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.
5. Investment choice
Consumers are being offered more and more investment portfolios. The choice can range from a simple managed portfolio with capital guarantees, invested across asset classes and in which you have no say in the investments, to a "fruit salad" of unit trust funds which you must select.
However, due to the volatility of investment markets in recent years, financial services companies have put together numerous investment portfolios that are aimed at minimising risk and beating inflation.
These portfolios come with various levels of risk. Most of these offerings also come with simple calculators to assess your risk profile. These risk profile calculators can be very misleading. Often they are based more on your psychological approach to risk than your actual financial ability to withstand investment risk. Consequently, people who are psychologically prepared to take high investment risks can land up without sufficient money on which to retire.
There are regulations, issued under the Pension Funds Act, which attempt to limit investment choice and therefore limit the risk to individual investors. These regulations are called the Prudential Investment Regulations (PIRs), and they restrict how much can be invested in the various asset classes, offshore and in specific sectors of the market and/or companies.
For example, no more than 75 percent of your money is allowed to be invested in shares and no more than 15 percent may be invested offshore.
The problem with these guidelines, however, is that they only apply at fund level and not to individuals. While some RA funds insist on applying the PIRs at fund and at individual level, others do not.
In other words, as a member of an RA fund, you may be able to choose an extremely high-risk portfolio, and invest 100 percent of your money offshore or 100 percent in shares.
As well as having a greater choice of investment portfolios/underlying investments, you are also free to switch between investment offerings at any time.
Before you opt for an RA that gives you a wide range of choices, you should consider the following factors:
- Cost. The greater the choice, the more it is likely to cost you, particularly if you switch between options on a regular basis.
- Expertise. Many people have lost huge amounts of money by continually switching into the investment flavour of the month, often because of poor financial advice. The switch often occurs when the sector is booming and they buy in at the top (remember the information technology bubble?). Then, when the sector collapses, investors sell out, only to jump into the next hot stock or sector.
On the other extreme, some investors opt for the most conservative portfolio, which reduces potential returns and the possibility of having a financially secure retirement.
There are a number of issues you should consider when making investment decisions. These include:
- Retirement saving is a long-term affair. Markets will fluctuate, but the trend historically has been up. Historically, shares have out-performed bonds and cash over the long term.
- You should be neither too aggressive nor too conservative. You should rather select a properly diversified, balanced portfolio in line with the PIRs. Obviously, the further you are from retirement, the more money you can - and should - invest in an aggressive portfolio.
- Costs. You are often charged higher costs if you opt for products that offer you a great deal of choice.
6. Preserving your retirement savings
If you leave or lose your job, you can transfer your retirement savings from an employer-sponsored fund to an RA.
If you leave an employer-sponsored pension or provident fund, you may have a number of choices. These are:
- You can take the cash, which will be taxed at your average rate of tax, and the first R1 800 will be tax-free. The average rate used will be the higher of the average rate in the tax year in which you leave your employer or the average rate in the year before your departure.
- If the rules of the fund permit, you can leave your retirement savings where they are and become what is known as a deferred pensioner. You will use the money to buy a pension when you retire, but neither you nor your previous employer will be able to make further contributions to your savings. You will, however, receive growth on your investment. There are no tax or cost consequences to deferring your pension. You will not be able to access the money until the date of normal retirement.
- If the rules of the fund permit, you can transfer your accumulated retirement savings to a fund sponsored by your new employer. There will be no tax or cost implications to transferring your savings. You need to check whether your years of membership of the previous fund will also count with the new fund.
- You can "warehouse" your retirement savings in a retirement product sold by a financial services company. You have a choice between a preservation fund or an RA fund. No tax is payable on the transfer (trans-location) of your savings to a preservation fund or an RA. However, you will incur investment costs, which can be as high as six or seven percent of your initial investment, and up to 2.5 percent a year thereafter, which is likely higher than the ongoing costs.
Before you choose either an RA or a preservation fund, you must understand the differences between the two. They are as follows:
* When you transfer your retirement savings to a preservation fund, you need to be aware that different circumstances dictate when you will be able to withdraw your savings from the preservation fund.
If you are unemployed, your retirement date is that of the pension or provident fund you left. If you join another pension or provident fund, the retirement age of that fund will apply. If you are employed, but you have not joined another pension or provident fund, the rules of the preservation fund will apply. In this case, you will normally be given a choice of retiring between the ages of 55 and 69.
If you transfer your retirement savings to an RA fund, the rules of the pension or provident fund you left do not determine when you can withdraw your benefits. You can withdraw them anytime between the age of 55 and 69.
