Monet’s garden, Giverney
Should you top up your RA before the tax season ends?
It is ‘retirement annuity (RA) season’, any contributions you can get into your RA before the end of the month can count toward your tax deduction for this financial year. If you have been ignoring all that advice, advertising and appeals from your broker like the plague, I don’t blame you. I have been around long enough to be tainted by some of the appalling business practices around insurance company RAs (and company pensions) myself, some of which still hang around today. With all the investment options available now, is there a place for retirement annuities today?
With the exception of a tax-free savings account which is capped at R33,000 pa, there are very few tax-efficient investment vehicles out there. Endowments are not ‘tax-free’, they are taxed within the fund at 30%, so unless your average tax rate is well above this, and you have maxed out on your annual interest and CGT allowances, they aren’t going to give you much real tax relief (except of course being out of sight so out of mind). They do however work really well for investments in a Trust.
Before looking at how tax effective an RA can be, let me just put some caveats in place: In my opinion, never use an insurance platform, nor add to an existing RA you already have on an insurance platform (beyond that which you are contracted to do so). Why? There are still nasty things called ‘early termination penalties’ that they can impose on your investment when life happens and you dare to want to reduce or stop the contribution. These penalties are levied because insurance companies pay brokers all the commission on the policies, for years into the future, at the start of the policy. Use a LISP platform.
The government have started to limit the amount of contributions you can deduct off tax – now at 27.5% of your taxable income or R350k pa, whichever is the lower. Taxable income can include interest on investments, rental income or income from other sources like commission (but allowable expenses related to these, like home-office or rental expenses, must be deducted first). At least these days all retirement savings – pension, provident fund and RAs are all lumped together for this allowance – in the past, if you had a company pension, irrespective of how much or little it was, you could only claim a minuscule additional portion of your RA.
What to do when you’re on a fixed income. Preparing for the eventuality.
The phrase ‘fixed income’ strikes fear into the heart of anyone anticipating retirement. The last thing any of us want is for that income to run out before we do. Making sure that doesn’t happen takes years, and decent investment advice, but irrespective if it is at age 65, 70 or older the chances are new ‘active’ income is going to stop flowing in and you’re going to have to start using ‘passive’ income (from whatever source). Thriving when your income is fixed (in other words just keeping up with inflation) is often a challenge especially when some aspects of your expenses exceed inflation (like medical aid) and force you to cut back. There is a limit to how you can ‘sweat’ those assets without exposing them to significant risk, so often consumption has to give. This is the ‘harvest’ period of your wealth lifecycle that you have been preparing for all your life.
Fifty years ago retirees were not expected to live much beyond 10 years after retirement at age 65, today you can easily live another 30 years, and this brings a whole slew of additional pressures to your fixed income.
The wealth equation goes like this:- Income minus Consumption equals Wealth. At retirement we are probably not adding to the Wealth side of the equation, so it must be managed properly and sustainably because it is going to feed back into the income – a closing of the wealth ecosystem/lifecycle as it were.
Before we get onto the consumption side of the equation, make sure that the fixed income is going to be structured properly. Diversify! Have a number of pots of wealth on the go, flexible investments, stock portfolios producing dividends, pensions/annuities, rental portfolios etc. If the ‘fire’ goes out under one of those pots temporarily, you aren’t going to starve. None of the pots are fireproof, especially not your own company if, like most entrepreneurs, you’ve poured all your investment into that. Every entrepreneur needs to have either an exit strategy that realises the wealth you’ve poured into the asset, or a solid succession plan that can produce an active/ passive income by way of dividends, director’s and consultant fees.
The Passive revolution
All over the world investment fees have fallen substantially, not just as a result of lost trust in investment bankers’ post 2008, but with the massive increase in the use of ‘passive’ funds that use cheap computers instead of expensive asset managers to structure long term portfolios. In other words they just follow what the stock market is doing and don’t try and get clever and ‘beat’ the market. The losers are the ‘mutual funds’ what we call Unit trusts or collective investments here in RSA. Gone are the days when asset managers could get away with fees of up to 3%. Passive investments usually come in below 0.5%, and some even lower than 0.3% and we haven’t seen the bottom yet. Why are we in SA dragging our heels to keep up with this global trend?
One answer could lie in our much higher inflation for the fees to hide behind. If you take 3% off a 10% growth you’re still getting 7%. Factor in inflation of 6% and the real growth is only one percent. It looks very different to taking 3% off a 5% growth ( which is in line with the kind of growth they have been experiencing in the West), their inflation is still around 1%, so the nett effect is the same – but the perception by clients is way different. Basically we have been hiding behind double digit growth. Investors are happy to share in times of good growth, but when things swing down they aren’t quite so magnanimous.
The trend to lower cost passive investing has already started in earnest and clients that are following offshore trends are (rightly) insisting on these lower fees, especially for long term investments like retirement funds.
Performance fees – which are essentially hidden – are another bone of contention and the government has woken up to the problem and started to demand ‘clean’ pricing (without the dirty performance fees) for retirement funding, starting with the Tax Free Savings accounts. Performance fees have a number of issues. Firstly they are imposed on future performance based on past performance. In other words, new money coming into the fund has to pay the fee despite not having enjoyed the return in excess of the benchmark. Secondly, some collective investments build their own benchmark – making it impossible for you to compare apples with apples. It’s like doing your own performance review.
