Written by Henri Raath B Acc(Hons), CA (SA), CFP®
Despite all the bad publicity that RAs have had over the past few years they are essential investment vehicles for retirement planning.
Like many individuals who criticise sports teams and sportsmen from their armchairs, much of the criticism towards these products are usually because of individuals’ lack of insight and knowledge, as well as an unwillingness to accept responsibility for their own financial wellness.
The bad publicity surrounding RAs were the result of the following:
• the life assurance industry previously charged high costs on RAs; and
• life assurance companies imposed one-sided and unfair contract conditions on policyholders which often resulted in significant reductions retirement savings, such as the case with the penalties imposed on RA members’ savings when they have reduced or stopped their contributions.
Instead of deterring you from investing in RAs, the bad publicity highlights how important it is that you understand RAs and their inherent characteristics.
What is an RA?
An RA is often referred to as a “policy” which is not entirely accurate. In a legal sense an RA is not a policy. When you take out an RA you are in fact signing up for membership of a pension fund which is administered in terms of the rules of the fund and governed by the Pension Funds Act (‘PFA’).
An RA fund makes investments on an investor’s behalf, normally purchasing a life assurance policy from the life company that set up the RA fund. Usually the life company that established the fund also administers the fund. The life assurance policy bought on an investor’s behalf is not the same as a normal endowment policy because it is structured to take advantage of the tax incentives provided by the government to encourage an investor to save for retirement.
RAs were introduced in South Africa in 1960 to give self-employed individuals similar tax incentives to save for retirement as those enjoyed by members of employer-sponsored pension funds. However, this does not mean that only self-employed people can use RAs to save for retirement and people who are members of employer-sponsored provident or pension funds can also join RA funds.
As most employer-sponsored retirement funds will not provide an individual with sufficient income in retirement to maintain his/her pre-retirement standard of living it is advisable that every member of an employer-sponsored retirement fund also contribute to an RA to supplement the shortfall.
As the state gives individuals tax concessions as an incentive to save it also places limitations on what investors can do with that money when they retire. Therefore, when an RA matures, an investor has to buy a monthly pension with at least two-thirds of the fund value of the RA.
Tax advantages of an RA
1) Tax on contributions to a RA
Up to certain limits, an individual do not pay tax on his/her contributions to an RA, whereas contributions to endowment policies are made with after-tax money. Contributions can exceed these limits, but the individual will not get the tax advantage on the amounts above the limits.
Under current legislation you can claim as a tax deduction the greater of:
• 15% of your non-pension funding income before other tax deductions; or
• R1,750; or
• R3,500 less your current contributions to a pension fund; or
If you contribute more than these limits, you may claim the amounts that exceed the limits in future tax years limited to R1,800 per year, provided your contributions in the years in which you claimed remained within the limits. Excess contributions which are not tax deductable may also be added to the tax-free portion of the lump sum you receive at retirement.
Retirement-funding income is normally your basic salary excluding any allowances, such as a car allowance. Most employers use only your basic salary to calculate how much they will contribute to your pension savings. Very few employers make pension contributions based on their employees’ gross pay packages (basic pay plus all allowances).
Non-retirement funding income is any income you earn that your employer does not take into account when contributing to a company-sponsored pension fund. Non-retirement funding income can include allowances paid by an employer, such as your car allowance (but only the portion not claimed as a deductible expense for business travel) and taxable income from other sources (for example, rental income from a second property).
2) Tax on income and capital gains in a RA
The accumulation of income aand capital gains in your RA is totally exempt from income tax and capital gains tax which is a massive advantage over unit trusts where an investor pays tax on income and capital gains, irrespective of whether the income is distributed or not.
This has the result that the after-tax returns on RAs over the longer term are materially higher than returns on unit trusts, endowment policies and fixed deposits. You can also refer to our newsletter entitled “Tax efficient structuring of investments” for more information regarding this.
3) Tax implications when you retire
3.1) Tax on the lump-sum payout
When you retire you may extract a maximum of one third of the fund value as a lump sum and you have to purchase an annuity with the remaining two thirds. You can however take no lump sum and use the full fund value to purchase an annuity.
As a general rule, individuals take the entire tax-free portion of the lump sum, even if they do not need the liquidity because they want to take advantage of the interest and dividend exemptions which SARS makes available to individuals. Individuals’ views on this differ substantially and it is therefore necessary to get proper advice when you retire.
