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Nic Oldert: Learn from my Old Mutual disaster

Not all retirement annuities are born equal. A far cry from bygone years, these days we can take our pick from a rather sizeable range of not only companies offering RA products, but of the products themselves. What are those exactly – and why should they matter to those who began paying into their own annuities years ago? Nic Oldert tackles, in his experience, why to be wary of the enticement of income tax deductions, and why it may be a very good idea to take another look at your old RAs. – Caitlin Hogg

By Nic Oldert*

RAs (retirement annuities) are contractual savings plans set up under South Africa’s pension legislation.  Up to certain limits, contributions to an RA are tax deductible.  In other words, you save pre-tax money.

This seems like a good idea.  The more money you save, the bigger your nest egg when you retire.  Although the proceeds of an RA are taxable on retirement, the investment growth on all the extra savings over 30 or 40 years should, in theory, far outweigh the tax payable as a retiree.

For example, R1 000 a month invested for 30 years at 12% per annum turns into R3.5m.  This yields about R20 000 a month after tax if you retire now age 65.

If instead you pay tax on the R1 000 every month and invest the after-tax amount (around R700) at 12% for 30 years you end up with only R2.5m.  Today that would give you about R15 000 a month after tax.  The RA pre-tax investment, in other words, should give you a significantly better retirement income – about 33% better in this case.

This doesn’t always work out so well in practice.

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Unfortunately for South Africans, it is difficult to compare retirement products.  It is easy to get performance figures for unit trusts but the similar  numbers are usually not available for old-style RAs.  Based on the poor returns of retirement products, one might conclude the performance is deliberately suppressed.

This is a strong statement, but if you look at my experience on an actual product from Old Mutual you may come to the same conclusion.

My attempts over the years to get performance data out of Old Mutual on this particular product were always unsatisfactory.  It would take months to get a response.  When a letter finally arrived the growth information would be months out of date.  With shares or unit trusts, by contrast, you can see the prices and calculate up-to-date returns every day.

Before getting into the facts and figures, I must emphasize that the product in question is a “life house” RA (referred to in the industry as an underwritten RA or an insurance-based RA).  This is very different to the RA “wrapper” offered by many companies today.  The RA wrapper allows you, the investor, to choose the underlying investments (i.e. unit trusts) which means that fees, pricing and performance are transparent.  This sort of product was not available in 1990 when I was persuaded to take out an RA with Old Mutual.  But old-style “life house” RAs are still sold by the big institutions.  The underlying fund is an opaque black box.  The moral of this tale, as you will see at the end, is to avoid life house RAs.

Let me add that my objective here is not to knock Old Mutual.  I have no reason to believe the performance of other “life house” RAs is any better.  This is precisely the problem with these products – objective, up-to-date performance data is not available.

I had already decided by 1990 that equities were the best long-term investment option.  The RA I chose would invest, I was told, the maximum allowable in equities.  So far so good.  The RA, in theory at least, would give me JSE-linked growth on money that would otherwise simply go to the taxman.

Fast-forward 24 years and the question is: what went wrong?

Here are the facts.  The policy ran from February 1990 to October 2014, a period of 297 months.  I started with a lump sum of R4 500 in February 1990.  From March 1990 to December 1996 I contributed R750 a month.  From 1997 – shortly after I realised just how poor the RA’s performance was – I reduced this to a R100 a month.  I would have stopped contributions altogether but this would have triggered significant penalties (the penalties for reducing the contributions were less severe).  As an aside, it remains incredible to me that, six years into a product, one can be penalised for reducing or stopping contributions.

My contributions (over just under 25 years) amounted to R213 600 (including some February top-ups).  Old Mutual’s marketing people would make this look good.  R213 600 turns into R1.6m, growth of 700% in under 25 years.  But this is exactly the kind of misinformation that enables life houses to keep misleading investors.  It’s not wrong, it’s just not the right information.  Because the correct question, of course, is: how did this investment perform against appropriate benchmarks?

That’s another R1.5m I could have had…

Old Mutual paid out R1 583 058 (one third in cash, two thirds transferred to a living annuity).

Here’s the rub.  The same cashflows invested in Old Mutual’s oldest unit trust, the Investors’ Fund, would have produced R2.4m.  The unit trust performed roughly in line with the JSE’s All-share index but underperformed Investec’s Equity Fund by around 2.5% p.a..

For the calculations in this article I set up a spreadsheet with every monthly payment made to Old Mutual over the 297 months.  I imported pricing and dividend data for the JSE All-share index, the Old Mutual Investors’ Fund and the Investec Equity Fund.  I deducted fees that would have been payable.  I reinvested dividends.

Old Mutual’s RA underperformed their own unit trust by a distressing 34%.  It underperformed Investec’s Equity Fund by a massive 52%.  Investec’s Equity Fund, on the same cash flows, would have returned R3.3m, more than double the amount paid out by Old Mutual.

