Feb 2, 2021
Tax-free savings accounts (TFSAs) were introduced in South Africa in 2015 to encourage individuals who are resident in South Africa to save more. The growth and income received on a TFSA investment are tax free. This means that you are not liable for any capital gains tax (CGT) or income tax on the dividends and interest received on your investment. But there are limits on how much you can contribute to a TFSA per annum, and over your entire lifetime.
The TFSA product is coming up for its sixth anniversary in February 2021, and over the past six years many product providers, including life companies, banks, unit trust companies and LISP investment platforms, have jumped on the bandwagon and launched TFSAs. This proliferation of options and the accompanying wave of good news marketing material have confused many advisors and investors, leaving them wondering how best to utilise a TFSA as one of several different tax-efficient savings tools.
In this article we share some of the questions and feedback we have received when discussing this matter with financial advisors and highlight the implications of some of the product options.
A lot of the media coverage on TFSAs appears to take people’s eyes off the fact that the first savings priority for any investor remains their contribution to some type of registered retirement fund (via their employer or a retirement annuity). In general, investors should first provide for an adequate contribution to their retirement fund before taking out a TFSA.
Over the course of 2020, amid the impact of COVID-19 on the SA economy and markets, South African retirement funds were on the receiving end of some bad publicity. Specifically, the investment restrictions imposed on South African retirement funds via Regulation 28 attracted significant media coverage. (The regulation limits equity exposure to 75% of a portfolio; there is a maximum limit of 30% in offshore assets and an additional 10% for the rest of Africa.) Many market commentators questioned whether retirement funds in South Africa still represent a good investment. Whilst this is an important debate for South African investors, it is a debate for a different article. Suffice to say that the tax benefits available to South African retirement fund investors remain significant. Especially when compounded over a period of twenty years or more, these benefits dwarf those of a TFSA. We remain convinced that retirement funds present good value to investors given the tax benefits.
Secondly, investors should remember to use their annual tax-free interest exemption (currently R23 800 per year for individuals under age 65). At current money market rates of between 4% and 5%, an investor in South Africa can keep up to R500 000 in a fixed income fund before paying any tax on the interest. Ideally, this allowance should be used to set up an investor’s emergency cash pool.
When TFSAs were originally launched, many investors and advisors underestimated the extent to which the tax benefits on TFSAs would compound over time. This happened because, unlike a retirement fund, the TFSA contribution is not tax-deductible upfront. This makes it difficult to calculate the rand value of the tax benefits.
These points are best illustrated by an example. In Figure 1 we project a TFSA’s fund values over a twenty-year period based on the following assumptions:
Figure 1: TFSA value projection split between contributions and investment return
From Figure 1 there are three takeaways:
From a tax benefit perspective, it appears to not make sense for an investor to utilise a TFSA for an investment horizon of shorter than five years. This position, however, changes drastically after ten years due to the well-known compounding effect of long-term investment returns.
Current TFSA product rules, as set out by National Treasury, do not allow an investor to recover any part of their lifetime TFSA contribution limit should they need to dip into the TFSA assets to fund an emergency expense. Every time an investor uses part of their TFSA contribution allowance, that allowance is gone forever.
Withdrawals from a TFSA therefore waste part of an investor’s lifetime contribution allowance – ideally something to be avoided.
Another point that frequently comes up in advisor discussions deals with the ideal investment portfolio for a TFSA. There are two key considerations when constructing an investment portfolio for a TFSA investment:
The simplest way to look at this problem is to evaluate different investment strategies with reference to a long-term return and volatility measure, and see how they stack up. In Figure 2 we give an example of such a comparison, looking at the fifteen-year annualised return and volatility statistics for several potential TFSA investment options.
Figure 2: Fifteen-year annualised return/volatility
Source: Morningstar Direct, as at 31.12.2020. Performance figures are based on a lump sum investment, NAV to NAV, net of fees. Highest and lowest annualised returns since inception of the Ninety One Global Franchise Feeder, Opportunity, Equity and STeFI Plus funds (12-month rolling performance figures) are: 45% and -40%; 43.8% and -15.7%; 65.8% and -34.8%; 13.8% and 4.2%, respectively. The total expense ratio of the Ninety One Global Franchise Feeder, Opportunity, Equity and STeFI Plus funds (A class) are: 2.10%; 1.59%, 1.59% and 0.70%, respectively. Funds shown are for illustrative purposes only and are not necessarily the classes available on the Ninety One platform for TFSAs.
Figure 2 illustrates what we know intuitively – more conservative, fixed income-orientated portfolios merely reduce the likely long-term investment returns without really adding anything to the portfolio (since long-term investors should not be concerned about volatility).
Secondly, even though fixed income investments seem attractive because they appear to maximise the tax benefit for the investor in the short term, they disappoint in the long term because of their significantly lower total returns.
It seems that a good starting point for most TFSA investors is to have a look at unit trust funds from the “ASISA South African Multi-Asset: High Equity” category, or something similar. These funds have historically produced attractive long-term risk-return trade-offs.
Given that TFSA investment portfolios are not restricted by regulation and are long term in nature, investors with time horizons exceeding ten years should even consider more aggressive investment portfolios. The most popular investment portfolio for the Ninety One TFSA has been the Ninety One Global Franchise Feeder Fund, an offshore equity fund, which makes up twenty percent of total assets in the Ninety One TFSA product.
Most large South African financial services companies have launched their own TFSA products, offering a range of options. Setting up a TFSA might sound like a daunting task. But it should not be – the best strategy really is to keep it simple.
There are several benefits to picking an investment platform, such as the Ninety One Investment Platform, for TFSAs:
TFSAs are a great initiative from government to encourage savings in South Africa and are important financial planning tools for financial advisors. However, it is important to set them up correctly as long-term investments in order to maximise a client’s lifetime tax benefit from the product.
The benefits of a TFSA are increasingly being recognised, as illustrated by the following summary data of Ninety One IP’s TFSA accounts as at 31 December 2020 (31 December 2019 details in brackets):