Question around the value of Retirement Annuities Q(RAs) within long term financial planning are frequently raised. The apparently simple response is complicated by constantly changing regulation, most notably the Income Tax Act. Over time I have witnessed and participated in countless debates – and read many articles – on the merits of RAs. The topic attracts controversy with viewpoints often varying according to which side of the fence one sits on.
Against this backdrop I decided that it was time for a full review of the value of RAs with due consideration for all of the advantages and drawbacks that this retirement savings vehicle offers. I am of the view – and even more so following the recent adjustments to allowable tax deductions – that the pros far outweigh the cons. What follows is a detailed consideration of the place for the RA within a financial plan.
*Building a pro-RA argument
The ‘value of the RA’ question that we are tackling today can have many answers; but I would ask that you ignore any distractions (noise) and rather focus on why you should include RAs as part of your client’s financial plan over the long term. Each reason for including an RA will build a picture of its overall value and will prove its ongoing viability. By the end of this article I hope to have built a holistic ‘pro-RA’ picture that is clearly understood and supported by the many facts presented in the following paragraphs.
Before we drill down into the detail, let’s consider some of the background information. Under the Financial Advisory and Intermediary Services (FAIS) Act and its General Code of Conduct, financial advisors have to go through a 6-step financial planning process. This process will include a detailed financial needs analysis conducted on the client’s portfolio and existing financial plan. The advisor will identify needs, shortfalls and opportunities in the financial plan and then select those products that will give the client’s plan the best chance of success.
Our task is to choose products that are as near as possible a perfect match for the client’s financial plan. The plan, enabled by products, should align with the client’s life stages and be flexible enough to accommodate any life changing events. This must all be done with due diligence, care and skill to the best interest of the client at all times.
*Knowledge on product and regulation
To succeed in this task financial advisors must ensure that they are both knowledgeable in respect of the products they recommend for the financial plan and up to date on current or future legislation which may impact on the performance of such products. It goes without saying that if the RA is a significant component in the holistic financial plan that the tax implications and the impact on the client’s financial plan be ‘top of mind’ when RA-related regulations change
This is a good time to reflect on the pre- and post-retirement advantages that make the RA an extremely viable commodity in your client’s life financial plan. During the tax discussion I will also touch on some non-tax issues which I will expand upon later.
*10 Pre-retirement tax benefits
1.Contributions to retirement funding vehicles, including RAs, are tax-deductible up to a certain maximum income. If you fall in the upper 45% marginal tax bracket, then the receiver is sponsoring almost half of your retirement contribution.
2.Since March 2016 the tax-deductible contribution was increased to 27.5 % (capped at a maximum of R350000 per annum) of your client’s income. The amendment makes RAs even more viable as a vehicle to take advantage of the allowable tax deductions. Contributions to pension funds, provident funds and RAs all qualify.
3.Any disallowed contributions in excess of the calculation made in 2 above (Section 11n in the Income Tax Act) can be carried over to the subsequent year of assessment and, if unused at the planned retirement date, can be utilised at retirement to increase the tax-free portion of the lump sum on unclaimed benefits.
4.Tax on the internal growth in the RA – previously applied at 9% on portfolios that derived returns from gross interest, net rental income and foreign dividends – was abolished from 1 March 2007.
5.The internal investment build-up of an RA is not currently subject to Capital Gains Tax (CGT). This means that any capital appreciation or growth is tax-free despite the upfront premiums being deductible – it’s a bit like having a tax-deductible share portfolio.
6.The recent increase in dividends withholding tax (DWT) to 20% from March 2017 has further strengthened the case for RAs because they are explicitly exempt from DWT. The result is that all dividends in the RA can be reinvested fully.
7.You can deduct a further R1800 per annum in respect of reinstatement contributions under certain conditions.
8.Should you leave your employer and receive a withdrawal benefit from your pension or provident fund, you can preserve your lump sum benefit by deferring the tax on this lump sum to your retirement date, when the tax treatment is more favourable.
