The pre-retirement period is a critical phase in planning for retirement, as it is within this phase that the base is laid for financial independence and the ability to maintain your preferred lifestyle during retirement.
Key elements of planning during this phase involve:
⦁ Setting your objectives for retirement
⦁ When you start saving for retirement
⦁ How much you save
⦁ The investment growth you achieve
⦁ The retirement product you choose
Step 1: Setting your objectives for retirement
The pre-retirement phase is characterised by the need to accumulate wealth during your economically active years. When setting your objectives, the following variables will be important to consider:
⦁ Your planned age of retirement
⦁ The ability to save and to maintain your contribution rate
⦁ Other elements of your complete financial plan
⦁ Your future expected standard of living
An investment objective needs to be:
⦁ Realistic and specific
⦁ Quantifiable (how much)
⦁ Time specific (when)
⦁ Set in real terms (considering inflation)
⦁ Match life stage priorities
Review your objectives periodically or when you have a change in your personal circumstances.
Step 2: When you start saving for retirement
The ability to retire comfortably is determined by how much has been saved before retirement, the time allowed for savings to grow and the return achieved on the savings.
Provide a sound base for achieving financial independence by:
⦁ Starting your contributions as early in life as possible
⦁ Saving as much as possible from your monthly income and/or other income
⦁ Combining your other income with the appropriate exposure to riskier asset classes to beat inflation
Starting early allows you to harness the power of compound growth. The table below illustrates how time allows you to exponentially grow your retirement capital. It is clear that the earlier you start to save towards retirement, the greater the chances of accumulating sufficient capital for financial independence.
For example, the decision to only start saving at age 40, assuming a retirement age of 60, will result in your retirement capital being worth less than a third of the amount you could have accumulated by saving from age 30.
(Figures shown in the table assume a starting contribution of R500 per month that escalates by 6% every year and a 10% investment growth per annum.)
Another way to illustrate the need to start saving for retirement as early as possible, is by looking at the capital built up expressed as the number of years of your final salary. For example, if you retire at 65 and start saving towards retirement at the age of 25, you would have built up capital to the equivalent of 9.4 years of your final salary.
However, if you only start contributing at age 40, you would only have 4.2 years of annual income which equates to a loss of 55% in income. This means that by delaying the start date of your contributions by 5 years, you reduced a R10 000 per month income to only R4 500 per month as a result of less capital accumulated.
Step 3: How much do I need to save?
Although it is important to start saving as early as possible, your rate of contribution to your retirement savings expressed as a percentage of your annual income is equally as important. The rate at which you contribute to your retirement savings will determine how long your savings will last in retirement. The graph on the next page illustrates how many years your savings will last at different rates of contribution.
To ensure that enough capital is accumulated to last you during your retirement, your monthly contributions as a percentage of your income needs to be as high as possible.
In conjunction with this, you need to ensure that your contribution rate is maintained throughout your economically active years.
The difference between your ability to build your retirement capital using a fixed amount of savings versus maintaining a fixed percentage of your monthly salary is illustrated below.
If you save R500 of a R10 000 monthly salary, your contribution rate will be 5%. Assuming you maintain this fixed R500 monthly investment over 10 years at a growth rate of 7% per annum, the future value of this investment will be worth R86 542. In this scenario, your monthly salary increases will result in your contribution rate diminishing over the 10-year period.
However, if you grow the initial monthly investment of R500 annually by 7%, which is in line with your annual salary increase, and achieving a growth rate of 7% per annum over 10 years, the future
capital value will be R124 190. Maintaining your regular retirement contribution as a percentage of salary will result in a significantly improved capital value at retirement.
Investment products for pre-retirement savings
During your economically active years, retirement savings can be accumulated as part of a formal retirement scheme of an employer in the form of a pension or provident fund, through additions to a retirement annuity or through contributions to a discretionary savings plan.
Employer pension schemes
⦁ A salary-related pension scheme provided by most employers which is either structured as a defined benefit or defined contribution scheme
Ideal investor
You are employed and your company offers one of the following options:
⦁ The defined benefit scheme works on the principle that your pension benefit is determined using your salary and the length of time you have been a member of the pension scheme.
⦁ The more commonly used defined contribution scheme builds up capital using your contributions (and your employer’s contributions if they make any), plus investment returns (if any) and tax relief.
Features
⦁ Money is normally deducted from your salary and you have the option to choose between the various investment options offered by the scheme. You need to consult your employer regarding the structure of the scheme and the investment options that they offer for retirement purposes.
Tax and employer pension schemes
⦁ This information will be determined by the scheme that you’ve opted for.
Retirement annuity fund
⦁ Commonly referred to as a retirement annuity (RA)
⦁ Offers you a versatile and tax effective vehicle through which you can make the necessary provision for your retirement years
Ideal investor
A retirement annuity is suitable for you if you:
⦁ are self-employed and do not belong to a pension or provident fund.
