Figures published by Statistics South Africa show that of the 16.1 million employed South Africans, only 40% have access to a retirement funds as a condition of service and only 25% have employer-managed medical schemes. This leaves most workers to make their own decisions.
Paying a financial adviser to design an investment plan for you when you are about to earn your first salary could be the best investment decision you will ever make.
But be wary of financial advisors who might not have your best interests at heart. At this time of the year, many young graduates are ‘ambushed’ by determined, commission-hungry product pushers. Their juiciest target? Financially-naïve graduates with potentially high incomes.
General rules for starting out
- Set up your banking system so that your salary is paid into a current account, with debit orders going off to pay for your medical scheme membership, insurance policies and your RA. Set up a second account for additional voluntary savings. You will know that you can spend what is left in your current account on rent, food, transport and entertainment.
- Don’t be intimidated by your financial adviser. It is critical that you know and understand the commissions earned by your adviser for the sale of different products. Ask for a breakdown of fees earned measured as both as a percentage of the value of the product sold and in rands. Most important, find out if there are penalties for cancelling or changing any recommended products.
- Look for cost-effective, fair and transparent fee structures when choosing investment products.
- As a young investor you have the luxury of time on your side. This means you can take more risk with your investments. If you start your first job at 25 and your investment horizon is 40 years, you will have 360 monthly salaries paid into your account. You can afford to take a longer view using the benefits of rand cost averaging, low investment costs and relatively high equity exposure.
Allocating your pay package
The first chunk of your salary will be allocated to Sars. Our revenue service has a sliding scale of taxation whereby high income earners pay more. Roughly if you earn R50 000 a month, count on paying Sars just short of 30% of your salary, if you earn R20 000 a month, your payment to Sars will be just short of 20%, and if you earn R15 000 a month, Sars will want 18% of your salary.
Saving for your retirement
The range of retirement-savings vehicles includes retirement annuities (RAs), pension funds and provident funds. If you join a company that requires you to join the in-house pension or provident fund as a condition of service, it is the norm that a part of your salary is allocated to the pension fund. For everyone else (self-employed people or those working on a cost-to-company basis) there is the RA. These funds can also be used to ‘top-up’ your contribution if you are employed by a big firm but want to save more. You can contribute to as many RAs as you wish and they are transferable. This is a tax-efficient way to house any excess savings, as you’re able to use the lump-sum amount to reduce your income-tax liability in that year.
- The upside of contributing to an RA or pension fund
If you start saving for your retirement within the rules of an RA or pension fund, you reduce the amount you pay to Sars and effectively get Sars to contribute to your retirement fund. You can save up to 27.5% of your income (capped at R29 166 a month or a maximum of R350 000 a year) tax free.
Further, if you are to become insolvent or sued, your retirement savings are excluded from your estate.
- The downside of contributing to an RA or pension fund
RAs and pension fund have strict rules. You can only access retirement savings at age 55 unless you become disabled, and the contribution to your RA must be invested according to Regulation 28 of the Pension Fund Act.
This limits exposure to equities to 75% and offshore exposure to 30%, including 5% in Africa. It can be argued that for a young investor, the 75% exposure to equities is too low. In the current economic environment, a limit of 25% to foreign investments is also considered too low.
It is worth bearing in mind that it would not be unprecedented for a cash-strapped government such as ours to pass new rules to force pension funds and RAs to allocate some of their investments to ‘prescribed assets’.
When your new self-appointed financial adviser catches you outside the engineering faculty, be alert to the fact that there are two different kinds of RAs; those sold by insurers and those sold by linked investment service providers (LISPs) or collective investment scheme managers. Insurance-based RA policies earn higher commissions and usually have higher fees.
RAs sold by insurers are usually contracts, with contractual obligations for policy holders. In the event that you want to stop paying into your RA, or change to another company, you might find yourself paying penalties for breaking the contract.
Your insurer / broker have the right to deduct certain upfront costs that would have been recovered over the term of that contract. It is similar to breaking a cellphone contract, where the cost structure assumes you pay for the device over the duration of the contract. Policies sold after January 1 2009 can incur penalties of up to 15% of the accumulated fund value.