9.In the event of death your RA will fall outside of your estate and therefore not attract estate duty (up to 20%) or CGT or executors fees (at 3.5 %).
10.Capital build-up in a RA is protected under the Pension Fund Act against creditors prior to retirement age. The RA can thus be utilised as a significant protection product by ‘locking’ funds into your client’s financial plan. This is of particular benefit to self-employed or professional clients, who inherently face a business risk of bankruptcy.
*Three post-retirement tax benefits
- The first R500000 of your lump sum at retirement is tax-free. Lump sums in excess of R500000 are taxed at favourable rates per the tax brackets for retirement tables. (Readers can refer to the sliding tax tables in the SARS booklet).
- Upon retirement you have a choice between converting the remaining two thirds (or more) of your RA into a conventional (fixed) annuity or an equity market-linked (living) annuity. By choosing the latter option you can control the taxable income you receive in retirement by opting for between 2.5% and 17.5% of the capital amount each year. This gives you reasonable ‘control’ of your income tax position, assuming your risk profile allows for the living annuity route.
- Most individuals experience a big increase in medical costs once they retire. Thankfully, once you reach age 65 your medical expenses become fully tax deductible. An RA can be used to build up a fund for post-retirement medical expenses in a tax efficient way, as already explained above. Upon retirement, although the annuity is fully taxable as income, to the extent that it is used to cover medical expenses it is again deductible.
*The ‘forced savings’ accelerator
The reasons already given support the RA’s case as a viable product in any financial plan; but there are a couple of others that you, as financial advisor, should make your clients aware of. By including RA product/s in your client’s portfolio you encourage a ‘forced savings’ culture – you are effectively helping your client to commit to a long term savings plan that goes hand-in-hand with the positive impact of compound growth, allowable tax deductions and reinvestment into RA products.
If your client contributes at a sufficient level and for a long enough time, then there is no reason why their RA would not work for them over the long term. This should hold even if the yield in the RA is reduced by costs or fails to match that of other non-tax-deductible investments.
The advisor plays a crucial role in ensuring this outcome and must make frequent assessments of the client’s financial needs. It is documented that good financial advice can add up to 300 basis points on average per annum to long term investment / retirement funding performance. This benefit, coupled with the ‘Eighth Wonder of the World’ – namely compound growth – adds significant value to your client’s retirement portfolio. And this all contributes to your value proposition as an advisor.
*Seeking a reasonable return
Perhaps we can illustrate by way of a short example. Let’s say your client is planning for an inflation-protected income after retirement at 75 % of his or her final salary at age 60. To accomplish this, your client will have to save 15 % of his or her income from age 25, with an underlying portfolio performance assumption of CPI plus 4%. (Most lifetime life stage portfolios achieve this return over the long term, being 10-20 years).
Your client can add to these returns by using a RA and benefiting from the great allowable tax deductions. The product is a winner thanks to the combination of tax deductions, forced savings and the fact that the saver is ‘locked in’ for the long haul. Further benefits accrue to the saver if they invest through a LISP RA that is free from as-and-when commission. Upcoming new regulations such as the Retail Distribution Review – which could see all RAs being exempt from as-and-when commission – will further enhance the RA as a product that is both in the best interest of our clients and the sustainability of the financial advice profession.
*Add to every retirement plan
I like to think of the RA as a ‘PLAN A’ – put this plan in place first and make sure it remains as a failsafe should everything else fail. A RA can ensure that your client is protected and provided with a secure income in retirement. I believe that RAs in any form – whether life assurance RAs or LISP RAs – have a viable place in your client’s financial plan.
In fact I will go one step further by saying they should be part of every client’s retirement planning. RAs should be purchased with due consideration for the client’s needs, affordability and return expectations. It is our responsibility as advisors to make sure that the overall portfolio is continuously managed over time.