⦁ receive a salary and wish to make additional provision for your retirement years.
⦁ wish to reduce your tax liability.
⦁ seek to invest in a flexible retirement savings vehicle.
⦁ wish to make lump sum investments and/or recurring contributions to a retirement fund.
Features
Most RAs have the following features:
⦁ Flexibility in terms of contributions and portfolio adjustments
⦁ Transparency related to fees, investment terms and underlying investment holdings
⦁ Regular reporting on portfolio holdings, investment values and transactions
⦁ No penalties related to aspects such as a minimum investment term or discontinuation of contributions
⦁ Investment term is dependent on the selected retirement age, which may not be prior to the age of 55
⦁ Tax-free transfers from approved pension, provident or other retirement annuity funds
⦁ Special arrangements in the event of death or disability
⦁ Choice which allows for the construction of a diversified portfolio from a comprehensive range of funds compliant to Regulation 28 of the Pension Funds Act*
On retirement, a cash lump sum of up to one-third of the retirement benefit may be taken. The remaining two-thirds of the retirement benefit is used to purchase a compulsory annuity.
Tax and retirement annuities
⦁ In terms of current legislation, members are entitled to deduct their contributions from taxable income, within certain limits. On retirement, the member may take up to one-third of the retirement benefit proceeds available in cash, of which a portion may be received tax-free. In addition to this, any contributions that the member may have made in the past that did not rank for deduction may increase the tax-free portion.
⦁ The balance of the retirement benefit proceeds must be used to purchase a compulsory annuity. The income from this annuity is subject to normal tax. During the term of the investment, no tax is levied on any interest income, net rental income and/or foreign dividends earned, within the fund.
Footnote
*Regulation 28 sets down what are called prudential investment guidelines (PIGs) for retirement funds. The PIGs limit the amount that a retirement fund may invest in any particular asset class. For example, no more than 75 percent of a fund’s assets may be invested in shares.
Preservation funds
Accessing your retirement monies prior to retirement can be detrimental to your future ability to retire financially independent. Preservation funds are designed to preserve your savings and offer members of a pension fund who are in the process of leaving the service of an employer, the opportunity to preserve their existing retirement benefits.
Ideal investor
Preservation funds are suitable for individuals who:
⦁ are in the process of leaving the service of an employer.
⦁ wish to preserve their retirement capital.
⦁ seek to invest in a flexible retirement savings vehicle.
Features
- Flexibility in terms of portfolio adjustments
- Increased control over pension benefits before retirement
- Transparency related to fees, investment terms and underlying investment holdings
- Regular reporting on portfolio holdings, investment values and transactions
- Investment term dependent on the selected retirement age, which may not be prior to the age of 55
- Special arrangements in the event of death or disability
- Choice, which allows for the construction of a diversified portfolio from a comprehensive range of funds compliant to Regulation 28 of the Pension Funds Act
- A single withdrawal prior to retirement, subject to the rules of the transferring fund, with the balance being retained within the fund until retirement for partial withdrawals
- Preservation of years of completed membership in the transferring fund, which could enhance the tax-free portion of the lump sum benefit on retirement
- Transferable between similar types of funds
- Divorcees are allowed to transfer the pension interest allocated to them in terms of a court order to a preservation fund of their choice
- Pension preservation fund members may take a maximum of one-third of the capital sum. The balance is used to purchase a compulsory annuity with the income being subject to normal tax.
- Provident preservation fund members may take the full capital sum. The member may also opt to use all or part of the retirement benefit to purchase a compulsory annuity.
Tax and preservation funds
- The overall maximum tax-free amount of all lump sums derived by you as a taxpayer during your lifetime as a result of your membership of any pension, provident or retirement annuity fund is subject to certain limits.
- In the event of a withdrawal from the fund prior to retirement, a portion is deemed tax-free (should this not have been claimed before), as well as any contributions not previously allowed as a tax deduction. The balance will be taxable at the higher average tax rate paid by the member in the year in which he or she withdrew, or in the previous year. On retirement or the death of the member, the benefits are taxable at the said average rate of tax, after allowing for any tax-free amounts, which may vary according to the members’ circumstances
- During the term of the investment, no tax is levied on any interest income, net rental income and/or foreign dividends earned within the fund.
Discretionary investments
Additional provision for retirement can be made by investing in products that are not regulated by pension fund legislation. These vehicles could range from a fixed deposit to an investment in property or the stock exchange depending on the investment objective and the tolerance for investment risk. Each type of investment will carry different tax implications. Factors to consider will include:
⦁ Level of regulation of investment product
⦁ Liquidity
⦁ Level of costs
⦁ Transparency of fees and charges
⦁ Product complexity
⦁ Penalties
Underlying investment options
Underlying investment options refer to the investment instruments available through retirement products that provide exposure to investment markets. The options offered by different financial service providers include collective investments, share portfolios, guarantees and international investments.
Courtesy: ABSA
