In spite of all the bad things you may have read about retirement annuities (RAs), they are essential investment vehicles for most people - provided, of course, you understand what they are and how to derive the maximum benefit from them. We outline the 10 most important things you need to know about RAs.
Retirement annuities (RAs) have received a bad press in recent months. But this does not mean they have become no-nos. RAs have a key role to play in the financial planning of most people.
The bad publicity surrounding RAs is the result of three things:
- The life assurance industry charges high costs on RA investments. This was brought to light late last year.
- Life assurance companies impose one-sided and unfair contract conditions on policyholders. These conditions often result in significant reductions in your retirement savings, such as has been the case with the penalties imposed on RA members' savings when they have reduced or stopped their contributions.
- Rulings by the Pension Funds Adjudicator against RA funds which have applied punitive penalties on members' savings.
Instead of deterring you from investing in RAs, the bad publicity highlights how important it is that you understand RAs and are aware of the potential pitfalls associated with these products.
1. What is an RA?
An RA is often referred to as a "policy". Legally, an RA is not a policy. When you take out an RA, you are, in fact, signing up for membership of a pension fund, which is administered in terms of the rules of the fund and governed by the Pension Funds Act.
Unlike an employer-sponsored pension fund, which has restricted membership, any individual under the age of 70 may join an RA fund.
When you become a member of an RA fund, the fund makes investments on your behalf, normally purchasing a life assurance policy from the life company that set up the RA fund. Usually, the life company that established the fund also administers the fund.
Alan McCulloch, the chairman of the Liberty Life-sponsored Lifestyle Retirement Annuity Fund, says a single life assurance policy may be bought for all the members of the RA fund, in which case the members receive a document that is little more than a certificate of membership. Alternatively, individual policies may also be bought by the fund.
With non-life assurance RA funds, such as those offered by some unit trust companies, you will be a member of the fund only and will receive a membership certificate.
The life assurance policy bought on your behalf is not the same as a normal endowment policy, because it is structured to take advantage of the tax incentives provided by the government to encourage you to save for retirement.
However, an RA is similar to a defined contribution pension fund, because at retirement you will have to use at least two-thirds of your savings to buy an annuity (a pension).
RAs were introduced to South Africa in 1960 to give self-employed people similar tax incentives to save for retirement as those enjoyed by members of employer-sponsored pension funds. However, this does not mean that only self-employed people can use RAs to save for retirement. People who are members of employer-sponsored provident or pension funds can also join RA funds. In fact, it is advisable that every member of an employer-sponsored retirement fund also contributes to an RA, because most employer-sponsored funds will not provide you with sufficient income in retirement to maintain your pre-retirement standard of living.
However, Jenny Gordon, a senior legal adviser at Old Mutual, warns that you should only contribute to an RA if you will receive a tax advantage. If you contribute to an RA using money that has already been taxed, you will pay tax on the money again when your RA matures.
McCulloch says that membership of an RA fund is no substitute for contributing to an employer-sponsored fund. He says an RA should be used "to supplement an employer-sponsored fund". The reasons include the fact that the total (employer plus employee) tax-deductible contributions to an employer-sponsored fund are greater than the tax-deductible contributions to an RA fund.
Gordon says you must also remember that when your RA matures, you are obliged to buy a monthly pension with at least two-thirds of the lump-sum payout from your RA. "An RA is a trade-off. The state gives us tax concessions as an incentive to save. Therefore it places limitations on what we can do with that money," Gordon says.
2. Tax advantages of an RA
One of the main reasons to use an RA is the tax advantage, both in the build-up to retirement, as well as in retirement. One tax structure applies when you use an RA to save for retirement, and another when you use the proceeds of an RA to buy an annuity (a pension).
Tax on your contributions to an RA
Up to certain limits, you do not pay tax on the money you contribute to an RA, whereas contributions to an endowment policy are made with after-tax money. When you contribute to an RA, you defer payment of tax on your contributions until you retire and are paid the proceeds of the RA.
This deferment of tax is beneficial in a number of ways. In most cases, when you retire, your marginal and therefore you average income tax rate is lower than when you were working. You are also entitled to certain tax deductions on lump sums paid to you by your RA fund at retirement.
Your contributions to an RA are deductible from your taxable income within certain limits. Your contributions can exceed these limits, but you will not get the tax advantage on the amounts above the limits. Each tax year in which you contribute to an RA, you can claim as a tax deduction the greater of:
- 15 percent of your taxable income, excluding your pensionable income, before other tax deductions; or
- R3 500 less your current contributions to a pension fund; or
- R1 750.
If you contribute more than these limits, you may claim the amounts that exceed the limits in future tax years, provided your contributions in the years in which you claim remain within the limits. Excess contributions may also be added to the tax-free portion of the lump sum you receive at retirement or when your RA matures.
