The Financial Coach™ - Managing people & their emotions around money » Retirement

Is there still a case for RA’s?

Gregg — Fri, 10 Jun 2011 04:31:57 +0000

The recent changes to Regulation 28 rules around retirement funds has caused a bit of “excitement” in the asset management industry and I have seen at least 2 articles making a case that the stricter enforcement of the Reg 28 rules make Retirement Annuities unattractive investments, especially for younger investors (see the article by Jan Mouton of PSG Asset Management – http://www.psgam.co.za/2011/05/psg-angle-regulation-28-amendments-reduce-attractiveness-effectiveness-for-savers/ ).

The basic argument goes around the fact that in a retirement fund an investor may not have more than 75% of his/her funds invested in equities and by default most investors tend to opt for “balanced” funds. Although balanced funds can have 75% equity exposure, most, in reality, do not and they tend to err on the lower equity side.

As a result of the lower equity exposure, a balanced fund will under-perform an equity fund over long periods of time. In fact, Mouton’s article suggests that as a result of the more “conservative” asset allocation, an investor in a retirement fund could have less than 1/3 of the money that an investor in an equity unit trust fund could have. Scary stuff indeed and certainly it sounds like a compelling reason not to use retirement annuities – especially if you are young. Or is it?

Let’s take a different look at the case and let’s assume that the chosen equity fund (outside of the RA) gives a total return of “x” over the period. Now if we use the same equity fund within the RA we could invest 75% of the contribution into this fund – the balance of the money would have to go into the other asset classes and for the purposes of this example let’s refer to that as “cash”. Over the investment term, the RA would then give the following: 0.75x + “cash”. Clearly this is less than the equity fund.

But this is where the financial planner in me comes out…

One of the primary reasons for using an RA is because of the tax saving involved. For every rand you contribute, you receive a “rebate” equivalent to your marginal tax rate. Simply put, if your marginal tax rate is 30% you will only effectively pay 70cents in every rand of the RA premium – the 30cents is the tax saving. Now if you are disciplined you can invest this amount and if we use the same equity fund used above, then over time your return will be 0.3x (or your marginal rate * x).

So your total “RA” return now becomes: 0.75x + “cash” + 0.3x.

This is equal to 1.05x + “cash” (this could be as high as 1.15x + “cash”).

Even without the “cash” portion, 1.05x > x (apologies for the maths but you should have paid attention in class!). And then it is also possible to invest the “cash” portion into a property fund – which would be significantly better than “cash” over the long term.

Now this is where the detractors of RA’s will jump up and say “yes but there will be tax on the income taken from the RA whereas there will only be capital gains tax payable on income taken from the equity fund”. You are correct and this could well be less than the income tax payable on the RA income. However, at death, there will be estate duty payable on the equity fund whereas the money in the RA will fall outside of your estate (there will also be no executor’s fees on it).

I am sure that there many responses possible to this article, not least of which would be to make sure that the voluntary money was invested via a trust but that has another whole set of implications. The point of this article was to show, mathematically, that there is still a case for RA’s.

Something’s gotta give and it’s not government

Gregg — Mon, 30 May 2011 13:52:10 +0000

Not for the first time, I received an email from a client whose domestic worker is close to retirement and who is concerned about having “too much money” and that this will impact on her ability to qualify for an old age pension. She has been told (via the grapevine) that when she applies for a pension the government will investigate her personal circumstances and if she is “rich” she will not qualify for a pension.

There are currently more than 15million South Africans who receive some form of State Social grant. Clearly this is not sustainable but more concerning than these figures is the perception that if one saves and acquires “wealth” during one’s working life then you will not qualify for a state pension. Something is seriously wrong when people are discouraged to save for the sake of receiving a pension of R1140pm.

There is currently fairly complicated way of working out who qualifies for state grants. For an old age pension (for 2012 tax year) it is as follows: anyone earning less than R13680 (R1140*12) per annum will qualify for the full pension. The pension decreases proportionately as the income rises and anyone earning more than R44880 pa would not qualify for any old age pension. In addition to this there is an “asset” test and anyone with assets of more than R547200 (excluding the value of their house) would also not qualify for a pension*.

