You can't afford to make rash decisions when it comes to selecting an income-earning investment in retirement, Evan Jones, the director of investment products at Cadiz Specialised Asset Management, says. Jones was speaking at a meeting of the Fairbairn Capital/Personal Finance Investors Club in Cape Town this week.
Your ability to earn an income as an employee or by running your own business ends when you retire. This means you need to give serious consideration to how to use the capital you have accumulated to generate an income, Evan Jones says.
All too often, retired people are tempted to invest in schemes that promise them an exceptionally high income. But, Jones says, you must be wary of any investment that offers returns that are far in excess of the market-related interest rates (currently seven or eight percent a year).
Jones says annuities (pensions) purchased today are about one-third less than they were six years ago.
A R1 million term certain annuity with a capital guarantee would have provided a monthly income of about R15 300 in 1998. Now, you will get about R6 100 a month. This significant decrease in income is a direct result of interest rates falling from 20 percent in 1998 to 11 percent, he says.
You have to accept that interest rates could decrease even further over the next five to 10 years, he says.
The reality of a low interest rate environment makes it all the more important that you select the most appropriate interest-earning investments at retirement and throughout your retirement years, Jones says.
He says investments that generate an income include life annuities,
living annuities, preference shares, voluntary purchase annuities with guarantees, RSA Retail Bonds, bank deposits, money market unit trusts and property.
Life annuities
Life annuities are usually purchased with two thirds of the proceeds you receive from a retirement fund, Jones says. At retirement, you are allowed to take up to one third of your pension fund payout in cash (subject to tax), while you must use the balance to buy a life annuity or a living annuity.
Life annuities are offered by life assurance companies and are paid to you for the rest of your life, and possibly to your dependants, depending on the guaranteed term of the annuity.
The annuity may be fixed or may increase annually, depending on the product you choose.
An annuity that increases each year will be lower than one that pays a fixed amount.
Jones says life annuities have the following advantages:
- The life assurance company assumes the mortality risk. This means it will pay you a monthly annuity whether you live for two months or for 20 years after you have retired.
- You know how much money you will receive each month.
- You can choose how frequently you want to receive your annuity - for instance, every month or twice a year.
He says the disadvantages of life annuities are:
- Depending on the guaranteed term of the annuity, it may end when you die. If you die before the term expires, the annuity will continue to be paid out to your dependants.
- You do not enjoy the benefits if the assets bought with your retirement lump sum perform well. The life company gets the advantage of any investment performance.
- A life annuity is fully taxable in your hands.
Living annuities
Living annuities have been on the market for a relatively short period of 10 years or so, Jones says.
A living annuity is paid by a life assurance company for as long as there are assets to back the annuity. Your income will drop if the assets in the living annuity dwindle.
A living annuity is a flexible investment - you choose the underlying assets and can switch between the underlying assets, although it may be limited to a single switch on the anniversary of the investment.
Each year, you choose the level of the monthly annuity, which must be between five and 20 percent of the value of the assets.
Jones says the advantages of living annuities are:
- You choose the monthly annuity you wish to receive;
- You select the underlying investments;
- You can transfer your annuity from one life company to another - but this may involve costs; and
- The assets can continue to produce an income for your beneficiaries after your death.
Jones says the disadvantages of living annuities are:
- You assume all the investment risk, because you choose the underlying assets. The choice of underlying assets ranges from low to high risk.
- The tendency for people to live beyond their means encourages them to take a higher monthly annuity than they should.
- The income is fully taxable in your hands.
Preference shares
Preference shares are issued by companies or banks in order to raise capital, Jones says.
An incentive for banks to issue preference shares is that they can be included in the bank's capital adequacy requirements. By law, banks must hold a certain proportion of capital to back the loans that they grant.
The preference shares issued by companies are not normally available to individual investors, because of the large investment amounts required, Jones says. However, banks list their preference shares on the stock exchange and this enables individual investors to buy them.
Holders of preference shares are entitled to receive dividends. The dividends are normally linked to the prime lending rate and the issue price of the shares, he says. For instance, dividends per share could be 70 or 75 percent of the prime rate.
The size of the dividend and how frequently it is paid is usually stated in the company or bank's share prospectus, and you should read the prospectus carefully before you buy the shares. Typically, banks pay dividends twice a year.
Unlike ordinary shareholders, investors in preference shares often have no voting rights at a company's annual general meeting.
Preference shares generally give you the right to receive dividends before all other shareholders. If the company is liquidated, holders of preference shares are entitled to be paid out before ordinary shareholders, but after the creditors.
Listed preference shares issued by banks are not redeemable, so if you want to cash in your shares, you have to sell them on the exchange.
Jones say the advantages of preference shares are:
- Dividends paid by South African companies are tax-free in the hands of the recipients; and
- Listed preference shares can be traded by investors.
He says the disadvantages of preference shares are:
- Individual investors who receive dividends from preference shares are at a slight tax disadvantage to com-panies that receive dividends.
