Too many South Africans treat their retirement savings like a bank account from which they withdraw money to spend on other things. The result is poverty in retirement. In the third part of our "How to" series on saving for retirement, we look at what you should do to ensure that you benefit from saving for retirement over the long term.

One of the major causes of poverty in retirement is that people cash in their retirement savings before they reach retirement.

Carel Basson, a senior financial planning consultant at Alexander Forbes, says that what makes it worse is that there are instances where people resign from their jobs simply to get their hands on their retirement savings so they can use them for other purposes, without understanding the long-term implications of doing this.

And in some cases, there are reports of people getting divorced so that they can get their hands on their spouse's retirement savings. This has been made possible with the introduction of the “clean-break principle”: at divorce the non-member spouse is entitled to a share of his or her former spouse's retirement fund savings. The amount can be taken as cash (less tax) or transferred (without any tax being deducted) to another approved retirement fund.

In a recent study conducted by Alexander Forbes, it was found that over 97 percent of benefits paid to non-member former spouses were not preserved and were instead taken as cash, Basson says.

Normally, retirement fund members may take their retirement savings as cash from an occupational retirement fund (pension or provident) only if they leave their job for whatever reason and thereby resign from the fund.

You may not access money saved in a retirement annuity fund before the age of 55, unless you emigrate.

Alexander Forbes's research shows that the average employee will have about seven jobs over a 40-year working life, Basson says. The evidence is that on average, depending on their age, only between 10 percent and 30 percent of people preserve their retirement savings every time they switch jobs.

Alexander Forbes has found that most retirement fund members retire from their last fund with as little as between five and 10 years of pensionable service; 12 percent have between 10 and 15 years of pensionable service; 14 percent have between 15 and 20 years; and only seven percent have between 35 and 45 years.

On average, pensionable service of the last fund prior to retirement is 19.5 years for men and 15.8 years for women. The effect of this is devastating, Basson says.

Assume you are a member of a retirement fund that provides you with a pension equal to 80 percent of your final salary after 40 years of service. If you halve the years of membership, you will receive a pension equal to only 28 percent of your final salary.

The reason that what is called your replacement value drops so severely is because if you save for 40 years, 60 percent of your final pension benefit will come from the capital and the returns on what you saved during the first 20 years (given the effect of compound interest).

CASHING IN BREAKS YOUR NEST EGG

The consequences of cashing in your retirement savings before you reach retirement include:

  • You will not have sufficient money on which to retire.

  • You will have lost the power of compounding growth on the contributions (remember that compounded growth is most beneficial for the earlier contributions.)

  • If you belong to a defined benefit retirement fund, where your end benefit (pension) is guaranteed, if you cash in your savings in the early years of fund membership, you may not receive the full amount that you and your employer have contributed plus investment growth because of the complex calculations that are used to fund defined benefit funds.

  • The withdrawal is subject to tax. Although the withdrawal is taxed at a beneficial rate, the tax-free portion is one-off. Once you have used it, you have used it for all time, even when you retire. Also, you have lost the benefit of earning returns on money that has been paid as tax. The advantage of tax-incentivised retirement savings is that the longer you save, even into retirement, the more you are making on money that would otherwise be paid as tax.

  • Your dependants could pay the price. If you die before you reach retirement, your dependants will receive a reduced income.

    * With a defined benefit fund, your spouse's benefit and any child benefit will be calculated on the number of years from joining a fund to normal retirement age. So the fewer the years of potential membership, the less your dependants will receive. And a spouse's pension can be reduced to about 60 percent of a member's pension, dramatically reducing the household income. Your dependants will also receive a lump sum life assurance benefit, which is normally about twice your annual pensionable salary.

    * With a defined contribution fund, your dependants will receive your accumulated savings plus any group life assurance. So the fewer years of membership without preserving the withdrawals, the less your dependants will receive.

    EXAMPLE: WHAT NOT PRESERVING DOES TO YOUR FINAL BENEFIT

    John Dludlu gets his first job at age 25. His starting pensionable salary is R8 000 a month. His salary increases with inflation.

    John has been contributing|six percent of his pensionable income to a retirement fund and his employer a further six percent. At retirement he has accumulated R1 114 621 (in today's money terms), assuming an average annual real rate of return (after deducting inflation) of four percent. John will then have sufficient money to provide him with a pension equal to 86 percent of his final salary (his net replacement ratio, or NRR).

