Understanding retirement annuities

In the not-so-distant past, retirement annuities fell exclusively in the domain of South Africa’s life insurance companies who sold very expensive retirement annuities that paid insurance brokers massive upfront commissions. In many instances, the actual investment portfolios of the RA were obscure and the investment reporting was negligible. In addition, life insurers made it impossible to transfer or cancel the investment without demanding exorbitant penalties from the policy-holder.

The entrance of unit trust companies into the sphere of retirement annuities has breathed new life and variety into what had become an archaic, rigid and punitive industry. An impressive spectrum of reputable unit trust companies now offer a gamut of low cost retirement annuities that invest exclusively in unit trusts. Over and above the refreshing flexibility afforded by these unit trust companies, their reporting is much more transparent and the costs have been substantially reduced so that you can now invest in a unit trust-based RA for a total cost of 1.75% per year, with no upfront commissions being paid to insurance brokers. Legislation governing retirement annuities has also been amended to allow investors to more easily move their RAs between product providers without have to pay massive costs. With the massive over-haul experienced in the industry over the past few years, unit trust-based retirement annuities are now an excellent choice for one’s retirement funding. Here are some important RA questions answered:

What is a retirement annuity?

Simply put, a retirement annuity is a tax-efficient investment vehicle for your retirement that allow you to build capital during your working years so that you have enough money to enjoy the same standard of living when you retire.

Who should consider a retirement annuity?

We recommend that the following people consider investing in a retirement annuity:

  • People who are self-employed;
  • Employees who do not receive pension or provident fund benefits from their employer;
  • Employees who earn a significant amount of non-pensionable income and want to ramp up their retirement funding;
  • Anyone who has a retirement funding shortfall and wishes to take advantage of the RA tax-break offered by the government.
What are the advantages of a retirement annuity?

Legislation allows one to invest 15% of one’s taxable income – less any amount that is being contributed towards a pension or provident fund –tax-free into a retirement annuity. Over and above the obvious advantage of investing with before-tax money, it is important to note that the investment returns earned on RAs do not attract income tax nor capital gains tax. Money invested in a retirement annuity is deemed to fall outside of your estate and can therefore not be touched by creditors. The only people who can benefit from your retirement annuity are you and your family.

Unlike the old-style insurance-based RAs, the new unit trust-based RAs are incredibly flexible. An RA offers one the ability to change the level of your monthly contributions, or even take a contribution holiday if needed. Investors are also permitted to make lump sum contributions into their RA, offering the perfect opportunity to invest one’s bonuses or additional commissions. 28 February marks the end of the 2014/2015 tax year, and most investors use this opportunity to maximise their allowable tax-free retirement annuity investments. Long-term, consistent retirement annuity contributions will average off any market fluctuations over one’s investment period. As one will draw out one’s retirement income over a prolonged period of time, what happens to the turbulent investment markets should be of no concern to the long-term investor, making retirement annuities an excellent vehicle for long-term investors.

What are the disadvantages of retirement annuities?

Although not necessarily a disadvantage, RA investors may not access the money in their RA until age 55, which removes the temptation to dip prematurely into one’s precious retirement funding.

What happens to my RA at retirement?

When you retire, you are able to withdraw one third of your RA investment as a lump sum. Of this, the first R500 000 is tax-free (assuming no other lump sums are taken from other retirement fund investments), with the balance being taxed on a favourable sliding scale. The remaining two thirds of your investment must be used to purchase an annuity which will provide you with an income during your retirement.

When should one start investing for retirement?

The best time to start funding for retirement is with your first pay cheque. If you haven’t already started, then the second best time is now.

Can I postpone my retirement funding until later?

You can, but it will cost you dearly. While you are invested, the power of compound interest works in your favour to exponentially grow your wealth. On the other hand, for as long as you remain un-invested, compound interest works against you – making it harder and harder every year to address your retirement funding shortfalls.

To understand the cost of delaying your retirement funding, consider this example:

John is 25 years old and earns an after-tax income of R14 000 per month. He currently contributes 15% of his pensionable income (R2 100) per month towards a retirement annuity, with the intention of retiring at age 65. If his investment premiums were to increase annually with inflation (assumed at 6%), he would have a capital amount of around R43 million (around R4 million present value) at retirement which would be sufficient to provide him with his desired post-retirement income. If John were delay saving for retirement until he reached age 35, he would then need to invest 30% of his pensionable income to achieve the same result. If he were to delay saving for a further 10 years (i.e. he only starts investing at age 45), he would need to invest a whopping 66% of his pensionable income to achieve the same investment outcome.

This graph reflects the % of John’s income that he would need to invest for retirement starting at age 25, 35 and 45.

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Setting up a suitable RA is both administratively easy and financially cost-effective, whilst at the same time providing investors with enormous flexibility. Being able to invest with before-tax income is a gift worth accepting. The sooner one starts investing, the longer compound interest has to perform its exponential magic, giving truth to the adage that time really is money.

Have a blessed weekend!

Sue & the Crue team



Categories: Financial Planning

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