Benefits of investing in a retirement annuity
It’s retirement annuity season, and as the end of the tax filing season draws near, now is a good time to remember that your retirement annuity (RA) is a great way to save for retirement and offers you very attractive tax benefits. But while tax efficiency and growth make RAs attractive, that’s not all. RA’s are often misunderstood in terms of the benefits they offer; here’s the full low-down:
Preparing for retirement
- An RA helps you to build up capital during your working years, and if well planned, may put you in a position to enjoy the same standard of living when you retire. RAs may also help to supplement insufficient pension / provident fund contributions.
Exposure to long term growth assets
- When investing in RA, you can gain exposure to growth assets such as equities, both locally and internationally. These are essential to produce inflation-beating investment returns over the long term.
Ensuring sufficient savings
- The conventional rule of thumb has been that one can comfortably retire on 75% of your final salary due to a general reduction in certain costs, downsizing to smaller homes, etc.
- If you contribute 15% of your salary over 35 years into retirement funding vehicles (RA and/or pension), you should comfortably generate income equivalent to 75% of your salary prior to retirement, as a pension (based on historic average return of a balanced portfolio.)
- The challenge is that your pensionable salary (the amount that your 15% pension contributions are calculated on) is usually about 70% of your total salary benefits which include, for example, a bonus, car allowance, medical aid and other benefits. Meaning this may result in having to retire on 75% of 70% of your salary – which is generally insufficient.
- For example, if your monthly package is R20 000, you would need to retire on the equivalent of R15 000 (75%). But your pensionable salary is significantly less at R10 500 (75% x R20 000 x 70%). By investing 15% of your non-pensionable income into a retirement annuity, you can make up the savings gap.
- In the South African context, it is an often-debated fact amongst financial and retirement advisors that the 75% rule is too low and should ideally be closer to 100%. Two contributing factors here are firstly, that affluent retirees in reality spend a significant amout on “maintaining their lifestyle” and secondly, having financial dependents in the family in retirement is becoming the norm.
- It’s important to save for these “extras” as they will help deal with living expenses at retirement. RAs can, for example, be used to provide for specific goals such as expected increases in medical expenditure in retirement.
- Annual bonuses are a good source of income which may be put towards the 15% non-retirement funding on your RA. This contribution will then be tax deductible.
- Currently, contributions to an RA of up to 15% of your annual “non-retirement funding” income are tax deductable.
- Going forward, however, with the new retirement reforms, this may increase to 27,5% and be capped at R350 000 per annum. However, unused annual amounts can be carried forward to future tax years and those previously disallowed contributions balances, if existing at retirement, can be offset against the taxation of living annuity withdrawals in retirement.
- When using an RA to benefit from the preferential tax treatment of contributions, one can view it as investing additional funds that would otherwise have been paid to SARS. Simply put – rather pay yourself, receiving the compounding effect of that investment as opposed to paying the taxman. Simple, right?
- An RA investment is tax neutral – i.e. there is no tax on income or capital gains applicable to assets within the RA. This adds further to the total growth and compounding effect on the investment annually, having dramatically positive effects on the investment value over the longer term.
- On retirement, you (“the annuitant”) may elect to take up to one-third of your RA investment as a cash commutation or lump sum. Of this, the first R300 000 is tax-free with a favourable tax-rate for higher amounts. The remaining two-thirds of the retirement annuity is invested in an annuity to provide you with income during your retirement.
The power of compound growth
- Using an RA as intended, that is, over the longer term (between 5 to 20 years plus) with regular contributions, the compounding effects are significant.
- EXAMPLE: A R100 000 initial contribution with R1,000 monthly contribution over a 20 year period, assuming a fairly modest growth rate of 9% per annum, would result in a portfolio value of R1 268 802,00 (total contributions = R340,000)
- You do not have access to your retirement annuity savings until the age of 55. This may sound like a disadvantage but it removes the temptation to dip into or deplete your savings while you are working. Plus regular debit order contributions are more paletable than larger lumpsum contributions.
- Rand Cost Averaging: As markets fluctuate during different economic cycles, your consistent contributions will average out this variability and reduces you cost entry point into the market.
- You also draw your pension over a prolonged period. Therefore, what happens in a turbulent or volatile investment market can be of less concern to you. It is important, however, to immunise your income from the market cycles by drawing it from cash.
Supporting your dependents
- RAs and the ensuing living or life annuities are not treated as part of your estate and because you are able to nominate beneficiaries for them, they become very effective tools for ensuring either capital or income is made available quickly to dependants should the annuitant die. Some life-underwitten RAs also offer additional life cover which is payable on the death of the annuitant but it is important to note here that this is not free. A portion of the monthly contributions are allocated to life cover and thus reduce the actual investable portion, often misleading investors as they often think that the investment values relative to contributions for this type of RAs are poor.
- You have access to different asset classes in a retirement annuity. You can invest up to 25% of your savings offshore too. You can also invest in varied types of portfolios through your RA, such unit trust funds, managed share portfolios, direct securities although the investment still has to adhere to Regulation 28 of the Pension Funds Act which provides prudential guidelines for exposure to various asset classes.
Freedom of choice
- With most retirement annuities, you can choose your underlying investment, giving you sufficient flexibility in how your funds and contributions are invested and therefore, how they grow. Financial advice here is critical.
Warning! Old versus New
- There is a common view held by many South African investors that RAs are expensive, lack flexibility and transparency and have historically poor investment returns. While this holds true in some respects, it is important to note that this is attributable exclusively to the more traditional life-underwritten RA’s (with life cover) which people approaching retirement were sold when they were in their early working careers.
- Investment-underwritten RA’s available today (and over the past 15-20 years) are much like any other linked product or unitised investment and offer very cost effective access to the market. They are flexible, offering the ability to manage or cease contributions at any time. They are transparent in terms of fees to the fund manager, product house and advisor.
Changes that can be expected with the new retirement reforms (T-Day) in 2016:
T-Day is the day when a new, more tax-effective tax regime for retirement funds will be introduced in 2016 or 2017 (changed from 1 March 2015). From this date most taxpayers will be able to deduct a higher amount in contributions from their income (27.5% of remuneration or taxable income, whichever is the higher, subject to a maximum of R350 000 pa).
T-Day will also remove the differences in the way tax is deducted from pension, provident and retirement annuity funds. In an attempt to simplify current tax incentives, employer contributions to retirement funds will continue to be deductible if they are taxed as a fringe benefit in the hands of employees. Employees will in turn be entitled to increase their deductions to 27.5%. Currently the limits are set out in the table below. Contributions that exceed the R350 000 threshhold may be rolled over to the following year. Most members will be much better off and will enjoy a greater level of deduction:
Source: Simeka Consultants and Actuaries, December 2014
Remember that members can continue to make tax-deductible contributions to a retirement annuity even beyond the age of 70. If the total amount in the provident fund, pension fund or retirement annuity fund is less than R150 000 at retirement, then the member may withdraw the full amount in cash.
Graviton Financial Partners (Pty) Limited is an approved discretionary Financial Services Provider in terms of the Financial Advisory and Intermediary Services Act, 2002 (FSP No 4210).The opinions and views expressed are for information purposes only and should not be viewed as independent research. The information in it does not constitute financial advice as contemplated in terms of the Financial Advisory and Intermediary Services Act. Although all reasonable steps have been taken to ensure the information in this document is accurate, Graviton Financial Partners does not accept any responsibility for any claim, damages, loss or expense, however it arises, out of or in connection with the information in this document. There are risks involved in the buying and selling of financial products and independent professional financial advice should always be sought before making an investment decision.