Retirement Annuities (RAs) and Preservation Funds in South Africa have come in for a lot of criticism in recent months, with some leading financial planners suggesting investors should stop contributing here and rather move these assets offshore.
The key issue for these financial planners is that investments in these funds are governed by Regulation 28 of the Pension Funds Act and this determines that no more than 30% of your RA can be invested offshore.
They argue, in part, that the JSE has been a serial under-performer for the last 10 years as tech heavy US markets have surged, meaning that investors have been left behind in terms of investment returns, and this is absolutely true, but it isn’t the whole story. If you look back 20 years then funds that could be used in a pension fund would have outperformed global equities.
Returns of various investment types over the last 10 and 20 years to September 2020.
SA Multi-Asset High Equity is being used as a proxy to measure returns to pension funds in South Africa that are required to invest in compliance to Regulation 28. Global High Equity is the peer group for global investment funds with a high proportion of equity exposure.
Source: Morningstar, returns calculated as the median returns within the respective ASISA peer groups. Returns are calculated over 20 years to 30 September 2020.
Using past performance as a way of deciding where to invest is the same as driving whilst looking in the rear-view mirror. Your pension fund also probably has much more offshore exposure than you think. Secondly, the tax benefits of a RA really add up. In fact, we calculated the extra annual performance you needed to make up for the tax advantages of an RA!
How much offshore exposure is there in local shares, probably more than you think?
The folks at CoreShares put together the research that indicates about 71% of earnings, adjusted by weight, of the top 50 largest shares on the JSE are from outside of South Africa.
So, the question is why was there a difference in performance between South African and Global Equities over the last 10 years if such a high proportion of earnings are offshore?
We believe that this is partly because there isn’t much exposure to the same sectors and stocks that are available in the US markets, especially the large technology companies.
This also means that at some point this performance difference may reverse, especially, if the share price growth in technology stocks were to slow for any reason. It’s worth remembering that historic performance isn’t necessarily a reflection of future returns.
What’s the impact of the tax benefits of an RA?
Now when you include tax it gets really complicated really quickly, and the spreadsheet we built to solve this was in a word “epic”. It even takes into account the tax rebates you get back from your contributions.
20 years ago, Naledi left her employer, and at the time had a pension fund worth R100 000. She then had two options, withdraw, take the tax hit and then invest it, or invest in a Retirement Annuity. In both examples she continued to contribute R2000 per month escalating at 6% per year. We assumed Naledi earned about R500 000 per year to calculate her tax rebate. You can calculate your estimated earnings by starting an RA journey here.
The results were eye opening. Assuming the same investment return the tax benefit to Naledi was the same as generating an extra 1.2% return per year, which equated to an extra R800 000 at retirement. To be clear, there are lots of assumptions in this calculation, but we still feel that tax matters, and for those of you who really want to know, the assumptions we used are at the end of the article
All we want to highlight here, is that when you are comparing returns, tax matters, and the tax benefits of RAs are still valuable and could potentially make the difference in overall returns to your investments.
The softer element of locking your money away.
While it is tempting to argue that investors have the financial discipline to leave their money to compound, the current savings rates in South Africa suggest otherwise.
By their nature, investments tied up in a RA, are locked up until the stipulated retirement age is met. Investors who run into cashflow issues cannot access these retirement savings in the same way that they could sell shares, Exchange Traded Funds (ETFs) or unit trusts that they hold.
The compounding effect of having money locked away for 20 – 45 years is often a key differentiator between those who are able to retire comfortably and those who consistently sell out whenever they need to access cash.
Lastly, investments in an RA are protected from creditors, and in the event of you becoming financially distressed, it could save your retirement.
Comparing investments based purely on past performance is not a good idea. Performance is merely the result of many different factors, including tax and fees. It is the hardest of all investment factors to control. We believe that Retirement Annuities are valuable investment vehicles, and not just because we sell them.
One of the most important factors remains how much you as an individual contributes to your retirement, it really is the defining factor of your future, and, of course, the fees you pay for your RA.
Every time you want to calculate something, you need to build a model, and ours was a monster that relied on the following inputs:
· Investment period was 20 years to end September 2020
o Performance data was sourced from Morningstar and represented the median returns for the respective peer groups, the ASISA SA Multi-Asset High Equity (which represented the estimated return from a high equity fund compliant with Regulation 28).
· Naledi’s marginal tax rate assumed was 36%, based on a gross income of R500k.
· Naledi’s withdrawal from her pension fund was taxed at the current withdrawal rates and taxes included dividend, capital gains and tax on income (where the exemption was exceeded).
OUTvest is an authorised FSP. All our investments are exposed to risk, not guaranteed and dependent on the performance of the underlying assets. Results are provided for illustrative purposes only and are amount and time horizon dependent.