* If you want to transfer your retirement savings to a preservation fund, your previous employer must be a "participating employer" before you make an application to join a preservation fund. This is an administrative requirement of SARS, and is met by your employer signing a declaration.
You do not need to involve your previous employer if you want to transfer your savings to an RA fund.
* In most cases, you can make additional contributions to an RA fund.
You cannot make additional contributions to a preservation fund, apart from adding lump sums from your employer-sponsored fund.
* With a preservation fund, the length of your contributory membership of the initial retirement fund is the main factor that determines the tax-free portion of any lump sum that you commute at retirement.
With an RA, only the years of membership of the RA will be taken into account in calculating the tax-free portion of a lump sum. In other words, your years of membership of the original pension or provident fund will not be taken into account.
* There are both pension preservation funds and provident preservation funds. If you were a member of a provident fund, you must transfer your savings to a provident preservation fund. If you were a member of a pension fund, you must transfer your savings to a pension preservation fund.
If you were a member of a provident fund, you should not transfer your savings to an RA, because those savings consist of after-tax money that would be taxed again at retirement. You should transfer your savings to a provident preservation fund so that you will not face double taxation.
* You are permitted to make one withdrawal from a preservation fund before retirement. That withdrawal may only take place after you have transferred your retirement capital to the preservation fund. Any deduction by your employer from the amount you transfer to a preservation fund - for example, to repay a loan, cover losses or to fulfil a maintenance or divorce order - counts as the one withdrawal from the fund. Once you have transferred your savings to an RA, you are not permitted to make any withdrawals before the age of 55.
* When you withdraw your savings from a retirement fund, you are allowed to place a portion of the money in a preservation fund and a portion in an RA. The transfer of benefits is not taxed. The portion transferred to the RA is not regarded as the single withdrawal you are permitted from a preservation fund.
In some cases, if you are dissatisfied with your RA fund - say, the administration, costs or something else - you can transfer your savings to another RA, tax-free.
However, Gordon says, the rules of your fund must allow you to transfer your money to another fund. Most RA funds only permit transfers after you have turned 55.
7. Protection from creditors
A limited number of institutions or people may claim money invested in your RA. They include SARS in the case of unpaid taxes and a previous spouse, but then only in terms of a court-approved divorce settlement.
The only time a creditor may lay claim to the money in an RA, or any other retirement savings vehicle, is when you retire, and then only from any lump-sum amount you are paid. A creditor may also not claim money that is paid to you as an annuity bought with the benefits of an RA. For this reason, you cannot borrow against an RA or use it as security for a loan.
8. What happens when you die
When you take out an RA, you should be asked to name a beneficiary or beneficiaries.
However, the beneficiaries whom you nominate will not necessarily receive the benefits. This is because, in terms of section 37c of the Pension Funds Act, the benefits from any registered retirement fund, including an RA fund, must be distributed first to the people who are dependent on you. This means that if you have nominated the proverbial cats' home as your beneficiary and not your spouse and six children who are dependent on you, the trustees of the RA fund have both a right and an obligation to ignore your request and pay the money to your dependants.
McCulloch warns that if you have no dependants, you must still nominate someone as a beneficiary or else the money will go into your estate. The Income Tax Act then limits the payment to a return of contributions plus a reasonable rate of interest - seven percent is the norm.
Your dependants are entitled to a limited cash lump sum (part of which will be tax-free), but must purchase an annuity with the rest of the benefit payout.
Gordon says no estate duty or capital gains tax is payable on your death on the portion of the benefit payout used to purchase an annuity. Your beneficiaries will pay tax on the monthly annuity at their marginal rate of taxation. Estate duty is payable on any lump sum portion of the benefit payout.
9. Should you include risk assurance cover?
You can combine risk life and disability assurance with an RA in a single policy. (No risk assurance can be linked to a preservation fund.) There are advantages and disadvantages to doing this. You need to consider the following issues:
- You can claim risk assurance premiums attached to an RA against your taxable income. However, you may still not exceed the limits for tax-deductible contributions to RAs. This means that in future when you may want to increase the savings portion of your RA, the premiums for the risk cover may no longer be claimable. So, you can only benefit from the tax deductions while the combined premium is less than the tax-deductible limit.
- On death, the life assurance benefit of an RA is taxable because the total contributions have been claimed as a tax deduction. The proceeds of a free-standing risk life policy are not taxable in the hands of your dependants, beneficiaries or estate. This is because premiums paid for such a policy cannot be claimed as a deduction against your taxable income.
- You cannot decide how the life benefit attached to an RA will be distributed. Although you may name beneficiaries, the proceeds must be distributed to dependants in terms of the Pension Funds Act.
