We continue with your strategy for surviving retirement - Part 2 of the story, Income for life.
OPTION 2: INCOME PRODUCTS
Linked investment product companies offer income products that allow you to choose the underlying investments. However, if you use these products, bear in mind that you could pay higher costs and commission than you would with, say, a single investment in a unit trust income product. You must also ask whether you really need the investment options provided.
OPTION 3: MONEY MARKET INSTRUMENTS
There are a number of money market instruments, but the main ones are money market investments, treasury bills and negotiable certificates of deposits (NCDs). From an investment point of view, you could also add bank term deposits, although these are not really money market instruments. The money market consists of investments where money is lent and borrowed for a period of less than 12 months and is traded on the wholesale market. As a result, large sums of money are required, from R20 000 for money market funds, through to millions on treasury bills.
Money market investments:
This type of investment is relatively new in South Africa and has yet to reach the level of sophistication achieved in many other countries. Money market investments are available in two forms: bank accounts and unit trust funds. In effect, a money market fund is a pooling of the money of small investors to obtain commercial or wholesale interest rates. Apart from receiving higher interest, another significant advantage is being able to access your money at relatively short notice - normally between 24 and 48 hours.
Interest rates on money market accounts are variable and will move in line with the prime lending rate. However, rates vary between accounts and you need to check the rates as well as how interest is paid. For example, if you receive the interest in advance, credited monthly, you receive more than if interest is paid in arrears and credited quarterly, even when the same rate is quoted.
Money market investments have two main uses:
1. Generating an income: You can use a money market account to generate an income. Your capital is fairly secure and would only really come under threat if the bank went bust or there was a big failure of borrowers to repay debt.
2. Parking zone: If you have a large lump sum of money, you should always phase the money into underlying investments - particularly investments in the equity market - over six to 12 months, to take out the bumps in market volatility. You can use a money market account within a living annuity to generate an income or to phase in investments. However, be aware that some companies offering money market accounts within living annuities do not offer competitive rates.
If you are phasing fully discretionary money into an income-producing vehicle with underlying investment choices, such as a voluntary annuity, you should take account of the cost and tax implications of doing this from a money market fund outside the vehicle. If you do it from within the vehicle you pay higher costs, but tax savings could be greater.
Negotiable Certificates of Deposit (NCD):
NCDs are issued by banks for periods ranging from 30 days to 360 days with fixed rates of interest that are normally higher than those of term fixed deposits. The minimum investment amount tends to be about R20 000. If you need the money before the maturity date, NCDs can be "sold" to other investors at a discount.
Treasury Bills (TBs):
These are short-term loans made by the government, normally for 91 days. TBs have a date of issue and of expiry and a nominal value. They do not contain an interest rate because they are normally sold by tender to institutions. They vary in amounts from R10 000 to numerous millions and are available through money market investments.
Bank term deposits:
As with NCDs and TBs, the advantage of bank term deposits over money market investments is that you have certainty of interest rates for the period. They have the advantage over all three money market instruments of allowing you to invest relatively small amounts of money.
Note: Interest income is taxable in your hands, apart from the first R10 000 if you are under the age of 65; and R15 000 if you are over the age of 65. The exemption applies to the total interest you earn.
OPTION 4: UNIT TRUST INCOME FUNDS
Income funds are unit trusts that invest in a selection of capital and money market instruments. An income fund is suitable for investors seeking the maximum level of income from their investments. It offers investors a good yield and some security, but your capital is not guaranteed, as capital market instruments can also suffer capital losses.
Unlike fixed deposits, these investments are very liquid and it is easy for investors to get hold of their money. There is no lock-up period, as unit trust companies normally require only a two-day notice period for withdrawals. The income earned by an income fund is paid out quarterly in arrears.
Unlike fixed deposits, these funds do not offer a fixed interest rate and the rate fluctuates as the yield on the underlying portfolio of investments fluctuates. Interest earned is fully taxable in the hands of the investor, but you will not be taxed on the first R10 000 (if you are younger than 65) and R15 000 (if you are 65 or older) of interest you earn in any tax year.