Clearly there is a lot more education that is required – people need to be encouraged to save, even at the risk of not qualifying for an old age pension. The current situation, just like defined benefit pension schemes, is not sustainable. More people are living longer and there are not sufficient new members entering the “scheme” to continue to cross-subsidise the elderly. Something’s got to give – and it cant continue to be government!

Note: R547000 invested into the RSA Retail Bond (2 years at 7.25%) would currently generate about R3300 pm and would still allow someone to qualify for a partial grant. R44880 pa equates to around R3740 pm. In addition to this it is my understanding that any money in a retirement product is not regarded as an “asset” and so workers should be encouraged to save into retirement products…even R1million in a living annuity with an income draw of 2.5% would still provide an income that is below the current old age pension threshold and would still allow pensioners to qualify for state assistance.

They prowl the empty streets at night…

Gregg — Wed, 02 Feb 2011 08:13:12 +0000

“They prowl the empty streets (at night), waiting in fast cars and on foot”* looking for unsuspecting consumers. Yes, it’s that time of year again when Retirement Annuity salesmen are on out in full force. February is “traditionally” RA month as it signifies the end of the tax year and anyone needing to put money into an RA has until the end of the month to do it.

RA’s have received a lot of press (not all of it good) and as a result there is probably a great deal of confusion about whether or not they are good investments. So let’s look at a few of the “issues:

RA’s are effectively “private” pension funds and as such they are most appropriate for people who have taxable income and who don’t belong to a pension fund. They are also great for commission earners.
Subject to tax limits, contributions to RA’s are tax deductible – this means that for every rand that you invest, the government is effectively subsidising your contribution and effectively “loaning” you money to invest until you retire.
Yes, RA’s are subject to restrictions and are taxed when you retire but the tax rate at retirement (i.e. after 65) is significantly lower than pre-retirement (for most people that is).

In my opinion, RA’s are great investments. However, not all RA’s are equal. Don’t ever invest money into an RA through an insurance company – you are contractually committing yourself to a long-term relationship where there will be penalties when you want to leave it. Contractually binding someone to a 30 year product is an archaic way of doing business.

Here is how the “insurance” RA works. You agree to pay a given premium, escalating at some number (inflation) for a given term. The insurance company then works out all the future “profit” from this contract and accounts for it today. As a result, if at any stage in the future, you want to adjust the premium down or reduce/remove the annual premium escalation, you mess with their profits and as a result, they penalise you for it. And very often, this penalty bears little or no resemblance to the actual “loss” of profit. For policies issued prior to 2009, the penalty is usually 30%, while for policies issued after Jan 2009, legislation has reduced the maximum penalty to 15%. Very often people have to reduce/stop their premiums through no fault of their own e.g. loss of employment, forced to join the company pension fund. In such circumstances, it is fundamentally and morally wrong to penalise the investor. But that’s the fault of the way the product is structured.

So if you should never ever use an RA through an insurance company, which RA should you use? Unit trust RA’s are a much better option – there is no contractual obligation! You pay a premium as and when you want/need to and the costs are taken off as and when you pay. You can change your mind as often as you want/need to and will never ever incur a penalty for doing so.

So why are more people sold unit trust based RA’s? The very simple answer is because of the commission structure on insurance company RA’s. Consider the following example: a 30 year old takes out an RA for R1000pm.

Through the insurance RA they need to “commit” to a term and so they agree to pay until they turn 55 (that’s the minimum age) and agree to a 10% annual premium escalation. The commission on offer to the salesperson would be R1304.40 upfront (paid in advance) and R25pm (escalating with the increased premium).
The same RA though a unit trust company would pay the salesperson a maximum commission of R30 per month each time the premium is paid (this will also escalate as the premium escalates).
So while there may be little difference in the total commission paid over the term of the RA, there is an incentive to earn upfront commission on the insurance based RA…and if you have a sales target then it is pretty obvious which one you are going to favour.

