A Retirement Annuity
(RA) is often referred to as a "policy". Legally, an RA is not a
policy. When you take out an RA, you are, in fact, signing up for membership of
a pension fund, a fixed amount of money you’ll receive on a consistent bases,
which is administered in terms of the rules of the fund and governed by the
Pension Funds Act.
Unlike an employer-sponsored pension fund, which has restricted membership, any
individual under the age of 70 may join an RA fund.
When you become a member of an RA fund, the fund makes investments in the stock
market on your behalf, normally purchasing a life assurance policy from the
life company that set up the RA fund. Usually, the life company that
established the fund also administers the fund.
A single life assurance policy may be bought for all the members of the RA
fund, in which case the members receive a document that is little more than a
certificate of membership. Alternatively, individual policies may also be
bought by the fund.
With non-life assurance RA funds, such as those offered by some unit trust
companies, you will be a member of the fund only and will receive a membership
certificate.
The life assurance policy bought on your behalf is not the same as a normal
endowment policy, which pays a lump sum on its maturity, because it is
structured to take advantage of the tax incentives provided by the government
to encourage you to save for retirement.
However, an RA is similar to a defined contribution pension fund, because at
retirement you will have to use at least two-thirds of your savings to buy an
annuity (a pension).
RAs were introduced to South Africa in 1960 to give self-employed people
similar tax incentives to save for retirement as those enjoyed by members of
employer-sponsored pension funds. However, this does not mean that only
self-employed people can use RAs to save for retirement. People who are members
of employer-sponsored pension funds can also join RA funds. In fact, it is
advisable that every member of an employer-sponsored retirement fund also
contributes to an RA, because most employer-sponsored funds will not provide
you with a lot income in retirement to maintain your pre-retirement standard of
living.
However, you should only contribute to an RA if you will receive a tax
advantage. If you contribute to an RA using money that has already been taxed,
you will pay tax on the money again when your RA matures.
McCulloch says that membership of an RA fund is no substitute for contributing
to an employer-sponsored fund. He says an RA should be used "to supplement
an employer-sponsored fund". The reasons include the fact that the total
(employer plus employee) tax-deductible contributions to an employer-sponsored
fund are greater than the tax-deductible contributions to an RA fund.
Gordon says you must also remember that when your RA matures, you are obliged
to buy a monthly pension with at least two-thirds of the lump-sum payout from
your RA. "An RA is a trade-off. The state gives us tax concessions as an
incentive to save. Therefore it places limitations on what we can do with that
money," Gordon says.
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ten things to know before buying a retirement annuity
Accumulation phase - The period of time prior to annuitization.
Annuitant - A person who receives benefit payments from an annuity.
Annuitize - A method of receiving annuity benefits through a series of income payments for life or some other defined period of time.
Annuity - A contract with a life insurance company which guarantees an income for life or some other defined period in exchange for premiums you pay.
Back-end load - Company expenses that are charged at the time benefits begin.
Beneficiary - When provided in a contract, the person who receives benefit payments if the annuitant dies.
Contractholder - A person who pays premiums for an annuity. Often the same person as the annuitant.
Death benefit - A provision in certain annuity contracts that pays the beneficiary when the annuitant dies before the payout phase begins.
Deferred annuity - A contract that begins the payout phase at some future date.
Equity-indexed annuity - A contract that combines a guaranteed minimum interest rate with earnings linked to the performance of an external stock or bond index.
Fixed rate annuity - A contract that specifies your funds will earn a specified interest rate and guarantees a return on your premium.
Flexible premium annuity - A contract in which the amount of each premium payment you make can vary.
Front-end load - Company expenses that are charged at the beginning of a premium payment period.
Free look - A period specified in the contract (such as 10 days) during which you can decide whether to keep an annuity or return it for a full refund of your premium. Your free-look period is 20 days when you buy an annuity contract to replace one you already had.
Guaranteed interest rate - A minimum rate of interest specified in a fixed annuity. The actual rate the insurance company credits your contract at any given time may be higher but can never be lower.