The issuer of the preference shares deducts secondary tax on companies (STC) before distributing the dividends. If a company that invested in preference shares declares dividends, it can offset the STC that was paid by the company that distributed the dividends against the STC that it has to pay on the distribution of dividends.
- There is credit risk attached to many preference shares. The risk is related to the ability of the company or bank that issues the shares to pay the dividends. In other words, if the bank collapses, your shares will be worthless and you will not receive your expected dividends.
Voluntary purchase annuities with guarantees
These annuities offer you a guaranteed annuity, Jones says.
He says an advantage of a voluntary purchase annuity is that they are tax-efficient, because only the interest portion of the annuity is taxed.
Jones says the disadvantages of voluntary purchase annuities with guarantees are:
- For some investors, the minimum investment term of five years is too long.
- Most life companies offer only a fixed monthly annuity for the entire investment term.
- You will lose your capital and monthly income if the life company collapses. Therefore, you should ensure that you buy an annuity from a company that is financially sound.
- The guarantee comes at a price - you receive a lower annuity than is the case with annuities that do not have guarantees.
RSA retail bonds
The National Treasury issued the first RSA Retail Bonds in May this year. You can invest for two, three or five years, Jones says.
You have the choice of receiving interest at the end of the investment term or twice a year for the duration of the investment.
Retail bonds are essentially "loans" by a government to investors. Retail bonds are common products, Jones says, and have been issued in countries such as Canada, the Philippines, Thailand and Australia.
He says the advantages of RSA Retail Bonds are:
- They are very well priced;
- Investors do not pay commissions to intermediaries, but buy the bonds directly from the National Treasury, on its website or at a post office;
- The counter party risk is very low, because retail bonds are backed by the government; and
- The minimum investment amount of R1 000 is affordable for many investors.
Jones says the disadvantages are:
- The maximum you can invest is R1 million.
- There are penalties for withdrawing early from the investment. The earliest withdrawal (and only for exceptional reasons) is after one year.
- Investors must be South African citizens or permanent residents, have a bank account and be 18 years old.
- The interest is taxable in your hands (except for the permitted exemptions on interest income).
Bank deposits
You can choose from a wide variety of bank deposit accounts. The types of bank deposits include call deposits, fixed deposits and notice deposits.
The banks set the investment terms, but you can choose how often to receive the interest payments, Jones says.
He says the advantages of bank deposits are:
- It is easy to invest, because you can do so at your local branch; and
- Banks often offer enhanced interest rates on certain deposits or to categories of investors, such a pensioners.
Jones says the disadvantages of bank deposits are:
- The returns on shorter-term deposits do not beat inflation; and
- The interest is taxable in your hands (except for the permitted exemptions on interest income).
Money market unit trusts
Jones says money market unit trust funds operate in the same way as other collective investments - they pool many people's money and invest it in money market securities, such as negotiable certificates of deposit and banker's acceptances.
You can choose from a wide range of money market unit trusts, he says. The minimum investment amounts are relatively low and you can sell your units whenever you want without incurring penalties. You can also reinvest your interest, thereby earning interest on your interest.
Jones says the advantages of money market unit trusts are:
- You are not locked into a lengthy investment term.
- The fees are low. For instance, entry costs are typically 0.25 percent a year of the investment amount.
- The fee structure is transparent.
- The returns are not volatile.
He says the disadvantages of money market unit trusts are:
- The short-term nature of the investment may undermine the interest rates on offer. Bonds, for instance, have longer investment terms and therefore offer higher returns.
- Interest is taxable in the hands of the investor (except for the permitted exemptions on interest income).
Property unit trusts
Unlike equity unit trusts, property unit trusts (PUTs) are listed on a stock exchange, Jones says.
PUTs mainly invest in commercial and industrial property.
He says investors who buy PUTs are allocated units that entitle them to cash disbursements, called dividends, which are paid twice a year.
The returns of most investments are correlated with interest rates, Jones says. When interest rates are high, the investments deliver good returns. On the other hand, property returns tend to have an inverse correlation with interest rates.
When interest rates decrease, it costs less to borrow money and so the demand for property grows, which in turn leads to an increase in property prices and rentals. The converse is also true.
PUTs derive their returns from two sources, Jones says. Firstly, in the form of income from the rentals paid by the tenants who occupy the buildings owned by the portfolio. Secondly, in the form of capital growth as the value of the units increases.
He says the advantages of investing in PUTs are:
- The entry and exit costs are low when compared to investing directly in property;
- There is a large selection of PUTs from which to choose;
- You gain exposure to a range of property types and to properties in various cities; and
- PUTs typically perform counter to the interest rate cycle. They do well when interest rates decrease and poorly when interest rates increase.
Jones says the disadvantages of investing in PUTs are:
- The income from PUTs, although it is paid in the form of dividends, is fully taxed in your hands;
- PUTs are not always as liquid as investors would like. In other words, someone has to want to buy your units if you want to sell them; and
- PUTs are "manager-specific", so your portfolio will be managed according to the investment style and preferences of a particular manager.