I am often surprised by how little people know about their retirement funds. In most cases, a combination of retirement funds will represent the largest asset in most individuals’ portfolios by the time they retire. That is if their retirement funds were preserved every time they left their employers in the past. Sadly, this rarely is the case…
It is notable that when we assist clients with their retirement income provisioning that in most cases the individuals who can retire most comfortably are the ones who were government employees all their lives. Although they are not the biggest earners, nor the most sophisticated investors, their constant contributions, and the fact that they could not access their funds in the past, created the perfect playing field for compound interest to take effect. This article is not about the importance of preserving retirement proceeds over time, although it probably is the most important factor that will lead to a comfortable retirement. This article is about the importance of understanding your retirement fund.
So, have you managed to answer all the questions positively at the start of this article? If your answer is “no” to any one of the questions, then you seriously need to start doing some homework on your fund/s.
Note: Although this article deals with retirement funds, it’s important to always consider all your assets when analysing your investment portfolio. Voluntary investments, shares, property (not your primary residence) and anything else of value (art, coin collections etc.) must be included in your analysis. For this exercise, however, I am going to be single-minded and focus just on your retirement fund.
What is the current value of your retirement fund?
This is the one fact that most people know about their retirement fund/s. It is important to know this if you analyse the current and future funding of your imminent retirement. Much has been written about what multiple of your salary you should have accumulated at different stages of your life. If you don’t have those figures drop me a line, then I will send them to you. In short, if you wish to retire earning a pension equal to 100% of the salary that you earned on your last day employed and you want to leave a large portion of your pension funding as a legacy, then you will need at least 24x your final annual salary. This is based on a drawdown of 5% against the capital value. Generally, people retire with no or very little debt and they no longer participate towards retirement funding, investments, bonds etc., so it becomes feasible to aim at 70-80% pension income of your final salary. If you require 70% of your last salary, then you should have accumulated at least 14x your final annual salary by the time you retire.
What is the net replacement value of your retirement fund?
The net replacement value works in unison with the capital value that I eluded to above. The net replacement value takes into consideration the fund value, fund returns and expected future contributions to provide you with a projection of what you can expect as a pension. This amount is projected as a percentage of your expected future final salary. It is one section of the road on your retirement planning roadmap. If your retirement fund is your only investment or asset and your net replacement value indicates anything less than 70% it is time to seriously start looking at ways to increase your funding or expanding your investment portfolio. Alternatively, you will have to consider retiring with a lower income than anticipated or carry on working for longer than planned.
Can you explain the portfolio of your fund?
In a previous article that I wrote, Beware of the cost of conservatism, I alluded to the importance of investing in a dynamic portfolio. The main objective of investing must always be to achieve returns ahead of inflation, preferably well ahead of inflation.
Retirement funds are often constructed too conservatively. The trustees of retirement funds have an obligation to protect capital and look after the affairs of members who are not investment “savvy” leading them to invest in a conservative manner. This often leads to portfolio construction that can be costly to younger and more assertive investors. Many modern retirement funds do however provide options on how your funds should be invested. This option must be exercised by the member. The “easy way out” is often taken by accepting the default portfolio (which every fund is obligated to have) often suggested by the HR departments. This generally is a more conservative portfolio.
As you know, retirement fund investment portfolios are governed by Regulation 28 of the Pension Funds Act. This in short restricts retirement funds to a maximum exposure of 75% to equities, 25% to property and an overall restriction of 30% to offshore assets. These limits can be tilted slightly by adding African equities (excluding SA) exposure and hedge fund exposure but to very limited amounts. It is therefore crucial not to only optimise your retirement fund investment portfolio but to also beef up your voluntary investments with more offshore and equity exposure.
A recent development is adopting a life stage investment strategy where the investment portfolio is adjusted to be more conservative the closer you get to retirement. This strategy can add value and reduce volatility as you approach retirement. However, keep in mind that when you retire you may still have 30 years or more that you will have to rely on decent investment returns to provide you with an income for decades to come. A portfolio that is structured too conservatively will fail miserably especially if you are forced to draw more than 4% per year. Even if your underlying investment portfolio provides returns of 6% consistently per year, capital depletion is imminent because your income will have to increase every year to keep up with inflation.
You should have the option to override the automatic life stage adjustment if that is the strategy of your retirement fund. Make sure that the investment portfolio retains sufficient exposure to growth assets to meet your long-term objectives. Be mindful of portfolio drift and be careful that your portfolio does not become too conservative by the time you retire.
What have the historical returns been on your retirement fund?
When we ask the question what the historical returns look like on an individual’s retirement fund the response is often “my fund is doing great!” What is forgotten is that in most cases the employer matches your contributions. Employees think of the R5 000 that they are contributing monthly and see the last years value that increased by R100 000 as fantastic. The fact that they contributed R60 000 for the year and their employer contributed an additional R60 000 means that the “fantastic” increase in value represents a reduction of R20 000 for the year!
Monthly contributions mask the actual performance of the underlying portfolio. The additional investments made by the employer masks it even further. This will become a huge challenge the day that you retire. You cannot merely look at the investment value, you need to understand how the values were derived at. Once the funds have been invested in a living annuity postretirement, there will no longer be monthly contributions that bump up the value. In fact, the monthly drawdowns will create the effect that the performance of the underlying portfolio is dismal even if the returns may be substantially better than what they were during the contribution phase.
