Preservation Funds are a popular vehicle for preserving retirement savings and avoiding tax penalities when you change jobs or retirement schemes. But every financial product has its pitfalls. We look at the 10 things you should know before taking the plunge.
One of the main reasons why many people do not have enough money when they retire is that they tend to cash in their retirement savings on their journey through their working lives. Some people even resign from their jobs to be able to draw on their retirement savings.
Not only do you place a financially secure retirement at risk when you access retirement savings for other purposes, but you also face a tax penalty. Money drawn from a retirement fund is subject to tax, whereas, if you retain your retirement savings in an existing fund or transfer it to another legally accepted retirement savings vehicle, you can defer paying tax until you retire and then get a more favourable tax rate.
When you change jobs there are a number of ways you can preserve your retirement savings. These are:
* Leave the money where it is and take what is called a deferred pension. Your investment, if you are in a defined contribution fund, will continue to grow until your normal retirement date. If you are in a defined benefit fund, the rules of the fund will provide details of how your pension will be calculated at your normal retirement date;
* Transfer the money into the new retirement scheme you are joining if the rules of the new fund permit this;
* Put your retirement savings in a retirement annuity. A retirement annuity is essentially a retirement fund managed by a life assurance company. Ensure that the retirement annuity matures when you turn 55 to give yourself maximum flexibility. You can always extend the maturity date to any age up to your 70th birthday. You may not make any withdrawals from a retirement annuity until the age of 55 unless you need to take early retirement because of a medical condition; or
* Invest in a preservation fund.
If you choose the preservation fund route you must be aware of the consequences. The answers to the following questions will provide you with the most important facts.
1 What is a preservation fund?
A preservation fund is intended to preserve your retirement savings until the day you retire. You have two broad choices of products provided by the financial services industry:
* A traditional life assurance product, where you have generally lower investment risk and lower costs, but limited investment choice and flexibility. Your money is usually invested in a guaranteed investment portfolio, where your capital and some growth are guaranteed. The rest of the growth comes in the form of bonuses declared annually depending on investment performance.
There is a trend to offering wider choice, including investment portfolios linked directly to the value of the underlying investments, both locally and internationally. In this case, you pay an initial fee, which includes a commission to an intermediary, and ongoing management fees.
* Linked investment umbrella products offered by both life assurance companies and so-called linked investment companies. With these products, you are offered a wide range of underlying investment choices, mainly in unit trust funds and life assurance portfolios, and the ability to switch between the different underlying investments. Increasingly, investors are being offered a wrap fund choice, with an investment manager putting together the underlying combination. The costs of these products, including commissions, tend to be higher, particularly when wrap funds are included. The risk is also higher, as you are having to make investment decisions for yourself. You should consider this option only if you have some knowledge of investment markets, or have a financial adviser with exceptional investment skills.
2 Are there different preservation funds for pension and provident retirement funds?
Yes. If you transfer from a pension fund (defined benefit or defined contribution) you must invest in a pension preservation fund; from a provident fund, you invest in a provident preservation fund. The reason for this is that pension funds and provident funds are treated differently for tax purposes and give you different options when it comes to drawing your retirement benefits at retirement. With a pension fund, you must take a minimum of two thirds as a monthly pension and not more than one third as a lump-sum payment.
Incidentally, there is no such distinction with retirement annuities. All retirement annuities are treated as pension funds, so you must be particularly wary of transferring from a provident fund to a retirement annuity. You could lose tax benefits, but even more importantly, you will not be able to withdraw all your money as a single lump sum at retirement, as you can with provident funds.
3 Can you make additional contributions?
No. Unlike a retirement annuity, a preservation fund does not offer you the option of making additional contributions. Each time you change jobs, you have to open a new preservation fund. The main reason for this is that the benefit rules of the original pension fund from which you transferred the money apply to your investments in the preservation fund.
4 Are there tax advantages?
There are two main advantages to placing retirement savings in a preservation fund. The first is that you do not have to pay any tax when you withdraw the money from the existing fund and transfer it to the preservation fund.
The second is that at retirement you will get the normal preferential tax rate based on the period when you were a member of the original fund and the preservation fund. Remember that contributions to a pension fund are tax-deductible. So although you will eventually pay tax on your retirement savings when you draw the money at retirement, in the meantime you are getting investment growth on money that would have gone into the taxman's pocket. Deferred tax is money earned. When you retire, any lump sum you withdraw is taxed at your preferential average rate of tax and not the higher marginal rate of tax, with the first R120 000 of the lump sum tax-free.
5 Can you make withdrawals?
Unlike a retirement annuity, from which, under normal circumstances, you cannot make any withdrawals before the maturity date (the earliest date is age 55), a preservation fund does allow you one withdrawal. This single withdrawal can be all or a part of your retirement savings in the fund. You are allowed up to R1 800 tax-free and the balance is taxed at your average rate of tax. The withdrawal may be made only after you have transferred to the fund. Many people believe that you can make the R1 800 withdrawal and then a further withdrawal. This is incorrect.
The facility of one withdrawal is designed to take account of life crises when you may urgently require the money. It is a safety net that should be used with caution. When you withdraw money from any retirement savings vehicle you should immediately make plans to repay it. Remember that very few employer funds will provide you with sufficient money for a financially comfortable retirement and you will probably always need to make additional retirement savings.
6 What if you withdraw from your retirement savings before investing in a fund?
If you take any portion of the money in an existing fund you are not permitted to transfer the balance to a preservation fund. Your only option is to transfer the balance to a retirement annuity. The only exceptions to this rule are:
* When you owe the company money - for example, on a housing loan - and the employer recovers the debt from your pension savings in accordance with the terms of the Pension Funds Act;
* When a portion of the money has been transferred to a retirement annuity; or
* Where the benefit has been reduced in terms of a divorce settlement.
The deduction of any of these amounts is counted as the one withdrawal you are permitted. You will not be allowed a further withdrawal.
7 When can you draw your retirement money to use as a pension?
A preservation fund does not stipulate the maturity date of your retirement benefits - the rules of your original fund apply. So if the rules of the original fund allowed retirement at age 60, the same will apply to your preservation fund. This is another significant difference between a preservation fund and a retirement annuity, which can mature at any age between 55 and 70, depending on your choice when you make the investment.
8 Can you gain by splitting transferred benefits between a preservation fund and an annuity?
Yes, particularly if you are planning to retire at a younger age. If your original fund set your retirement age at say 65, you would be due to receive your benefits from the preservation fund at age 65 too. However, if you split the benefits between the two, you can get the advantages of both - including maturing the retirement annuity at age 55 - although you lose the single withdrawal benefit of the preservation fund.
9 Can you take a loan or use a preservation fund as collateral?
No. As with all retirement savings vehicles, preservation funds cannot be used as security for a loan and may not issue loans. At the same time, no creditor can claim any money you have saved in a preservation fund. This is the government's way of trying to ensure that you will have money to live on when you retire.
10 Can civil servants transfer money to a preservation fund?
Civil servants must be cautious about preservation funds. Until recently, all civil servants received their entire one-third lump-sum benefit payment tax-free. However, in March 1998 retirement savings ceased to be exempt from tax. If a civil servant transfers to a preservation fund, the tax exemption that still applies to the pre-March 1998 portion of retirement savings is lost and the lump-sum benefit at retirement is subject to taxation as it would be for anyone else. So anyone who joined the civil service before March 1998 should not transfer to a preservation fund.
This article was first published
in the January 2001 issue of Personal Finance magazine. See what's in our latest issue