Retirement fund choices can be confusing. This week we explain how defined contribution provident funds work and how they compare with other retirement fund choices.
A defined contribution provident fund is similar to a defined contribution pension fund in that the contributions you and your employer make to the fund are set down, or defined, in your employment contract, and by the rules of the fund.
On the other hand, a defined contribution provident fund differs from a defined benefit pension fund in that the size of the benefit paid to you when you retire is not guaranteed.
Your employer guarantees to make a contribution to your provident fund, but does not guarantee you a pension.
If the investments made with your retirement fund savings perform poorly, you carry this loss. If they perform well, you pick up the benefit.
The big difference between a provident fund and a pension fund lies in the taxation. You cannot deduct your contributions against tax every year, but you can take your entire retirement savings as a lump sum when you retire.
You are not required to buy a monthly pension with the money.
Your contributions to the fund are also not taxed at retirement, but contributions made by your employer will be taxed.
How much does it cost?
The contributions to the fund, both by your employer and yourself, are fixed when you join the fund, or when you start employment.
The contributions of both yourself and your employer are calculated as a percentage of your pensionable salary, which normally excludes allowances, such as those for motor vehicles. While the percentage is constant, the size of contributions increases as your basic salary increases.
The ratios between what you and your employer contribute can vary.
With a provident fund your employer will normally, but not always, make the entire contribution. This is because your employer, not you, can claim the contributions as a tax deduction, but this means the portion of the amount you receive at retirement that came from your employer is taxable.
How your pension is calculated
A record is kept of exactly 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 can take the entire benefit in cash.
At retirement, your tax-free portion is calculated in the same way as for a defined contribution pension fund, but you can claim your own contributions, with a minimum of R24 000 as a deduction.
Further tax may be levied on any income generated from your investment, depending on how the income was generated, and your employer's contributions.
Unlike a defined benefit scheme, you cannot predict what your pension will be, as you cannot predict how much capital you will have when you retire.
Because you have to take the investment risk, you are normally given at least two investment choices.
The usual 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 has 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 will 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, members are increasingly being offered "umbrella" investments, which give you the choice as to what particular instruments to invest in (mainly unit trust funds). This, however, pushes up costs and exposes you to the risk of making the wrong decisions. Unless you have the time and expertise, this is an option best avoided.
An example of payment on retirement:
Length of service: 30 years
Your total contributions: R200 000
Plus employer's contributions: R200 000
Plus income and capital growth: R600 000
Pre-tax total: R1 000 000
(Tax is ignored in this calculation)
If you have been in a market-linked fund, it is normally best to switch to a guaranteed fund if markets are high and you are nearing retirement.
When you retire you if you do not want to take the lump sum and want to receive a monthly pension, you can buy a voluntary annuity. This can be structured in a number of ways, including in such a way as to give you an increase each year to take account of inflation, or in a way that will ensure that the pension is paid to your spouse after you die.
However, a guaranteed annuity in which you are guaranteed a pension for life, can also have a downside. This is because these annuities 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 lower.
In making the decision on where to buy an annuity, and in cases where a pension is bought for you individually from a life assurance company, you should ask your fund to provide quotations from various firms.
Advantages of defined contribution provident funds
- You may get a higher pension than you would have received from a defined benefit retirement fund as a result of good investment performance;
- At retirement you can invest the entire lump sum benefit as you see fit, giving you greater choices. You can buy an annuity of your choice and from any company you like, set up a post-retirement business and invest in a wider range of investments. In other words, you can control your investments yourself;
- If you live in a remote area with little infrastructure or where it is difficult to receive pension payments, a lump sum can be preferable; and
- As with a defined contribution pension fund, you have a greater say in the investments of contributions during your working life. However, here again, you need to be cautious about how you decide on the option most suitable for you.
Disadvantages of defined contribution provident funds
- The risk of having insufficient money to see you through retirement is yours. This risk is greatest with a provident fund.
Not only do you have the risk in the build-up of the fund, where investment returns will determine what you will receive at retirement, but you also need to make your money last you through retirement.
If it is poorly invested, you may find yourself destitute, particularly if you live for a long time. It is impossible for you to know how long your natural life will be, making it very difficult to decide how much money you will need for the rest of your life.
Therefore, it is best to use at least part of the money to purchase a pension, so that you are at least assured of a certain income until you die;
- Your contributions are not tax deductible;
- Your family may not receive much if you die young, or if you have to take early retirement because of ill-health, particularly when you are younger.
The reason for this is that you or your family will receive a pension based on your accumulated retirement savings at that point.
However, group life and disability benefits are normally better than for a defined benefit scheme. You need to take into account the structure of group life benefits. If there is a shortfall, particularly when you are younger, you may need to buy additional personal 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 24:
Umbrella retirement funds