Retirement savers still free to sabotage themselves
Even after the final reforms are in place investors will remain free to be their own worst enemy, writes Mica Townsend, Business Development Manager and Employee Benefits Consultant at 10X Investments.
Almost 10 years after National Treasury embarked on its mission to strengthen South African retirement savings, as reflected in the Taxation Laws Amendment Bill of 2020, the final reforms are scheduled to come into effect on March 1 but, unfortunately, fund members will still be free to sabotage their own retirement.
As pertinent as some of these reforms are, they are unlikely to achieve the overarching objective, to “improve preservation … and ensure higher levels of income in retirement”.
The reforms do not adequately incentivise, or enforce, appropriate behaviour. This means that fund members are likely to continue to make poor investment decisions and cash in their savings early, a very common course of action that tends to have a crippling effect on a retirement saver’s final outcome.
In its initial discussion paper in 2012, “Strengthening retirement savings”, Treasury argued that the complexity of the existing tax laws – the arbitrary differences in tax deductions, access rules and annuitisation requirements across fund types – discouraged saving and added unnecessary costs.
It has, therefore, acted to harmonise these rules. Since 1 March 2015, the maximum annual tax-deductible contribution to pension and provident funds and retirement annuities has been standardised as 27.5% of gross remuneration or taxable income (with a cap of R350 000). In the final aspect of these reforms, which is scheduled to come into effect on 1 March 2021, provident fund members must use at least two-thirds of their savings to buy an annuity that will pay them an income in retirement (as pension fund and RA fund members are already obliged to do).
In principle, this is a good thing. For the great majority of people, purchasing an annuity is the most sensible and tax effective way to manage their retirement savings. It is sensible because the legal draw-down limits will enhance the longevity of those savings, and tax effective because it lowers the average rate at which those savings are taxed.
Those entering the workforce after this reform has been enacted will find a far simpler system. They will see no difference between pension and provident funds; only RA funds will stand out, and only because there is no option to cash out savings when changing jobs as these funds are not connected to an employer.
Current provident fund members who are younger than 55 when this reform is enacted will have to contend with a complex blend of the old system and the new one. The new rules will apply only to contributions (and returns made thereon) after the reform is enacted. So-called vested rights (the provident fund balance on the day before the reform is enacted and subsequent returns thereon) may be still claimed under the old rules (i.e. as a lump sum) at retirement.
Fund administrators will have to separate these balances, possibly for the next 40 or 50 years still.
If nothing else, this separation will underline the importance of preserving even seemingly small amounts. To illustrate, in the context of a 40-year savings plan, the vested balance after just 10 years (plus subsequent returns) will make up some 45% of the final savings balance.
Even those who had been saving for just five years on the scheduled enactment day of 1 March 2021 would have 30% of their fund balance subject to the old provident fund rules. Add in the one-third lump sum portion available from the non-vested portion, and these savers would still be able to cash in more than half their savings in 2055. The potential for significant lump sum leakage at retirement will thus be with us for decades to come.
But even doing away with vested rights would not stop it all. There is just no point locking the stable door after dark when it stands open all day. Without mandatory preservation pre-retirement, those who are determined to avoid an annuity will simply exit their fund before retirement. The lump sum tax penalty will not dissuade them, just as it doesn’t dissuade most people today.
So, unfortunately, by protecting vested rights and avoiding compulsory preservation, the mandatory annuitisation of provident funds will do little to raise income levels in retirement. That outcome will still be largely down to individual behaviour, meaning most fund members will continue to focus on their short-term needs at the cost of their retirement lifestyle.