Where to for living annuities?

Looking at it purely from a tax perspective, investment in retirement funds is knocking the socks off other investment vehicles.

Investment in one’s own name – through an endowment policy, a company or a trust – just cannot match a tax-deductible investment; followed by tax-free growth while invested and only partial taxation on maturity of the investment.

Times change

Just 10 years ago retirement funds were out of vogue due to retirement funds tax and other perceived threats. Now the pendulum has swung in the other direction. And who is to say it will not all change again?

For most of us there is still some time to go before retirement. And therein lies the biggest detraction from all retirement funds – one cannot simply withdraw and invest elsewhere if the investment playing field changes again. Simply put, withdrawal from a retirement fund prior to retirement age (usually at 55) is discouraged by fund rules and adverse taxation implications.

In his February 2012 National Budget Speech, Finance Minister Pravin Gordhan stated: “A series of discussion papers will be released this year on promoting household savings and reforming the retirement industry…Among the issues are improved governance over pension funds… and ways to improve preservation of retirement fund assets and to ensure higher levels of income in retirement”.

In May 2012, the National Treasury Discussion paper, ‘Strengthening Retirement Savings’, followed suit. The paper does not break much new ground and will be followed by more detailed papers addressing various concerns about the state of the retirement industry and pensioners in South Africa today.

The discussion paper makes quite a fuss about the distinction between ‘conventional life annuities’ and ‘living annuities’.

Conventional life annuities pay an income to investors until they die, pooling longevity risk protection and using the insurer’s capital to guarantee income in the case of mismatches between assets and liabilities and unanticipated fluctuations in mortality rates.

living annuity provides a phased withdrawal savings account with no longevity risk protection. Individuals must withdraw between 2.5% and 17.5% of the account each year. A wide range of investments is possible and the individual exposure to investment risks may be substantial.

In recent years many investors have favoured living annuities. When asked why, investors say it is the ability to preserve capital at death, the flexibility to select income drawn and the ability to make appropriate investment decisions that drive them towards living annuities.

But the downside, and this is often not taken into account fully, is that when markets do not perform or investors hit hard times their annual withdrawals can exceed the investment return. So, long before the grim reaper knocks on the door, retirement capital is exhausted.

The National Treasury paper hints at the potential implementation of preservation regulations and moving away from the pure living annuity principle towards the conventional annuity.

Is this a fair reflection?

The risk inherent to the living annuity principals is obvious, get it wrong and your kids will inherit you and not your money. But it is so easy to blame it all on living annuities. The question should rather be: ‘why have some taxpayers, who moved over to the living annuity principle, failed?’

  • First and foremost, most of those presented with a retirement based on a conventional life annuity face a grim retirement prospect from day one in the shady pines retirement village. Income provided by conventional annuities, especially those where income will keep pace with inflation, just do not provide an appealing income on day one.
  • Increased energy prices. Only a Ponzi scheme has any prospect of yielding an after-tax return that can keep pace with today’s ESKOM increases.
  • Beware the KIPPERS (Kids In Parents Pockets Eroding Retirement Savings). Many living annuities have been overdrawn and spent on family rather than the pensioner.

The National Treasury paper does not recognise the above as real-life factors that have caused many of the living annuity disasters we so often hear about today.

Living annuities underpinned with equity investments at least provide a hope of generating a high enough return, in the long-term, to finance a comfortable retirement. And there are many responsible investors in living annuities who are more than happy with the concept.

Investors also enjoy the freedom of choice of investment, which is inherent in the living annuity. This has allowed investors to create actively managed portfolios heavily weighted to equity markets. But reading between the lines of the discussion paper, this freedom could change if Regulation 28 of the Pension Funds Act is amended.

Yes, the living annuity can be more expensive to administer. But will a cheaper alternative based on a passive investment policy and bonds (as proposed in the discussion paper) do the trick? I doubt it. Not with today’s long-term interest rates and without tackling the above realities.

There is no reason to panic

There is a long, long way to go before the National Treasury paper becomes law. And it can be anticipated that the financial planning industry will hotly debate the National Treasury’s views on living annuities. Remember that many proposals made by National Treasury take an extreme view and this is usually curtailed through the participation processes that follow.

National Treasury will have to recognise that interference with the living annuity principles may well have the same disastrous consequences as were experienced on the introduction of retirement funds tax.

My predictions
    • Lump sum withdrawal benefits
      The simplest move for National Treasury is to avoid increasing the income tax concessions in respect of lump sums withdrawn from retirement funds. Concessions contained on the Second Schedule to the Income Tax Act have hardly been revised since its introduction in 2007.The tax-free lump sums on retirement (so popular 20 years ago) are of far less significance today. Yes, a R630 000 lump sum taxed at an average rate of 9% is attractive, but it is not the major draw card to invest in living annuities.Tax-deductible investment in a living annuity, followed by tax-free growth while invested in the fund, is far more important. All indications are that these principles will remain intact, subject to the ‘capping’ of contributions proposed for implementation in the 2014 tax year – (R250 000 per annum for taxpayers under 45 and R300 000 for taxpayers over 45).Even if tax efficiency on lump sums is no longer the incentive, most taxpayers will still benefit when the annuity income withdrawn from a retirement fund is taxed at a far lower rate than the rate applicable to the tax deduction granted on contribution.
    • Implementation of compulsory life annuity component
      It is respectfully submitted that it would be very difficult for National Treasury to change the rules in respect of living annuities already in place at the time of an amendment. It can even be argued that such a move would be unconstitutional.
    • Reduction of the maximum permissible annual withdrawal
      The maximum annual withdrawal from a living annuity was determined long before the global financial crisis and the resultant international downward adjustment in interest rates. Today it is difficult to justify any circumstances where any person should be withdrawing 17,5% per annum from any accumulated retirement fund benefit. Another simple, obvious and justifiable measure would be for National Treasury to reduce this level to 12%.
    • Prescribed investment for living annuities
      Currently Regulation 28 of the Pension Funds Act prescribes appropriate levels of investment for all retirement funds. This regulation could be reviewed to provide for mandatory investment in interest bearing instruments and Government Bonds. But the impact of such a move on local markets would be enormous. Thus no substantial changes are anticipated. Especially for living annuities that are already in place.
  • New specifications for new contributions to retirement funds
    The National Treasury paper hints at the creation of alternative funds with passive investment strategies largely based on bonds. If this were to happen it is possible that the taxation consequences on contribution to a retirement fund may be redefined. But that would take a few years to regulate and establish. Until that happens one can view living annuity investments as ‘game on’.
My suggestions

Investors have to play by the rules that they know and not over-react to what may be on the horizon.

National Treasury discussion papers are just that – ‘Discussion Papers’. It must be emphasised that there is a very long way to go before there will be any substantial changes. When changes come, the tendency is to avoid a retrospective effect on implementation.

Certainly there are no huge threats to retirement funds that are sufficient reason for the investor to turn away from the tax concessions currently enjoyed by living annuities.

The concerns about living annuities in the light of the National Treasury discussion paper are not the only concerns facing investors today. There are other real threats to investments other than living annuities (for example the prospect of increased capital gains tax inclusion rates) that should also be considered.

‘Diversity’ remains the key. Certainly it may not be appropriate for any investor to ever invest only in living annuities. A balanced approach to investment tax strategy is as important as a balanced approach to the investment decisions.

This article originally appeared in Where to for living annuities? in glacier by Sanlam, The {Inside} Story


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