Are you considering a retirement annuity (RA) but unsure about its advantages? In this article, we’ll explore the numerous benefits of a retirement annuity, aiming to provide you with valuable information to make informed decisions about your financial future. Retirement annuities offer tax advantages and serve as an investment product designed to secure your financial security during retirement. But they do also have their downsides! Let’s delve into the key aspects and consider their pros and cons.
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Understanding the Aims of a Retirement Annuity
A retirement annuity serves as a valuable tool to help you achieve financial security in your retirement years. It acts as an investment product that provides tax advantages, incentivizing you to save for your future. The government encourages personal retirement savings to reduce dependence on state-funded support during old age. If you belong to an employer-sponsored fund, such as a pension or provident fund, a retirement annuity can supplement your existing retirement savings. For those who are self-employed or not part of an employer fund, a retirement annuity can become your primary investment for retirement—a personal pension plan.
Decoding How Retirement Annuities Work
When you opt for a retirement annuity, you can make regular contributions or lump sum payments. Additionally, you have the freedom to choose how your retirement annuity funds are invested, which we’ll discuss in more detail later. Think of the retirement annuity as a protective “wrapper” that houses your investments. The type of wrapper, in this case, the RA, determines the tax implications, as different investment wrappers have varying tax consequences. When you reach the minimum retirement age of 55, you can use the funds accumulated in your retirement annuity to invest in a post-retirement product. These products, such as living annuities or guaranteed life annuities, provide you with a regular income stream during your retirement years. Modern retirement annuities offer flexibility, allowing you to start or stop contributions based on your financial circumstances, such as periods of financial difficulty or job loss.
Exploring Investment Options for RAs
All retirement annuities in South Africa are governed by Regulation 28 of the Pension Funds Act. This regulation prescribes the allowable asset classes and maximum allocations for retirement fund investments. As per the asset allocation restrictions, a retirement annuity can invest a maximum of 75% in equities and up to 45% offshore, an increase from the previous limit of 30%. Other possible asset classes for retirement annuity investments include bonds, property, hedge funds and cash. Most retirement fund assets in South Africa are invested in balanced funds that adhere to these prescribed limits and are categorised as the South African Multi-Asset-High-Equity fund category according to ASISA.
Unveiling Retirement Annuity Tax Benefits
Retirement annuities offer several key advantages that contribute to disciplined and flexible retirement planning. One significant benefit is that you cannot access the funds until you reach the minimum retirement age (currently 55), ensuring that your retirement planning remains on track without succumbing to temptation. That will be changing with the new two-pot system however. Let’s explore the tax benefits associated with retirement annuities:
1. Tax-Free Growth: The funds invested in a retirement annuity grow tax-free, meaning you are exempt from income tax or capital gains tax on the investment’s growth.
2. Tax-Deductible Contributions: Contributions made to a retirement annuity are tax-deductible, up to a maximum of 27.5% of your gross income or capped at R350,000 per annum. This allows you to reduce your taxable income by the amount of your contribution.
For example, let’s say you earn R1 million per year gross. Assuming no other factors, you would pay approximately R300K in taxes for the year. However, if you contribute 10% or R100K p.a. to a retirement annuity (whether monthly or as a lump sum), your taxable income decreases to R900,000. As a result, the tax you pay reduces to approximately R257K for the year, saving you over R40K in taxes.
Accessing Your Retirement Annuity: Estimating Your Retirement Income
Once you reach the age of 55 or decide to retire, you can access the total value of your retirement annuity. This value comprises your contributions and the growth accumulated in your investments. You have the option to withdraw up to one-third of the total value as cash. The first R550K of this cash withdrawal is tax-free, assuming you haven’t previously utilized any portion of this tax-free allowance. The remaining balance is used to purchase a product specifically designed to provide you with a steady income stream throughout your retirement years. A rule of thumb figure to use as a sustainable income level, would be a starting drawdown rate of about 4% p.a. So for every R1 million invested you should be able to generate about R40,000 p.a. before tax. While this income is taxable, tax rates during retirement are typically lower compared to your working years. If the total value of your retirement annuity is less than R247,500, you have the option to withdraw the entire amount in cash.
Best Retirement Annuity in South Africa
Determining the “best” retirement annuity depends on your specific criteria. Factors to consider include fees, performance, and brand reputation. The brand or institution your retirement annuity is with, matters less than the underlying funds or investments held within the RA. Because the underlying investments determine the growth.
Balanced funds are the type of investment that house most retirement annuity savings. And most of the best performing balanced funds you can invest in are not the big brands, but are amongst the less well-known or boutique asset managers.
