They prowl the empty streets at night…
“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.