Old Mutual’s RA is probably the worst investment I have ever made.

I began this article by describing the benefits of pre-tax investment.  The incredible reality is that I derived absolutely no benefit from the tax-saving structure of the RA.  Had I paid more tax every year since 1990 and invested the after-tax equivalent in Old Mutual’s Investors’ Fund I would now have about R100 000 more than the RA paid out.  And bear in mind that this R1.7m would be completely unencumbered, mine to do with as I please, whereas two-thirds of the RA money has to be used to buy a pension.

Had I paid my tax and invested the after-tax amounts in the Investec Equity Fund I would now have R2.3m.

Let me restate this for emphasis.  Every month for 24 years Old Mutual invested, on my behalf, 43% more money than I would have had available to invest had I first paid tax (I assumed an average tax rate of 30%).  Yet had I instead taken the after-tax amounts and invested them in Old Mutual’s unit trust I would, today, have more money than I got from the RA (and the cash would be freely available to me).  How is this possible?  It’s almost inconceivable.

Of course, the RA fund has the disadvantage that it is forced by legislation to invest 25% of its cash in so-called low-risk securities (ie, not equities).  This is meant to protect investors but over the long-term it does exactly the opposite – it penalises investors.  This is because equities are consistently, over the long term, the best performing asset class.  They are riskier in the short term, but this volatility is usually not a problem over 20 or 30 years.

This is one reason the Old Mutual RA would have underperformed their unit trust.  It could be argued that I should be comparing to a balanced fund (a Reg 28 compliant fund) rather than an equity fund – the problem is that no such unit trust has enough history.  The performance of Investec’s Managed Fund, which started in 1994, is roughly in line with the Old Mutual Investor’s Fund – in other words, much better than the Old Mutual RA.

But here’s an interesting figure: even if the Old Mutual RA enjoyed a zero return on the 25% that it could not invest in equities the expected return (based on their unit trust) would be about 14% better than they actually paid out.  In other words, three-quarters of my monthly contributions invested in the Old Mutual Investors’ Fund (the unit trust) would have produced over R1.8m (compared to less than R1.6m paid out by the RA).  On the most conservative calculation (using interest rates), the remaining 25% should have produced another R100 000.  Based on the unit trust, therefore, R1.9m is the minimum one might have expected the RA to have produced.

It’s hard to imagine where the surplus went.  Institutions tend to follow similar investment strategies across related products.  In other words, it is likely that the Old Mutual RA fund held a similar equity portfolio to the Old Mutual unit trust.  What, then, happened to the extra R300 000 which the investment should have produced?  If this all went in fees my RA must rank as the most expensive financial product of all time.  (Bear in mind that the Investors’ Fund figures are already net of fees recouped by Old Mutual.)

And now the tax pain…

In addition to poor investment performance, the post-retirement tax treatment of the RA is unfavourable.  Had I invested in Old Mutual’s unit trust (or any unit trust) I would be in a far better tax position.  Cashing in a unit trust today would mean paying CGT at a maximum effective rate of 13.3%.  Using the weighted-average method of establishing base cost for CGT purposes, the actual CGT on the investment would have been 10.1%.  This would be a once-off tax event.

By contrast, I will pay income tax (up to 40%) on all amounts I receive from the two-thirds of the RA I have been forced to invest in a pension.  The one-third cash payout attracts 30% tax off the top (assuming the R500 000 lifetime exemption is used elsewhere).

In view of the above – apart perhaps from the “enforced saving” created by an RA contract – it’s hard to imagine why anyone invests in these products.

As I said at the outset, the rationale for investing pre-tax income is sound – provided decent investment returns are achieved.  RA wrapper funds which allow you to choose the underlying unit trusts are transparent and cost-competitive.  And you can monitor how your investments are performing.  But “traditional” RA products sold by life houses are, based on my experience, best avoided.

The bottom line is this: if you are contributing to “traditional” RA products, consider converting these to RA wrappers.  In theory life houses are no longer allowed to charge onerous penalties when you make an RA paid-up or reduce contributions, although this needs to be scrutinised on a case by case basis – penalty disputes remain a headache for the Ombud.  But if you can do so without crippling penalties, make your old RAs paid up and switch your contributions into RA wrappers.  Or abandon the false allure of income tax savings and invest directly in unit trusts, you may well find yourself better off in the long term.

*Nic Oldert, an active equity investor, co-founded the Profile Group and served as MD for 20 years.  He continues to serve as editor of Profile’s Unit Trusts Handbook in between other consulting work.  He holds an MA in psychology which has proved advantageous in making sense of stock markets.

* For more in-depth business news, visit biznews.com or simply sign up for the daily newsletter.

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