It is possible for an income fund to record capital growth. However, this will depend on the fund's exposure to the capital market and how these instruments perform.
Not so taxing
Don't be scared off by the prospect of paying tax on interest-earning investments in retirement. In recent years, Finance Minister Trevor Manuel has significantly improved the situation of people living off interest-earning investments.
- Marginal tax rates have eased, particularly for lower- to middle-income individual taxpayers;
- The threshold before you have to pay tax is R30 000 a year if you are under the age of 65 and R47 222 if you are over the age of 65.
- The primary tax rebate has been significantly increased to R5 400 for individuals under 65, while for anyone over 65, the total rebate is R8 500.
- Tax-free interest allowances for the under-65s have been increased to R10 000 and for the over-65s to R15 000.
So, if you are over 65, this means you can have an income stream of R62 222 a year without paying tax. You can double that figure if the income can be attributed to two pensioners, husband and wife or partners.
OPTION 5: PROPERTY
Property is both an interest-earning (rent) and a capital growth investment (its underlying value can increase). A property investment can be much more than buying your own home. These are the various options:
- Residential property, where you own a property, but someone else pays you rent to live in it.
- Commercial or industrial property, where you own the property and a business pays you rent.
- Mortgage participation bonds, where you lend money to someone to buy property. A financial services company seeks out people needing money to buy property and investors to lend the money. The interest rates paid are normally competitive and often better than money market funds. You can invest as little as R5 000, but your money is tied up for five years. These pooled investments are protected under the Collective Investments Schemes Control Act. You need to check on the effective rate of interest you would receive.
- Property syndications. With these investments you join up with a number of other buyers to purchase a commercial or industrial property. These investments may be high risk, if buildings need repair or there turns out to be little tenant demand.
- Property unit trusts. These are not normal unit trust funds, but investments listed on the stock exchange. As with a unit trust fund, you can invest small amounts of money in companies that specialise in investing in property. Like unit trusts, these investments are highly regulated.
- Property loan stocks. You invest in a listed company with a portfolio of properties. Unlike property unit trusts, property loan stocks can borrow money to buy properties and do not require a management company.
- Normal unit trust funds that invest in property companies.
- Life assurance endowments where the underlying investments are in property. Although rentals are part of the income of these policies, for the first five years you do not receive a monthly income and they only contribute to the growth in your investment. After five years you can draw an income tax-free (in your hands) from the policy. The life assurance company pays the tax on interest and rental income on your behalf at a rate of 30 percent. For this to be tax effective, you need to be on a marginal tax rate of more than 30 percent.
The last two types of property investments are often included in retirement funding products and can be used to diversify your investments.
Property investments can provide a solution for the volatility that often occurs in living annuity underlying investments.
Life assurance property portfolios have historically provided relatively stable returns from year to year, because of the underlying rental component, while still generating long-term real returns, since rentals tend to increase with inflation.
OPTION 6: HIGH-DIVIDEND YIELD SHARES
Before the advent of pension funds, many people invested in shares that provided solid dividends. One of the advantages of investing in shares is that the dividends from local companies and foreign-based companies listed on the JSE are not subject to income tax. The dividend yield is calculated by dividing the dividend received by the price paid for a share.
OPTION 7: MATURE ENDOWMENTS
If you have an endowment policy that is due to mature around the time of your retirement, keep it in force. You can draw an income that is tax-free in your hands by making partial surrenders (preferably equal to, or less than, the investment returns). The life assurance company pays tax on your behalf on your investments, but at an income tax rate of 30 percent on interest and net rental income, and an effective 7.5 percent in capital gains tax. If your income tax rate is greater than 30 percent, you score.
If you have a lump sum of money you won't be needing for at least five years, consider using it to invest in a single-premium endowment policy. After five years you are permitted to make as many surrenders as you like. Before five years, you are only permitted one surrender by law and you will also be subject to early surrender penalties by the life assurance company. Smoothed bonus policies, which declare annual bonuses while guaranteeing your capital, are the best policies to use for this investment.
