Retirement fund choices can be confusing. We look at defined contribution pension funds as one of the choices you can use to build up retirement savings.
A defined contribution pension fund (also known as a money purchase scheme) is what the name suggests. The contributions made to the fund are set down, or defined, in your employment contract and by the rules of the fund.
A defined contribution pension fund is similar to a defined benefit pension fund, with one significant difference: your pension or benefit when you retire is not guaranteed.
Your employer guarantees to make a contribution to your retirement fund, but does not guarantee you a pension.
If the investments from your retirement fund savings perform poorly, you carry the loss. If they perform well, you benefit.
How much does it cost?
The contributions that both you and your employer make to the fund, are fixed when you join the fund, or when you start work. The contributions both you and your employer make are calculated as a percentage of your pensionable salary. This normally excludes allowances, such as car allowances. The ratios of what you and your employer contribute can vary. Normally you pay and your employer each pay about six percent of your pensionable salary.
How is my pension calculated?
A record is kept of how much you and your employer have paid into the fund, as well as the capital and income growth of the investment from the contributions.
When you retire, you are obliged by law to purchase a pension with at least two-thirds of the accumulated savings. Up to one-third of the benefit may be taken in cash.
However, because you cannot predict how much capital you will have when you retire, you cannot predict what your pension will be.
You take the investment risk that you will have sufficient funds on which to retire. When you join a defined contribution fund, you are normally given at least two choices of how your money will be invested. The most common ones are:
- Guaranteed: Here your capital is guaranteed as well as some growth. You get additional growth by way of annual bonuses, which are based on the market performance of the underlying investments.
Bonuses come in two forms: vesting (which cannot be taken away once given); and non-vesting (which can be taken away if the life assurance company giving the guarantees is having an extremely bad time in investing).
- Market linked: Here your retirement fund savings are worth exactly the same as the underlying investments. If the value of the underlying investments goes up by 40 percent, so will your retirement savings. But if there is a market crash, your retirement savings diminish in value.
Market-linked investments also come with choices. The main market-linked option is one where you have no say in the investments. The fund trustees hand over the money to an asset manager with instructions about how they would like to see the money invested. However, increasingly members are being offered "umbrella" investments where they can choose the underlying investments (mainly unit trust funds). This does, however, push up costs and exposes you to making incorrect decisions. Unless you have the time and the expertise, this option is best avoided.
It is normally best to switch to a guaranteed fund when markets are high and you are nearing retirement.
When you retire you will have to buy a pension. Depending on the rules of your fund, you may be given a wide range of choices, such as: a pension provided by your fund; buying an annuity (pension) from a life assurance company; a wide range of guaranteed annuities; or a living annuity, where you take the risk of your retirement savings lasting you until you die. Guaranteed annuities can also have a downside as they are based on interest rates.
If long-term interest rates are high, you will receive a better pension; but if interest rates are low, then your pension will also be low. When it comes to buying an annuity from a life assurance company, you should ask your fund to provide you with quotations from various firms.
As with a defined benefit scheme, you are allowed to take one-third of your accumulated retirement funds as a lump sum. So, if you have accumulated R1 million in retirement capital, you are allowed R333 333 as a lump sum. The lump sum is subject to tax.
An example of payment on retirement:
Length of service: 30 years
Your total contributions: R200 000
Plus employer's contributions: R200 000
Plus income, capital growth: R600 000
Total: R1 million
One-third lump sum: R333 333
You buy your pension with remaining R666 667 (Tax is ignored for the purposes of this calculation.)
Advantages of a defined contribution pension scheme:
- As a result of good investments, you may have the advantage of a higher pension than you would have received from a defined benefit retirement fund.
- You have a greater say in the investment of your funds, with increasing choices being given to members.
Investment choices should be carefully considered. For example, if you choose the market-linked option and the markets collapse the day before you retire, you could be in dire straits, as you would be paid out your retirement capital on the ruling prices or values. If you had chosen the guaranteed category, the bump would have been taken out, as you would have received the average growth of the past years.
As a general rule, you should consider swapping into a guaranteed fund some years before retirement, particularly if you are considering early retirement, such as for reasons of poor health, or even if you are considering resigning. Normally, you are allowed to make this choice on an annual basis. You need to check the rules of your fund. This requires early planning.
- Your contributions are tax deductible. Tax is deferred until benefits are received, and the lump sum is taxed (after an initial tax-free amount) at your beneficial average rate of tax, rather than the harsher marginal rate. The monthly pension is taxed at your marginal rate.
Disadvantages of a defined contribution pension scheme:
- You take the investment risk. In other words, you do not know what you will receive when you go on pension. If the markets collapse, you have to find the extra money to make up any shortfall in the pension you require. If markets had continued to perform the way they did in the nineties, then you might very well have a better pension than you would have received from a defined benefit pension scheme. Remember, however, that when markets go sour, as they did last year, your pension benefits can also be undermined.
- There are seldom guarantees that your pension payments will keep up with inflation. If guarantees are provided, particularly when an individual pension is bought from an assurer, it comes at the cost of a lower benefit, that is: your pension will start at a lower point, but will increase in line with inflation. In the case where the employer provides the pension directly, increases are normally dependent on the excess investment income of the fund. The decision on whether to increase pensions is taken by the board of trustees of the fund.
- Your family may not be better off if you die or have to take early retirement because of ill-health while still employed, particularly when you are younger.
The reason for this is that you and your family receive a pension based on what you have accumulated - not on what you may have received at retirement age.
However, group life and disability benefits are normally better than in a defined benefit scheme. Take into account the structure of the group life benefits. If there is a shortfall, particularly when you are younger you may need to buy additional disability and life assurance for a limited period; and
- Aids could have a significant impact if your employer is forced to increase payments for group life cover and reduce payments towards your retirement funding.
Part 23:
Defined contribution provident funds