Over 7 years to the end of June 2023, the Aylett Balanced Fund has been the top performing balanced fund generating at average annual return of 11.47%. (it doesn’t yet have a 10-year track record). And over 10 years the two standout performers are the ABAX Balanced Fund and Long Beach Managed Fund with returns of 11.48% and 11.63% p.a. respectively. *retail share classes used. The big brands like Allan Gray, Coronation and Ninety One etc. don’t really feature anymore because their funds have become so big, they lack the flexibility and adaptibility of a smaller or boutique name.
Important Point: In the article above we also make the point of the underwhelming returns of balanced funds over the last decade – and that despite all the tax advantages, you need to be looking at other investment options that can offer better returns if you want to achieve financial security. The median return of funds in this category is about 7.50% p.a. over 10 years, which is about Inflation Plus 2, which making achieving a successful retirement one day almost impossible. You need to be aiming for returns of Inflation Plus 5 or above 10% p.a. ideally.
How Do Sygnia Skeleton Balanced 70 Fund and Other Low-Cost Options Compare?
Regarding affordability, the Sygnia Skeleton Balanced 70 Fund is one of the most cost-effective retirement annuities available, with an all-inclusive fee of approximately 0.53% per annum. Unlike many other passive and index options, they do not charge platform or administration fees. However, their seven-year average return stands at 7.85% per annum, significantly lower than the Aylett fund’s performance. And we only show 7 years because most don’t have a 10-year track record yet. Interesting too how closely their performance correlates, except for the Gryphon Prudential Fund, which stands out significantly. Note we haven’t added the performance of 10X because their performance data on Morningstar does not date back 7 years, for whatever reason.
What this does demonstrate is the value of conducting thorough research to explore options beyond the familiar, including boutique managers who have delivered strong returns. Blending strong performing actively managed funds with low-cost index or passive options can also give you the best of both worlds – better performance with lower fees.
Managing Your Retirement Annuity in the Event of Your Death
In the unfortunate event of your passing, the value of your retirement annuity falls outside of your estate, eliminating the need for estate duty. The distribution of benefits is regulated by section 37C of the Pension Funds Act. Trustees of the fund exercise their discretion to identify and arrange equitable payment of the benefits to your dependents, both legal and factual, even if you have nominated a beneficiary. The definition of a dependent is broad, and the trustees have the final say, making the process potentially complicated. To better understand the intricacies and challenges surrounding section 37C, we recommend reading this informative article on the subject.
Once the trustees have determined how to distribute the benefits among your dependents, they can choose to receive the amount as cash (subject to taxation) or use the capital to purchase an income-generating product through a living or life annuity.
Benefits of a Retirement Annuity vs. Investing Offshore
A longstanding debate revolves around whether investing in a retirement annuity, with its tax benefits and advantages, outweighs the benefits of investing offshore, which offers a broader range of opportunities and potentially higher returns. Consider also that the Rand has depreciated by approximately 5-6% p.a. on average as well for the last 30 years, how do you ever make that up? That’s especially true today as more people want to be internationally mobile, travel and even emigrate. So should investing offshore not also be a cornerstone of your financial independence or retirement strategy?
Using the S&P500 as the global or offshore benchmark clearly comes out the winner. And by a long way. Long-term total returns on the S&P 500 dating back to the end of WW II are about 10% p.a. in USD terms. The period 2000-2010 where the S&P 500 went nowhere for a decade and emerging markets did fantastically due to a booming China, was the one decade where a balanced fund via a retirement annuity would have performed better.
Just to be clear, we’re not saying don’t use retirement annuities as part of a diversified retirement planning strategy – but you do need to be using a broader toolkit that includes offshore to generate the kind of long-term returns needed to achieve financial independence.
Conclusion: Weighing the Benefits of a Retirement Annuity
When assessing the benefits and drawbacks, retirement annuities continue to play a valuable role in diversified retirement investment strategies. These annuities offer significant tax and estate planning advantages, especially when considering the wide range of low-cost options available, including those managed by boutique fund managers with impressive track records.
However, relying solely on retirement annuities may not optimize your ability to achieve financial security. It is essential to explore additional options, such as investing offshore, to capitalize on the vast world of investment opportunities. The global market presents diverse possibilities, and taking advantage of them can help diversify your asset base effectively.
When opting for offshore investments, we recommend engaging in proper diversification by investing in hard currencies, such as USD, rather than relying solely on feeder funds. With streamlined processes and easier access to offshore investment opportunities, embracing these options can enhance your retirement investment strategy.
By understanding the benefits of a retirement annuity and exploring other investment avenues, you can create a comprehensive retirement plan that aligns with your financial goals and maximizes your long-term wealth potential. Remember, the world is full of opportunities—seize them wisely to secure a prosperous future.
Carl-Peter Lehmann
Carl-Peter is a Director and Partner at Henceforward. He has more than 20 years experience, is a CERTIFIED FINANCIAL PLANNER, and is passionate about helping his clients think differently when it comes to securing their retirement and financial future.
