As most investors now know, the last 10 years have certainly not been the decade of seeing the kind of returns we were used to from South African growth asset classes like equities and listed property. At the same time, global equities especially in rand terms have completely dominated traditional SA Regulation 28 retirement funds. If this was not bad enough the prospect of prescribed assets for retirement funds has provided even more anxiety. All this within an uncertain economic landscape.
Within the context, as a financial advisor, I have been facing questions such as; “should I reduce my contributions to my retirement fund?; “Should I stop contributing completely to my retirement fund?”; “Should I try where possible to ‘cash-in’ my retirement fund, pay the tax and take the net proceeds offshore?”
These are all tricky questions to handle as most are emotionally presented because of the context mentioned at the start of the article. Before you completely capitulate, it is worth looking at some of the facts of this argument. This debate was recently aired in a webinar hosted by Ninety One where they went through the pros and cons of the different choices a client might make, but I have decided to focus on the questions as they pertain to retirement funds for this article.
The cold facts behind this debate are that the tax advantages of retirement funds still make them incredibly powerful savings vehicles. They are subject to Regulation 28 of the Pension Fund Act. This regulation is designed to protect retirements savings against imprudent exposure to having too high a weighting to riskier asset classes, including offshore assets. In particular, this offshore “protection” has frustrated local investors of late with local returns lagging offshore returns quite substantially.
Research though provided by Ninety One’s deputy managing director Sangeeth Sewnath has presented that the tax benefits alone associated with a retirement fund could potentially compensate an investor for any outperformance that might be enjoyed by increasing your offshore exposure in a non-retirement fund discretionary investment.
In his research, which looked at a 30-year investment and drawdown cycle, consisting of a 15-year phase of contributions and a 15-year spending phase, converting the consequent savings into a living annuity to draw an income. His calculations demonstrated that an unrestricted discretionary investment would need to outperform a Regulation 28 compliant retirement fund portfolio by approximately 2.5% p.a. over the full 30-year period to leave your investment better off.
Consistently generating this kind of additional return is certainly a tough ask. Additionally, and often neglected, upon passing away, associated fees and taxes can have a huge negative impact on the remaining value of a discretionary portfolio compared to a retirement product which largely escapes these.
So before taking the irreversible plunge of trying cash out your retirement fund, it might be time to think through this with a cool head. If one decides as an example to withdraw 100% of your preservation fund and invest the proceeds in an offshore investment, the withdrawal tax tables can significantly reduce the net amount available for the offshore investment. Say your preservation fund has a value of R5m, the taxes lost on full withdrawal would be a staggering R1.7m. This is equivalent to starting with the new investment with a 34% loss on day one!
The withdrawal and reinvestment example is represented in the graph above which shows that even during the last decade where we saw significant outperformance by offshore equities over one of Ninety One’s flagship Regulation 28 funds, it would have taken more than eight years before the offshore discretionary strategy starts to move ahead of the retirement fund investment, due to the reduced starting value.
The graph then also shows some of the other negative consequences from moving out of your retirement fund including the further reduction in value that will be passed onto loved ones from estate taxes and executor fees assuming they were felt at the end of this 10-year period.
We don’t know what the future holds from a return perspective but if this offshore outperformance trend reverses just a bit, the above graph will make the decision even more extreme. As advisors, we are often dealing with the client’s emotions. Two of the most destructive to wealth creation are usually greed and fear.
I am firmly of the philosophy that it is quite acceptable to be scared or anxious about current issues that we feel might affect our investment outcomes but it is usually a bad idea to act on these fears. Retirement funds still do provide real benefits to savers and a holistic view should be taken before your decision gets made. Remember also that living annuities usually allow for a full offshore exposure so maybe you can have your cake and eat it too when your pre-retirement fund converts to a post-retirement fund.