Retirement funds: Do the benefits outweigh the risks?
December 7, 2020
Ronald King, Head of Public Policy and Regulatory Affairs at PSG Wealth
It is often argued that there is no real tax benefit to investing in a retirement fund, because while contributions are tax deductible, the resultant annuity is taxable. Does it then make sense to invest in a retirement fund, considering the restrictions imposed on these funds by Regulation 28?
Understanding the tax benefit
However, this argument ignores the fact that the tax rates of retirees are normally significantly lower than prior to retirement when they received the tax benefits from contributions. It also ignores the benefit of tax-free growth within the portfolio as well as benefits in estate duty. The table below compares an endowment, a voluntary investment plan, a tax-free investment plan and a retirement annuity.
|Tax comparison between different investment options|
|Endowment||Voluntary investment plan||Tax-free investment plan||Retirement annuity|
|Tax deductibility of contributions||Non-deductible||Non-deductible||Non-deductible||Deductible up to prescribed limits|
|Taxation of fund growth||Interest taxed at 30%
Dividends taxed at 20%
CGT taxed at 12%
|Interest taxed at 45%*
Dividends taxed at 20%
CGT taxed at 18%*
|Tax free||Tax free|
|Taxation of maturity value||Tax free||Tax free||Tax free||Lump sum taxed according to tax table; annuity taxed as normal income|
|Estate duty||Subject to estate duty||Subject to estate duty||Subject to estate duty||Only the excess contributions made to the fund are subject to estate duty|
*After exemptions have been exhausted.
|Tax impact on investment example|
|Endowment||Voluntary investment plan||Tax-free investment plan||Retirement
|Contribution||R1 000 p.m.||R1 000 p.m.||R1 000 p.m.||R1 818 p.m.|
|A tax-deductible contribution of R1 818 to a retirement annuity equates to a non-deductible contribution
of R1 000, as R818 will be saved on taxes.
|Term of investment||15 years|
|Pre-tax fund growth||10.8%|
|Post-tax fund growth||8.93%||8.17%||10.8%||10.8%|
|See table below for assumptions used. CGT on endowment and VIP is deducted annually.|
|Maturity value||R378 823||R353 690||R450 306||R818 656|
|Tax on maturity value||R0||R0||R0||R294 716|
|Taxed at 36% as this is the average rate for an individual earning R1 500 000, and top band of lump sum tax table.|
|Net maturity value||R378 823||R353 690||R450 306||R523 940|
|% invested||Asset class return||Pre-tax return||Tax on VIP||Net return on VIP||Tax on endowment||Net return on endowment|
|Assuming a balanced portfolio of 40% cash and 60% equities. Returns are deemed to be net of costs.|
Understanding Regulation 28
Regulation 28 is aimed at preventing fund members or trustees from selecting highly concentrated portfolios and running the risk of losing everything. However, the most negative publicity retirement funds receive is probably because of Regulation 28 and the limitations it imposes – such as the 75% limitation on equity and 30% on offshore investments. It is argued that a retirement fund is a long-term investment and there should therefore be no limitation to investing in equities, which have historically provided the highest returns over the long term.
The same argument is made about the limitation on offshore assets. Research, however, shows that only a small percentage of investors invest close to the limitations that apply in terms of Regulation 28. In addition, it is possible to build a diversified aggressive portfolio within the confines of Regulation 28. Even where an investor believes a Regulation 28 portfolio is not the optimal choice for them, the potential return foregone by choosing a ‘more conservative’ portfolio is outweighed by the benefit of the tax savings realised (on contributions and returns).
Base decisions on facts, not fears
The issue of retirement funding is one that elicits many emotions from the public, but these are often not founded on facts, but rather on fears. While there are reasons for concern, these are often not as dire or cataclysmic as imagined. Retirement funds offer their investors a multitude of benefits, and these are best considered holistically when making an investment decision.