A 1% additional return makes a substantial difference in the final value of your retirement funding over a 40-year period. I mention 40 years because that is how long the average person contributes (or should contribute) towards retirement funding. The 1% difference return scenario not only applies to retirement funds but all investments. Let’s look at an example. I am going to ignore annual contribution escalations to make the figures look more realistic.
Assumption: R10 000 monthly contribution for 40 years.
- Scenario 1, a return of 10% per year. Amount accumulated after 40 years = R63.7 million.
- Scenario 2, a return of 11% per year. Amount accumulated after 40 years = R86.8 million.
The above indicates almost a 37% difference in the final value! In today’s value if you assume inflation to be 5% per year over the next 40 years then the following will apply:
- Scenario 1, at today’s value = R9.1 million.
- Scenario 2, at today’s value = R12.3 million.
Using the 5% drawdown scenario the 1% difference in returns effectively means that in today’s value, there will be a variance in income of R13 330 per month depending on your investment outcome. That is R51 250 per month versus R37 920 per month. I don’t think there are many people who can ignore the significance of such a small difference in returns.
If we work with lump-sum contributions the results are even more significant. Considering the 1% per year variance in returns, a capital difference of 44% will be applicable after 40 years. This indicates the importance of the investment portfolio structure in retirement as I referred to in my article “Beware of the cost of conservatism”.
What risk cover does your fund offer you?
Risk cover refers to life assurance, lump-sum disability cover, income protection (that replaces your monthly income should you be unable to work due to illness or injury), dread disease cover and funeral benefits.
The above benefits are generally calculated and offered as a multiple of your salary. The benefits can either be as a stand-alone benefit or they can be owned by the fund and paid by the fund during the claim stage. Funeral cover is generally an amount based on the insured amount you choose.
It is important to know exactly what cover you enjoy as an employee and what the tax implications may be under each cover. This is crucial when you do comprehensive financial planning and estate planning.
Is your cover approved or unapproved?
In short, this means whether the benefits are offered as a stand-alone benefit or whether they are owned by the retirement fund.
If the benefits are unapproved the payout of the death and lump sum disability benefits will be tax-free and they will pay directly to you or your beneficiaries. The proceeds will however be treated as a deemed asset in your estate in the case of death cover, and it will attract estate duty. Benefits paid to a spouse will not be subject to estate duty under Section 4Q of the Act. Payout will be according to your wishes as you stipulated on your beneficiary nomination form. It is important to review your beneficiary nominations regularly. If you for instance got divorced and your ex-spouse is still nominated as a beneficiary, the assurance company will honour the beneficiary nomination and pay your ex-spouse in the event of your death!
In the case of unapproved benefits, the payout is quick and efficient.
If the benefits are approved the assurance company will pay the proceeds to the retirement fund. The trustees of the retirement fund will then determine who inherits what amount irrespective of who you nominated as a beneficiary, although your wishes will be taken into consideration. Since the contributions paid by your employer are tax-deductible in the hands of the employer, the proceeds paid to you, or your estate or beneficiaries will be taxed at your marginal tax rate. This means that the insured amount may be reduced by as much as 45%.
Approved benefits are seen as part of your retirement fund and will therefore be excluded from your estate meaning that the proceeds will not attract estate duty.
Approved benefits take longer to pay out, they are reduced by personal taxes and someone who you may not wish to benefit from the proceeds may be a major benefactor due to a decision made by the trustees.
Note: Benefits paid as income replacement are paid out tax-free and are limited to 75% of your salary in the event of permanent disability. The first two years income payout will be paid at 100% of your salary.
Does your personal portfolio complement your retirement fund/s or are there conflicts?
It is crucial to look at your retirement fund benefits, personal portfolio, trust (if applicable) and will in unison.
The structure of your overall investment portfolio must complement and fit your risk profile and objectives. Where your retirement fund portfolio is rigid, compensations and adjustments should be made to your personal portfolio to optimise your overall portfolio.
Be mindful of the limitations on retirement contributions. We often encounter situations where high earners contribute more towards retirement funding than what Sars allows them as a tax deduction. Current legislation allows you to deduct contributions calculated at a maximum of 27.5% of your taxable income with an annual limit of R350 000 per tax year. These limits apply to the total amount contributed towards all retirement funds combined for example pension fund + provident fund + retirement annuities. Although you are allowed to contribute more than R350 000, your tax deduction will be limited to a maximum of R350 000. It is our view that one should not contribute more than what one can get the tax deduction on. Rather bump up your direct offshore investment portfolio with excess funds.
The regulatory limit to pay income replacement in the event of an injury or illness to an amount of 75% of your final salary does create the situation where many assurers aggregate your total cover amount. If you are insured at 100% of your allowed limit (75% of salary) by your employee benefits, the chances are that your personal cover may not be paid out in the event of a claim due to the limit imposed. This results in premiums being paid for cover you may not receive should you claim. Confirm with your assurance company whether they aggregate in the event of a claim or not. Rather re-direct those premiums to an investment than to discover years down the line that your claim may not be honoured.
Treat your retirement fund which includes pension funds, provident funds, preservation funds as well as retirement annuities as one of your most important assets. Use the above guide and obtain the information as stipulated to understand your retirement fund/s better. If you need more insight into your retirement funds, please contact your financial advisor or us for an analysis. We are more than happy to assist you and provide you with a report that will cover all the above.
This article was published on the Moneyweb Website on 07 September 2021.