If you want to avoid penalties make sure that you either pay your adviser a once-off advice fee or invest directly in a unit trust RA with no advice.
So why not split your retirement savings?
It makes a lot of sense to split your savings between a retirement fund, with the tax benefits, and a ‘discretionary’ (your own choice, with no rules) savings fund. This way you can benefit from the tax rules, but build in the flexibility that a discretionary savings fund allows.
From an investment mandate point of view, you can invest the total contribution offshore, or wherever you expect to get the highest returns. You could sell this investment if you need to pay for the deposit on a house, the fees for a post-graduate degree, or buy into a professional practice if this opportunity becomes available. Consult an adviser to make sure that you invest according to your expected time frame and risk appetite, while taking costs into account.
Don’t forget your free savings allowance
Tax-free savings accounts (TFSAs) were introduced by the (then) Minister of Finance Pravin Gordhan in 2015. Every tax payer can invest R33 000 a year, or R500 000 over a lifetime, in especially designated funds made available by asset management companies. Count on a ten-year or longer investment horizon when choosing a TFSA in order to get the full benefit.
Medical scheme membership
There are currently 82 medical schemes: 22 open schemes and 60 restricted schemes. Many companies require that staff members join a medical scheme as a condition of service. Contributions made by your employer to your medical scheme are taxed as a benefit. If you have to make a decision on your own about choosing your scheme and option, do your research thoroughly. If your salary is less than R12 000, there are some good deals offered by medical schemes that offer salary-banded premiums. Expect to pay between R1 000 and R1 500 for a single adult member for an entry-level option. Research the available options in terms of medical gap cover. This can be helpful to pay for the expenses not covered by your plan when you have to be hospitalised.
Be alarmed if the adviser who finds you in the university parking lot suggests buying a life insurance policy before discussing your other investment requirements. Current rules that guide commissions and adviser remuneration do not reward the sale of different products equally.
So who really needs life insurance? If you have ‘dependents’ (including aging parents or siblings whose education you contribute to, for example) who would suffer if you died, life insurance is a good investment. For everyone else; not so much.
The purpose of life insurance is to provide for your dependents if you die. The price of your premium depends on your age and your health at the time of buying the policy. Unlike a medical scheme, insurers are allowed to charge you more if, for example, you have a high blood pressure or if you are a smoker.
Underwriting relies on good faith, and the honesty of clients to openly disclose all their relevant information; it is extremely important that you answer the questions asked of you accurately and honestly. This will ensure that your claim is not rejected when your family needs it.
Life insurance policies are structured in different ways: according to the term, whether or not premiums increase with inflation or how much the insurer is obliged to pay at claim time. Make sure you understand what you are buying.
Disability and critical illness protection
If your first job is with a big company, it is likely that part of your retirement benefit is allocated to a group disability insurance fund. For everyone else, we would strongly recommend that you buy an insurance policy that pays a lump-sum benefit in the event that you are disabled or become critically ill and are unable to work. As a young worker, your future earning potential is your biggest financial asset.
Statistics from the US (and ours are probably higher) show that one in four workers will become disabled or be diagnosed with a critical illness at some point in their careers. And your expenses do not stop when you are no longer earning. These benefits are designed to provide you with a lump-sum payment. It can be used to pay for medical expenses and reduce existing long-term debt, like a home-loan.
The cost of these lump-sum benefits depend on a number of factors, including the benefit period and the comprehensiveness of the benefits. Make sure your adviser explains the implications of insuring your ‘own occupation’ versus a ‘similar occupation’.
An income protection benefit pays you a monthly income during the period you are not able to earn an income due to injury or illness. If your employer gives you three weeks sick leave as a condition of employment, an income protection policy would not be your first priority. However, if you are working as an entrepreneur, or as a professional who charges clients by the hour or per consultation, protecting your income is highly recommended.
- Decide on your long-term goals and ensure your savings plan reflects this.
- Do your own research. Invest in your own financial literacy.
- It is essential to get advice on which products to invest in from someone who has your interests at heart.
- Start early.