Chapter 3: Retirement planning
Retirement planning should ideally start from the first pay check a person gets. At least in an ideal world that would happen.
It would be nice if schools would consider helping the future retirees to plan for that time in their lives when they will not have an income from an employer. The reality is very different, as most young people do not see retirement as a reality. Retirement is too far away on the horizon. Most youngsters are not taught how to plan to next week, let alone 40 years into the future.
I am a certified financial planner training professional, one of the most educated and trained professionals in the world. It has been my journey to retirement that means today, it is with deep knowledge, I can tell my students to go to the person they are advising and ask certain important questions. The first question is to ask people what type of retirement planning they have.
The common response is an employer sponsored retirement. This answer shows a lack of deep understanding of the retirement process. There are different employer retirement plans that will definitely have a strong material effect on retirement savings.
To learn what retirement should consist off, let us start by learning what a pension fund, retirement annuity and other pension saving tools we have.
The pension fund is meant to generate stable growth over the long term, and provide pensions for employees when they reach the end of their working years and commence retirement. Pension funds are commonly run by the state itself or some sort of financial intermediary for a company and its employees, although some larger corporations operate their pension funds in-house.
Pension or retirement funds are a tool for the creation of wealth. Creation of wealth for retirement entails the implementation of techniques for the optimisation and utilisation of pre-retirement income streams and the effective use of existing assets in such a way that it increases the net worth of a person, whilst they are still economically active. In our financial planning hood we call that wealth creation.
Wealth creation for retirement includes, amongst other things, the following:
We need to investigate these briefly, to give the future retiree the knowledge on retirement planning that is needed.
The first question we need to answer is what is a pension fund? We have to ask this because all pension funds are not created equal.
All pension funds are created from a collective savings pot and there are broadly two main types:
We have three ways of funding pensions- a pay as you go system, a notational system and a capitalisation system. Let’s look at what this means to us as the man on the street.
In a public pension fund, the payment into the fund is generally compulsory and taken from the income of the person before the final post tax amount is paid to the person. A public fund referred to as a pay-as-you-go pension plan means pensions of current pensioners are paid each year with the contributions of active workers. Unfortunately this pay as you go system is vulnerable to unemployment and demographic changes. We say this type of pension provision is dependent on inter-generational solidarity. In other words the financial balance of the system depends on the ratio of the number of contributors to that of the pensioners. There is then a ratio between pensioners and contributors, and the ratio between average pensions and average wages. If the pensioner gets an average wage in such a system then there must be more contributors to the system than pensioners. If the pensioner lives longer then this ratio will not be sustainable. This problem is found in many countries which is why many of them are raising the pensionable age to 67 years of age.
A second pension fund is one which uses a notional accounts. In Notational accounts the person will pay into the system and draw out at retirement, with regard to the history of what they put in. However unlike our third system of capitalisation, contributions paid in, will in part meet the pensions paid out. In other words excess contributions would buy the assets which are designed to pay pensions for retirees. Individual accounts do not pay out a pension on the amount of funds accumulated. The government or the company will keep the liability to insure the pensioner gets their share of the pension pot.
Capitalisation is where we look at the amount of capital needed at retirement for each monetary unit of pension to be paid annually. Capitalisation means that relatively small changes in financial returns may represent huge changes in pension values and, as a result, very uncertain retirement conditions for individuals. Actual contribution rates when using capitalisation are a problem. For a pension fund offering a defined benefit at retirement of say 60% of salary, the fund would have to take into account the extent to which individuals fail to make regular contributions throughout their lives. For instance, if the future retiree were to skip half of the monthly contributions every year, required contributions rates would have to double to reach the same amount of capital at the end of their working lives.
In a full-capitalization system each individual receives a pension that comes entirely from the capital accumulated in the individual account. Most private pensions will use this method. Capitalization with defined contribution funds generally offer a certain amount of freedom of choice to the individual in deciding the form in which he would like his pension paid when he reaches retirement. The individual therefore has to monitor the amount they will receive from the fund at retirement and the risk they wish to take in order to get the required return.
A private pension fund is normally established by an employer to facilitate and organise the investment of employees' retirement funds, contributed by the employer and employees. Each private pension fund is governed by the pension funds laws of that country and the rules of the fund. The rules of the fund are made up by the trustees who are elected to the board of the fund. These rules are approved by the Pension Fund Regulator of the country.
North America, as can be expected, has the largest pension fund region in the world, followed by Europe and Asia Pacific. South Africa has a fairly mature pension fund environment.
