JOHANNESBURG – Investors often underestimate the benefits of using a pension or provident fund or retirement annuity to save for their old age.
While contributions to a retirement fund can be made tax free (within the 27.5% and R350 000 annual limits), growth within the vehicle is also tax free. Pension funds qualify for lower institutional fees and whilst inside the vehicle, the funds are protected from creditors.
Therefore, investors would typically have to contribute significantly more over their lifetime (or get much higher returns) outside such a vehicle to be in the same position at retirement as someone who saved within the vehicle and preserved (all else being equal).
Despite indications that early withdrawals from retirement benefits is one of the main reasons most South Africans aren’t in a position to maintain their standard of living in retirement, a recent Moneyweb article ignited significant debate and wide-ranging views on the topic of early withdrawals.
While investors should be allowed to make decisions based on their personal circumstances (and there may be instances where it could make sense to withdraw), it is important that these should be informed choices and that the broader implications of cashing in when changing jobs should be considered. (Although it is not the focus of this article, the tax implications of early withdrawals can be very punitive.)
The impact of early withdrawals
If an individual started contributing 12% of her salary towards retirement at the age of 25 (assuming a 40-year career), preserved diligently and received returns of 4.3% above inflation per annum on average, she would have around 9.6 times her annual salary at retirement. The calculation assumes her salary increases by 1% ahead of inflation per year over her working career.
This would be able to replace roughly 70% of her final salary as an income. If she achieved post-retirement after-inflation returns of 3.5% this income could grow by inflation and the money would last another 20 years. This is probably not long enough, but to keep the example relatively simple, the issue of longevity won’t be addressed here.
Andrew Davison, head of implemented consulting at Old Mutual Corporate Consultants, says by age 35, the individual would have saved 1.4 times her annual salary. If she changed jobs at this point, her retirement pot would already be quite a substantial amount of money in relation to her annual income, and with 30 years to go to retirement, it may seem that she would have plenty of time to catch up if she cashed out.
Source: Old Mutual Corporate Consultants
If she did cash out at 35, she would have to contribute an additional 7.5% of her salary for 30 years (19.5% in total) in order to be in the same position at retirement (in the graph above, she would move from the red line onto the green line).
That is quite onerous, Davison says.
If she made the same decision at age 45 (see graph below) and cashed in her retirement benefits, she would have to contribute 35% of her salary (an additional 23%) for 20 years to be in the same position.
“That is a long time to be saving 35% of your salary. Most people can’t afford it and that is the problem with the lack of preservation.”
Source: Old Mutual Corporate Consultants
The difficult issue is that there are often competing interests at play and people may argue that they would rather use the money now and play catch-up later on.
Davison says unfortunately behavioural issues often ruin even the best investment plans. If someone could choose between paying off a home loan faster or investing in a unit trust, it could make sense to pay additional money into the home loan.
“However, as soon as you have paid off your home loan faster, the same contribution that you’ve been paying into the home loan should now be redirected to saving so that you play catch-up on the savings as well.”
But often this doesn’t happen. People may argue that because their home loan is paid off and they have a significant disposable income, they can afford to spend more.
“Because of behaviour, the right answer is not ‘put it in your bond’. The right answer is save AND pay off your bond because people don’t have the discipline to do one thing and then shift the focus to the other.”
Due to behavioural issues, what may theoretically be the right answer may not be the best thing to do in practice, Davison argues.
Often however, part of the problem is that people don’t use their retirement savings for buying a house, but to go on holiday or to buy a car, adds Malusi Ndlovu, head of Old Mutual Corporate Consultants.
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