Are we too focused on tax-savings pre-retirement?

With 2022 having approached quicker than most of us had anticipated, some eyes are already set on the end of the financial year (February 2022) where many investors are faced with a key question: Should I top up my annual contributions to my retirement funds? The obvious answer to this question for most is a resounding “yes” especially considering the various tax advantages offered by retirement products in South Africa.              

Arguably the most favourable investment vehicle remains the retirement annuity (RA) for many South African investors, especially when investing locally. They provide a great mechanism for investors to invest as there are numerous tax benefits pre-retirement that not only reduce your income tax liability but lead to more growth as there is no tax on interest, dividends, or capital gains while you remain invested.

Since 2016, investors can contribute up to 27.5% of their total annual income to a retirement fund (the contribution is capped at R350 000) and get a tax refund. Examples of a retirement fund include a pension fund, a provident fund, and a retirement annuity.

For this reason, we see many investors topping up their annual contributions to a RA in February each year to further benefit from the income tax deduction provided by Sars. This income tax deduction can be used to settle debt, fund annual holidays, fund children’s education costs, or put down a deposit for a house. Some people might even use the tax refund to contribute to an additional investment. In practice, however, most people end up spending this tax refund. A further additional benefit on offer from retirement funds is that the proceeds of pension, provident, preservation, and retirement annuity funds do not fall into a deceased estate and, as a result, do not attract estate duty.

This then raises an important question: Is the retirement annuity the most appropriate investment vehicle for surplus contributions or annual top-ups? Or are we too focused on tax-savings pre-retirement and are there other considerations such as tax efficiency in retirement, liquidity, and income longevity that should be considered when deciding where to invest surplus investment contributions?

The answer to this important question differs for investors based on various factors such as pre-and post-retirement earnings, expected retirement expenses, liquidity needs, investment time horizon, the utilisation of exemptions, etc. Since all the growth in the RA vehicle is tax-free, one can expect to have the most capital accumulated in this vehicle at retirement, but does this then lead to more income longevity in retirement?

Using Old Mutual Wealth’s flagship financial planning tool, “The Wealth Integrator”, we unpacked this question for ‘Bob’ to better help illustrate the outcomes of different investment vehicles and how they could potentially impact his overall retirement plan.

Bob is 40 years old, and he earns a monthly salary of R60 000. His employer is currently contributing R10 000 per month (pm) on his behalf towards his pension fund (which is a taxable fringe benefit but then offset against his deduction for this contribution). His contributions are assumed to be adjusted (increased) in line with inflation every year which is assumed as 5%. He has accumulated R3 000 000 to date into this pension fund and he plans to retire at age 60 (20 years from now). Upon retirement, he wishes to fund the following expenses in today’s money:

• Living Expenses: R25 000 pm after tax in today’s money assumed to increase with inflation of 5% every year.
• Medical Aid: R3 5000 pm after tax in today’s money assumed to increase at 4% above inflation, i.e. at 9% every year.

Bob has a surplus of R5 000 pm which he would like to save towards his retirement (to be adjusted every year for inflation) and is unsure as to what the most appropriate investment vehicle would be for this additional monthly contribution. Using the Wealth Integrator, we considered all the following investment options along with Bob:

• Option 1: Investing the R5 000 into a retirement annuity.
• Option 2: Investing the R5 000 pm into an endowment (life-wrapped investment).
• Option 3: Investing the R5 000 pm into a unit trust/linked investment assuming an annual tax rate of 10% applicable for taxation on interest and capital growth.
• Option 4: Investing the R5 000 pm into a unit trust/linked Investment assuming an annual tax rate of 20% applicable for taxation on interest and capital growth.
• Option 5: Investing the R5 000 pm into a retirement annuity and using the annual tax saving because of the tax deduction received on contributions and re-investing these proceeds into a unit trust/linked investment assuming an annual tax rate of 10% applicable for taxation on interest and capital growth.
• Option 6: Investing the R5 000 pm into a retirement annuity and using the annual tax saving as a result of tax deduction received on contributions and re-investing these proceeds into a tax-free investment until the annual or lifetime limit is reached after which the balance is invested into a unit trust/linked Investment assuming a tax rate of 10% applicable for taxation on interest and capital growth.
• Option 7: Investing R3 000 pm into a tax-free investment and the balance of the R2 000 into a unit trust/linked investment assuming a tax rate of 10% applicable for taxation on interest and capital growth. The total R5 000 pm is to be adjusted for inflation every year and the tax-free annual and lifetime limits are not to be exceeded. Any excess contributions are redirected into the unit trust.

We have applied the following assumptions:

• We assume Bob receives a moderate return of Inflation Plus 4-5% (9.5% per year) after all costs.
• It is further assumed that at retirement his compulsory funds (pension and retirement annuity funds) are converted to a living annuity and the minimum of 2.5% is initially drawn and the balance is funded from liquid, discretionary funds (unit trust, endowment, tax-free investment, etc). Once discretionary funds are depleted then the 2.5% is automatically increased until the 17.5% legislative limit is reached on the proposed living annuity investment.
• For discretionary funds (unit trust and endowment), tax is deducted annually from the 9.5% growth rate as mentioned above. We assume his 9.5% growth is made up as follows:
  • 1.19% interest
  • 1.14% dividends and
  • 7.17% capital growth
• Tax applied to interest and capital gains are described in each scenario for discretionary investments and a 20% tax rate is applied for dividends.
• Annual Interest and capital gains tax exemptions are ignored to simplify the scenarios (conservative assumption).
• It is assumed that the R5 000 pm RA contribution reduces his taxable income from R60 000 to R55 000 which equates to a monthly income tax saving of R1 950 pm

The outcome of the different scenarios looks as follows:

Scenario 7 above here provides the best outcome for Bob where he directs his surplus to a tax-free investment and unit trust. However, Scenario 6 is very similar to Scenario 7 with only a one-year difference in overall longevity. One might consider this scenario to be superior when you also consider the estate planning benefits offered by the retirement annuity.

One thing that is quite clear is that a retirement annuity compares favourably with when a surplus is invested into discretionary funds (i.e. unit trust, tax-free investment, endowment, etc.) and the tax savings also invested. When the annual tax saving is not invested the RA does not compare all too well. The reason for this is due to the negative impact of taxation on the income drawn from the retirement annuity post-retirement. Every R1 is fully taxed as income, whereas in the tax-free investment there is no taxation applied and, on the unit trust and endowment, tax is only levied on interest, dividends, and capital gains.

The retirement annuity might provide the most capital at retirement, however, accessing that capital in the form of an income comes at quite a price for investors with higher expenses in retirement as there will be a bigger income tax liability that might need to be considered.

These scenarios do make an argument for the consideration of discretionary (liquid) investments in your retirement portfolio. However, investors need to be aware of the risks of having access to the capital in the discretionary investment vehicles and be disciplined enough to not access this capital before retirement. It is always urged to have emergency funds set aside for this purpose.

One could also further make the argument that discretionary funds allow you to potentially earn a higher return over the long term as you are not constrained by Regulation 28 that applies to retirement funds, and essentially limits asset managers’ allocations of retirement savings to certain assets classes, including equities, property, and foreign assets.  In our scenarios, we have assumed the same return is received on all investments.

Deciding on the right investment vehicle for your unique retirement needs can be quite complex so we always urge clients to speak to a professional financial planner to get advice on the most suitable investment vehicle for their needs.

 Tiaan Herselman is head of advice at Old Mutual Wealth.