Immediate annuity - A contract that begins the payout phase within one year after you pay the single premium.
Level premium annuity - A contract in which the amount of each premium payment you make stays the same.
Loan provision - A feature in certain annuity contracts that allows you to borrow up to a specified percentage of the value. Contract loans are usually subject to taxes.
Morality Tables - Statistics that project ones life expectancy based on many variables.
Payout phase (also called the annuity phase) - The period of time when benefit payments are being made to the annuitant.
Premium - The money you pay to fund an annuity contract.
Refund Annuity - Refunds part or all of the premiums paid if the insured dies before the start of the liquidation period.
Surrender charge - A fee the insurance company will charge you if you cash in (surrender) an annuity before the payout phase begins, or if you make a withdrawal larger than specified in the contract.
Variable annuity - Traditionally, a contract with no minimum guarantee (some newer products do include guarantees). Because the benefit amount depends on the insurance company's investment gains or losses, you share some part of the investment risk with the insurer.
Withdrawal privilege - A provision in many annuity contracts that allows you to withdraw an amount less than the surrender value, without paying a surrender charge. Any withdrawal may be subject to taxes and penalties.
Retirement Annuities (RA) funds have to be approved by SARS and must be registered with the Financial Services Board (FSB) in terms of the Pension Funds Act. This Act provides you, as a member of an RA fund, with a fair amount of protection. You are also afforded protection under the Long Term Insurance Act, because in most cases when you join an RA fund you indirectly become a life assurance policyholder as well.
However, this distinction between being a RA fund member and a
life assurance policyholder has become blurred in recent years. McCulloch says recent rulings by Vuyani Ngalwana, the Pension Funds Adjudicator, have focused the attention of trustees of RA funds on the distinction.
In terms of the Pension Funds Act, RA funds must have trustees, who tend to be appointed by the financial services company that established the fund. The trustees have a fiduciary (legal) duty to approve and amend the rules of the fund, ensure the money in the fund is properly managed and that the benefits are correctly paid out. You have no say in the election or appointment of the trustees, but it is becoming more common to have at least two independent trustees on the boards of RA funds.
If you have a problem with your RA fund, you can complain to:
- Ngalwana;
- Charles Pillai, the Financial Services Ombud (in cases of poor advice);
- Piet Nienaber, the Ombudsman for Long Term Insurance; and
- Jeff van Rooyen, the Registrar of Pension Funds and the chief executive of the FSB, which regulates the retirement industry.
Pension funds adjudicator rejects penalties
In a spate of determinations, Vuyani Ngalwana, the Pension Funds Adjudicator, has ruled that life assurance company-sponsored retirement annuity (RA) funds may not penalize you for reducing or stopping your contributions to RA funds.
The basis of Ngalwana's rulings is that the rules of an RA fund must provide for such penalties, which, he says, they do not.
He has also criticized life assurance companies for muddling the distinction between membership of an RA fund and the life assurance policy that is bought on behalf of an RA fund member from the life assurance company that sponsors the RA fund. Ngalwana says a member's contract is with the fund and not with the life assurance company.
Ngalwana has issued determinations against RA funds sponsored by Sanlam, Liberty Life and Old Mutual. The RA funds (and their sponsoring life companies) have appealed to the High Court against Ngalwana's rulings. They argue in their appeal documents that:
- Ngalwana does not have the jurisdiction to make the rulings. The life companies say that because life assurance policies were issued via their RA funds, the fund members' complaints should be heard by the Ombudsman for Long Term Insurance and not by the Pension Funds Adjudicator.
The ombudsman's office was set up by the life industry, while the adjudicator's office was established by statute.
- Complaints about penalties levied for reducing or stopping contributions are not defined in the Pension Funds Act.
Ngalwana has rejected both these arguments, saying the life assurance companies and their RA funds are using technicalities to appeal against his rulings.
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Consumers are being offered more and more
investment portfolios. The choice can range from a simple managed portfolio with capital guarantees, invested across asset classes and in which you have no say in the investments, to a "fruit salad" of unit trust funds which you must select.
