UK offers an enticing route to old-age ruin

Governments really have only three options when it comes to regulating how people withdraw their pension funds.

The first, the life annuity option, forces pensioners to buy guaranteed annuities based on life expectancy.

The second allows pensioners to withdraw the entire benefit when they want, and then assume the responsibility for preserving the wealth in the funds.

Third option is the living annuity principle, which allows pensioners to withdraw only a percentage of their capital every year, and whatever remains after they die is distributed to their families.

Now I am fascinated but unconvinced by recent announcements in the UK that pensioners will be given greater access to their retirement funds, rather than traditional life annuities.

This is popular stuff. Not even Britain’s opposition Labour Party is opposing the move.

South Africa’s Treasury, however, thinks otherwise, and is taking steps to retain retirement savings in the fund, allowing only a third of the fund money to be withdrawn as a lump sum on retirement.

Allowing pensioners to cash in is an easy move for government. It’s popular with voters — it scores them tax on the withdrawal, more tax when the money is spent and potentially even more when the taxpayer dies and pays estate duty.

The downside is that pensioners will blow the loot long before they die and become a burden on the state.

In the UK, this is dismissed as a frivolous accusation. The analogy drawn in the UK of pensioners buying Lamborghinis is ridiculous — and there is obviously merit of drawing down a pension lump sum to settle a home loan, for example.

But it doesn’t stop there.

From 1994 to 2000, South Africans withdrew billions from retirement funds as early retirement packages were common. Tremendous tax efficiency was available through the average tax rating formula.

At the time, we thought these premature pensioners would live out a comfortable life on a golf course development. But many haven’t. Why is this?

Well, first, many people invested their retirement lump sums on overly aggressive investment strategies.

Second, the increased holding cost of South African properties is fast swallowing the pensions.

Third, generation Y has scoffed the remainder.

Pensioners may choose responsible investment strategies, and even downsize their properties. But they can’t refuse children or grandchildren.

Perhaps the living annuity principle is a fair compromise between the life annuity and the withdrawal option.

However, in South Africa we currently have the living annuity principle wrong by allowing a maximum annual withdrawal benefit of 17.5% of capital. But that can be fixed.

Originally published in the Sunday Times: Money & Careers Tax Talk column.

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