In South Africa and certain other countries there are different laws for pension funds that are government based, such as the government services themselves, railways or post office funds.
The employer will have different forms of pension scheme for their employees- a defined benefit or defined contribution pension fund and a provident fund.
We first look at the South African pension fund
A pension fund has a restricted lump sum available for members who retire from the fund. You cannot access the full lump sum, but only one third of the member’s interest- that is the amount you and your employer have put into the fund via your contributions.
In the defined benefit pension fund, the employer will carry the liability that the assets in the fund or contributions to the fund will meet the requirements of the retirees. A defined benefit fund will have an obligatory fund run annuity for after retirement as the employer carries the risk and will decide the fund investment.
In the defined contribution the employee will carry this risk that the funds will be sufficient to provide a pension. As a result these funds allow the member to choose the investment mix in the fund. Unfortunately most people do not possess the knowledge to do that, so from the 1 March 2019 the Government made it a law that the fund has to have a default pension option. This default has to be appropriate, reasonably priced, well communicated to members, and offer good value for money. Trustees are required to monitor investment portfolios regularly, to ensure continued compliance with these principles and rules. On retirement the fund must also offer either a life annuity or a living annuity. The annuity can be member owned or owned by the fund (we call this in-fund). The annuity must be appropriate and suitable for the specific class of members who will be enrolled into them, must be well communicated and offer good value for money.
In addition all pension funds have to provide retirement benefit counselling to members leaving the funds.
In both types of schemes there may be not only the employer contributions but also employee contribution plans. Employees make deposits (contributions) to an account. Contributions are deducted from employee's pay; some companies match those payments, while other companies give a fixed percentage of the salary in to the pension fund. Governments give a tax relief to these payments in the form of rebates or deductions in the tax payable. Governments do not want older people dependant on social welfare and it is therefore in their best interests to give these tax breaks. The tax relief is given to the member in their own capacity even if the employer pays into the fund. The employer payment is considered a fringe benefit in the hands of the employee. This is often called a salary sacrifice scheme.
A provident fund is an endangered animal. The provident fund is a pension fund, as defined by the Income tax act, so you get the tax relief as in a pension or retirement fund. The large difference is on leaving the fund the full amount of the member’s interest (member and employer contributions) is available for withdrawal. The government does not want this to continue and has tried to stop the lump sum withdrawal, but unions have protested.
Why does the government want the lump sum to fall away? People often use the provident fund as an extra savings account. The result is that they can never retire with a decent income, because it takes a long time to build up sufficient capital to earn an income on retirement.
A second consideration is that pension funds invest heavily in the infrastructure of a government and so stabilise an economy. Governments need the savings to stabilise the country’s economic situation.
Since pension savings investment stabilises an economy the government would rather not encourage an early withdrawal of retirement funds. When an early withdrawal is made, the investor usually incurs an early withdrawal fee, which acts as a deterrent to frequent withdrawals before retirement date. The rationale is that an investor would usually only opt for early withdrawals if there were pressing financial concerns that warranted it, or if he or she had a markedly better use for the funds. Unfortunately that premise is based on the reasonable and educated person. Most people are more excited by the cash, than concerned around the implications of obtaining that cash. Different countries have different rules: In Europe for example is against EU law for an EU country to have rules that deter you from moving around in the EU. In the UK you or the employer may use a trust to preserve the pension monies. In some countries preservation funds are used.
In South Africa, funds that have members enrolled into them as a condition of employment (i.e. pension and provident funds), were required in 2019 to change their rules to allow for default preservation Pension funds did not allow resigning workers to leave their accumulated retirement savings in the fund. In 2019 the employee will still have the right and option to withdraw, upon request, the accumulated savings or to transfer them to any other fund, thereby achieving portability. Employees will also be required to first seek retirement benefits counselling, before they make a decision. The fund values may also be preserved in a preservation fund.
Preservation funds are the retirement funds used when a person leaves a pension fund for any reason such as resignation, retrenchment or dismissal from employment or on the winding up of the employer retirement fund. Preservation funds ensure the pension savings keep the tax protection, while allowing a withdrawal from the fund, should the member require this. It means the pension fund members can keep all their pension savings in one place.
Some countries call such arrangement “qualifying recognised overseas pension scheme” for people to move pension funds to, in order for the person to keep their benefits. Tax can be a problem and it is advised that professional advice is obtained before action is taken.
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Summary of the South African situation and preservation of pension funds. South African employers may use three types of funds for employee pension purposes.