However, due to the volatility of investment markets in recent years, financial services companies have put together numerous investment portfolios that are aimed at minimizing risk and beating inflation.
These portfolios come with various levels of risk. Most of these offerings also come with simple calculators to assess your risk profile. These risk profile calculators can be very misleading. Often they are based more on your psychological approach to risk than your actual financial ability to withstand investment risk. Consequently, people who are psychologically prepared to take high investment risks can land up without sufficient money on which to retire.
There are regulations, issued under the Pension Funds Act, which attempt to limit investment choice and therefore limit the risk to individual investors. These regulations are called the Prudential Investment Regulations (PIRs), and they restrict how much can be invested in the various asset classes, offshore and in specific sectors of the market and/or companies.
For example, no more than 75 percent of your money is allowed to be invested in shares and no more than 15 percent may be invested offshore.
The problem with these guidelines, however, is that they only apply at fund level and not to individuals. While some RA funds insist on applying the PIRs at fund and at individual level, others do not.
In other words, as a member of a
Retirement Annuities (RA) fund, you may be able to choose an extremely high-risk portfolio, and invest 100 percent of your money offshore or 100 percent in shares.
As well as having a greater choice of investment portfolios/underlying investments, you are also free to switch between investment offerings at any time.
Before you opt for an RA that gives you a wide range of choices, you should consider the following factors:
- Cost. The greater the choice, the more it is likely to cost you, particularly if you switch between options on a regular basis.
- Expertise. Many people have lost huge amounts of money by continually switching into the investment flavour of the month, often because of poor financial advice. The switch often occurs when the sector is booming and they buy in at the top (remember the information technology bubble?). Then, when the sector collapses, investors sell out, only to jump into the next hot stock or sector.
On the other extreme, some investors opt for the most conservative portfolio, which reduces potential returns and the possibility of having a financially secure retirement.
There are a number of issues you should consider when making investment decisions. These include:
- Retirement saving is a long-term affair. Markets will fluctuate, but the trend historically has been up. Historically, shares have out-performed bonds and cash over the long term.
- You should be neither too aggressive nor too conservative. You should rather select a properly diversified, balanced portfolio in line with the PIRs. Obviously, the further you are from retirement, the more money you can - and should - invest in an aggressive portfolio.
Costs. You are often charged higher costs if you opt for products that offer you a great deal of choice.
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When you take out a Retirement Annuity (RA), you should be asked to name a beneficiary or beneficiaries.
However, the beneficiaries whom you nominate will not necessarily s because, in terms of section 37c of the Pension Funds Act, the benefits from any registered retirement fund, including an RA fund, must be distributed first to the people who are dependent on you. This means that if you have nominated the proverbial cats' home as your beneficiary and not your spouse and six children who are dependent on you, the trustees of the RA fund have both a right and an obligation to ignore your request and pay the money to your dependants.
McCulloch warns that if you have no dependants, you must still nominate someone as a beneficiary or else the money will go into your estate. The Income Tax Act then limits the payment to a return of contributions plus a reasonable rate of interest - seven percent is the norm.
Your dependants are entitled to a limited cash lump sum (part of which will be tax-free), but must purchase an annuity with the rest of the benefit payout.
Gordon says no estate duty or capital gains tax is payable on your death on the portion of the benefit payout used to purchase an annuity. Your beneficiaries will pay tax on the monthly annuity at their marginal rate of taxation. Estate duty is payable on any lump sum portion of the benefit payout.
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A limited number of institutions or people may claim money invested in your Retirement Annuity (RA). They include SARS in the case of unpaid taxes and a previous spouse, but then only in terms of a court-approved divorce settlement.
The only time a creditor may lay claim to the money in an RA, or any other retirement savings vehicle, is when you retire, and then only from any lump-sum amount you are paid. A creditor may also not claim money that is paid to you as an annuity bought with the benefits of an RA. For this reason, you cannot borrow against an RA or use it as security for a loan.
