Retirement funds were designed for people to save for their retirement. Although they have built-in limitations, they have distinct advantages over discretionary investments. Do the advantages outweigh the limitations, even when market conditions favour discretionary investments? Research by financial services firm Alexander Forbes shows that they do.
Many investment professionals are critical of Regulation 28, the rule under the Pension Funds Act that imposes limits on the extent to which retirement funds (which comprise occupational pension and provident funds, retirement annuity funds and preservation funds) can invest offshore and in higher-risk asset classes, such as property and equities. The critics maintain that the limits are too restrictive and that funds should have more flexibility to invest where they choose, to optimise long-term returns for their members.
A major point of contention is the limit on investing offshore, which restricts funds to a maximum of 30percent in foreign markets and a further 10percent in Africa outside of South Africa. In other words, a minimum of 60percent of any retirement fund portfolio must be invested locally.
Calls from the investment community for retirement funds to be allowed greater access to offshore markets have become louder in recent years because of the poor performance of JSE-listed equities and the ongoing depreciation of the rand against the major foreign currencies, both indicative of South Africa’s shaky economy. The stellar performance in 2020 of the United States stock market, driven largely by a handful of giant tech companies, further fuelled anti-Reg-28 sentiment.
There was a flutter of excitement in November, when National Treasury, in an attempt to encourage foreign investment in South Africa, issued a circular that changed the status of JSE-listed rand-denominated offshore instruments to domestic instruments. Providers of exchange traded funds (ETFs) tracking offshore market indices saw this as a way of circumventing Regulation 28’s offshore limit. However, when the government became aware of this “loophole”, it withdrew the circular.
The offshore brigade was appalled at this seeming about-turn. Some financial advisers went so far as to advise their clients to put as much as they could of their retirement savings into discretionary investments, in which the only offshore limits are the rand amounts imposed by the exchange control regulations. (Your offshore investment allowance is R10 million a year.)
How responsible were these advisers in giving such advice? Would you genuinely be better off having the bulk of your retirement savings offshore? Or are you better off in a retirement fund, even if the JSE performs poorly?
John Anderson, executive of investments, products and enablement at Alexander Forbes, and his team of actuaries set about finding answers to these questions, and he shared the results at a recent media presentation.
Unlike many countries, Anderson said, South Africa does not have a safety net for pensioners, apart from the paltry old-age grants for the destitute. It’s left to us as individuals to save for retirement, and, unfortunately, we don’t appear to do that very well. He said fewer than one in 10 South Africans preserve their retirement savings when they change jobs throughout their careers.
It’s in the government’s interests that we save enough for our retirement – it cannot afford old-age grants for everyone. But there is another good reason for maintaining a large pot of retirement savings within South Africa: it’s one of the country’s largest resources for economic development. In 2018, retirement fund assets totalled R4.2 trillion, according to the 2017/18 Annual Report of the Registrar of Pension Funds. At least three-quarters of this money is invested locally, mostly in listed equities and bonds. South Africa’s largest pension fund, the Government Employees’ Pension Fund, which manages assets of about R1.6 trillion, has half of its portfolio invested in domestic equity and 31percent in domestic government and corporate bonds.
Retirement fund tax breaks
The government provides powerful incentives for us to save in retirement funds, in the way of generous tax breaks on what goes into them, but it also restricts how you can use the money you have saved. The major features of retirement funds are:
• You can deduct your contributions from your taxable income. The tax break applies on contributions up to 27.5percent of your annual gross remuneration, and up to R350 000 a year. If you contribute more, you can roll over the excess amount, to be deducted in a subsequent year.
• The investment itself is not taxed: income tax on interest earned, capital gains tax, and the 20 percent withholding tax on dividends do not apply to retirement funds.
• When you retire, you can take up to one-third of your savings as a lump sum, of which R500 000 is tax-free. With the remaining two-thirds (or more), you must buy a pension (annuity), which can take various forms. In these post-retirement investments returns are not taxed, but you do pay income tax on your pension.
• To counteract the generous tax breaks and encourage preservation, you are taxed heavily if you cash in your retirement savings when you change jobs or take the allowed once-off cash withdrawal from a preservation fund.
If you save in anything other than a retirement fund – for example, in a collective investment scheme such as a unit trust fund or ETF – you do so using after-tax funding. These discretionary investments are subject to taxes on interest, dividends and capital gains. However, there are no restrictions on deposits and withdrawals. Anderson said there are vehicles, such as tax-free savings accounts, which have some tax benefits. A rule of thumb, he said, is that the more flexibility you have, the fewer tax incentives there are.
He said it is important that you have a greater allocation to South African assets than offshore ones because your liabilities – your expenses, such as food, accommodation and debt repayments – are in rands. The volatile exchange rate can work against you both when taking money offshore and when bringing it home. “In three months (from August to November), the rand went from R19 to R15 to the dollar, an increase of 26 percent. When it was at R19 people were jumping up and down saying we should go offshore. This is typical: at the point of greatest pain, people tend to make the wrong decisions, and forget about good investment principles,” Anderson said.