All withdrawals before age 55 years are subject to taxation. This taxation is found in Schedule seven of the Income Tax Act. There are two tables that can apply, one is an early withdrawal table and the second is a retirement or retrenchment table. The withdrawal table gives a very low lump sum amount of R25 000 tax free and then taxes the amount withdrawn at 18 % until R 660 000. After this amount it increases to 27% for the next R 330 000 and then goes to 36% tax rate. The retirement and retrenchment table gives a R 500 000 tax free withdrawal. It makes sense to not use the withdrawal of pension fund monies beyond R25 000 unless you are retiring. These tax free amounts are once off amounts and should the person withdraw from a pension fund again they will not get a tax free amount but be taxed at the higher rate of the full first withdrawal. Terry left his work and used his provident fund withdrawal of R 660 000 to pay for his daughters university education. Terry got R 25 000 tax free given to him His tax was worked out on R 660 000 – R25 000=R 635 000 He paid R 114 300 on the withdrawal and received R 545 700 after tax A year later Terry withdrew from another provident fund one year later and took R 100 000. He paid a 27% tax rate on the full amount or R 27 000 and only receive R 73 000 of this amount. When Terry retires he will only get R 475 000 tax free of any lump sum amount instead of the R 500 0000 others will receive and any amount above this will be taxed at a starting rate of 27%. To protect both the member’s tax status and the investment base of the country, on leaving a pension fund, the member may transfer the pension benefit to one preservation fund only, as splitting of the benefit is not permitted. There is a proviso though, if the member belonged to both a pension and provident fund, the pension benefit must be transferred into a preservation pension fund and the provident fund benefit into a preservation provident fund. Other deductions from the lump sum are allowed before transferring to a preservation fund, and these are limited to:
You may have heard of people talking about deductions in terms of Section 37D of the Pension Funds Act, these are them. There is also a situation if you have a claim in terms of the Divorce Act. Any divorce claim is treated as the first and final withdrawal from the preservation fund. No further withdrawals from the preservation fund will be allowed. Retirement from the preservation fund is at any time between the ages of 55 and 70. The preservation fund also allows retirement earlier than 55 years of age as a result of disability |
So far we have discussed employed persons in the retirement (pension) fund world, but what happens when the person is put into an employee required Retirement Annuity or is self-employed or has extra funds to invest?
When a government realises that a large pension fund base ensures that the country grows, they also accept that a normal pension fund by employment may not be sufficient. Self-employed people also need retirement funding and so a retirement annuity fund is the answer. A retirement annuity fund can be thought of as the individual’s personal and portable pension fund. In some countries this is called a private retirement or pension fund. Such funds never have to be transferred between employers. Each retirement annuity is governed by the countries Pension Funds Acts and the rules of the fund. The rules of the fund are made up by the trustees who are elected to the board of the fund. These rules are approved by the Pension Fund Regulator of the country concerned.
In South Africa the retirement fund has become very popular due to the tax advantages of investing in one. The government is very aware that the pension environment supports the economy and encourages people to invest in the pension provision. This tax deduction follows similar paths as in other countries but is set at a whopping 27.5% of taxable income. Like other pension monies in other types of pension funds, the retirement annuity will not be considered an asset in your estate when you die. For those with more than 3.5 million Rand in estate assets, this is a marvellous tool to save estate duty as well as income tax.
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Tom has a company pension fund and two other RA funds. He wishes to retire. What is Tom’s age? This is an important question. In South Africa, Tom can only access the RAs when he reaches a minimum age, however he may contribute to the fund until he dies and not retire from it at all. There is no mandatory retirement age in an RA. This means if he has excess funds, he can use the tax deduction on his pension income to create an annuity for his children or grandchildren after his death. Is Tom still employed? He cannot access the funds in his Pension fund while he is employed but only after retirement. His company Pension fund will state the retirement age in the rules of the fund. This may be 60 years of age or even older. The pension fund may not allow early retirement before these ages, but Tom may retire from his RA independently of his company pension fund. He may access the RA funds after age 55. |
There are two types of these retirement annuities. The best type is a platform or unit trust (collective investment scheme) based annuity and I would advise caution in the policy based type of Retirement annuity which is often called a life annuity. You may hear the term legacy product used to describe this in many cases. A “legacy” product is a contractual savings product, such as an RA or endowment policy, sold by life assurers in South Africa before 2009. Legacy products have higher charges than the newer products, however moving from a legacy product to a new generation product has serious pitfalls. Brokers get paid commission on products and will often advise on the higher commission or those that get them higher sales credits or book values, rather than the best product for you, the client. Unethical brokers and financial advisors do this, secure in the knowledge that there are few consumers that will understand the implications. A good retirement advisor is worth his weight in gold, while a bad one will cost you dearly.