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If you leave or lose your job, you can transfer your retirement savings from an employer-sponsored fund to a
Retirement Annuity (RA).
If you leave an employer-sponsored pension or provident fund, you may have a number of choices. These are:
- You can take the cash, which will be taxed at your average rate of tax, and the first R1 800 will be tax-free. The average rate used will be the higher of the average rate in the tax year in which you leave your employer or the average rate in the year before your departure.
- If the rules of the fund permit, you can leave your retirement savings where they are and become what is known as a deferred pensioner. You will use the money to buy a pension when you retire, but neither you nor your previous employer will be able to make further contributions to your savings. You will, however, receive growth on your investment. There are no tax or cost consequences to deferring your pension. You will not be able to access the money until the date of normal retirement.
- If the rules of the fund permit, you can transfer your accumulated retirement savings to a fund sponsored by your new employer. There will be no tax or cost implications to transferring your savings. You need to check whether your years of membership of the previous fund will also count with the new fund.
You can "warehouse" your retirement savings in a retirement product sold by a financial services company. You have a choice between a preservation fund or an RA fund. No tax is payable on the transfer (trans-location) of your savings to a preservation fund or an RA. However, you will incur investment costs, which can be as high as six or seven percent of your initial investment, and up to 2.5 percent a year thereafter, which is likely higher than the ongoing costs.
Before you choose either an RA or a preservation fund, you must understand the differences between the two. They are as follows:
When you transfer your retirement savings to a preservation fund, you need to be aware that different circumstances dictate when you will be able to withdraw your savings from the preservation fund.
If you are unemployed, your retirement date is that of the pension or provident fund you left. If you join another pension or provident fund, the retirement age of that fund will apply. If you are employed, but you have not joined another pension or provident fund, the rules of the preservation fund will apply. In this case, you will normally be given a choice of retiring between the ages of 55 and 69.
If you transfer your retirement savings to an RA fund, the rules of the pension or provident fund you left do not determine when you can withdraw your benefits. You can withdraw them anytime between the age of 55 and 69.
If you want to transfer your retirement savings to a preservation fund, your previous employer must be a "participating employer" before you make an application to join a preservation fund. This is an administrative requirement of SARS, and is met by your employer signing a declaration.
You do not need to involve your previous employer if you want to transfer your savings to an RA fund.
In most cases, you can make additional contributions to an RA fund.
You cannot make additional contributions to a preservation fund, apart from adding lump sums from your employer-sponsored fund.
With a preservation fund, the length of your contributory membership of the initial retirement fund is the main factor that determines the tax-free portion of any lump sum that you commute at retirement.
With an RA, only the years of membership of the RA will be taken into account in calculating the tax-free portion of a lump sum. In other words, your years of membership of the original pension or provident fund will not be taken into account.
There are both pension preservation funds and provident preservation funds. If you were a member of a provident fund, you must transfer your savings to a provident preservation fund. If you were a member of a pension fund, you must transfer your savings to a pension preservation fund.
If you were a member of a provident fund, you should not transfer your savings to an RA, because those savings consist of after-tax money that would be taxed again at retirement. You should transfer your savings to a provident preservation fund so that you will not face double taxation.
You are permitted to make one withdrawal from a preservation fund before retirement. That withdrawal may only take place after you have transferred your retirement capital to the preservation fund. Any deduction by your employer from the amount you transfer to a preservation fund - for example, to repay a loan, cover losses or to fulfil a maintenance or divorce order - counts as the one withdrawal from the fund. Once you have transferred your savings to an RA, you are not permitted to make any withdrawals before the age of 55.
When you withdraw your savings from a retirement fund, you are allowed to place a portion of the money in a preservation fund and a portion in an RA. The transfer of benefits is not taxed. The portion transferred to the RA is not regarded as the single withdrawal you are permitted from a preservation fund.
In some cases, if you are dissatisfied with your RA fund - say, the administration, costs or something else - you can transfer your savings to another RA, tax-free.