Longevity isn’t for sissies
Every year we get a greater understanding of what shortens or prolongs life. Medical research finds ways of extending life and life expectancy increases – to universal celebration. This increase in life expectancy has to be funded in the retirement years. In countries that have decent government sponsored pensions this is causing a severe problem, exacerbated by the slowing birth rate. In effect in those countries they are using pension contributions from the young to pay the old, because estimates made decades ago as to how long people would live were way out. This is all going to implode one day.
In South Africa, where most working South Africans will have to make their own provisions for retirement, and cannot rely on the government safety net, this problem is right on our doorstep. The retirement models that many financial planners use, still assume that we will live maximum 20 years past retirement age of 65. In other words 85. These models assume total capital consumption because preserving capital makes the required savings ratios out of reach for most struggling families.
Unfortunately it is much more realistic to assume that you will live 30 years past retirement. There is another growing trend that is going to impact this even more. Families are postponing having children into their thirties, and even their forties. This means they will have dependants will into the traditional ‘accumulation’ years, perhaps right to the edge of retirement. It’s an uncomfortable fact that children put a significant dent in your consumption and makes it very difficult to top up retirement savings. If couples that delay starting family are doing that high accumulation and retirement saving before children, then there wouldn’t be an issue, unfortunately most couples are consuming much of that income on travel, leisure and lifestyle assets. It is going to take 20 years for that problem to become really apparent, but if you fall into that demographic I recommend you sit down with your financial advisor and plan out a happier outcome. The good news is that the proportion of your income you need to put away is going to be fraction of what it would be in your fifties.
Wealth is what is left after you have consumed your income. So it is simple, if you want to increase your wealth, increase your income or decrease your consumption.
Beware the rushed Section 14 transfer
Legacy investment products are those investments where “early termination” results in a penalty to the client – usually endowments and retirement annuities on life insurance platforms. Investments started before 2007 can still result in a 30% penalty, thereafter 15%. This penalty is not on the premiums but the full fund value. The reason for this is that those penalties is because the broker took upfront commission equal of up to 27 years of commission in the future. “Unrecouped expenses” the insurance companies call it. Guess what, it is still happening. I shudder when brokers justify these products as ‘doing a service to South Africans who wouldn’t otherwise save’. Excuse me while I puke.
Anyone who follows my blogs knows that these products are my pet hate, but the good news is that the much maligned “Retail Distribution Review” is likely to have these products first on their hit list, awesome news for the man on the street who is still conned into these products by brokers out there who prey on the fear of retiring in poverty. I would like to see this prohibition extending to all the historical products too but, with all due respect, I am not sure that the FSB has the teeth or the b*lls to take on those big insurers. I have been in business long enough to know that if I was an insurer I would have written off those costs a long time ago and not feel the need to gouge 30% of a fund value of a pensioner who has been with my company for 30 years because his broker sold him a ‘graveyard’ policy that matures when he is 85.
What is the alternative? For many years brokers have had the option of placing a client’s retirement annuity on a LISP platform where they get ‘as-and-when commission’, ‘trail fees’ and/or ‘fees for assets under management’ or ‘ongoing financial advisory fees’ – and no early termination penalty. I know this sounds like industry gobbledygook, but it is very important to understand how commissions, fees and penalties work so that you can make an informed long term decision – so bear with me.
When your business = Your retirement plan
By their very nature, entrepreneurs are risk takers, and thank goodness for that. They are prepared to plough every last cent of their earnings and savings into their business and go for broke. Sometimes, yes, going broke.
- Cash-in retirement savings to start the business. This is very common when someone leaves a decade or so of a corporate career that an entrepreneur will cash in their pension or provident fund to kick start their business. Despite the tax penalties (that you never get back) it is a very tempting and quick way to get cash.
- Your business = your retirement plan and no other provisions are made. Is this realistic? If the business is small and tied up in the skills of the entrepreneur then this is a disaster looking for a place to happen. There should always be a back-up plan. Run some scenarios with your financial advisor for your minimum monthly needs at retirement – run the debit through payroll so you don’t even miss it, then everything else is a bonus.
- Not making use of Group Retirement or Life funds. Once your company gets over about a dozen people, this becomes a no-brainer. It is way cheaper than taking out the insurance yourself, promotes staff morale and reduces your potential risk if one of them (or you) become disabled while working for you. An umbrella retirement fund usually has low expenses, and because it comes straight off payroll, y u won’t miss it. Make sure the life cover is structured properly so that there is always the option of taking it out in your own name later.
- Over-confidence in investment abilities. Entrepreneurs like to do it themselves and that often includes investment, and usually, that means additional risk. When cash-flow is tight it is tempting to make your investments “work” for you and this is fraught with danger if you don’t understand the risk/return trade-off, asset allocation and a very good idea of the state of the economy. Money and emotions walk hand in hand, and it’s very difficult to control them both at the same time. Greed and Fear can do ugly things to your investment. If your advisor does nothing else but protect you from yourself, then the money is well spent.