The platform based annuity is largely driven by the fee structure, where the fees (advisor, platform and fund manager) are based on current, and not projected, investment values. There should be no penalty of any kind applied to your fund value should you withdraw from the fund or stop paying the contribution to the fund. Essentially you have the freedom to change, stop and resume your contributions, as your needs dictate. It is also very easy to do additional single (or ad hoc) investments at any stage. You should also be able to switch the underlying funds or invest in new funds in the offering for no extra cost.
The fee structure in a life retirement annuity differs, in that the financial advisor is typically remunerated based on your future premiums. If at inception you commit to a fixed year term with a 10% premium escalation, the advisor is paid upfront a commission, based on the assumptions, which are that you will pay the full period of time. If you then reduce or stop your premium, a penalty is almost always applied to your investment value, to reimburse the issuer for commissions that were paid upfront to the advisor (which were based on future premiums and future investment value). In South Africa some investment policies may also incur a service charge to a maximum of R 300.
These fees can be levied when you:
Since the financial provider incurred upfront costs, which consist of administration charges and broker commission they are entitled to recoup these costs from the customer. The commission is based on the contributions expected over the life of the policy. The provider raises a loan account against this retirement annuity, charges interest on it, and then recovers this loan over the life of the retirement annuity. If the member lowers the contribution or stops making contributions, the provider accelerates the recovery of the loan, which is the "penalty" they charge.
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Jasper was forced into early retirement and could no longer afford to keep up with his retirement annuity (RA) contributions. He requested his financial advisor to explain the implications of this situation to him. Jasper had taken out the policy a number of years ago, from November 2006 and was paying a premium that was to increase by 10% per annum. Jasper was shocked to discover that by cancelling his monthly premium the value of his policy would be reduced from R542 000 to R 449 860– a reduction of R 92 140. Angrily Jasper told his transfer his financial advisor to transfer the RA to another product provider, a collective investment scheme based investment. His advisor strongly advised against this action. Jasper would pay further penalties and his retirement investment would fall by a total of R 140 974 to R 401 025. |
The insurance company may also claw back the commission from the broker who sold the policy. After the penalty is paid, should a person resume paying into the annuity they will not re-coup the penalty as in all likelihood the existing policy has been made “paid up” and the new premiums will be put into a new annuity with the balance of your paid-up retirement annuity. Ironically this situation will likely cause new costs which will be recovered monthly/deducted from your investment balance).
What can you do with a South African legacy product or a life insurance product that has such high costs?
You have four options which can be explored:
Keep the policy until it matures. This option may be particularly suitable if the life assurer will agree to stop or reduce the annual contribution escalations without imposing any charges.
Make the policy paid up (stop paying the contributions). This could result in a penalty. If you then contribute to a new-generation RA, you need to establish whether, over the long term, the benefits of the new RA will outweigh the loss to your savings from the penalty.
Transfer your savings to a new-generation RA offered by the same life company. Some life companies call this a conversion. When you transfer or convert, you might not have to pay a penalty. If you later elect to change insurers you could be liable for a penalty.
Transfer your savings to a new-generation RA offered by another product provider. The chances are you will pay a penalty for this move. Do your sums, if the penalty is 10 000 and you have five years to go on your policy, the fees you save by moving the RA must at least exceed 10 000.
In South Africa this will require a section 14 transfer. You could be hit with a penalty, so you should first weigh up whether the fees you will save on the new product will outweigh the impact of the penalty.
South Africans often get told they need a section 14 on their retirement funds. A section 14 transfer is when you move the fund from one provider to another. It is a transfer of retirement fund benefits from one retirement fund to another in terms of section 14 of the Pension Funds Act.
A section 14 transfer can take up to 150 days. Section 14 transfers may create a situation which could cost more than staying with the existing provider.
The potential losses include:
Your new investment will have to comply with regulation 28 of the Pension Funds Act. Regulation 28 was amended in 2011, and individual policies issued before that date are exempt from complying with the asset allocation limits, whereas new policies must comply. For example, your old RA has an allocation of more than 85 percent to equities and you transfer to a new fund, you have to reduce your exposure to equities to 75% in order to be compliant.
The maximum commission allowed for a broker is based on a percentage of the policy. This commission may be as high as 20% of the premium paid. On newer life policies these fees that may be deducted are limited to 15% of the investment value.
Some brokers and advisors have changed to a fee based practice. Often this can save a person money, but ask for a comparison and refuse to pay for that comparison. According to the laws in