Tax advantages of formal retirement savings
How well is your pension savings growing in a traditional savings vehicle and should you consider an alternative? We look at the comparison between these and the tax implications thereof.
Government provides a means-tested old age pension benefit primarily targeting the most vulnerable individuals in society. The current benefit is a pension of up to R1 860 per month from age 60 years and up to R1 880 per month from age 75 years, on condition that you don’t earn more or have assets more than specified amounts. Therefore, for most working South Africans, formal retirement savings vehicles are their only source of retirement income. However, insights from the Alexander Forbes Member WatchTM show that the current retirement savings environment is characterised by low contributions, a culture of low preservation rates and a significant proportion of the working population not making provision for retirement.
On average, 8% of people retire comfortably and this is despite South Africa’s real returns being one of the best over the last 120 years. The reasons for this include the fact that 33% of people don’t make provision for retirement and, where they do, less than 10% preserve their retirement savings when leaving jobs throughout their working career.
Regarding the debate around offshore allocations, increasing Regulation 28-compliant funds’ offshore exposure outside South Africa from the current 30% all the way to 100% is not the most prudent retirement strategy for the vast majority of South Africans. Most South Africans’ liabilities such as school fees, bonds and food expenses are in South Africa and for these, having a greater allocation to South African assets makes sense. Offshore allocations are necessary and do provide diversification benefits to improve the likelihood of meeting retirement income goals and in managing risks. In addition, the most optimal allocation depends on the individual circumstances and risk appetite. Hence, additional flexibility around the current prudential offshore limits would be welcomed to improve outcomes. However, it is understandable that this needs to be balanced against a number of the other goals the regulations are looking to achieve – especially as these restrictions are a condition of the significant tax benefits provided.
For investors currently looking to unshackle themselves from the prudential investment limits prescribed under Regulation 28, an entry into discretionary savings vehicles to achieve retirement objectives may not be justifiable. Discretionary growth portfolios with greater flexibility to invest 100% offshore rarely beat Regulation 28 funds in rand terms in the long run once tax effects are considered.
In order to compare formal retirement savings and discretionary savings vehicles, Alexander Forbes modelled the outcomes over a 35-year period using a range of asset class assumptions, tax assumptions and taxable income levels. The modelling also looked at various scenarios, where offshore returns are expected to be higher than local returns and vice versa. Comparing retirement outcomes between formal retirement savings vehicles and discretionary savings, the tax benefits realised from formal retirement savings vehicles result in accumulated capital being significantly greater. The after-tax lump sums and income at retirement was shown to be between 35% and 70% higher when making use of a retirement savings vehicle in the base case scenario. As well as the initial income being better, the income in retirement is also expected to last longer using formal retirement savings vehicles. Retirement outcomes under a formal retirement savings vehicle continued to outperform those achieved under discretionary savings vehicles – even in the modelled scenarios where local equities disappoint and offshore returns do well.
The case for matching formal retirement savings vehicles with the objective of saving for a retirement income is extremely strong. Best advice for meeting retirement objectives with the highest likelihood is to save for retirement through formal retirement savings vehicles (despite the restrictions in relation to Regulation 28). Additional and gradual flexibility of Regulation 28 would be welcome and would improve the outcomes further. Any advice suggesting that individuals should cash in their formal retirement savings, pay tax, and then invest the proceeds outside the formal retirement savings system (in, for example, offshore schemes), should be treated with extreme caution.
The case for matching formal retirement savings vehicles with the objective of saving for a retirement income is extremely strong. Best advice for meeting retirement objectives with the highest likelihood is to save for retirement through formal retirement savings vehicles.