The Case for Retirement Annuity (RA) Funds as a Savings Vehicle for Retirement
Mike Brown, Managing Director, etfSA.co.za
November 2013
In this article, the following issues are discussed:
RA Funds versus other retirement vehicles, such as pension funds, provident funds and
preservation funds.
The impact of the tax incentives allowed for investment in Retirement Annuity Funds.
Other benefits of RA Funds.
Retirement annuity investments versus discretionary investments.
1. RETIREMENT PRODUCTS
1. A) Occupational Retirement Funds
These are typically pension or provident funds operated on a non-commission basis. Employer
organizations operate such funds, typically on a standalone basis, on behalf of their employees.
Membership of such funds is compulsory for employees. They can claim tax deductions for up to 7,5%
of their non retirement funding income for contributions to the funds. The employer can claim a
deduction for all contributions made for the benefit of an employee to an occupational retirement fund.
The employer contributions cannot be included in the taxable income of the employee.
Individuals benefit from being members of a retirement fund to which the employer makes
contributions, but can only claim their own deductions for up to 7,5% of taxable income. The
individual member has little say in the choice of investment, nor on costs, which is often, in practice,
controlled by the Accounts or Human Resources Department of the employer. Sometimes performance
and other critical issues for the individual members are not a priority for the employer.
A member of occupational retirement funds can make withdrawals of the amount they contribute to the
retirement fund, on leaving the company, but such amounts are taxable. Alternatively, the retirement
amount can be transferred to another retirement fund or preservation fund with no tax implications.
The Government has indicated that it intends introducing legislation in 2015 to require all retirement
fund member balances to be paid out to a preservation fund. A retirement annuity fund also acts as a
preservation fund in that it prevents withdrawals until retirement age is reached.
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1. B) Umbrella Funds
These are group arrangements, offered on a non commercial or commercial basis by providers, which
can be asset managers, insurance companies or specialised administration companies.
An umbrella fund offers a company an alternative to operating a specific occupational fund for its
employees. It can save on the cost and administration problems associated with operating an
independent pension fund.
The umbrella fund providers offer, either a segregated fund in name of the company, or access to a
Collective Umbrella Fund, where membership is made on a group basis. The umbrella funds provide
asset management, administration and other management services on a collective basis. Although this
should have some positive impact on costs, because of the sharing of the share of services, in practice,
there is no regulation governing the disclosure of costs and charges after entry into a commercial
umbrella fund.
The National Treasury paper on Retirement Fund Charges, found that administration costs of umbrella
funds could be up to 5%, before commission payments to intermediaries, with asset management costs
of 1,30% per annum. Some of these costs are picked up by the companies enrolling their employees in
an Umbrella Scheme, but members of the Fund often suffer low relative performance because of high
costs.
In addition, individual members of Umbrella Funds have a limited or no choice in fund selection and
typically do not have a say in the election of the Board of Trustees. The Umbrella Fund appoints a
Trustee Board, where only one member is required to be fully independent. The individual can claim
tax deductions of up to 7,5% of the taxable income from contributions to an Umbrella Fund.
1. C) Retirement Annuity Funds
Retirement Annuity Funds (RA Funds) are issued in the names of the individual member. The member
has the choice of picking their own RA Fund, rather than being compelled to be a member of a fund
chosen by their employer.
The freedom of greater choice for the member means that RA Funds are provided in a competitive
environment by issuers, so the member has a wide choice of Funds, with greater transparency in costs
and performance, increasingly becoming the norm.
The investment choice offered to members is also wide, although since the publication of Revisions to
Regulation 28 of the Pension Funds Act in April 2011, every RA fund, even for each individual, has to
be Reg 28 compliant at all times.
There are numerous benefits attached to building up retirement savings through Retirement Annuity
Funds.
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The RA Fund is in the name of the individual member
o The member has full control of their investment.
o Funds from occupational or umbrella retirement funds can be transferred to the
member’s own RA fund to ensure preservation, if they cease membership of these
employer funds or reach retirement age.
o Any contributions to the RA fund are tax deductible up to 15% of the member’s taxable
income. The member can continue to make contributions up until or even past
retirement age, if they keep their RA Funds intact without drawing an annuity.
o For people who are self employed or employed by small companies, individual RA
Funds are an ideal savings vehicle.
o For employers, setting up individual RAs for each person they employ is often the
optimal answer in terms of costs and ease of administration. In future, it will probably
become compulsory for all employers to establish a retirement fund for their employers.