Alexander Forbes research
Anderson’s team of actuaries first considered what the optimal offshore allocation would be for a retirement fund, bearing in mind the prudential requirements for such funds. They targeted returns of five percentage points above inflation, while seeking to keep investment risk as low as possible. Looking backwards over the past 15 years, the team found that the optimal offshore allocation would have been 40 to 45 percent. However, looking forwards, based on the Alexander Forbes house view of the markets in November, they found that the optimal offshore allocation was likely to be lower, at 25 to 27.5 percent. These figures are not far off the Regulation 28 limits and “nowhere near 100 percent offshore allocation recommended by some advisers”, Anderson said.
He said: “We believe additional flexibility would be welcome, but on the whole you don’t need more flexibility than up to 50 percent. So our view is that a gradual raising of the current limits is desirable, but it should be done in a way that balances the other objectives that the regulations are aiming to achieve.”
The team then compared the performance of formal retirement savings with that of discretionary investments with a 100 percent offshore allocation over 35 years into the future. Their model considered a range of outcomes under different income brackets (contributing 15 percent of income) and under different equity return scenarios, where local returns were higher than offshore returns and vice versa. They took into account an average annual depreciation of the rand of 7.2 percent a year over the 35 years, and based their calculations on the 2020/21 tax tables adjusted for inflation over the period. They did not take investment costs into account.
The actuaries considered three scenarios: where offshore and local returns were roughly the same (base case), where offshore equities outperformed local equities, and where local equities outperformed offshore equities. The asset allocation of the portfolios was as follows:
• Retirement fund portfolio: local equities 45 percent, local bonds 25 percent, offshore equity 30 percent, in line with the Regulation 28 restrictions.
• Discretionary vehicle: 100 percent in offshore equities for the base-case scenario and the scenario in which offshore equities provided the best returns; 100 percent local equities in the scenario in which local equities provided the best returns.
The results, Anderson said, were quite staggering. They found that, under all scenarios, and whatever your income level, the retirement fund significantly outperformed the discretionary offshore investment, and this was wholly due to the tax benefits. And the more you earned, the more the tax benefits worked in your favour.
In the base-case scenario, where the average before-tax real (after-inflation) returns of the two portfolios were almost equal (retirement portfolio 5.58 percent a year; discretionary portfolio 5.60 percent a year), the after-tax real returns in the discretionary portfolio were:
• 3.82 percent for someone earning R500 000 a year. You’d need a real return of 7.55 percent to compensate.
• 3.44 percent for someone earning R1 million a year (8.10percent needed to compensate).
• 3.16 percent for someone earning R2 million a year (8.50percent needed to compensate).
In this scenario, for someone earning R500 000 a year, after 35 years the accumulated savings in the retirement fund was R7.3 million. In the discretionary investment it was just over half of that: R3.9 million.
In the scenario where the retirement portfolio delivered 5.60% and the offshore discretionary portfolio did better, providing an average annual pre-tax real return of 6.50%, the after-tax real returns in the discretionary portfolio were:
• 4.62 percent for someone earning R500 000 a year. You’d need a real return of 7.65 percent to compensate.
• 4.21 percent for someone earning R1 million a year (8.15percent needed to compensate).
• 3.91 percent for someone earning R2 million a year (8.55 percent needed to compensate).
In the third scenario, where local equities surprised investors and performed well, the advantages of being in the retirement fund were even more pronounced. Where the retirement portfolio delivered 7.27 percent percent and the discretionary portfolio
(now also invested in local equities) delivered a pre-tax real return of 7.50 percent, the after-tax real returns in the discretionary portfolio were:
• 5.51 percent for someone earning R500 000 a year. You’d need a real return of 9.50 percent to compensate.
• 5.06 percent for someone earning R1 million a year (10.10percent needed to compensate).
• 4.75 percent for someone earning R2 million a year (10.55percent needed to compensate).
The tax benefits do not stop at retirement, Anderson said. His team showed that outcomes in a formal postretirement vehicle such as a living annuity continued to surpass those offered by a discretionary investment.
The situation becomes more complicated if you plan to leave the country at some point – for instance, if you aim to retire in Mauritius.
Anderson said that over the 35-year period modelled, you would still be better off investing in a local retirement fund. “Such a strategy would make sense for younger members who have that period of time and who don’t need to be overly concerned with shorter-term currency fluctuations.
“However, as the term to retirement decreases, it becomes increasingly important for the assets to be invested in a way that reduces shorter-term currency risk. This is because once one starts drawing an income, sequence-of-returns risk becomes important. Many retirees would find it hard to absorb the short-term currency fluctuations in their income in retirement,” he said.
Therefore, Anderson said, you would need to phase your investments into a vehicle that would better match the currency of your ultimate retirement destination. “This would need to be done carefully – and over a sufficient period to ensure short-term currency risks are smoothed out – in the period before starting to draw an income.
“For individuals close to or in retirement, it remains important for their investment strategy to reflect the currency they need their income in,” he said.