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There have been a number of events and government proposals that have forced us to reconsider whether formal retirement savings, especially Retirement Annuities are still worth it. The Green Paper that was introduced and withdrawn a couple of weeks later is a case in point. This has been withdrawn and is not dead; I have no doubt that it will be resurrected sometime in the future. Retirement Annuities (RAs) have had a bad rep for decades now and much of that flack is well deserved. The latest draft tax proposals have put them under the spotlight yet again – so is it time to excise them from our portfolios altogether?
Most of the bad reputation stink that RAs carry around come from the RAs sold by insurance companies – rather than the ‘new generation’ RAs from LISPs (like Ninety One, Alan Gray.) I have always detested RAs on insurance platforms and tried (mostly unsuccessfully) to help my clients to extricate themselves from their slimy grip and the ‘early termination penalties’ that can be has much as 30% of the capital. There has been a lot of talk about the evils of ‘Regulation 28’ – these are the ‘Prudent Investment Guidelines’ (we used to call it PIGs compliance) which was put in place to protect future pensioners from overly aggressive investments. In a nutshell, Equity is capped at 75%, Offshore capped at 30%.
It is this 30% capping of offshore that got pundits out there bleating. Offshore has done way better than the JSE over the last 10 years, but because they are riskier equity assets, made even more volatile by the exchange rate – large exposures could be problematic. For the average future retiree, there is just not enough capital in retirement to take the risk of losing it all. Ironically, Compulsory annuities (which is what you have to out 2/3rds of your retirement savings into. do not have to be Reg 28 complaint, and you can put all the capital in (Rand Denominated) offshore if you want.
Regulation 28 isn’t the only problem with RAs – it is the fees and how and when they are paid to brokers. The alternative to Insurance RAs are LISP RAs. These 2 platforms pay advisors differently, even though the legislated ‘fee’ is the same.
The new draft Tax legislation has increased the ‘tax penalties’ for emigrants, this time targeting retirement funds. There is a lot of heated rhetoric out there over this issue – mostly born out of frustration, but also because bad news sells and gets clicks and eyeballs.
In a nutshell, if you decide to become non-resident for tax purposes (in the previous iteration called financial emigration) then you will not be able to ‘commute’ (cash in) your RA for 3 years, and it will be taxed ‘as if’ you had withdrawn the day before you emigrate, and interest paid on that tax at 7%pa (currently). This may or may not be ‘legal’ (double taxation agreement breaches, potentially), but that is beside the point… If you wanted to use your RA proceeds to fund your emigration you’re out of luck. This is going to impact investors under the age of 55 most.
Yes, this is your money, and you should be able to do with it as you please but let me make an unpopular observation…
There are numerous ways you can save money that are not governed by the Pensions Funds Act and its various restrictions: – money market, flexible investments, endowments and sinking funds. When you make an investment, the first question any Financial Planner should ask you is ‘what is the objective of the investment’ and ‘what are your future needs’. Retirement Annuities have the objective right there in the title. Retirement.
RAs come with a bunch of investment restrictions – but are the tax benefits inconsequential? Are RAs dead?
Let’s look at a tax example:
We’ll pick a marginal tax rate, say 40%, and an RA contribution of R200,000 per annum. (You can find your own marginal rate from the table below).
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In this scenario, you’d get a tax rebate of circa 40% of R200,000 = R80,000pa (roughly, it is obviously going to depend on your age, other deductions, allowances, abatements etc, but this is the underlying calculation.)
• If you do this for 10 years, you will then have contributed R2 million to the RA, and have R800,000 in rebates (before any investment growth obviously). So, in total, your funds, some tied into the RA, some flexible, is R2,800,000.
• If you took the R200,000 per annum and put it into a purely flexible investment (because you need it to be available and liquid) the contributions would be R2,000,000 (no rebates).
Both of these investments could be invested in the same funds, but you would have the option in a flexible investment to go beyond the ‘Regulation 28’ restrictions. You can, for example, place it in 100% Rand denominated offshore funds – or, even better IMHO, use your annual allowance to take it offshore altogether.
Now look at the tax breaks within the funds (rather than the allowances you get in your income tax). In an RA there is no tax on interest, dividends tax is rebated back, no CGT – all of which would apply to your flexible investment (with some annual allowances). This increases your RA/rebate investment versus flexible investment even further.
From the age of 55 you can ‘retire from’ these RAs (unless you’ve been sucked into an insurance platform and a broker who has wanted to maximise his commission by pushing your retirement out to 65). These tax rebates are really ‘tax postponed’ – you know SARS well enough by now to know that he always gets his bite of the cherry. On ‘retirement from’ an RA that capital turns into income and is taxed at income tax rates (as per the table above).
Danger of prematurely retiring from a RA, or Preserver.
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If you’re still earning income at age 55 and ‘retire from’ an RA then the income you take is going to be ADDED to your ‘active income’ and so taxed at your marginal rate!
I know it has been popular in some quarters to encourage you to ‘retire from’ your RAS (and pension/provident preservers) so that you can magically escape the dreaded ‘Regulation 28’ which restricts your investments (with offshore restriction to 30% being the most problematic). In Compulsory annuities (minimum 2/3 of your RA) there are no such investment restrictions. YAY! Not so fast…
Let’s take that R2m RA, and retire from it ‘in full’ (you can take 1/3 in cash, with the first R500k (lifetime amount) being tax-free), take the maximum 17.5% pa (so that you can move it offshore obviously) or R350,000 pa, but assume you’re still earning and on the 40% marginal tax rate… You’d lose R140,000 of that to tax (bye-bye rebate). That is 7% of your R2m. That is quite some catching up your offshore investment would have to do to fill up the hole.
There is another often overlooked benefit of RAs, Preservers and Annuities – they are not Estate dutiable. If your Estate is going to have to pay Estate Duty (your Planner can work that out for you) then would you rather give SARS a 20% present or build up your RA over the next few years, even in retirement, to offset this? Rebates still apply and there is no requirement to ‘retire from’ an RA at present. Only the capital inside the annuity is not Estate Dutiable, once it is paid out it is not. Something else to think about before doing a rapid, 17.% drawdown.
1. I know this blog is too long already, but there a couple of other related myths that need to be debunked. Your Planner, using a LISP platform, is not going to earn more commission from an RA over a flexible investment. (You now know why not to use an insurance platform).
2. Most large Asset Managers have pure offshore and Rand denominated offshore funds available on their platform – so they get fees on your assets anyway, they don’t care which assets you use. If legislation allowed all pension funds to use 100% Rand denominated funds you would see a sell-off of shares on the JSE, and this would hurt the Stock Market to some extent.
3. Offshore investments come with an additional layer of risk created by the exchange rate, which doesn’t just go up, it goes down too. The Rand/Dollar is at 2015 levels. If you hit a sweet spot with the asset growing and the Rand depreciating, then you get double the joy. If markets decline and the Rand appreciated, then it is double the sorrow.