Retirement Annuities - Not A Tax Haven As Some May Think

As South African taxpayers approach the end of the 2011/2012 tax year on 29 February, retirement annuities (RA's) are being touted as an efficient means of making further provision for retirement whilst reducing current tax liability.

However, RA’s might not be as attractive an option as they are made out to be. This is according to Darron West, writing for Foord Asset Management, who says that the apparent tax benefits of investing in such products are overstated in some circumstances and that investors should not be blinded by the seemingly attractive tax savings arising from RA investments. A lower tax liability today does not necessarily translate into a better retirement tomorrow.

“Foord Asset Management conducted an analysis between investing in an RA and discretionary investing, keeping in mind at all times that forecasting the long-term effects of investment requires thorough and realistic assumptions on items such as ‘tax bracket creep’, inflation and increased medical expenses (and their tax deductibility) post retirement.”

“Even a cursory examination will show that average differential return between equity funds and balanced funds is some 3% per annum,” says West. “Over long investment horizons, this seemingly small increment makes a substantial difference to accumulated wealth. Of course, the incremental return is earned over time with increased volatility. However, a young investor with a long investment horizon should have a greater propensity to tolerate that volatility.”

In Foords’ analysis, provision was made for the switching of an equity-only discretionary investment into a balanced portfolio 10 years before retirement (and the associated capital gains tax liability was also taken into account, as well as the taxable yield arising).

According to West, it is true that an investor who invests discretionary, after-tax funds will invest a lower quantum than an investor who puts money into an RA on a tax deductible basis.

“Simply put, at the maximum marginal rate of 40%, the discretionary investor is investing R600 for every R1 000 of the RA investor. On the face of it, the discretionary investor would appear to be prejudicing his or her wealth from the start. However, this is not true. On retirement, the discretionary investor would be able to draw down from his or her investments and pay the more benign capital gains tax on such drawdowns, whereas the RA investor would pay income tax on the amount of the annuity drawn.”

West advises that whilst it is true that the discretionary investor would also have to pay income tax on the taxable yield arising from the discretionary investments, this has been factored into the analysis. “It is also true that many investors will enjoy lower tax rates after retirement than applied during their years of employment - this too has been factored into the analysis. Also included in the analysis is the fact that an RA investor may withdraw up to one third of the accumulated amount on retirement, subject to specific tax treatment (with the further assumption that the amount so withdrawn is invested on a discretionary basis, rather than spent!).”

So what of the combined result?

“At worst, the analysis reveals that investors should be indifferent between the discretionary and RA investment options. Whilst the rational outcome of the analysis indicates that RA’s should be regarded at least a little circumspectly, investor behaviour should also be assessed,” says West.

“Some investors are their own worst enemy, and need to be protected from themselves. To this end, the restrictions on how amounts accumulated in a RA should be accessed, the protection of RA’s from creditors and their exclusion from the estate of a deceased might very well be qualitative overrides to the cold, numerical study. It is noteworthy, though, that these self-same behavioural protections may be offered by other, less restrictive vehicles; to this end, some investors might consider the use of a trust.”

“Foord Asset Management has never discouraged and will never discourage investors from saving for their retirement, particularly in an environment where the savings culture has been criticised justifiably as being unsatisfactory. However, investors must remain apprised of the full extent of the advantages and disadvantages of financial products so that they might evaluate these on the merits rather than accept them by default.”

“On the basis of our analysis, we remain convinced that the RA is not a panacea for all investors (although it may be appropriate for some). As a result, investors should consider carefully the optimal means of building wealth to fund their retirement,” concludes West.