To summarise then, RA’s have an important role to play in helping investors to save for retirement. There are significant tax incentives when RA’s are used correctly. A contractual based RA (such as the insurance company RA) is an archaic way of doing business – stick to RA’s where there are never any penalties for changing your mind about the premium.

*for those that remember “Squad cars” on Friday evenings on Springbok radio way back before TV in South Africa.

Money or the box?

Gregg — Fri, 12 Nov 2010 11:48:05 +0000

It is incredible how often the same “issue” or question comes up in quick succession…just this week 2 clients have both asked about cashing in their preservation funds to try to use the funds elsewhere – 1 to invest the funds into her bond and the other to invest the money into a share portfolio. This article will deal with the tax implications of doing this (we will explore the merits of this at a later stage)*.

For those that are not familiar with preservation funds they are essentially a vehicle into which can transfer your pension or provident fund if you leave your employment before retirement…the money is invested into some unit trust (or similar) funds and will remain there until such time as you reach retirement age. In other words, your pension fund is “preserved”. The transfer is “tax neutral” i.e. there is no tax on the transfer and one of the attractive options available with a preservation fund is the “once-off” withdrawal option. This is done before retirement age and can be a portion of the fund or the full amount.

Currently if you withdraw from your preservation fund before retirement you will receive the first R22500 tax-free. The balance of the amount will be taxed according to the “pre-retirement” tables with the next R577500 being taxed at 18%, the next R300000 at 27% and the balance at 36%. Not too bad you might think…and indeed it isn’t, right now. But the problem comes at retirement when you want to take the 1/3 lump sum out of your fund…any amount that you have taken out before retirement will be taken off the tax-free portion available to you at retirement (currently the first R300000 is tax free at retirement).

To illustrate the effects of the tax, let’s consider an example and assume that Mrs X wants to withdraw the full amount of her preservation fund which is currently sitting at R1.4million.

If she withdraws now (pre-retirement) the following should happen (based on current tax tables):

The first R22500 will be tax free
The next R577500 will be taxed at 18% (i.e. R103950)
The next R300000 will be taxed at 27% (i.e. R81000)
And the balance will be taxed at 36% (i.e. R180000)
So she will pay R364950 in tax and will she will leave with R1035050 to do with as she pleases (invest into her bond or into a share portfolio).

Now let’s move forward a few years to her retirement and assume that she has a retirement annuity and/or pension fund with her current employer and that the value has grown to R3million (it is an amount that easily divides by 3). Under current legislation she is entitled to take up to R1million out of the fund and do with it as she pleases. If she had not taken anything from her preservation fund she should get the following:

The first R300000 would be tax-free
The next R300000 would be taxed at 18% (R54000)
The next R300000 at 27% (R81000)
And the balance of the million would be taxed at 36% (R36000)
All told she would pay R171000 in tax and she would walk away with R829000 (or she could even limit her withdrawal to the R300000 tax-free and leave the balance in the fund to increase the annuity she receives).

Unfortunately for her, however, she took R1.4million out of her preservation fund prior to retirement and as a result, this amount will be taken into account when the tax is calculated on the 1/3 withdrawal. As a result, anything she takes out of now will be taxed at 36% (the sliding scale is applied after taking into account anything she has already withdrawn from her retirement funds). So if she does withdraw R1million at retirement she would effectively lose R360000 in tax – the entire tax-free portion has been used up prior to retirement and the sliding scale kicked in and is now applied at 36%.

As a result of taking a pre-retirement draw from her funds she effectively forfeits R277500 tax free money (she got R22500 from the pre-retirement withdrawal).

Let’s consider another example where Mr Y takes R300000 out of his preservation fund prior to retirement. His tax calcs will look something like this:

The first R22500 will be tax free
The next R277500 will be taxed at 18% (i.e. R49950)
So he should pay R49950 in tax and should leave with R250050 to do with as he pleases.