However, Gordon says, the rules of your fund must allow you to transfer your money to another fund. Most RA funds only permit transfers after you have turned 55.
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One of the main reasons to use a Retirement Annuity (RA) is the tax advantage, both in the build-up to retirement, as well as in retirement. One tax structure applies when you use an RA to save for retirement, and another when you use the proceeds of an RA to buy an annuity (a pension).
Tax on your contributions to an RA
Up to certain limits, you do not pay tax on the money you contribute to an RA, whereas contributions to an endowment policy are made with after-tax money. When you contribute to an RA, you defer payment of tax on your contributions until you retire and are paid the proceeds of the RA.
This deferment of tax is beneficial in a number of ways. In most cases, when you retire, your marginal and therefore you average income tax rate is lower than when you were working. You are also entitled to certain tax deductions on lump sums paid to you by your RA fund at retirement.
Your contributions to an RA are deductible from your taxable income within certain limits. Your contributions can exceed these limits, but you will not get the tax advantage on the amounts above the limits. Each tax year in which you contribute to an RA, you can claim as a tax deduction the greater of:· 15 percent of your taxable income, excluding your pensionable income, before other tax deductions; or· R3 500 less your current contributions to a pension fund; or· R1 750.
If you contribute more than these limits, you may claim the amounts that exceed the limits in future tax years, provided your contributions in the years in which you claim remain within the limits. Excess contributions may also be added to the tax-free portion of the lump sum you receive at retirement or when your RA matures.
If you are a member of an employer-sponsored or a trade union-sponsored retirement fund, the limit of "15 percent of your taxable income, excluding your pensionable income," is important if you want to contribute to an RA.
As an employee, your salary is made up of two main parts for the purposes of retirement taxation: your pensionable income and your non-pensionable income.
Your pensionable income is normally your basic salary, excluding any allowances, such as a car allowance. Most employers use only your basic salary to calculate how much they will contribute to your pension savings. Some, but very few, employers make pension contributions based on their employees’ gross pay packages (basic pay plus all allowances).
So, your "pensionable income" is the portion of your income that employers use to calculate how much they will contribute to a company-sponsored pension or provident fund.
After deducting your pensionable income from your gross income, you can contribute 15 percent of the balance to an RA and deduct that amount from your taxable income.
Your non-pensionable income is any income you earn that your employer does not take into account when contributing to a company-sponsored pension or provident fund. Non-pensionable income can include allowances paid by an employer, such as your car allowance (but only the portion not claimed as a deductible expense for business travel) and taxable income from other investments (for example, rental income from a second property).
You can reduce your non-pensionable taxable income by contributing 15 percent of non-pensionable income to an RA. In other words, the contributions are deducted from your taxable income, with the result that you pay less tax. If you are on the top marginal tax rate of 40 percent, instead of paying 40 cents in every rand you earn in tax, you will be saving 40 cents on every rand you contribute to your RA. You will also receive investment growth on each of those 40 cents that you save.
Tax on your investments in an RA
The retirement annuity investments build-up on your retirement savings is not entirely tax-free. In 1998, the government introduced Retirement Fund Tax. This is a tax on the interest, foreign dividends and net rental income (any rent on property investments less the costs) earned by any retirement fund, including RAs. Life assurers pay this tax on your behalf at a rate of 18 percent a year.
Tax on your RA benefits
When you retire, the retirement annuity benefits will be subject to tax. You must take two taxation issues into account. These are tax on your lump-sum payout and tax on your monthly annuity.
1. Lump-sum taxation
When your RA matures, you may take one-third as a lump sum and spend it as you wish. You must use the remaining two-thirds to buy a compulsory purchase annuity (a monthly pension).
The tax-free portion of your lump-sum payout from your RA is calculated on the number of years that you have been a member of the fund, multiplied by R4 500. So, if you have been a member of an RA fund for 40 years, you will receive R180 000 tax-free (that is, 40 x R4 500). There is, however, one condition to this: You do not receive the tax-free amount twice.