3.2) Tax on your monthly pension (annuity)
There is no tax applicable to the build up of income in the investment (interest, foreign dividends and net rental income) and you are only taxed on the income that you withdraw from the investment on a monthly basis in the form of a pension.
The term of an RA
You cannot access your funds in your RA until you are 55 unless you become disabled before that age. In other words 55 is your earliest retirement date. However, you can extend the period beyond 55 if you wish. If you stop paying premiums (make the RA “paid-up”) the funds will remain invested in the funds specified until you are at least 55 years old. This is to ensure that your money is kept for retirement.
Individuals can contribute to RAs even if they are older than 70. From a tax point of view it is often worth delaying retirement from an RA as late as possible because individuals can continue to claim their contributions to an RA against their taxable income after they have reached the age of 69.
Previously the penalties that life assurance companies levied if you retired early or ceased your contributions were considered to be too high. If you took an early retirement benefit (before a premium period of 20 years has expired) your fund value could have been reduced with a 30% adjustment levy. If you ceased your contributions (before a premium period of 20 years has expired) the fund value would have been reduced by a 20% adjustment levy.
Under new legislation these penalties have been substantially reduced. If you take an early retirement benefit (before a premium period of 10 years has expired) your fund value will be reduced with a maximum 15% adjustment levy. If you cease your contributions (before a premium period of 10 years has expired) the fund value will be reduced by a maximum 15% adjustment levy. These percentages reduce by 1.5% per year as the term of the product continues.
Investors should still however establish the exact criteria in writing for any penalties that may be applied if they have to reduce or stop paying their premiums.
Consumers are being offered more and more investment funds to choose from. The choice can range from a simple managed portfolio with capital guarantees, invested across asset classes and in which you have no say in the investments, to a wide variety of unit trust funds which you must select from fund managers like Allan Gray, Coronation, Nedgroup, Sanlam, Old Mutual, etc.
These investment funds come with various levels of investment risk. Most of these offerings also come with simple calculators to assess your risk profile which can be misleading. Often these calculators are based more on your psychological approach to risk than your actual financial ability to withstand investment risk. Consequently, people who are not psychologically prepared to take high investment risks can land up without sufficient money on which to retire.
There are regulations, issued under the PFA, which attempt to limit investment choice and therefore limit the risk to individual investors. These regulations are called the Prudential Investment Regulations (“PIRs”), and they restrict how much can be invested in the various asset classes, offshore and in specific sectors of the market and/or companies. For example, no more than 75% of certain funds are allowed to be invested in shares and no more than 15% may be invested offshore.
The problem with these guidelines, however, is that they only apply at fund level and not to individuals. While some RA funds insist on applying the PIRs at fund and at individual level, others do not. In other words, as a member of an RA fund, you may be able to choose an extremely high-risk portfolio, and invest 100% of your money offshore or 100% in shares. These regulations are currently under review and there is a strong possibility that the PIRs will be applicable on both the fund level as the individual level in future.
Before you opt for an RA that gives you a wide range of investment choice, you should consider the following factors:
• Costs: The greater the choice, the more it is likely to cost you, particularly if you switch between options on a regular basis. Most RA platforms allow 2 free switches per year and thereafter they charge a standard fee for switching the funds in your investment.
• Expertise: Many people have lost huge amounts of money by continually switching into the investment flavour of the month, often because of poor financial advice as well as behavioural finance patterns. On the other extreme, some investors opt for the most conservative portfolio, which reduces potential returns and the possibility of having a financially secure retirement.
Protection from creditors
A limited number of institutions or people may claim against your RA. They include SARS in the case of unpaid taxes and a previous spouse, but then only in terms of a court-approved divorce settlement.
The only time a creditor may lay claim to the money in an RA, or any other retirement savings vehicle is when you retire, and then only from any lump-sum amount you are paid. A creditor may also not claim money that is paid to you as an annuity bought with the benefits of an RA. For this reason, you cannot borrow against an RA or use it as security for a loan.
What happens when you die?
When you take out an RA, you should name a beneficiary or beneficiaries. However, the nominated beneficiaries will not necessarily receive the benefits. This is because, in terms of section 37c of the PFA, the benefits from any registered retirement fund, including an RA fund, must be distributed first to your dependents and then to nominated beneficiaries.
If you do not nominate a beneficiary the money will go into your estate and estate duty will become applicable.
Please feel free to contact us should you wish to discuss anything regarding the above or if you want to review your existing RAs.