If you are a member of an employer-sponsored or a trade union-sponsored retirement fund, the limit of "15 percent of your taxable income, excluding your pensionable income," is important if you want to contribute to an RA.
As an employee, your salary is made up of two main parts for the purposes of retirement taxation: your pensionable income and your non-pensionable income.
Your pensionable income is normally your basic salary, excluding any allowances, such as a car allowance. Most employers use only your basic salary to calculate how much they will contribute to your pension savings. Some, but very few, employers make pension contributions based on their employees' gross pay packages (basic pay plus all allowances).
So, your "pensionable income" is the portion of your income that employers use to calculate how much they will contribute to a company-sponsored pension or provident fund.
After deducting your pensionable income from your gross income, you can contribute 15 percent of the balance to an RA and deduct that amount from your taxable income.
Your non-pensionable income is any income you earn that your employer does not take into account when contributing to a company-sponsored pension or provident fund. Non-pensionable income can include allowances paid by an employer, such as your car allowance (but only the portion not claimed as a deductible expense for business travel) and taxable income from other investments (for example, rental income from a second property).
You can reduce your non-pensionable taxable income by contributing 15 percent of non-pensionable income to an RA. In other words, the contributions are deducted from your taxable income, with the result that you pay less tax. If you are on the top marginal tax rate of 40 percent, instead of paying 40 cents in every rand you earn in tax, you will be saving 40 cents on every rand you contribute to your RA. You will also receive investment growth on each of those 40 cents that you save.
Tax on your investments in an RA
The investment build-up on your retirement savings is not entirely tax-free. In 1998, the government introduced Retirement Fund Tax. This is a tax on the interest, foreign dividends and net rental income (any rent on property investments less the costs) earned by any retirement fund, including RAs. Life assurers pay this tax on your behalf at a rate of 18 percent a year.
Tax on your RA benefits
When you retire, the benefits from your RA will be subject to tax. You must take two taxation issues into account. These are tax on your lump-sum payout and tax on your monthly annuity.
1. Lump-sum taxation
When your RA matures, you may take one-third as a lump sum and spend it as you wish. You must use the remaining two-thirds to buy a compulsory purchase annuity (a monthly pension).
The tax-free portion of your lump-sum payout from your RA is calculated on the number of years that you have been a member of the fund, multiplied by R4 500. So, if you have been a member of an RA fund for 40 years, you will receive R180 000 tax-free (that is, 40 x R4 500). There is, however, one condition to this: You do not receive the tax-free amount twice.
There is no limit to the number of RA funds that you may join. However, the tax-free portion takes account of all your retirement savings, including your pension fund. You cannot claim it on each source of retirement savings.
As the above calculation indicates, it is to your advantage to join an RA as early as possible so that you derive the maximum tax benefit.
The balance of any lump sum you withdraw in excess of the tax-free amount (from all retirement sources) is taxed at your average rate of tax. The average rate used is the higher of the average rate in the tax year in which you retire or the average rate in the year preceding your retirement. (Your average rate of tax is lower than your marginal rate of tax.)
As a general rule, you should take the entire tax-free portion of the one-third lump sum, even if you do not need the money, and reinvest it. You should avoid withdrawing more than the tax-free portion of your one-third lump sum, because you will lose the benefits of deferring tax on this money.
2. Tax on your annuity (monthly pension)
The minimum of two-thirds you must use to buy a monthly pension is not taxed as a lump sum when you retire. However, the annuity you buy is taxed as income, as and when you receive the money.
Your income in retirement from all sources, including your RA, is taxed at your marginal rate. So, both the capital (on which you did not pay tax when you were saving for your retirement), as well as any growth on the accumulated savings will be taxed at your marginal rate of tax when you receive your pension. You are still able to get investment growth on, and defer tax on, the balance of your retirement capital.
Some tips
- The 18 percent Retirement Fund Tax is not levied on the portion of your retirement savings you use to buy an annuity after you retire.
- A husband and wife are taxed separately and can each take advantage of the tax breaks in an RA.
- If you stop paying your premiums on your RA and resume paying them later to make up for the shortfall, you may deduct R1 800 a year from your taxable income as reinstatement RA contributions.
- If you have spare money towards the end of a tax year (February), you should sit down (with a financial adviser if you are not sure of how this works) and calculate the maximum that you can contribute to retirement savings investments to take full advantage of the tax breaks associated with adding a lump sum to your RA fund.
Most employer-sponsored retirement funds do not allow you to contribute additional lump sums to boost your retirement savings. If you are already contributing 7.5 percent of your pensionable salary to the fund, there will be no point in making additional contributions as you will not derive a tax advantage. You should check with your fund whether top-ups are permissible. Most RAs, however, do allow you to make lump-sum contributions to the fund.