There is no limit to the number of RA funds that you may join. However, the tax-free portion takes account of all your retirement savings, including your pension fund. You cannot claim it on each source of retirement savings.
As the above calculation indicates, it is to your advantage to join an RA as early as possible so that you derive the maximum tax benefit.
The balance of any lump sum you withdraw in excess of the tax-free amount (from all retirement sources) is taxed at your average rate of tax. The average rate used is the higher of the average rate in the tax year in which you retire or the average rate in the year preceding your retirement. (Your average rate of tax is lower than your marginal rate of tax.)
As a general rule, you should take the entire tax-free portion of the one-third lump sum, even if you do not need the money, and reinvest it. You should avoid withdrawing more than the tax-free portion of your one-third lump sum, because you will lose the benefits of deferring tax on this money.
2. Tax on your annuity (monthly pension)
The minimum of two-thirds you must use to buy a monthly pension is not taxed as a lump sum when you retire. However, the annuity you buy is taxed as income, as and when you receive the money.
Your income in retirement from all sources, including your RA, is taxed at your marginal rate. So, both the capital (on which you did not pay tax when you were saving for your retirement), as well as any growth on the accumulated savings will be taxed at your marginal rate of tax when you receive your pension. You are still able to get investment growth on, and defer tax on, the balance of your retirement capital.
Some tips· The 18 percent Retirement Fund Tax is not levied on the portion of your retirement savings you use to buy an annuity after you retire.· A husband and wife are taxed separately and can each take advantage of the tax breaks in an RA.· If you stop paying your premiums on your RA and resume paying them later to make up for the shortfall, you may deduct R1 800 a year from your taxable income as reinstatement RA contributions.· If you have spare money towards the end of a tax year (February), you should sit down (with a financial adviser if you are not sure of how this works) and calculate the maximum that you can contribute to retirement savings investments to take full advantage of the tax breaks associated with adding a lump sum to your RA fund.
Most employer-sponsored retirement funds do not allow you to contribute additional lump sums to boost your retirement savings. If you are already contributing 7.5 percent of your pensionable salary to the fund, there will be no point in making additional contributions as you will not derive a tax advantage. You should check with your fund whether top-ups are permissible. Most RAs, however, do allow you to make lump-sum contributions to the fund.
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The period (term retirement annuity) for which you sign up for a life assurance Retirement Annuity (RA) is one of the issues over which you must take great care. As a result of bad advice from often unscrupulous financial advisers and representatives of the life assurance industry, many people have, to their detriment, signed up for membership of retirement annuity funds for excessive terms.
The government has set two restrictions on the term for which you can belong to an RA fund. These are: · Earliest retirement date. You cannot draw on or surrender an RA until you are 55, unless you are disabled. In other words, 55 is your earliest retirement date. You can extend the period beyond 55, but you cannot access your money before you reach 55, unless you qualify for an ill-health pension. If you stop paying premiums, the money will remain invested until you are at least 55 years old. This is to ensure that your money is kept for retirement.· Maximum RA contribution period. You may not contribute to an RA past the age of 69. The government regards 69 as the latest age by which you should retire. This maximum is to prevent you deferring tax until you die, to the benefit of your heirs.
If you are a member of an employer-sponsored pension fund, you have to retire as a contributing member of your fund on the day that you retire from your job.
But, you can retire from an RA fund at any stage between the ages of 55 and 69, whether you are still working or not. In fact, from a tax point of view it is often worth delaying retirement from an RA as late as possible for a number of reasons, particularly if you belong to an employer-sponsored retirement fund. The reasons for delaying retirement from an RA include:· You can continue to claim your contributions to an RA against your taxable income until the age of 69;· You have the potential to increase the tax-free portion of your lump sum, although the amount will be quite small; and· Your marginal rate of taxation, and therefore your average rate of taxation, is often lower in retirement. This means that any amount you take as a lump sum, in excess of the tax-free amount, could be taxed at a lower rate than would have been the case if you retired simultaneously from your employer-sponsored fund and your RA. However, there must be an interval of two years between the two retirement dates for you to benefit from a lower average tax rate.
