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Key retirement funding concepts

Exploring retirement vehicles and funds and the associated legislation.

The South African retirement funding industry is heavily regulated, enormously complex and somewhat difficult to navigate alone. Understanding the difference between the various retirement funding vehicles, together with their respective tax implications, is key to ensuring a well-structured retirement portfolio that meets your needs.

Let’s explore these vehicles, funds and associated legislation in greater detail:

Retirement fund

In South Africa, all retirement funds are governed by the Pension Funds Act, but they are structured differently and serve different needs. Generally, ‘retirement fund’ is a broad term that refers to a pension fund, provident fund, preservation fund or retirement annuity. The money invested in a retirement fund is strictly legislated and is sometimes referred to as ‘compulsory’ money. Whereas pension and provident funds are considered workplace funds, retirement annuities are generally better suited for individual investors. However, all retirement funds are governed by a board of trustees and each has its own set of rules that need to be adhered to. 

Pension Fund

A pension fund is a retirement fund set up by an employer for the investment of employees’ retirement fund savings. Each pension fund has its own set of rules, so it is important to have insight into these rules. Both employers and employees may contribute towards the pension fund, and the government provides tax relief on these contributions in the form of rebates or deductions in the tax payable. At retirement, a member can make a maximum one-third withdrawal from the pension fund, subject to tax, and the remaining two-thirds must be used to purchase a life or living annuity to provide a post-retirement income.

Provident Fund

A provident fund is similar to a pension fund in that it provides employees with the ability to fund for their retirement. A key difference, however, is that at retirement members are permitted to make a full withdrawal from a provident fund. The government intends to align the benefits of provident fund to those of pension funds, but this legislation has been postponed until March 2021. 

Preservation Fund

A preservation fund is specifically designed to invest the proceeds of your pension or provident fund in the event of dismissal, retrenchment or resignation to preserve your investment and the tax benefits. Funds transferred to a preservation fund are not taxed provided you move the funds directly from a pension fund to a pension preservation fund, or from a provident fund to a provident preservation fund. Investors cannot make contributions to a preservation fund, and the investment will therefore only grow in line with its investment returns. Legislation permits investors to make one partial or full cash withdrawal from their preservation fund at any time before retirement. At retirement, investors can take a maximum one-third cash withdrawal, while the balance must be used to purchase an annuity.

Retirement Annuity

Retirement annuities are ideal for those who are self-employed, do not contribute to a workplace fund, run their own business or earn irregular income. RAs are tax-efficient investments that allow you to invest up to 27.5% of their taxable income – less any amount that is being contributed towards a pension or provident fund – on a tax-free basis, up to a maximum of R350 000 per year. Other than in the case of emigration or ill-health, the funds in an RA cannot be accessed before age 55. Unlike traditional RA insurance policies, unit trust RAs offer investor flexibility, transparency and cost-effectiveness by investing through a unit trust portfolio in the investor’s name. These RAs allow you to adjust the level of your monthly premiums, or even take a contribution holiday, without any penalties being charged. You may also make lump sum contributions into your retirement annuity as and when you like. When you retire, you can withdraw one-third of your retirement annuity investment as a lump sum. The remaining two-thirds of your investment must be used to purchase an annuity.

Collective investments

Otherwise known as unit trusts, this type of discretionary investment can be effectively used in your retirement planning to provide cashflow to supplement post-retirement income or for large capital outlays. Collective investments are transparent and well-regulated vehicles that are suited to a wide range of investment objectives and their benefits include professional portfolio management, the ability to diversify a portfolio cost-effectively, relatively low transaction costs and the ability to buy and sell at will. It is important to bear in mind that Capital Gains Tax can be triggered when units are sold, so it is important to seek financial advice before selling any units. Unit trust owners are essentially unitholders in a fund that in turn invests its money in a range of assets, including shares, property, bonds and/or money market instruments, depending on the mandate of the fund.

Section 14 Transfer

Retirement annuity investors are permitted to transfer their RA to another retirement annuity fund without paying any tax. However, this process needs to take place in accordance with Section 14 of the Pension Funds Act and may take several months to complete. Before deciding to move an insurance RA it is important to establish if your provider is going to penalise you for early termination. Insurers generally incur upfront costs on your policy which they recover over the life of the contract. Your early termination may result in them charging you a penalty, and it is important to weigh up the financial consequences of such a penalty.

Lump-sum withdrawals

In essence, two lump-sum benefits are payable by a retirement fund. Firstly, there is a withdrawal benefit that is paid to a member when he leaves the fund before his normal retirement age through resignation, withdrawal or divorce. Secondly, there is a retirement benefit that is payable on the member’s death, retrenchment or retirement. When a member of a retirement fund retires, he is entitled to make a lump sum withdrawal from the fund which is subject to tax as per the Withdrawal and Retirement Tax Tables in the 2nd Schedule of the Income Tax Act, and which are also published on the Sars website.

