Sometimes it pays to pay a penalty…

Sometimes it pays to pay a penalty…

Let’s face it; RA’s have a bad rap. Hardly a week goes by (in our practice) that we don’t hear someone lamenting the fact that they have an RA that they wish they did not and that RA’s are “rubbish”. Sadly, in many cases, they are correct and not all the bad opinion around RA’s is unwarranted.

As a result, many people are no longer interested in making use of RA’s for their retirement. What they don’t realise is that not all RA’s are equal and that while RA’s with contractual obligations should be banned (in my opinion) there is a different and better way to invest into an RA.

Many investors who have old RA’s are also being advised to move their old RA’s to “new generation” RA’s. Again, not all “new generation” RA’s are equal (many are still forcing the investor into a contractual relationship with potentially heavy penalties for failing to comply).  There has also been much written in the media about transferring RA’s (a process known as a Section 14 transfer because of the particular section of the pension fund act that deals with this) and much of the reporting implies that investors should not transfer. This is mainly because of the often heavy penalties that are levied by the insurance companies for the breaking of the contractual obligation and because of the potential “double” fees on the money.

For many investors these penalties appear huge (and they often are) but should a hefty penalty really stop you from moving and is there a case when it makes sense to move in spite of the penalty? Before we look at some examples of moving an RA there are some issues that need to be considered:

Penalties on transfer – insurance companies used to be able to levy just about any penalty they wanted if you altered the premium or term before the RA matured. Penalties were very heavy (even if the amount bore no resemblance to the actual “loss” the company would suffer) and there are more than a few examples of investors being penalised 100% of the fund value in the first few years of the RA. Since 2009 these penalties have been regulated (thanks to Trevor Manual) and insurance companies can now levy penalties of up to 30% on RA’s taken out before Jan 2009 and up to 15% on RA’s post then. (I am still not convinced that the penalty bears any relation to reality and suspect that they are still higher than the real “losses” the company will incur. Some companies also appear to be worse than others when it comes to levying the penalties.)

Performance of new and old – sadly, many of the old insurance company RA’s have horrific performance track records. This is a function of 2 things, namely underlying funds and the fees on the RA’s. Historically, many of the underlying funds have performed poorly and the fees were very high (and not transparent). While we have occasionally come across an insurance based RA that has managed to beat inflation, in many instances, the compound return over time seldom appears to even match inflation (too often investors are also sitting in smooth bonus or guaranteed portfolios which are not appropriate for 20+ year investments).  With a unit trust (or ETF) RA, the performance is much more transparent and is relatively easily established – in fact, if you opt for a “balanced” fund you should reasonably expect a return of inflation plus 5% over a 20+ year period. As a rule too, the fees are significantly lower than on the old RA’s (you can access just about any unit trust/etf RA at no initial fees these days).

Period to retirement – one of the big factors that needs to be considered before doing a S14 transfer is the term left on the RA. This is because even though the new option might appear to offer a better return over time, the effect of the penalty that is being applied could mean that you end up with a lower value at retirement.

Some of the other attractions of unit trust/etf RA’s include the fact that you are not contractually bound to pay a premium and if/when you need to change the contribution amount (for whatever reason) there are never any penalties applied. You can increase/decrease/stop/start your premium as often as you like with no penalty – ever!

Let’s consider an example: RA through life insurance company X…does it make sense for the client to transfer the RA to a different RA?

If we look at the above example, the average compound return on the RA has been around 5% pa*, (this is below CPI under the current inflation scenario). Based on these figures and keeping everything else the same, the projected value at retirement in 2031 should be around R1.7million.

If we apply for a Section 14 transfer on the above example, get a penalty of R23k, keep the contribution at R2200pm and assume a return of CPI+5% for the rest of the term, then the projected retirement value should be around R4.2million. I can hear the sceptics saying that CPI+5% is too high so let’s use CPI+3% over the period – the final value should be around R3million. It is, as they say, a “no-brainer”!

In fact, the maths seems to suggest that if you have more than 11 years to go to retirement that you could afford to absorb a penalty as high as 23%** of the fund value (although there are few investors who could deal with the emotions around this kind of “loss”). Sometimes it pays to pay a penalty, but don’t take my word for it, do the maths!

Notes: The maths is based on the following assumptions:

• Return on “old” RA – cpi+3% pa (very generous)
• Return on new RA – cpi+5% pa.
• Where the penalty is around 15% of the fund value then you would be better off after 8 years and for penalties of 8% the break-even happens after 4 years.

*this is very difficult to determine as there have been a few premium alterations since inception

**as long as the difference in return is more than 2% pa