A slew of media reports in recent months have focused on encouraging investors to disinvest from retirement products and move funds offshore. However, while there are risks associated to retirement annuities, these need to be weighed up against the benefits.
There are two risks that need to be considered when it comes to retirement products. The first risk is a limited choice regarding asset allocation. According to Regulation 28, retirement funds may not invest more than 30% offshore. Ironically, Regulation 28 was introduced to protect investors from losing money due to overexposure to offshore assets. However, since the regulation came into effect in 2011, offshore investments have significantly outperformed local investments.
Talk about unintended consequences! More than anything, this kind of regulation shows that attempting to regulate human behaviour is often a mistake. The solution to poor investment decisions is not regulation, but education.
The second risk is that of government intervention, particularly in the form of prescribed assets. Government is currently paving the way for fund managers to invest in infrastructure projects. This move may sound innocuous and, in its present form, very well may be. The fear, however, is that this requirement is just a small step away from compelling fund managers to invest in projects that ultimately lose money for their clients. Given the history of corruption associated to state projects this fear is not unfounded.
It would be unwise to diminish these fears - they are legitimate and could have severe consequences on retirement provisions. However, investors can mitigate their risks and move funds offshore without losing out on the benefits of retirement funds.
Through holistic, client-specific planning it is possible to achieve positive long-term results with retirement funds.
The risk is that investors blindly follow media advice and cash in retirement products – in the process incurring negative tax consequences - and move funds offshore.
To follow this trend currently means that funds are placed in offshore markets when they are at a near all-time highs and at the tail end of the longest bull run in history.
To achieve positive returns offshore, funds will need to be placed into Equity Markets as other assets in developed markets such as cash and bonds are yielding low or, in some cases, negative returns. The risk is that when these low-yielding markets recover, as they inevitably will, investors will have sacrificed the benefits and followed the herd headlong into long-term capital losses.
The benefits of retirement funds
There is no question that there are benefits to retirement funds. Contributions are tax-deductible up to a maximum of the lesser of R350 000, or 27.5%, of taxable income. This means that, if you are in the top tax bracket, you receive R0.45 deduction for every R1.00 invested. Other benefits include that no tax is levied on interest, capital growth or dividends; there is no estate duty or executor fees levied at death.
The below example (courtesy of Ninety One) illustrates the significant outperformance these compounding benefits create over time. The following scenario is based on the performance of the Ninety One Opportunity Fund:
For a term of 15 years ending 31 December 2020, R10 000 per month is invested in a Retirement Annuity (RA) while R5 500 per month (R10 000 – 45% Tax Saving) is portioned to a discretionary investment with both investments escalating at 5% per annum.
This scenario is based on the following assumptions: the R10 000 RA contribution is within the investor’s allowable deduction for retirement fund contributions; 20% of the fund’s generated return is of an income nature; the discretionary investment is taxed at 45%; the investor’s annual interest exemption has already been maximised and is not available in this case; and there are no fund disposals.
At the end of the 15-year term, the RA and the discretionary investment would be worth R4 867 324 and R2 541 623, respectively. Evidently, the investment increased by R2 325 701 or 91% over the term. This increase is attributable to the effect of compounding growth on the additional capital which awards the investor greater returns, the longer the investment horizon.
It could be argued that if not for Regulation 28, investors could have 100% of the fund asset allocation offshore. Although typically the MSCI World Index significantly outperforms the JSE on a pre-deduction basis, once the tax deductions have been factored in, the perspective of performance is widely different. In accordance with the above figures and assumptions, if, alternatively, 100% of the funds were to be invested offshore, the RA and discretionary values would be R2 200 604 and R1 875 923, respectively. This translates into a R324 681 or a 17% increase in the investment over the 15-year term. The comparatives speak for themselves.
Business markets exhibit cyclical trends and although offshore investments have outperformed South Africa’s local investments over the past ten years, the opposite is true for the previous decade.
From 2000 to 2010, the JSE All Share Index delivered growth margins of 18.2%pa while the MSCI World Index delivered -0.9%pa in Rands. Admittedly, South Africa has its problems, but so does the rest of the world and the JSE may very well outperform the MSCI yet again.
This scenario, however, illustrates only half of the picture. We need to be aware of post-retirement tax implications or those arising from the fund’s conversion to a living annuity. If this were the full picture you would still be better off due to the enhanced capital value of no tax being paid on interest, dividends and capital growth. The investor still receives the same tax and estate planning benefits as noted earlier; however, they are required to withdraw a fully taxable income.
I often hear the argument that this simply means that whatever you received as a deduction on the way in is now paid as income tax on the way out.
However, careful financial planning will delay or limit the withdrawal from the RA and instead utilise discretionary investments held in tax free savings accounts and endowments, the latter which are taxed at 30%. Sound financial planning will ensure that any income withdrawals from the living annuity are taxed at a rate substantially lower than the tax deduction received on investing.
Instead of a generic push to encourage investors to withdraw their retirement funds and transfer them offshore, investors should undergo a comprehensive financial planning exercise that takes their specific requirements into account. This plan should collectively utilise all available options including geographic and tactical asset allocation while also employing available tax structures to maximise long-term returns.
Retirement provision is one of the most critical aspects of every individual's investment portfolio. Planning for retirement is the most important thing you can do for your future today, partner with an NFB advisor today
| This article was originally published in The Herald