RA Funds ensure preservation of contributions to Retirement Funds
Many individual workers will change their jobs a number of times during their careers. It
makes sense to keep retirement savings intact by transferring any contributions made to
occupational or umbrella fund to the member’s own RA fund. In this case, full tax free status is
preserved and the member can continue to make tax deductible contributions to their own RA
Fund.
In this way, RA Funds are superior to preservation funds, where no further contributions can be
made by the member. Because preservation funds represent “captive” money, they often suffer
from high costs, lack of investment choice and poor investment options as managers “park”
their poorer investment into these captive preservation funds. RA Funds are preservation
funds as no income or capital can be withdrawn until at least 55 years of age.
For this reason, RA Funds are rapidly replacing preservation funds as the optimal means of
preserving retirement savings. From 2015, the National Treasury has indicated that it will make
preservation of all retirement savings compulsory.
Members of RA Funds can pick their own retirement age
The earliest retirement age has to be at least 55 years of age. However, many individuals will
carry on working until well after 55, or do not require to draw a monthly pension until a later
date. By retiring at the latest possible date and age, the member’s retirement savings can stay
invested and this will improve the prospects for drawing a liveable pension on retirement. Of
course, the capital in the member’s retirement pool will continue accumulating, and additional
contributions to the Fund can be made, in a tax efficient manner, until the member elects to take
retirement and take out a living annuity.
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RA Funds are tax efficient
Contributions to a RA Fund are tax deductible up to 15% of non-retirement funding income.
Any excess can be carried forward and the deduction claimed at a future date for contributions
to a RA Fund.
From March 2015, the National Treasury have indicated that up to 27,5% of taxable income can
be used for contributions to a RA Fund, but that an annual cap (currently proposed at R350 000
per year), will apply.
In essence, the Fiscus is picking up the costs of the member’s contributions to an RA Fund, by
allowing the member to reduce their taxable income by the contribution amount. Furthermore,
all growth of capital and income received in the RA Fund is not taxed.
RA Funds assist in estate planning
If a member dies, the proceeds of the RA Fund are paid out to their beneficiaries without
becoming part of their Estate. In this way, Estate Duty; the costs of the Executor; and the need
for approval of the Courts, is avoided. The Trustees of the RA Fund, will decide on the award
of the RA proceeds to the beneficiaries and/or dependents in the event of a member’s death.
This also reduces the time to settle this part of the Estate significantly.
RA Funds cannot be sequestrated
Retirement Funds fall outside of the reach of liquidation procedures brought against a taxpayer.
2. TAX BENEFITS OF RA FUNDS
2. A) Tax Deductions
The South Africa Revenue Services (SARS), allow both tax deductible contributions to a RA Fund by
the individual taxpayer, as well as for all growth and income received in the member’s RA Fund to go
untaxed, until such stage that the member takes retirement. This is a generous concession, as tax
authorities in many other countries only allow one of these legs to be tax deductible.
The current tax legislation allows a taxpayer to make contributions of up to 15% of non retirement
funding income to a RA Fund. As many individuals contribute up to 7,5% of their income to an
occupational pension fund, the RA contributions will be calculated after this contribution to a pension
fund.
In 2015, the National Treasury proposes increasing the tax deductible contribution level to a RA Fund
to 27,5% of taxable income. They are also proposing a cap of R350 000 per annum for annual
contributions. This effectively means that taxpayers with a taxable income exceeding R1,27 million
per annum, would be affected by this cap. This could be of impact for some 65 000 taxpayers
according to SARS.
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For most taxpayers, a contribution to a RA Fund of some 10% of taxable income should be considered,
on an incremental basis, i.e. if your salary goes up by 5% per annum, the contribution to the RA Fund
should rise accordingly. In doing this over a period of 15-20 years, in a Fund such as the etfSA Wealth
Enhancer Fund, which targets a CPI +7% return on a rolling 3 year basis, it is very possible to achieve
the 70% or more replacement rate of your final salary, which is the optimal target for retirement
savings. This will enable a purchase of a living annuity that will preserve living standards on
retirement.
Even for high income taxpayers, the proposed R350 000 cap is not a deterrent to contribution to a
retirement annuity fund. A contribution of R350 000 per annum over a 20 year period, with a real rate
of growth of 7% in the RA portfolio, would mean a retirement pool of some R8 million. If the cap is
increased progressively, this retirement sum could be considerably higher.
