Over many years the traditional retirement annuity (RA) has received a bad rap.

Article written by Paul Jennings, NFB Gauteng, Private Wealth Manager.

One could say an 'oldie, but a goodie' – Over many years the traditional retirement annuity (RA) has received a bad rap. Often for good reason as it was sold indiscriminately, was inflexible, salesmen were over incentivized to make the sale through taking commissions up front without due care and after sales service and advise, heavy penalties were incurred by investors making such policies paid up, there was a lack of transparency, fiscus support was small and contributions were age restricted.

Today the game has changed to such an extent that for the right circumstances there are few investments available to the South African investing public which are more attractive, particularly on an after tax basis. It could be said that the RA is a 'virtual tax haven'. Having said this it is important to emphasize that the essential purpose of the RA is to provide or supplement one's retirement savings as it is not designed to provide an investment over and above this purpose. For such investments there are better vehicles available which provide greater flexibility and purpose.

The focus of this article is therefore on your retirement savings. This is particularly relevant when one considers that in South Africa today about 1,3 million taxpayers make tax deductible contributions to pension and provident funds through their employers. Only about 18,000 make any additional voluntary contribution to these funds. 1,8 million make tax deductible contributions to retirement annuity funds. Many of these are the same investors who are contributing to pension and provident funds. From which ever angle one considers this matter there are less than 3 million South Africans with a pension fund of any sort. This represents only 6% of the South African population. Coupled with this is the reality that most people, even those who do have retirement provisions, cannot afford to retire at even close to their current standard of living. This fact is exacerbated by the fact that people are living longer and therefore need to provide for a longer period in retirement. For those who may think that they can rely on Government provision in their old age need to be reminded that the current old age pension is R1070 per month.

So let us unpack the retirement annuity to investigate whether it can be considered a 'virtual tax haven'

But please explain you may be asking!!!

• The investor is incentivized by Government in that up to 15% of non-retirement income is invested with before tax income – effectively Government pays part of your contribution calculated at your marginal tax rate.
• For those who are employed for the tax year ending 28th February 2012 these tax deductions to retirement funds will be determined as follows:
  • Employers' contributions to pension and provident funds and related benefits may be as much as 20% of employee earnings. It is noted that Finance Minister, Pravin Gordhan alluded in his 2011/12 Budget Speech, to an overhaul of contribution thresholds, suggesting that in 2013 employer contributions may increase to 22,5% of employee earnings with total tax deductible contributions capped at R200 000 per annum per tax payer. The implication of this proposal is that very high net worth individual tax payers may have their last chance to contribute an unlimited 15% of retirement funding income to a retirement annuity.
  • Employee contributions to pension funds is 7.5%.
  • As already noted, individual tax payer's contributions to retirement annuity funds is 15% of non-retirement funding income subject to a minimum of the greater of R3 500 pension fund contribution or R1 750. One is able to contribute more than this amount, but any excess contributions do not enjoy the deductibility on this additional contribution. Nevertheless, any excess contributions may be deducted tax free on retirement.
• While invested in the retirement annuities fund no income or capital gain tax is paid by the fund. Effectively all gains within the fund are tax free. The only times your retirement annuity is taxed is on your allowable one third lump sum benefit, and even in this instance the first
• R315 000 is tax free, and on average the first R945k is taxed at an average rate of 15%. The balance of the one third lump sum benefit can be taken, but at the dis-incentivised rate of 36%. The balance of your retirement annuity remains to provide you with a pension or an annuity taxed at your marginal rate. In all probability this will be at a lower rate than when you were employed.
• Reference is made to the fact that the balance of your retirement annuity needs to provide you with either a pension or an annuity. By pension we refer to a traditional pension as provided by an insurance company. This is a guarantee by the insurance company to pay you and your spouse a certain pension for the duration of your lives. The advantage of such an arrangement is that you have the certainty of a pension which is not influenced by the future vagaries of the market – the insurance company takes this risk, but does so at a cost. Alternatively you have the choice of a living annuity. This allows you annually to select the amount of your annuity ranging between 2,5% and 17.5% of the balance of your investment. The advantage of this option is that you can effectively 'dial up' sufficient income to cover your annual consumption, but remembering any percentage taken at a higher level than the earning of the fund, plus taking account of inflation, will erode the value of your capital. Apart from this risk of capital erosion one also accepts the uncertainty of market risk. In making the decision between taking a certain pension or living annuity one also has the option of a combination between the two and the option at any time to convert a living annuity to a traditional pension.
• A further important distinction between a traditional pension and a living annuity is that with a pension the value of this investment ceases with the death of you and your spouse, but with a living annuity you have control of this asset in terms of investment decisions and nominating beneficiaries in the event of your death. What this effectively means is that the living annuity is not part of your estate which ceases on your death.
• In the past the inflexibility and lack of transparency of the retirement annuity has been a deterrent. This has radically changed with new generation investment platforms which are far more cost effective, plus offering greater flexibility with respect to contributions, choice of investment managers, transferability of investment, and importantly, absolute disclosure of all costs.
• Historically a member of a retirement annuity fund could not belong to such a fund beyond the age of 70; in other words at age 70 the member would have to take a pension. In July 2008 this upper age limit was removed which could mean that the member never retires from their retirement annuity meaning that this asset is effectively excluded from their estate thereby potentially providing a savings with respect to both estate duty and executor fees when a beneficiary has been nominated. Such a strategy can therefore be effectively utilized as an estate planning tool particularly for a very high net worth investor who will continue to enjoy the tax free status of the retirement annuity plus be in a position to continue to make annual contributions of up to 15% of their non-retirement income.
• The RA offers protection from creditors. This is particularly significant to the self employed person who may have their personal assets at risk in the event of insolvency.
• Some have argued that Regulation 28 of the Pension Funds Act is a disincentive to invest in a retirement annuity. This Regulation limits investment exposure to a maximum of 75% exposure to equities, 25% to property, 90% to growth assets which are effectively a combination of equities and property, and 25% to off shore investments. We absolutely support this principle of asset class and geographic diversification as an effective measure to control investment risk. No investor or investment manager has twenty/twenty vision when it comes to making investment decisions hence the wisdom of diversification. This supports the old adage of 'not putting all your eggs into one basket'.
• In a country that has a concerningly low savings discipline and poor provision with regards to providing for retirement, the RA could be seen as a forced savings plan which cannot be readily accessed until retirement.
• One final thought is that one is only able to access ones' retirement annuity at the minimum age of 55 or in the events of death, becoming disabled and immigration. In the event of immigration then this withdrawal is considered a 'withdrawal benefit' meaning that the first R900k is, on average, taxed at 20,6% and the balance at 36%.

This article has merely highlighted the often unsung benefits of the retirement annuity. For analysis more specific to your requirements we urge you to consult with your NFB Advisor.