• Grain pain

    Corn crops could break records this year, but for farmers the bounty has a dark side.

  • Node joins TV revolution

    The movie-on-demand business has a new contender, says Arthur Goldstuck.

  • SA market needs Nokia

    A user says the brand should stay as it has great offerings at reasonable prices.

Loading...
See More

Rethinking retirement annuities

Mar 25 2010 11:03 Helena Wasserman

Related Articles

Life companies can honour payments

RA refund deadline looms

Pensions cashed in to survive

Employers keep pension payments

'Worst time to cash in savings'

Should I stop my annuity?

 

Johannesburg - With changes in legislation that may restrict the investment choices of retirement annuity investors, should you reconsider your saving strategy?

The treasury and the Financial Services Board are currently reviewing Regulation 28 of the Pension Funds Act, which limits where retirement funds can invest your money and how much exposure it may have to particular assets.

For example, pension funds are only allowed to invest 20% of your money overseas.

Currently, most retirement annuities (RAs) are excluded from these restrictions. These days, when you buy an annuity you can choose from a range of unit trusts or other investments, and - if you want to - invest all of it in one type of asset.

But the proposed changes may mean you won't have carte blanche when choosing where your RA money should go - you won't be able to invest more than a prescribed percentage in a certain type of investment.

"These restrictions may ultimately render the RA a fundamentally less desirable product, as RA clients who sought the apparent benefit of the tax deduction but the freedom to invest in pure equity or pure offshore exposures will no longer be afforded that discretion," says Darron West of Foord Asset Management.

He thinks investors are better off investing their retirement savings directly into discretionary unit trusts - which don't have the "opportunity costs inherent in restrictions" - rather than in RAs.

"An unrestricted mandate allows the investment manager to diversify the portfolio far more thoroughly than under a restricted mandate, since there are no 'default' allocations - every investment decision is made on its merits and in comparison to other opportunities."

Peter Dempsey, deputy CEO of the Association for Savings and Investment South Africa (Asisa), says it is important to note that the proposed amendments to Regulation 28 are still in draft format and under discussion.

"Consumers who are concerned about the potential impact of the proposed Regulation 28 amendments need to bear in mind that the sole purpose of this regulation is to protect their retirement savings."

For example, once implemented, RA fund members may no longer expose their entire portfolio to shares. The new regulations are also likely to ensure that investors do not end up investing large portions of their money in complex instruments they do not understand, says Dempsey.

"Regulation 28 quite specifically sets boundaries to mitigate against the risk of the investors having all their eggs in one basket - important, unless you believe that everything always goes according to plan."

He also says the amendment won't take away from the tax benefits or any of the other advantages currently offered by RAs.

Tax and retirement annuities

RAs do offer a number of advantages.

They are seen as a good way to enforce self-discipline to save for retirement. You may not withdraw from a RA before reaching the age of 55 and with some of the traditional products, you are bound to a contractual term and harsh penalties are levied (up to 15% of the value of your investments) if you stop or decrease your premiums.

New generation RAs have removed much of the costs and penalties associated with old-style products. (There has been a recent explosion in these types of annuities, which are usually on offer from unit trust companies and invested directly in unit trusts.)

Other benefits include that creditors can't touch your retirement annuity investments. And RAs can be a useful estate planning tool; after your death the benefits will be paid out to beneficiaries without attracting executors' fees.

But the main reason RAs are popular is tax.

About 15% of your taxable income (after taking into account other pension investments) invested in RAs can be claimed back from tax, and the first R300 000 lump sum paid out on retirement is tax free.

Typically, RAs have been favoured by investors with higher incomes who have sought to use the tax deductibility of contributions to RAs to lower their immediate tax liability, says West.

However, he is doubtful about the real tax benefits of RAs.

"In principle, investors in an RA are obtaining a tax benefit on a relatively small invested amount. This amount should grow considerably, and the resulting annuity (conceivably a greater amount) will be subject to income tax.

