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Following the recent 2016 Budget Review, and more specifically the massive increases in South African capital gains tax (CGT) announced by finance minister Pravin Gordhan, I compared the mindset of many investors towards endowments to the driver that has been taking the same road to their chosen destination for years, simply because they thought that it has been, and always will be, the best route.
I also mentioned that investors may be pleasantly surprised when they discover the incredible advantages hiding in an endowment, especially in this increased CGT environment.
I would like to discuss these advantages in greater detail, by specifically referring to trusts (excluded special trusts which may not have a 41% tax rate) that have a need to invest in shares in a portfolio, which can be opened and managed within an endowment.
The taxable portion of a trust’s capital gains prior to the budget announcement earlier this year was 66.6%.
This has now been increased to 80%, which means that its effective CGT rate has been increased from 27.3% to 32.28% (at a fixed tax rate of 41%). Nearly a third of any capital gains generated within a trust, therefore, will have to be paid over in taxes.
With shares still remaining the asset class that offers the highest growth expectations, this increase in CGT can make a real difference in a trust’s after-tax returns.
Although the CGT rate within an endowment has also been increased from 10% to 12%, it’s still only 36.5% of the CGT that a trust would have to pay on a direct share portfolio.
I’m sure most readers would like to stop me right here to point out the extra costs involved in an endowment.
These costs are one of the main reasons why this product was such an extremely unattractive investment option in the past, so would it still be a worthwhile investment after taking these costs into consideration? In short, absolutely, yes!
When we take a look at the three largest investment and insurance companies that offer the option of investing in shares directly via an endowment, you will see that those who invest, administrate and manage R1m in shares via an endowment, will pay an extra 0.65% (excluding VAT) in fees per year, while a R5m portfolio will cost an extra 0.5% (excluding VAT) in fees per year.
If you had invested your capital in the FTSE/JSE All Share Index exactly 10 years ago (31 March 2006), your returns before taxes would have been 243% by the end of March 2016. By realising those profits, your after-tax return would have dropped to 163%.
If a R1m trust investor (according to the five-fund approach) in which all listed beneficiaries are natural persons, decided to follow the endowment route, its net matured return after 10 years would have totalled 195%, while the R5m investor’s return would have totalled 199%.
That is a whopping R320 000 extra after 10 years for the trust investor who originally invested R1m in shares via an endowment!
Further criticism may include the obligatory five-year period that your capital will remain invested before you can make any withdrawals, but even this is no longer an issue.
Most of the new-generation endowments include one interest-free loan facility within the first five years, as well as one withdrawal (with certain limits).
Endowments in general have evolved over time and new-generation endowments (specifically those offered by investment platforms) offer greater choice of underlying instruments, enhanced flexibility to switch between these, and no early termination penalties.
I really want to urge investors who own trusts (in which all listed beneficiaries are natural persons) and who would like to invest in direct shares to change the way they look at endowments.
With the new tax legislation now in effect, there is no doubt that an endowment offers a better vehicle for a trust’s share portfolio.
*Schalk Louw is a portfolio manager at PSG Wealth.
This article originally appeared in the 5 May 2016 edition of finweek. Buy and download the magazine here.