In terms of the Income Tax Act, your accrued RA investments, as well as the risk benefits, are treated as a single amount and must be distributed as part lump sum and part pension. This means at least two-thirds will have to be used to buy a pension, while the tax structures for lump sums apply. The annuity portion will be taxed in the hands of the recipients at their marginal rate of taxation.
With free-standing risk life assurance, you decide on the beneficiaries and the entire amount is paid out as a tax-free lump sum.
- The life cover attached to an RA ceases on maturity of the RA. When your RA matures and your life cover ceases, you will be older and more likely to be in poorer health. These factors will count against you when you try to get life cover.
- You will be penalised if you reduce your premium or make the RA paid-up. There will be two consequences if you make the RA paid-up. Your accrued investment will be reduced by the amount of the penalty. Any remaining amount, if there is any, will be used to continue to pay the risk premiums, unless you specifically cancel the life cover as well. The penalty will then be larger as it will include the calculations on unrecouped costs on both the investment portion as well as the risk portion. If you do not cancel the risk cover, your risk cover will lapse when the accrued investment amount is used up.
This ability to draw down on your accrued investments to pay risk cover can be both an advantage and a disadvantage. If you have lost all sources of income, you will at least know you still have life cover, but this comes at the expense of your retirement savings. If and when you lose the life cover because the investment amount is used up, you then face the prospect of having to take out a new life policy.
- Your need for risk cover will change according to your lifestyle. For example, if you have children, you will need more cover when they are living with you than when they leave home.
You have more options and flexibility if you have a straight life policy. You can reduce the cover on the policy without incurring any penalties.
- Risk life assurance is becoming more competitive, and better and cheaper risk cover is being provided. You can cancel an ordinary life policy without any financial penalties being applied. There is no investment portion, so there is nothing a life assurance company can confiscate by way of penalties.
- As a general rule, you should keep your risk assurance separate from your investments.
10. Your rights
RA funds have to be approved by SARS and must be registered with the Financial Services Board (FSB) in terms of the Pension Funds Act. This Act provides you, as a member of an RA fund, with a fair amount of protection. You are also afforded protection under the Long Term Insurance Act, because in most cases when you join an RA fund you indirectly become a life assurance policyholder as well.
However, this distinction between being a RA fund member and a life assurance policyholder has become blurred in recent years. McCulloch says recent rulings by Vuyani Ngalwana, the Pension Funds Adjudicator, have focused the attention of trustees of RA funds on the distinction.
In terms of the Pension Funds Act, RA funds must have trustees, who tend to be appointed by the financial services company that established the fund. The trustees have a fiduciary (legal) duty to approve and amend the rules of the fund, ensure the money in the fund is properly managed and that the benefits are correctly paid out. You have no say in the election or appointment of the trustees, but it is becoming more common to have at least two independent trustees on the boards of RA funds.
If you have a problem with your RA fund, you can complain to:
- Ngalwana;
- Charles Pillai, the Financial Services Ombud (in cases of poor advice);
- Piet Nienaber, the Ombudsman for Long Term Insurance; and
- Jeff van Rooyen, the Registrar of Pension Funds and the chief executive of the FSB, which regulates the retirement industry.
Pension funds adjudicator rejects penalties
In a spate of determinations, Vuyani Ngalwana, the Pension Funds Adjudicator, has ruled that life assurance company-sponsored retirement annuity (RA) funds may not penalise you for reducing or stopping your contributions to RA funds.
The basis of Ngalwana's rulings is that the rules of an RA fund must provide for such penalties, which, he says, they do not.
He has also criticised life assurance companies for muddling the distinction between membership of an RA fund and the life assurance policy that is bought on behalf of an RA fund member from the life assurance company that sponsors the RA fund. Ngalwana says a member's contract is with the fund and not with the life assurance company.
Ngalwana has issued determinations against RA funds sponsored by Sanlam, Liberty Life and Old Mutual. The RA funds (and their sponsoring life companies) have appealed to the High Court against Ngalwana's rulings. They argue in their appeal documents that:
- Ngalwana does not have the jurisdiction to make the rulings. The life companies say that because life assurance policies were issued via their RA funds, the fund members' complaints should be heard by the Ombudsman for Long Term Insurance and not by the Pension Funds Adjudicator.
The ombudsman's office was set up by the life industry, while the adjudicator's office was established by statute.
- Complaints about penalties levied for reducing or stopping contributions are not defined in the Pension Funds Act.
Ngalwana has rejected both these arguments, saying the life assurance companies and their RA funds are using technicalities to appeal against his rulings.
This article was first published in Personal Finance magazine, 3rd Quarter 2005. See what's in our latest issue