Words on Wealth:
Retirement funds were designed for you to save for your retirement. Although they have built-in limitations, they have distinct advantages over discretionary investments. Do the advantages outweigh the limitations, even when market conditions favour discretionary investments? Research by financial services firm Alexander Forbes shows that they do.
Many investment professionals are critical of Regulation 28, the rule under the Pension Funds Act that imposes limits on how much retirement funds can invest offshore and in higher-risk asset classes, such as property and equities. They say the limits are too restrictive and that funds should have more flexibility to invest where they choose, to optimise long-term returns for their members.
A major point of contention is the limit on investing offshore, which restricts funds to a maximum of 30% in foreign markets and a further 10% in Africa outside of South Africa.
Calls for retirement funds to be allowed greater access to offshore markets have become louder in recent years because of the poor performance of JSE-listed equities and the ongoing steady depreciation of the rand against the major foreign currencies.
In November, in an attempt to encourage foreign investment in South Africa, National Treasury issued a circular that changed the status of JSE-listed rand-denominated offshore instruments to domestic instruments. Providers of exchange traded funds (ETFs) tracking offshore market indices saw this as a way of circumventing Regulation 28’s offshore limit. However, when the government became aware of this “loophole”, it withdrew the circular.
The offshore brigade was appalled at this seeming about-turn. Some financial advisers went so far as to advise their clients to put as much as they could of their retirement savings into discretionary investments in order to take their money offshore. How responsible were these advisers in giving such advice? Would you genuinely be better off having the bulk of your retirement savings offshore?
John Anderson, executive of investments, products and enablement at Alexander Forbes, and his team of actuaries set about finding answers to these questions, and he shared the results at a recent media presentation.
It’s in the government’s interests that we save for our retirement – it cannot afford old-age grants for everyone, even at a paltry R1 700 a month. But there is another good reason for maintaining a large pot of retirement savings within South Africa: it’s one of the country’s largest resources for economic development. At least three-quarters of this R4.2 trillion savings pot is invested in local industry and infrastructure.
The government provides powerful incentives for us to save in retirement funds, in the way of generous tax breaks on what goes into them, but it also restricts how you can use the money you have saved. The major features are:
- You can deduct your contributions from your taxable income. The tax break applies on contributions up to 27.5% of your annual taxable income, and up to R350 000 a year.
- The investment itself is not taxed: income tax on interest earned, capital gains tax, and the 20% withholding tax on dividends do not apply to retirement funds.
- When you retire, you can take up to one-third of your savings as a lump sum, of which R500 000 is tax-free. With the remaining two-thirds (or more), you must buy a pension (annuity), which can take various forms. In these post-retirement investments returns are not taxed, but you do pay income tax on your pension.
Discretionary investments, on the other hand, are subject to taxes on interest, dividends and capital gains. However, there are no restrictions on withdrawals.
Anderson said it is important, if you intend to remain in South Africa, that you have a greater allocation to South African assets than offshore ones because your liabilities – your expenses, such as food, accommodation and debt repayments – are in rands. The volatile exchange rate can work against you both when taking money offshore and when bringing it home.
Anderson’s team of actuaries first considered what the optimal offshore allocation would be for a retirement fund. They targeted returns of five percentage points above inflation, while seeking to keep investment risk low. Looking backwards at market performance over the past 15 years, the team found that the optimal offshore allocation would have been 40 to 45%. However, looking forwards, based on the Alexander Forbes house view of the markets in November, they found that the optimal offshore allocation was likely to be lower, at 25 to 27.5%. These figures are not far off the Regulation 28 limits and “nowhere near 100% offshore allocation recommended by some advisers”, Anderson said.
He said: “We believe additional flexibility would be welcome, but on the whole you don't need more flexibility than up to 50%. A gradual raising of the current limits is desirable, but it should be done in a way that balances the other objectives that the regulations are aiming to achieve.”
The team then compared the performance of formal retirement savings with that of discretionary investments with a 100% offshore allocation over 35 years. Their model considered a range of outcomes under different income brackets (contributing 15% of income) and under different equity return scenarios, where local returns were higher than offshore returns and vice versa. They took into account an average annual depreciation of the rand of 7.2% a year over those 35 years, and based their calculations on the 2020/21 tax tables adjusted for inflation each year over the period.
The results, Anderson said, were quite staggering. They found that, under all scenarios, and whatever your income level, the retirement fund significantly outperformed the discretionary offshore investment, and this was wholly due to the tax benefits. And the more you earned, the more the tax benefits worked in your favour.
In the base-case scenario, where the average before-tax real (after-inflation) returns of the two portfolios were almost equal (retirement portfolio 5.58% a year; discretionary portfolio 5.60% a year), for someone earning R500 000 a year, after 35 years the accumulated savings in the retirement fund was R7.3 million. In the discretionary investment it was just over half of that: R3.9 million.
In the scenario where the retirement portfolio delivered 5.60% and the offshore discretionary portfolio did better, providing an average annual pre-tax real return of 6.50%, the after-tax real returns in the discretionary portfolio were:
- 4.62% for someone earning R500 000 a year. You’d need a real return of 7.65% to compensate.
- 4.21% for someone earning R1 million a year (8.15% needed to compensate).
- 3.91% for someone earning R2 million a year (8.55% needed to compensate).
The tax benefits do not stop at retirement, Anderson said. His team showed that outcomes in a formal post-retirement vehicle such as a living annuity continued to surpass those offered by a discretionary investment.
PERSONAL FINANCE