The Money Guide: Retirement (part 4)
What happens to your savings when you retire?
We set out all the possibilities for you
Reaching retirement after many years of saving in a retirement fund enables you to make some choices. Knowing your options and the implications of your choices can make a difference to your finances for the many years you hope to spend in retirement.
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If you are employed and have reached the retirement age chosen by your employer, you can choose whether you want to keep working beyond your retirement date. Retirement funds are obliged to allow you to preserve your savings in the fund if you choose to keep working beyond your retirement date, and legislative changes allowing you to transfer savings to a retirement annuity are being considered.
If you have not saved enough for your retirement, finding work after your formal retirement will give your savings more time to grow and shorten your retirement years, boosting the amount you can enjoy as a pension.
Should you decide it is time to start drawing a pension, your choices will be more limited if you are one of the few members of a defined-benefit pension fund. A defined-benefit fund is, as the name suggests, one that pays a defined benefit or pre-determined pension when you retire. This benefit is typically based on a formula that includes:
- your final salary (often an average of your salary for the last two or three years of employment);
- the number of years of service for which you have been a member of the retirement fund; and
- a factor that is typically a percentage of your salary at retirement.
In a defined-contribution pension fund, there is no defined pension. Your pension is determined by what you have saved and the monthly annuity or pension those savings can buy.
Provident funds have traditionally paid out the full benefit on retirement. In 2016, the Pension Funds Act was amended and the requirement on members of provident funds to purchase an annuity or monthly pension on retirement was introduced for new contributions after the effective date. However, the effective date has been delayed indefinitely as discussions about social security benefits continue between unions, the government and business.
For now, the difference between pension and provident funds on retirement remains: pension-fund members (including members of retirement annuities) may withdraw up to one-third of their savings as a lump sum and must use the remaining two-thirds to buy a monthly pension or annuity, while provident-fund members can withdraw their entire benefit as a lump sum.
The exception is when the total value of your fund is R247,500 or less – these amounts can be withdrawn in full.
Members of defined-benefit pension funds can also commute or convert up to one-third of the value of their benefit into a lump sum that can be taken on retirement, but commuting your lump sum in this way reduces your monthly pension proportionally.
What lump sum to take in cash
Although pension-fund and retirement-annuity members can take up to one-third of their savings as a lump sum, you can take less and your decision should take into account the tax on that lump sum and how much you need to buy the level of income you need from an annuity or pension.
When it comes to tax, the first R500,000, or the balance of this amount remaining if you have already retired from another fund, can be taken tax free. If your lump sum is more than R500,000, tax is applied as follows:
Taxable income and rate of tax
- R0–R500,000: 0% of taxable income
- R500,001–R700,000: 18% of taxable income above R500,000
- R700,001–R1,050,000: R36,000 + 27% of taxable income above R700,000
- R1,050,001 and above: R130,500 + 36% of taxable income above R1,050,000
Provident-fund members have traditionally taken the entire benefit as a lump sum, but if the fund rules allow, they can minimise the tax implications by taking only a portion as a lump sum (up to the tax-free limit) and investing the balance of their savings in a compulsory purchase annuity. In this case, only the monthly annuity payments are taxed at marginal tax rates.
Your annuity choices
Living or guaranteed annuity?
You may be obliged to buy an annuity, but you can choose between a guaranteed or life annuity and an investment-linked living annuity, or some combination or hybrid of the two.
A guaranteed annuity guarantees you a predetermined income for life, while a living annuity allows you to choose where to invest your retirement savings and how much of those savings to draw as an income each year.
There are several differences between the two (listed below), but the risk you take is the key difference between the two annuity types.
- Provided by life assurers.
- Your pension is guaranteed for as long as you live.
- The life assurer has a pool of annuitants and works out annuity rates based on the average life expectancies and prevailing bond rates.
- The amount paid to you as a pension is a variation of these rates and the increase you want in your income, whether the pension must be paid to you alone or to you and a surviving spouse, and whether there is a guarantee period (see below).
- Guaranteed annuities can be level (which means the monthly rand amount never increases), have a fixed annual escalation for the rest of your life, such as 5%, or increase with inflation.
- The starting or day-one pension from a level annuity will be higher than that of an annuity with a fixed escalation or an inflation-linked escalation, but the escalating annuities will in time overtake those of a level annuity.
- Depending on the increase you choose for a fixed-increase annuity, it may not keep up with inflation – for example, the escalation may be 5%, whereas the inflation rate is more consistently 6%.
- If you die before your capital has been repaid to you, this is the price you pay for being protected from the risk of running out of money in retirement.
