The difference between compulsory and discretionary investments – and why you need both
A third of working South Africans do not have any retirement savings at all. Also, only eight per cent will have saved enough to live on three-quarters of their salary once they have retired.
This is according to Rita Cool, financial planner at Alexander Forbes Retail, who adds that South Africans do not generally save as a result of strain on their income, high debt levels and not having a culture of saving.
Compulsory or optional saving
When it comes to putting money away, South Africans have two choices depending on the purpose:
1. Compulsory saving by investing in retirement products
2. Optional saving by putting money into discretionary products
Tax benefits or easy access to money?
Cool explains that saving in compulsory products could make more sense than saving in discretionary products.
“This all depends on the reason you are saving. Do you want more tax benefits gained from compulsory investments, or are you looking for easy access to the money? Compulsory investments provide yearly and ongoing tax benefits, but you cannot access them whenever you want. Discretionary accounts, conversely, provide accessibility but limited tax benefits.”
Tax-free savings accounts seek to balance easy access to money and tax benefits:
- You can easily access the money and
- You don’t pay tax on the growth earned, whether from interest or dividends received or capital gains earned.
However, as Cool explains, you can invest only R36 000 a year up to R500 000 over a lifetime. Do not let that put you off from starting a TFSA as these amounts add up over time before you know it.
Regulation 28 governs compulsory investments. It regulates the extent to which retirement funds may invest in asset classes and offshore to protect members’ retirement savings from the effects of poorly diversified investment portfolios. Many people do not like the limits of Regulation 28, as it restricts their investment options, says Cool.
Some investors may want to invest more overseas, or 100 percent into shares. Regulation 28 limits investments up to 75 percent in shares and 30 percent in offshore investments as prescribed by the Reserve Bank.
Ironically, restrictions lead to outperformance
“Is it better to save in a discretionary investment without restrictions, or in retirement products governed by Regulation 28? Research has shown that the additional growth achieved due to the tax benefits on retirement products far outperforms most unrestricted discretionary investments,” says Cool.
You benefit from two different tax benefits when you contribute to retirement annuity, pension or provident funds:
1. Tax deductions on the contributions
You can contribute up to 27.5 percent of your taxable income towards a retirement product, up to R350 000 a year and get the tax back. It does not matter if this is contributed to a pension or provident fund or an RA, it is a cumulative rate for everything contributed that year.
“If, for example, you earn R250 000 a year and contribute 15% of this salary every year to a retirement fund compared to investing the same amount to a discretionary product, you will have around 30 percent more in your retirement savings over a working career of 35 years. On a salary of R1 million, this benefit will give you more than double in your retirement product than your discretionary savings over the same period.”
2. Tax benefits on the tax-free growth
One of the main reasons for the outperformance of compulsory assets is that the growth within the products are tax free. There is no Capital Gains Tax, tax on interest or dividends tax deducted that would be applicable to discretionary investments.
At retirement you can take up to one-third of your retirement savings in cash from retirement annuities and pension funds, and in the future this limit will apply to provident funds as well for people currently younger than 55. You need to set up a monthly income like a Living Annuity or Guaranteed Annuity with at least 2/3rds of your retirement funds in that case.
“Any retirement savings you withdraw would be taxed. In the above examples, the one-third cash from your retirement savings would still be 50 percent more than the one third of your discretionary savings, even after tax. Not only that but the monthly income on the balance would be up to 30 percent more, even after income tax.”
A ‘living annuity’ is a flexible pension where the capital at retirement is invested to provide an income after retirement. Regulation 28 does not govern living annuities, so your investment strategy can be more flexible than before retirement but the main benefit is that growth is also tax free in a living annuity.
Income can last three years longer
On a five percent drawdown rate, your income can last up to three years longer, depending on the taxable salary, if you draw from the living annuity instead of discretionary assets. Discuss your specific case with your financial adviser to see how this can benefit you.
“Do not discount contributions to retirement annuities or additional contributions into your company fund or even the smaller contributions allowed to a tax-free savings account. The compounding effect of the tax benefits is worth it,” concludes Cool.