Low-cost, highly flexible RAs make sense
Recent figures from the Life Offices Association show that the sale of retirement annuities (RAs) as a percentage of the life industry business has fallen over the past six months. With the bad publicity and rulings against the life industry by the Pension Funds Adjudicator, it would appear that investors have real concerns about the appropriateness of RAs as a savings vehicle.
But when one looks at the real purpose of an RA, which is to provide a tax incentive to save for retirement, there is a place for the investment in your retirement planning as long as costs are contained and you have flexibility—two aspects the life industry failed to address.
Pieter Koekemoer of Coronation Asset Managers argues that the reason for the fallout regarding RAs is that, when sold through a life company, they are linked to an underlying life contract, making them inflexible.
“The target market for RAs is self- or temporarily employed people who need more flexible investment products.
They want the flexibility of adding to their RAs when they have additional funds, or changing contributions as their financial situation changes. Life companies do not offer this flexibility as their products are wrapped in endowment-type structures.”
Koekemoer says the dominance of life companies in the retirement industry is particular to South Africa. Overseas, the majority of retirement funds are not sold through life companies but through investment houses, so they are more flexible and the costs are more transparent.
Koekemoer says that by investing in RAs through a collective investment scheme (unit trusts) you can start and stop your contributions as you wish and make “as and when” lump sum contributions without any penalties—the only restriction is that you cannot access the funds until retirement under the Income Tax Act.
Allan Gray was the first asset manager to offer RA products that invest directly into its managed funds, and Coronation is launching an RA product that will charge an annual fee of not more than 0,2% to administer the RA, over and above the normal asset management fees. There are no upfront fees paid to Coronation. “The investor needs to realise that we are not giving advice. If an investor wants advice they would need to contact a financial adviser and agree on a fee with them,” says Koekemoer.
While there is a substantial cost saving when investing your RA directly with an asset manager, on the negative side there is less flexibility in the switching of asset managers. According to the Pension Fund Act, you can move your RA to another fund manager, but it takes time to sort out the administration. If you invest through a linked investment service provider you have the switching capability but the annual costs are substantially higher.
Costs and taxes
According to Greg Fury, CEO at Allan Gray, the most appealing feature of RAs is their tax-efficiency. Investors who are not contributing to a pension fund can contribute 15% of their taxable income to an RA, tax-free. Investors who are, can contribute, tax-free, 15% of any income that is not taken into account when calculating their pension contribution. Any additional investments made (over the 15% limit) may be carried forward and offset against taxable income in future years.
RAs also ensure that savings are preserved for retirement purposes, as capital can only be drawn when the investor reaches retirement age (between 55 and 75). At retirement, investors can draw up to one-third of their RA capital in cash. The rest will be taxed either at the same tax rate of the year in which the investor retired or at the preceding year’s rate—whichever is higher.
According to Andrew Bradley, head of the Financial Planning Institute, if a person with a marginal tax rate of 40% and average tax rate of 35% wanted to invest R10 000 a year of pre-tax income, he or she could increase his or her final investment value by 76% by investing through an RA. If the individual invested R10 000 of before-tax income in a regular unit trust fund, he or she would first have to pay R4 000 tax at a marginal tax rate of 40%. This would only leave R6 000 to invest in the unit trust. With an RA, the full R10 000 would be invested. The compounding effect of this over 20 years at a growth of 12% per annum would give you a lump sum off R754 495.The unit trust investment of R6 000 per annum would result in a final return of R429 714.
However, this is where costs become important. For every 1% additional annual fee on your investment, you lose 24% of your return over a 20-year period. Costs need to be considered carefully to ensure they are not offsetting the tax benefit, which is not as substantial for people on lower tax thresholds.