- Guaranteed annuities are offered with guarantee periods – for example, a 10-year period – and if you die before the guarantee period, payments will continue to be made to your heirs for that period.
- A joint-and-survivorship guaranteed annuity pays a pension to the surviving spouse until he or she dies. A single life annuity will provide a higher income than an annuity for joint lives. The percentage of the initial annuity – between 1% and 100% – that you choose to be paid as an annuity to your surviving spouse will influence your initial pension.
- Some guaranteed annuities offer a bonus or 13th cheque every year.
- Tax is payable on the income at your normal income tax rate.
- The costs of a guaranteed annuity are built into the income you are quoted and are therefore not transparent. The cost of advice is deducted from the annuity upfront.
- You cannot change or move your annuity from one provider to another – your choice is fixed for life.
Most guaranteed annuities are only partially underwritten – the rate you get depends on your age, how much you invest and your gender.
It is possible, however, to get individually underwritten, or enhanced, annuities that take into account medical and lifestyle factors that may reduce your life expectancy, such as:
- your smoker status;
- your occupation – people working in certain professions such as nursing are expected to live shorter lives than others such as accountants;
- your earnings – the more you earn, the better the healthcare you can afford and the longer you are expected to live; and
- your health – past medical diagnoses and your current health status can reduce your life expectancy.
If you are expected to live for a shorter period, the assurer can pay you a higher pension.
- Living annuities are provided by life assurers, linked-investment service providers (LISPs) and pension funds, and are governed by the Long Term Insurance Act.
- Your pension depends on your choice of investments and the returns on these, as well as how much income you choose and can draw from those investments.
- The Income Tax Act obliges you to draw an annual income of between 2.5% and 17.5% of the capital.
- You can change the amount you withdraw once a year only, on the anniversary date.
- You take on the risks of poor returns or returns that do not beat inflation, a poor sequence of returns while drawing an income from which your capital is unable to recover, drawing too high an income and the risk that the capital may not be sufficient to sustain the income you need for the rest of your life. Once you reach the 17.5% limit, your income will decline in real (after-inflation) terms each year.
- The major attraction of a living annuity is that when you die, you can leave what remains to your children without estate duty.
- Your underlying investment choice can include actively managed portfolios, passively managed portfolios, multi-managed funds and even shares.
- If the living annuity income is not in line with the income you would earn from a guaranteed annuity, it probably isn’t sustainable.
- Tax is payable on the income drawn, but the income, dividends and capital gains earned by the annuity investments are not taxable.
- The costs of a living annuity include the ongoing fees you pay to use the investment platform, the cost of the underlying investment and the cost of advice.
A with-profit annuity
A with-profit annuity is a hybrid of a guaranteed annuity and an investment-linked living annuity. You share the investment profits and losses made on the portfolio with the assurance company providing the annuity.
- The initial pension, with a potential annual increase, is guaranteed for the rest of your life, even if you do not know how much the increases will be.
- The rate of investment return or a post-retirement interest (PRI) rate determines the level of the initial pension and the size of your future increases.
- The assurer decides how much of the investment profits or losses to attribute to your policy, depending on the PRI rate, the longevity of the annuitants on its books, and its expenses. It does not have to disclose the reasons for its decision but its decisions affect the future increases in your pension.
It is now also possible to buy a hybrid annuity that combines some of the advantages of both guaranteed annuities and living annuities.
Some hybrid annuities offer a choice of a guaranteed minimum income equal to a percentage of your capital or a percentage of the previous year’s returns.
Some switch you from a living to a guaranteed annuity at what is regarded as the most appropriate time, which is determined from your desired income level and when it is affordable to lock in guaranteed annuity rates.
Other offer a guaranteed income asset class that you can purchase with other unit trust funds on an investment platform.
Remember, you are entitled to transfer from a living to a guaranteed annuity under the Long Term Insurance Act, but once you have bought a guaranteed annuity you are locked in for the rest of your life.
Your retirement fund is obliged in terms of regulations under the Pension Funds Act to offer you a default annuity – a guaranteed annuity, a living annuity or a hybrid of these.
An “in-house” living or guaranteed annuity will typically have low costs negotiated by the fund on a group basis.
If you take an annuity offered by your fund, when you die, your savings in the fund will be distributed in line with section 37C of the Pension Funds Act. This means that the trustees will determine who your dependants are and distribute the money equitably among them.
Funds can offer with-profit annuities without meeting the capital adequacy requirements that life assurers need to provide for, but the lack of reserves could be a danger for you.
This guide was written by the Money editorial team at Tiso Blackstar, sponsored by 10X Investments.
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