tracking income through retirement. But many pension fund members discover too late that their employer-backed pension funds provide too little capital to achieve this goal. And thousands of formally and informally employed South Africans who don’t belong to formal retirement funds have to find other ways to prepare for retirement. One of these “methods” is the ever popular retirement annuity.
Additional retirement saving a must for most South Africans
Marais says investors can consider supplementing their company pension or provident fund with a retirement annuity (RA), particularly one that offers exposure to outperforming unit trusts. “Investors who do not contribute to a pension fund can invest 15% of their taxable income into an RA tax free – and those who currently contribute to a pension fund can contribute 15% of any income that is not taken into account when calculating their pension contribution, also tax free,” she says Additional payments (over and above the 15% limit) may be carried forward and offset against future taxable income. Andrew Davison, acsis Head of Institutional Asset Consulting agrees. “RAs are still popular tools to bolster retirement capital, especially for self employed, commission earners and those who earn large bonuses,” he says.
An RA can be viewed as a portable personal pension vehicle. “RAs linked to investment funds such as balanced unit trust funds have solved most of the structural problems historically associated with RAs, providing a flexible, easy to understand, reasonably priced and transparent way to access the tax deferral benefits of a pension savings vehicle,” says Pieter Koekemoer, head of Personal Investments, Coronation Fund Managers There are numerous other benefits to using RAs as retirement savings vehicles. One of these is “choice”. Investors can choose the underlying funds they want to invest in, and can switch between funds at no extra cost! A second is that contributions are excluded from personal taxable income and any interest and growth (including interest and dividends) is tax free! In addition, at retirement the tax exemptions and subsequent tax rates are favourable.
Savers should certainly consult with their financial advisers to make sure they maximise the tax benefits of RAs before the end of February each year. “If you have done an assessment and believe you owe tax, contributing to an RA can reduce the amount of tax you owe, while building up your retirement investment,” says Marais.
The impact of changes to dividend tax
It was recently brought to our attention that the replacement of secondary tax on companies (STC) with a new dividend withholding tax (DWT) would create yet another “advantage” for RA holders. “DWT will be positive for RAs,” says Koekemoer. “A retirement fund incurs no tax for investment income or capital gains – and they will also be exempt from the DWT!” Marais explains: DWT shifts the liability for the dividend tax liability from the company paying the dividend to the shareholder. But while the tax cost will be that of the shareholder, the company declaring the dividend will have an obligation to withhold the tax on behalf of the shareholder and pay it over to SARS. The tax is set at 10% of the final dividend paid. “There are various exemptions from dividend tax, the most common being where the shareholder is another South African-resident company or a tax-exempt institution, such as a public benefit organisation or a retirement fund!” she says.
Still not sold on RAs?
Investors who aren’t keen to go the RA route – or those who wish to save additional funds outside the RA space – can consider a variety of other investments. A popular technique is to build up a discretionary portfolio of unit trusts. This method will prove even more popular after Regulation 28 takes effect. “All retirement fund accounts must be compliant with Regulation 28 at individual level,” says Marais. “Having a discretionary non-retirement portfolio enables an investor to be more aggressive, by taking larger equity or offshore exposures than will be possible within retirement funds.”
“The most accessible non-retirement fund growth assets are listed shares and property, often accessed through multi-asset unit trusts,” says Koekemoer. But investors who wish to use their primary residence as part of their retirement funding plan should weigh up the pros and cons very carefully. “Most people who use their home to supplement retirement capital end up violating the objective of maintaining their lifestyle in retirement!” he says. “Remember, lock-up and go units in retirement villages can trade at significant premiums to large free-standing houses in the suburbs, making the ‘equity release’ available from trading down uncertain.”
Editor’s thoughts: Changes to Regulation 28 have introduced some challenges to individual members of RAs and Provident funds – the most obvious being the ‘cap” on growth assets and offshore investments. This limitation on exposure to growth assets could, over the longer term, erode the tax benefits associated with RAs. Are you concerned with Regulation 28 changes to individual RAs and provident funds – and do you still experience an RA ‘push” each tax year end? Please add your comment below, or send it to gareth@fanews.co.za
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