Unscrupulous advisers and life assurance companies have often deliberately misinterpreted the minimum and maximum contribution periods of an RA set by the South African Revenue Service (SARS).
The life companies claim they only encouraged people to take out long-term policies so that you did, in fact, save for retirement.
If you join an RA fund when you are, say, 20 years old, this does not mean that you have to commit to paying premiums until 55 or, even worse, until 69. You do have to remain a member of the fund until at least 55, but you do not have to be a contributing member of the fund for the longest possible term.
In most cases, you can limit your contractual premium payments to five years or pay a single-premium lump sum.
Tax law requirements do not dictate how much you should pay in premiums, how often you should pay premiums, or that you must pay premiums until age 55. The tax requirements only dictate that you may not withdraw money from an RA before the age of 55.
This does not imply that you should not save aggressively for retirement, making full use of all the available tax breaks. It does mean that you must protect yourself from the confiscatory penalties that life assurance companies apply if, through no fault of your own, you cannot continue to make contributions to your RA fund.
Commission
Many people were encouraged to take membership contracts of RAs underwritten by life companies up until the age of 55 or older because of the way that commission is paid to financial advisers selling RAs.
On a life assurance underwritten RA, advisers are normally paid commission based on the number of years of the contract multiplied by the premiums multiplied by three percent, with a maximum of 75 percent of the first year’s premium paid in the first year of the contract. In the second year, the adviser receives one-third of the commission paid in the first year. So, there is an obvious incentive to get you to sign up for the longest possible term.
You may not realize it, but you are affected by the way commission is calculated and paid to advisers by life assurance companies.
The life assurance company effectively gives you a "loan" to pay the commission and other costs associated with issuing an RA. Commission makes up at least half of this "loan", which life assurers often refer to as the "un-recouped costs". Part of your premium goes to pay off this loan. Interest is also charged on the loan. The interest rate varies between life assurance companies, but some life assurers charge close to the maximum permitted in terms of the Usury Act. The consequence of this is that less of your money is going towards your retirement savings.
If your financial circumstances change, and you decide to reduce your RA premiums or stop paying them altogether, the life assurance company will deduct this outstanding "loan" – or un-recouped costs – from the value of your investment. Life assurers often add on other costs – even future profits that they expected to make from your policy. The amount appears to be entirely at the discretion of the life companies. The "confiscatory" penalty may be even greater than your accumulated savings – this is particularly likely in the early years of your membership of an RA. The life assurance industry euphemistically calls the penalty a "benefit reduction".
You cannot foretell the future and neither can your financial adviser, the RA fund or the life assurance company issuing the RA. You may not be able to continue paying the premiums on an RA for any number of reasons, from losing your job to your business going bankrupt. Working women are particularly vulnerable as they often take time off to have children and cannot afford to continue paying their premiums.
RA premiums may also become unaffordable for people who change employers and become obliged to join the retirement fund sponsored by their new employer. Often they cannot afford to belong to both the employer-sponsored fund and an RA fund, and have no choice but to stop contributing to their RAs.
The advantage of unit trust RAs that are not under-written by a life assurance company is that, in most cases, commissions and other costs are only deducted as and when you pay the premiums. As a result, you can reduce or stop paying your contributions without incurring any penalties.
Avoid being stung by commission
There are a number of ways you can prevent yourself from becoming a victim of confiscatory penalties and perverse commission structures of RA funds sold by life assurance companies.· As a general rule, you should not sign a contract for more than 10 years, or beyond the age of 55. When the contract period is reached, you can always extend it for another five or 10 years.
However, you should establish the terms for extending a contract to ensure that additional costs are not loaded on to your policy.· Insist that commission is only paid as and when you pay your premiums, as is the case in the unit trust industry. There are RA products on the market that allow for this. They include:
* So-called new generation RA products. With these products, you are given the option to pay commission upfront or as and when you pay your premiums. But you must still be wary of these products because they can be costly, particularly if they offer you the choice of a wide range of underlying investments, which you may not really need, and if they add fees for investment performance. You should also be wary of products on which financial advisers are paid both commission on your premiums and a fee based on a percentage of your accumulated RA savings.