3. The term of an RA
The period (term) for which you sign up for a life assurance RA is one of the issues over which you must take great care. As a result of bad advice from often unscrupulous financial advisers and representatives of the life assurance industry, many people have, to their detriment, signed up for membership of RA funds for excessive terms.
The government has set two restrictions on the term for which you can belong to an RA fund. These are:
- Earliest retirement date. You cannot draw on or surrender an RA until you are 55, unless you are disabled. In other words, 55 is your earliest retirement date. You can extend the period beyond 55, but you cannot access your money before you reach 55, unless you qualify for an ill-health pension. If you stop paying premiums, the money will remain invested until you are at least 55 years old. This is to ensure that your money is kept for retirement.
- Maximum RA contribution period. You may not contribute to an RA past the age of 69. The government regards 69 as the latest age by which you should retire. This maximum is to prevent you deferring tax until you die, to the benefit of your heirs.
If you are a member of an employer-sponsored pension fund, you have to retire as a contributing member of your fund on the day that you retire from your job.
But, you can retire from an RA fund at any stage between the ages of 55 and 69, whether you are still working or not. In fact, from a tax point of view it is often worth delaying retirement from an RA as late as possible for a number of reasons, particularly if you belong to an employer-sponsored retirement fund. The reasons for delaying retirement from an RA include:
- You can continue to claim your contributions to an RA against your taxable income until the age of 69;
- You have the potential to increase the tax-free portion of your lump sum, although the amount will be quite small; and
- Your marginal rate of taxation, and therefore your average rate of taxation, is often lower in retirement. This means that any amount you take as a lump sum, in excess of the tax-free amount, could be taxed at a lower rate than would have been the case if you retired simultaneously from your employer-sponsored fund and your RA. However, there must be an interval of two years between the two retirement dates for you to benefit from a lower average tax rate.
Unscrupulous advisers and life assurance companies have often deliberately misinterpreted the minimum and maximum contribution periods of an RA set by the South African Revenue Service (SARS).
The life companies claim they only encouraged people to take out long-term policies so that you did, in fact, save for retirement.
If you join an RA fund when you are, say, 20 years old, this does not mean that you have to commit to paying premiums until 55 or, even worse, until 69. You do have to remain a member of the fund until at least 55, but you do not have to be a contributing member of the fund for the longest possible term.
In most cases, you can limit your contractual premium payments to five years or pay a single-premium lump sum.
Tax law requirements do not dictate how much you should pay in premiums, how often you should pay premiums, or that you must pay premiums until age 55. The tax requirements only dictate that you may not withdraw money from an RA before the age of 55.
This does not imply that you should not save aggressively for retirement, making full use of all the available tax breaks. It does mean that you must protect yourself from the confiscatory penalties that life assurance companies apply if, through no fault of your own, you cannot continue to make contributions to your RA fund.
Commission
Many people were encouraged to take membership contracts of RAs underwritten by life companies up until the age of 55 or older because of the way that commission is paid to financial advisers selling RAs.
On a life assurance underwritten RA, advisers are normally paid commission based on the number of years of the contract multiplied by the premiums multiplied by three percent, with a maximum of 75 percent of the first year's premium paid in the first year of the contract. In the second year, the adviser receives one-third of the commission paid in the first year. So, there is an obvious incentive to get you to sign up for the longest possible term.
You may not realise it, but you are affected by the way commission is calculated and paid to advisers by life assurance companies.
The life assurance company effectively gives you a "loan" to pay the commission and other costs associated with issuing an RA. Commission makes up at least half of this "loan", which life assurers often refer to as the "unrecouped costs". Part of your premium goes to pay off this loan. Interest is also charged on the loan. The interest rate varies between life assurance companies, but some life assurers charge close to the maximum permitted in terms of the Usury Act. The consequence of this is that less of your money is going towards your retirement savings.
If your financial circumstances change, and you decide to reduce your RA premiums or stop paying them altogether, the life assurance company will deduct this outstanding "loan" - or unrecouped costs - from the value of your investment. Life assurers often add on other costs - even future profits that they expected to make from your policy. The amount appears to be entirely at the discretion of the life companies. The "confiscatory" penalty may be even greater than your accumulated savings - this is particularly likely in the early years of your membership of an RA. The life assurance industry euphemistically calls the penalty a "benefit reduction".
You cannot foretell the future and neither can your financial adviser, the RA fund or the life assurance company issuing the RA. You may not be able to continue paying the premiums on an RA for any number of reasons, from losing your job to your business going bankrupt. Working women are particularly vulnerable as they often take time off to have children and cannot afford to continue paying their premiums.