    Let us assume that John changed jobs a number of times and never preserved his retirement savings. This is what would happen if he was a member of his last fund before retirement for:

  • 10 years - a pension of R872 a month in today's money terms or an NRR of 10.9 percent;

  • 15 years - a pension of R1 448 a month in today's money terms or an NRR of 18.1 percent;

  • 20 years - a monthly pension of R2 160 in today's money terms or an NRR of 27 percent; and

  • 25 years - a pension of R3 016 a month in today's money terms or an NRR of 37.7 percent.

    If John had preserved half his accumulated retirement savings each time he changed jobs, he would would have improved his position as follows:

  • If John had changed jobs once, at age 35, he would have received a pension of R5 472 a month in today's money terms or an NRR of 68.4 percent;

  • If John had changed jobs at age 35 and again at age 45, he would have received a pension of R3 816 a month in today's money terms or an NRR of 47.7 percent; and

  • If John had changed jobs at 35, 45 and again at 55, he would have received a pension of R2 344 a month in today's money terms or an NRR of 29.3 percent.

    THE BETTER OPTIONS TO TAKING YOUR SAVINGS AS CASH

    If you resign, are fired or are retrenched, you have a number of options that are better than taking the savings from your occupational retirement fund as cash. These options are:

    Choice 1. Take early retirement. If you are 55 years or older, you are allowed in terms of the law to take early retirement. However, the rules of your fund must also allow for early retirement in order for you to exercise this option.

    Taking early retirement could be the best option in terms of tax, particularly with regard to the taxation of a lump sum withdrawal, because the tax-exempt portion is far greater on retirement than on early withdrawal.

    But if you retire at 55 instead of 60 or 65, you are losing five to 10 years during which you could have lived off the income you earn rather than your retirement savings. You will also not be contributing to your savings.

    Choice 2. Defer your pension. You may be able to remain a member of your retirement fund if the fund's rules allow for this. If so, you will become a deferred pensioner. Once you reach normal retirement age in terms of the fund's rules, you will retire.

    The advantages of remaining a member of your fund are that there are no tax consequences and no reinvestment costs.

    Choice 3. Transfer your savings to a new sponsored fund. The rules of most occupational retirement funds allow you to transfer your accumulated retirement savings from your previous fund to a fund that you join. There will be no tax consequences or reinvestment costs.

    Choice 4. Transfer your savings to a retirement annuity or a preservation fund. There are no immediate tax consequences in transferring your accumulated savings to a retirement annuity (RA) or preservation fund in order to "warehouse" your savings until you retire. There will, however, be reinvestment costs.

    Taxation is deferred until retirement, so you continue to earn investment returns on money that would otherwise have been paid to the South African Revenue Service.

  • Preservation funds. There are both pension and provident preservation funds. If you transfer your savings from a defined benefit or a defined contribution pension fund, you must transfer them to a pension preservation fund.

    If you belong to a provident fund, you must transfer your savings to a provident preservation fund. The reason is that savings withdrawn from pension or provident funds are taxed differently at retirement.

    You are permitted to make one withdrawal from a preservation fund before retirement. The withdrawal may be a portion or all of your savings in the fund. Any amount deducted from the savings you transfer to a preservation fund will count as that one withdrawal. The deduction could be made by an employer (to repay a loan, cover losses or theft) or to fulfil the terms of a maintenance or divorce order.

    You cannot make additional contributions to a preservation fund, but you can consolidate funds if you have more than one. You can retire from a preservation fund from age 55.

  • RAs. You can transfer your retirement savings from either a provident or a pension fund to an RA fund, but you will not be able to claim the amount as a deduction against tax, because you will have already made the claim when the contribution went to the fund from which you are transferring your savings.

    You must wait until the age of 55 before you can retire from an RA fund.

    Note: Most preservation funds and RA funds, and an increasing number of occupational funds, give you investment choices, which are circumscribed by regulation 28 of the Pension Funds Act.

    The regulation compels you to diversify your investments to reduce risk. For example, you may not invest more than 75 percent of your retirement savings in equities.

    It is in your own interests to obtain proper financial advice on how your retirement savings should be invested.