Oct 8, 2020
Regulation 28 of the Pension Funds Act (1956), designed to protect retirement savings from imprudent exposure to riskier assets, including offshore assets, has frustrated some local investors of late. Local returns have lagged offshore returns, and some have argued that a discretionary investment fully offshore would be preferable to a retirement vehicle, limited as it is by Regulation 28. However, a previous article penned by Deputy Managing Director Sangeeth Sewnath discussed the impact of Regulation 28 on portfolio returns concluded otherwise.1
Sewnath argued that the tax benefits associated with a retirement fund potentially compensate an investor for any out-performance that might be enjoyed by increasing your offshore exposure beyond what is allowed by Regulation 28, in a discretionary investment. He investigated a 30-year investment and drawdown cycle, consisting of a 15-year phase of contributions to a retirement annuity and then a 15-year spending phase, converting the consequent savings into a living annuity, so creating an income. His calculations demonstrated that an unrestricted discretionary portfolio would need to outperform a Regulation 28-compliant retirement fund portfolio by approximately 2.5% p.a. over the full 30 year period to leave a client better off.
Generating an extra 2.5% p.a. consistently over an extended period is very difficult to do. Additionally, upon passing away, the associated fees and taxes can have a huge negative impact on the remaining value of a discretionary portfolio, making the case for a retirement annuity or retirement fund even more compelling.
A retirement fund is incredibly powerful in preserving the value that can be transferred to a loved one on death, as it may provide protection from executor’s fees (up to 4.03%), capital gains tax (“CGT”) (up to 18%) and estate duty (up to 25%). A discretionary investment can provide no such protection unless the benefit passes to a spouse on death. (It should be noted, However, that the next time the benefit changes hands the full executor’s fees, CGT and estate duty would be incurred).
Not only have local assets disappointed, but speculation about the potential for the introduction of prescribed assets has further depressed sentiment surrounding retirement fund savings. Together, this has fueled a trend which has meant some investors have reduced their contributions to retirement funds and allocated the capital to offshore discretionary investments instead. More concerning, we have also seen some investors cashing in retirement funds, paying the tax and redeploying the proceeds in a discretionary offshore investment.
In our view this latter approach could be very dangerous. It involves making an irreversible decision, with very certain negative consequences, in fear of a change that is at this stage uncertain. When withdrawing capital from a retirement fund the impact of the withdrawal tax tables can significantly reduce the net amount available for the offshore investment. As an example, a pre-retirement withdrawal of a R5m pension fund benefit would result in nearly R1.7m of its value being lost to tax. This is equivalent to starting the investment with a 34% drawdown on day one. The impact of this is illustrated in Figure 1. And while offshore equities remain our preferred asset class across our multi-asset capabilities, it is unlikely that the trend experienced over the past decade will persist at the same magnitude into the long-term future.Figure 1: Taxes and executor fees can have a material impact on outcome
Source: Morningstar and Ninety One. Performance net of fees. Starting value in offshore discretionary investment adjusted to reflect current withdrawal tables assuming the client had no disallowed contributions remaining on death. 2% p.a. of total return for offshore investment assumed to come in the form of dividends and taxed accordingly. On death capital gains tax, executors’ fees and estate duty deducted from end value in offshore investment, assumes R3.5m abatement used elsewhere.
Over the 10 years to end December 2019 global equities outperformed the Ninety One Opportunity fund by 7.4% p.a. in rand terms, and thus provided a perfect tailwind for an offshore investment strategy. Despite this significant out-performance however, it would have taken more than eight years before the offshore discretionary strategy starts to move ahead of the retirement fund investment, due to the reduced starting value. The other consequence of taking funds out of a retirement product and placing them in a discretionary investment means that those funds now form part of your estate. Therefore, when you pass away the fees and taxes associated with death have a destructive impact on the total value that can be received by your loved ones. A retirement annuity, on the other hand, allows for the full value to be preserved on death if the beneficiary takes over as an annuity in their own name.
We hence believe clients should fully consider the significant financial planning benefits presented by retirement annuities before deciding how they allocate, or reallocate, their savings. As outlined, the outperformance required to compensate for the lost tax benefit is extreme, while factoring in the estate planning benefits make a retirement annuity almost impossible to beat. The extent of the benefits will vary based on individual client circumstances, so as always, we suggest investors consult their financial adviser before making irreversible decisions.Download PDF
1. First published in Taking Stock, 18 November 2019: https://ninetyone.com/en/south-africa/how-we-think/insights/regulation-28-is-restrictive-but-not-in-the-way-you-might-think