The Tax Act also allows for contributions in excess of the limits on taxable income, in which case,
these contributions may be carried forward to a subsequent year/s of assessment and become deductible
at a later stage. Contributions to RA funds may now be made beyond 70 years of age, so these carried
forward tax deductions may have considerable value at a later date.
Accumulated non tax deductible contributions to a RA Fund can be added to the tax free portion of any
lump sums taken on retirement. Furthermore, if the taxable income of a taxpayer is increased by the
payment of a bonus or execution of share options, 15% of this income can be contributed to a RA
Fund, thus reducing the effective tax rate of the individual.
In addition, any growth within a RA Fund is exempt from taxation (including any tax on income from
dividends or interest and any capital gains tax). This significantly increases the investment return on
retirement funds and might also be a reason to prolong the retirement date for an individual taxpayer.
2. B) Estate Duty
A RA Fund will pay out the total sum in the Fund to a member’s beneficiaries and/or dependents in the
event of a member’s death.
No estate duties, capital gains taxes, or other estate wrapping up fees are payable. These collective
taxes in an estate can add up to a considerable portion of a deceased member’s estate. The time and tax
savings from an award directly out of a RA Fund to the member’s beneficiaries is significant.
Some people believe that Trusts are a preferable means of saving taxes in the event of death. However,
certain factors need to be taken into account.
Trusts can be very expensive to set up and administer. RA Funds are relatively low cost to set
up and run and do not require the appointment of independent Trustees, legal expertise, etc.
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Donations to a Trust must be done at the full market value of the asset being transferred into the
Trust, with transfer duties and possible capital gains tax liabilities. These assets cannot be
simply contributed tax free to the Trust. Only the subsequent capital growth in the asset in the
Trust is shielded from taxation.
Income received in a Trust is taxable in the hands of the drawer, beneficiary or the Trust itself.
Whereas in a RA Fund, any income received by the Fund is not taxable.
The taxation implications of Trusts are currently being reviewed by the National Treasury and it
is possible that tax changes for assets held in a Trust will be instituted, in due course, leading to
some uncertainty at present.
3. RETIREMENT ANNUITY INVESTMENTS VERSUS DISCRETIONARY
INVESTMENTS
Daniel Wessels, an independent researcher with DRW Research, has published a paper “Saving for
Retirement”, released in April 2013.
Wessels looks at a series of scenarios for different sizes of investment and for the duration of
investments. A critical issue is the marginal rate of taxation after retirement paid by the investor
drawing an income from the retirement fund or from discretionary investments.
The graph below summarises the results. The greater the annual contribution by the investor to an
investment product and the greater the investors marginal tax rate, then the bigger the outperformance
required for the discretionary investment to equal the return received from a retirement annuity
investment. As can be seen, this annual outperformance premium required by the discretionary
investment ranges from 0,5% to 2,0% per annum, which is hard to achieve over a 20 year period.
Most likely scenarios
Outperformance required
Outperformance per annum required by discretionary investment No return difference between retirement funded investment and discretionary investment
over twenty-year period
%
2.5
50% of proceeds from
discretionary
investment taxable
2
1.5
25% of proceeds from
discretionary
investment taxable
1
0.5
0
Annual contributions (real terms)
Source: DRW Research (April 2013)
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Some conclusions that can be derived from this research.
The tax incentives, both for contributions and for tax free growth within the RA Funds, do assist
materially in building up retirement savings over time. This provides a measurable advantage
over discretionary investment which do not receive the same tax treatment.
The marginal rate of taxation at retirement of the investment is critical. But the discretionary
investor would also be taxed at the marginal tax rate for any income taken out of their
investments.
A scenario, Daniel Wessels seems to have not considered, is when the investor sells
discretionary investments at retirement and only pays capital gains tax on such investments.
Daniel Wessels derives the following conclusion from his study.
New-generation versus traditional retirement annuity products – the latter typically expensive
and inflexible – not recommended!
Investment strategies – consider low-cost, index-tracking strategies as part of your portfolio as
opposed to a 100% actively-managed portfolio.
Irrespective of the outcome of quantitative comparisons between RA and discretionary
investment options, perhaps the most important, non-quantifiable aspect to consider is that the
discipline of a retirement annuity structure will invariably protect yourself against your own
fallible investment behaviour as you will experience the roller coaster of investment emotions
over time!
By far the majority of people will benefit greatly by saving for retirement by using an approved
requirement funding structure such as a retirement annuity product. In only exceptional
circumstances, people with considerable wealth may be better off after tax by structuring their
own discretionary investment portfolio, yet additional factors such as potential estate duties
must be carefully considered.
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