* Unit trust RAs. A number of unit trust management companies and linked investment services product companies (LISPs) provide RAs that have the same cost and commission structures as unit trust products that permit you to change your contributions without incurring penalties. Unit trust companies and LISPs sometimes "borrow" a life licence to avoid setting up their own funds, but they are entitled register an RA fund of their own.
LISPs are essentially investment administration companies that provide products, including RAs, that allow you to choose from a wide range of underlying investments from a number of different companies, mainly unit trust companies. LISPs normally pay part of the commission upfront, based on the contribution, and part as an annual fee, based on a percentage of your accumulated savings. Again, you must exercise care when dealing with LISPs. They have developed a poor reputation for protecting your interests and, apart from their often excessive commission/fee structures, provide sales people with perverse incentives to sell, such as luxury foreign trips.· Establish whether you are being issued with a "loan" on which costs and interest are being charged. If the interest rate is above what you would pay on a home loan, do not sign up for membership.· Establish the exact criteria, in writing, for any penalties that may be applied if you have to reduce or stop paying your premiums.
To learn more about the top ten things to know before buying retirement annuities
There will always be costs associated with investing in retirement annuities. The issue is the quantum of the costs and whether you are receiving value for money.
The issue of the costs levied on retirement products has come under scrutiny since independent actuary Rob Rusconi presented a paper on the subject at the annual conference of the Actuarial Society of South Africa last year. Rusconi’s argument was not that the costs were not justified, but that the level of costs was not justified.
His research showed that retirement funding costs are extremely high in South Africa, particularly on life assurance products. He posed the question of how much more money people would have for their retirement if the costs were lower.
The issue was taken up by Parliament’s Portfolio Committee on Finance and filtered through to the National Treasury, which is redrafting the Pension Funds Act. Since the government focused its attention on the issue, the life assurance industry has been under pressure to come up with better low-cost products that do not include confiscatory penalties if you reduce your contributions.
One of the problems with costs is that RA product providers manage to conceal the real impact of costs. When they do disclose these costs, they do so in a number of confusing ways to ensure that you will not have a clue what you are actually paying.
It is important that you insist on costs being disclosed to you in various ways.
Costs should be fully disclosed and limited. In other words, they should not be left to the future discretion of a life company. The costs should be disclosed as initial and on-going and in three ways:· In rands;· As a percentage of premiums; and· On a reduced-yield basis.
The reduced-yield method is a simple way of showing the impact of costs.
To calculate costs on a reduced-yield basis, take the total amount you would pay in premiums over the contractual period and then deduct the total costs.
It is also best to use an assumed growth rate, particularly if the costs include investment performance fees. If you are being charged a performance fee, you should assume different growth rates of, say, five, 10 and 15 percent, so that you can see the effect that the performance fees will have on your investment.
You must get a full list of all costs, including all underlying costs that may be involved in complex investment structures.
It is important that you compare the cost structures of the products offered by different companies.
Here is a table that you should have your financial adviser complete:· List all costs/fees:
* Commissions/advice fees
* Administration fees
* Policy fees
* Asset management fees
* Underlying asset management fees
* Performance fees
* Other fees· Initial costs:
* As a percentage of premiums
* As a rand amount
* Annual (on-going) costs:
* As a percentage of assets
* As a rand amount· Reduction in yield calculation:
* Total amount invested
* Less total costs paid in rands
* Annual percentage reduction-in-yield
* Total percentage reduction-in-yield
* Total rand reduction-in-yieldIn spite of all the bad things you may have read about retirement annuities (RAs), they are essential investment vehicles for most people – provided, of course, you understand what they are and how to derive the maximum benefit from them.To learn more about the top ten things to know about a retirement annuity