Now let’s skip forward a few years to retirement and again assume a pension fund of R3million and that he wants to take out 1/3 as a lump sum. His tax calculations should look something like this:

The first R300000 (tax-free) has been used up (pre-retirement) and so the sliding scale should kick in immediately with the first R300000 being taxed at 18% (R54000)
The next R300000 at 27% (R81000)
And the balance of the million would be taxed at 36% (R144000 – 36% of R400k)
All told he should pay R279000 in tax and he should walk away with about R721000.

It should be clear from these 2 examples that from a tax point of view it does not pay to make early (pre-retirement) withdrawals from your preservation or pension funds – and we have not even got into what you would have to invest in order to replace the money taken out.

Note: * the above examples are for illustration only and should not be relied upon for advice. You should get a professional tax opinion before making these decisions.

A timely reminder…

Gregg — Thu, 01 Oct 2009 07:16:57 +0000

A wealthy businessman was horrified to see a fisherman sitting beside his boat, playing with a small child.

“Why aren’t you out fishing?” asked the businessman.

“Because I caught enough fish for one day, “replied the fisherman.

“Why don’t you catch some more?”

“What would I do with them?”

“You could earn more money,” said the businessman. “Then with the extra money, you could buy a bigger boat, go into deeper waters, and catch more fish. Then you would make enough money to buy nylon nets. With the nets, you could catch even more fish and make more money. With that money you could own two boats, maybe three boats. Eventually you could have a whole fleet of boats and be rich like me.”

“Then what would I do?” asked the fisherman.

“Then,” said the businessman, “you could really enjoy life.”

The fisherman looked at the businessman quizzically and asked, “What do you think I am doing now?”

Retirement – life event, not just a financial event!

Gregg — Mon, 14 Sep 2009 18:51:29 +0000

Results from the American Demographics poll showed that retirement is more difficult than becoming a parent or than getting married*. Those that felt retirement was the most difficult adjustment said that they struggle with the monotony, boredom, lack of purpose and lack of intellectual stimulation that traditional retirement offers. So if this is the case, why is there still such a one-dimensional approach to retirement from the financial services industry as a whole?

The focus has traditionally been on the financial side with little thought or emphasis being given to the emotional/psychological side of retirement. This has been largely driven by the financial services industry (insurance companies) and their focus on getting people to put money away (into their products) for retirement. If the stats are to be believed though then it has been hopelessly unsuccessful and very few (South Africans) will retire financially independent…

When the concept of retirement was first introduced (1930’s), the retirement age was older than the average life expectancy and anyone who did make it to retirement was not expected to live for more than 20-24 pay checks. These days, it is expected that many people will live for 20-30 years after retirement and some stats even suggest that some may be retired for almost half of their lives if we continue with the traditional approach to retiring at 60-65! Little wonder that few can afford it financially!

But what if we never stop working altogether? What if we just work differently or less? What if we continue working after we’ve “officially” retired? Could more of us then “afford” to retire? I recently met an 80+ year old doctor who was studying so that he could specialise further. Was he working because he had to? Nope; because he loves what he does! For him, work is not a means to an end (retirement), it is a way of life (a vocation or calling). While he can, he will always be earning – it might be less than it once was because he works fewer hours per day and fewer days per week, but in this scenario, the “huge pot at the end of the rainbow that he once needed” is no longer a necessity. Not only does he have longer to accumulate that pot, but he will also need to draw off it for a much shorter time period than someone who stopped working at 65!

It is also interesting to read that over 1/3 of male retirees in the US go back to some form of work within one year of retirement and over 2/3 of them take full-time jobs. Far too much emphasis is being placed on the financial aspect of retirement and not nearly enough is being given to the “other” aspects of retirement. Retirement is not a financial event, it is a life event and we need to plan accordingly!

That’s all for now…

Gregg

*41% of people polled said retirement was the most difficult adjustment of their lives compared to 23% who said it was parenthood and 12% who said it was marriage.