Clean Break Principle

Recent legislative changes to the Divorce Act have made provision for pension funds to pay a portion of the fund to the member’s former spouse in the event divorce. This is a contentious issue as retirement funds have historically always been protected from creditors. There are strict legal requirements for those claiming against their spouse’s retirement fund benefit, and administrators generally stick to the letter of the law when processing these payouts. For a pension payout order to be binding, it must be included in the divorce order and must meet certain conditions. The order must be specific in terms of the amount to be paid out, must indicate exactly which fund it must be paid from (i.e. the name of the fund) and the order must be directed to the fund.

Paid Up RA

Old-style insurance retirement annuities were essentially insurance policies that provided very little flexibility for investors. Unlike unit trust RAs, if you stop contributing towards an insurance RA, the insurer will deem the policy to be ‘paid up’ and you may be charged a termination penalty. Once a policy is paid up, it is considered to be closed and you cannot resume making payments. You would need to enter into a new retirement annuity policy should you wish to continue contributing towards an RA.

Beneficiary Nomination

Section 87C of the Pension Fund Act governs the distribution and payment of lump-sum payments on the death of a retirement fund member. Even though you may have nominated a beneficiary (or beneficiaries) to your retirement fund, it remains the function of the trustees to allocate and apportion these funds. It is the trustees’ job to determine who your dependants are and who should receive the benefit, with the aim being to ensure that no dependents are left without financial support. As such, the trustees will use your beneficiary nomination as a guideline when making their decision. When identifying beneficiaries, the trustees will consider those people who the deceased had a legal obligation to maintain, spouses, permanent life partners, stepchildren, adopted children and even unborn children.

Umbrella Fund

As opposed to a standalone retirement fund set up by a single employer, an umbrella fund is a retirement fund that multiple smaller employers can join. Generally, an umbrella fund is set up by a large financial institution so that smaller employers can benefit from the economies of scale offered by the umbrella fund. With an umbrella fund, the average cost per member is generally more cost-effective and members can benefit from higher after-fee returns. Once formed, the founding institution will arrange for professional trustees, source an administrator, and implement group life and other services for the fund.

Life Annuity

The proceeds from your retirement fund can be used to purchase a life or living annuity, depending on your specific needs. A life annuity is essentially an insurance policy that promises to pay the insured for as long as he lives. In doing so, the insurance company takes on all the investment risk. Inflation risk can be mitigated by choosing an escalating annuity as opposed to a level annuity. Because a life annuity is an insurance policy, the policy dies with the retiree when he passes away and there will be no benefit for his heirs.

Living Annuity

A living annuity, on the other hand, is a unit trust investment in the name of the retiree, and the investor bears the investment, inflation and longevity risks. Living annuities are more flexible and transparent and allow investors to choose their investment strategy in line with their particular objectives. Legislation allows investors to draw down at a rate of between 2.5% and 17.5% of the value of their investment each year, and this level can be adjusted annually. When the investor dies, whatever is left in the living annuity can be passed on to the investor’s heirs.

Section 37 transfer

It is not possible to transfer a life (or guaranteed) annuity to a living annuity as the former is an insurance policy whereas the latter is an investment-linked annuity. However, in terms of Section 37 of the Pension Funds Act, investors can transfer a living annuity from one platform to another, and this process can take several months to complete. 

Drawdown

The rate at which you draw down from your living annuity is set on an annual basis and should be reviewed every year before the anniversary of your policy. Once you have set your drawdown level, this amount will be paid to you monthly, quarterly or annually, depending on your selection. It is vitally important to choose the most appropriate rate at which to draw down from your investment, as drawing at a higher rate can have tax consequences and affect the longevity of your capital. On the other hand, if you draw down at a rate that is too low you may not have enough money to cover your living expenses. Your annual drawdown rates should be done with the guidance of your financial advisor taking all other investments into account.

Retirement plan

Having a retirement fund in place is different to having a retirement plan. A retirement fund is a vehicle into which you channel your retirement savings, whereas a retirement plan is a detailed roadmap of how to achieve your retirement objectives. Through the retirement planning process, you and your advisor will identify your various sources of income, estimate your post-retirement expenditure, balance the risk and reward of your various investments, and structure an investment portfolio while taking into account other factors such as timeline, longevity and tax. Ensuring tax-efficiency, protecting future cashflow and appropriate structuring your estate all form part of developing a robust retirement plan.

ADVISOR PROFILE

Devon Card

Crue Invest (Pty) Ltd

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