RA premiums may also become unaffordable for people who change employers and become obliged to join the retirement fund sponsored by their new employer. Often they cannot afford to belong to both the employer-sponsored fund and an RA fund, and have no choice but to stop contributing to their RAs.
The advantage of unit trust RAs that are not under-written by a life assurance company is that, in most cases, commissions and other costs are only deducted as and when you pay the premiums. As a result, you can reduce or stop paying your contributions without incurring any penalties.
Avoid being stung by commission
There are a number of ways you can prevent yourself from becoming a victim of confiscatory penalties and perverse commission structures of RA funds sold by life assurance companies.
- As a general rule, you should not sign a contract for more than 10 years, or beyond the age of 55. When the contract period is reached, you can always extend it for another five or 10 years.
However, you should establish the terms for extending a contract to ensure that additional costs are not loaded on to your policy.
- Insist that commission is only paid as and when you pay your premiums, as is the case in the unit trust industry. There are RA products on the market that allow for this. They include:
* So-called new generation RA products. With these products, you are given the option to pay commission upfront or as and when you pay your premiums. But you must still be wary of these products because they can be costly, particularly if they offer you the choice of a wide range of underlying investments, which you may not really need, and if they add fees for investment performance. You should also be wary of products on which financial advisers are paid both commission on your premiums and a fee based on a percentage of your accumulated RA savings.
* Unit trust RAs. A number of unit trust management companies and linked investment services product companies (LISPs) provide RAs that have the same cost and commission structures as unit trust products that permit you to change your contributions without incurring penalties. Unit trust companies and LISPs sometimes "borrow" a life licence to avoid setting up their own funds, but they are entitled register an RA fund of their own.
LISPs are essentially investment administration companies that provide products, including RAs, that allow you to choose from a wide range of underlying investments from a number of different companies, mainly unit trust companies. LISPs normally pay part of the commission upfront, based on the contribution, and part as an annual fee, based on a percentage of your accumulated savings. Again, you must exercise care when dealing with LISPs. They have developed a poor reputation for protecting your interests and, apart from their often excessive commission/fee structures, provide sales people with perverse incentives to sell, such as luxury foreign trips.
- Establish whether you are being issued with a "loan" on which costs and interest are being charged. If the interest rate is above what you would pay on a home loan, do not sign up for membership.
- Establish the exact criteria, in writing, for any penalties that may be applied if you have to reduce or stop paying your premiums.
4. The costs
There will always be costs associated with investing. The issue is the quantum of the costs and whether you are receiving value for money.
The issue of the costs levied on retirement products has come under scrutiny since independent actuary Rob Rusconi presented a paper on the subject at the annual conference of the Actuarial Society of South Africa last year. Rusconi's argument was not that the costs were not justified, but that the level of costs was not justified.
His research showed that retirement funding costs are extremely high in South Africa, particularly on life assurance products. He posed the question of how much more money people would have for their retirement if the costs were lower.
The issue was taken up by Parliament's Portfolio Committee on Finance and filtered through to the National Treasury, which is redrafting the Pension Funds Act. Since the government focused its attention on the issue, the life assurance industry has been under pressure to come up with better low-cost products that do not include confiscatory penalties if you reduce your contributions.
One of the problems with costs is that RA product providers manage to conceal the real impact of costs. When they do disclose these costs, they do so in a number of confusing ways to ensure that you will not have a clue what you are actually paying.
It is important that you insist on costs being disclosed to you in various ways.
Costs should be fully disclosed and limited. In other words, they should not be left to the future discretion of a life company. The costs should be disclosed as initial and on-going and in three ways:
- In rands;
- As a percentage of premiums; and
- On a reduced-yield basis.
The reduced-yield method is a simple way of showing the impact of costs.
To calculate costs on a reduced-yield basis, take the total amount you would pay in premiums over the contractual period and then deduct the total costs.
It is also best to use an assumed growth rate, particularly if the costs include investment performance fees. If you are being charged a performance fee, you should assume different growth rates of, say, five, 10 and 15 percent, so that you can see the effect that the performance fees will have on your investment.
You must get a full list of all costs, including all underlying costs that may be involved in complex investment structures.
It is important that you compare the cost structures of the products offered by different companies.
Here is a table that you should have your financial adviser complete:
- List all costs/fees:
* Commissions/advice fees
* Administration fees
* Policy fees
* Asset management fees
* Underlying asset management fees
* Performance fees
* Other fees
- Initial costs:
* As a percentage of premiums
* As a rand amount
* Annual (on-going) costs:
* As a percentage of assets
* As a rand amount
- Reduction in yield calculation:
* Total amount invested
* Less total costs paid in rands
* Annual percentage reduction-in-yield
This article was first published in Personal Finance magazine, 3rd Quarter 2005. See what's in our latest issue