"By contrast, while no tax deduction is offered on a discretionary investment into unit trusts, the later drawdowns are subject principally to the more benign capital gains tax."

Foord has conducted research which takes into account the effects of estate duty (from which RAs are exempt), variations in the taxable yield on unit trusts (on which a unit trust investor would be taxed whilst accumulating savings, and on which no tax is payable in an RA fund), differing pre-retirement income scenarios, measures taken by the revenue authorities to reduce fiscal drag, and a variety of accumulation and drawdown periods.

"The analysis shows that the discretionary unit trust investment, devoid of any upfront and seemingly attractive tax benefits, trumps the RA over time," claims West.

Weigh up the pros and cons

Ian Beere, a chartered accountant, director of Netto Financial Services and a past winner of the Financial Planning Institute's Financial Planner of the Year, agrees that you should not just assume that a retirement annuity is better due to the tax breaks.

"You should consider the facts objectively in the light of your circumstances."

He says Foord's research about the tax benefits of RAs differs depending on the assumptions used.

"It is for this reason that all-or-nothing action and opinion should be tempered with a balanced approach when splitting your savings or assets between unit trusts or retirement funds. Thus, if you are properly funded for retirement, a split between retirement funds and unit trusts may be a good idea."

However, if like many you are under-funded for retirement, you will need every tax break you can get and having more exposure to a RA may be appropriate.

The primary advantage of the RA regime is that investors with a material taxable income can invest more with an RA than they can in a unit trust, says Beere.

Say you can afford to invest R1 000 per month.

With a unit trust, that would be what you can invest. But with a retirement annuity, because of the tax saving, you would be able to invest R1 666 (For someone with a 40% income tax rate, the R1 666 contributed to a retirement annuity amounts to a difference of R1 000 in cash flow post tax).

The other advantage of the retirement annuity, which is relevant as the portfolio grows, is that there is no tax on the interest income earned by the investment and there is no capital gains tax on capital gains in the portfolio.

While you will pay tax on whatever you draw from the portfolio after retirement, you will have enjoyed tax-free growth and being able to invest 66% more.

"Also as you will have paid off your home and educated your children, you will need a lower taxable income to sustain the same lifestyle cost after tax, thus your tax rate will be lower in retirement. This will differ for each person depending on their circumstances," says Beere.

"While interest exemptions and capital gains tax exemptions mean tax is not a large concern when starting off with a unit trust investment, as the fund grows this can become more relevant and affect the decision."

However, discretionary unit trusts offer flexibility in respect of access to capital as well as where and how it is invested, he adds.

The proposed changed to the regulation may also constrain RAs to be conservative and long-term returns may be lower, says Beere. There are fewer constraints on unit trusts, which may be an advantage in the hands of a good asset manager.

If possible, you should have a balance of capital between unit trusts and RAs.

"By housing conservative investments in retirement annuities, your high-yield cash investments can earn tax-free interest and the growth investments can be held in discretionary unit trusts."

The net present benefit of a retirement annuity versus a unit trust will depend on a number of factors in the future, including inflation rates and tax rates.

"The trend in tax rates over the last 10 years may have favoured retirement funds, but this trend can always reverse itself in the future which we need to be mindful of. Treasury could also resort to taxing retirement funds again in the future."

The bottom line, says Beere, is to get objective, independent professional advice about your investment strategy.

- Fin24.com

NEXT ON FIN24X

 
 
 

Read Fin24’s Comments Policy

24.com publishes all comments posted on articles provided that they adhere to our Comments Policy. Should you wish to report a comment for editorial review, please do so by clicking the 'Report Comment' button to the right of each comment.

Comment on this story
2 comments
Add your comment
Comment 0 characters remaining
 

Company Snapshot

We're talking about:

Small Business

New forms of digital technology are changing the very ways in which entrepreneurs run their businesses.
 

Money Clinic

Money Clinic
Do you have a question about your finances? We'll get an expert opinion.
Click here...
Loading...