You could consider switching the underlying investment into a money market-type fund to give you a more predictable and secure income stream.
OPTION 8: EXOTICS
There are other more exotic investments, such as tank containers, from which you can generate an income. However, you must be extremely cautious with these types of investments as they are subject to numerous risks, including currency risk (most are dollar-denominated), usage-of-container risk and life-of-container risk. Many people have seen their returns evaporate as the rand has strengthened against the dollar.
MIX AND MATCH FOR OPTIMAL RESULTS
The best way to generate an income in retirement may be to use a combination of investment products. Here are some options:
Split annuities
Take the two-thirds of your retirement fund destined for a compulsory purchase annuity and use a portion of it to buy a traditional annuity that will provide an income to cover your minimum needs. Use the balance to buy a living annuity. If the living annuity goes wrong, you still have an income on which you can survive. This is known as a split annuity. There are two ways to do this:
- Two separate annuities: You would buy a living annuity and a traditional annuity. However, in terms of the law, when a split annuity comes from the same source (for example, a retirement fund) one annuity must have a minimum income flow of at least R150 000 a year, the annuity may not be split more than four ways, and the capital value of each of the annuities must exceed R25 000.
- Some companies, such as Old Mutual, have products which contain both types of annuities under one wrapper and you can allocate any amount to either portion. The split annuity regulations do not apply to these products.
Conservative underlying investments
Structure the assets within a living annuity so that the income can withstand equity market volatility. There are various ways to do this, including:
- Using interest-earning and dividend-earning underlying investments: To do this, you need to ensure that the linked investment product company is able to provide income from only that portion of your investment. A strategy worth considering is to keep an amount equal to your required annual income in a separate investment account focused on interest-earning investments and to draw your annuity from this amount. This means that you would not have to cash in the equity portion of your investments when markets were low. When markets are performing well you can cash in some of your profits and transfer them to your money market account. Only a few living annuity product providers offer this facility. Generally, your income is drawn proportionally from all your underlying investments.
- Using guaranteed underlying investments: Some living annuity product providers have capital guaranteed underlying investment options that will protect you from underlying volatility. These are normally invested in interest-earning assets.
A temporary living annuity
If you buy a traditional living annuity when markets are low, you lock into the low interest rates for the rest of your life. This is because when you buy a compulsory annuity (CPA), the life assurer will invest your money mainly in long-term bonds.
With a CPA you should invest your money in a living annuity that will offer you the option of switching to a traditional annuity when interest rates increase. It is important to ensure that the switch does not cost you anything. Additional commissions are prohibited by regulation, but there could be other fees involved. The combination products offering both traditional and living annuities would probably be the solution. Also bear in mind that you are not permitted to transfer from a traditional annuity to a living annuity.
Joint and survivorship
If you buy a compulsory purchase annuity and you are in a permanent relationship, the best combination traditional life annuity to get is an increasing (to take account of inflation), joint and survivorship annuity. This is the reason: Say in June 1998 you retired and invested the R1.2 million proceeds of a retirement annuity in a joint and survivorship, but level, annuity. You would receive, after tax, an annuity of about R13 650 a month.
But if you invested the proceeds in a joint and survivorship annuity linked to an inflation rate of 10 percent, you would receive, after tax, an annuity of about R5 800 a month. Your quick reaction might be to go for the level annuity of R13 650. But, be warned, inflation would eat its way into it very rapidly. At 10 percent inflation, the buying power of R13 650 would diminish to R2 000 in 20 years.
It takes about nine years for an annuity linked to an inflation rate of 10 percent to catch up with a level annuity. So you take the pain upfront and not later on, when you may need the additional money more urgently.
A joint and survivorship annuity can be structured in a number of ways, including selecting a drop in income for the surviving partner. This means you will receive a larger amount while both partners are alive. You should, however, not drop the annuity below two-thirds of the initial levels for the surviving partner. It is generally estimated that the difference between supporting one person or two people is about one-third and not half as many fixed costs such as rates, electricity and transport will not decrease.
This article was first published in Personal Finance magazine, 3rd Quarter 2003. See what's in our latest issue