One of the primary goals of investing in a personal capacity is to be financially independent at retirement. In most cases, people work and receive a salary that’s generally quite reliable in amount and timing. However, it’s up to them to gather enough assets during their employed years so as to be financially independent at retirement.
A retirement annuity is one of a number of ways of achieving financial independence at retirement. This type of account is often promoted by asset managers and financial advisers as the ideal way to save for retirement. However, the reasons as to why a retirement annuity is a great savings option is often confusing to most. This article intends to illustrate, as simply as possible, how and why a retirement annuity works.
Retirement in Mind
A retirement annuity is long-term in nature, ideally contributing towards it from the day you start working until the day you stop. Most retirement annuities currently have a retirement age of 55 years. This means that when you turn 55 you have the option, but not the obligation, to mature the retirement annuity and access the money.
Apart from a select few scenarios including disability, divorce and immigration you won’t be able to access the money in the retirement annuity until you reach retirement age. This makes the investment long-term in nature. For instance, someone contributing to an RA from the age of 21 to 55 is doing it over 35 years.
A retirement annuity is also governed by the Pensions Fund Act. The Act dictates the asset allocation limits within the RA. The asset allocation is guided by Regulation 28, which essentially states that an RA cannot currently have more than 75% invested in equity, 25% in real estate and 30% offshore. Fortunately, almost every asset manager has an investment offering that abides by Regulation 28 on your behalf for retirement annuity purposes.
The logic behind Regulation 28 is that the government wants you to have enough money at retirement to look after yourself. Insufficient savings at retirement means the government would invariably have to subsidize your retirement in some way, such as providing social grants. The point is the government doesn’t want to spend money on you at retirement. So they put Regulation 28 in place to help ensure your money isn’t invested in a risky way.
In fact, the government wants you to be financially independent at retirement so much so that they give you tax benefits if you contribute to an RA. It’s these tax benefits that make a retirement annuity a great long-term savings vehicle, despite the restrictions.
The Tax Benefits of a Retirement Annuity
The tax benefits of a retirement annuity are two-fold. First, all income and capital gain within a retirement annuity is tax-free. Secondly, SARS actually gives you a tax refund if you contribute to a retirement annuity. It’s this tax refund that really makes an RA shine.
The way the tax refund works needs some explanation with regards to the logistics. An employed individual will usually receive their net salary after tax has been deducted. The employer pays this tax, in the form of PAYE (pay as you earn), directly to SARS and gives you the net amount after tax. Thus, your tax has already been handed over to SARS before you get your salary.
Once you have your net salary, you make a contribution to your retirement annuity. This contribution then reduces the amount of money you should actually be taxed on. SARS looks at how much tax you’ve already paid during the tax year according to the income tax tables, then takes into account the retirement annuity contributions and recalculates how much tax you should have paid. SARS then gives you back the difference in the form of a tax refund.
The amount you can deduct from your taxable income each year is currently the maximum of either 27.5% of your taxable income (excluding capital gains) or R350,000. Any contributions that exceed these amounts are then carried over to the next tax year and reduce next year’s taxable income, subject to the same rules.
It’s not unusual to find instances where amounts are carried over year after year. Eventually though, you’ll reap the tax rewards of these carried over amounts down the line. But this is for another article.
For example, consider a situation in which an individual earns an annual salary of R150,000. They contribute R10,000 to a retirement annuity at the beginning of the year. The tax refund calculation as well as the cash flow illustration is shown below:
The Effect of a Tax Refund
What’s happening conceptually with this tax refund is SARS is sponsoring some of your RA contribution. In our example, R10,000 was contributed but then R1,800 was given back by SARS into your bank, effectively making the net RA contribution R9,200 (R10,000 – R1,800).
To illustrate the significance of this, consider the investment schedule below where R10,000 is invested each year and the investment grows at 10% a year.
The above is pretty straight forward. Without taking the net effect into account, the investment made an annualized return of 10% as one would expect. Now consider the situation in which we apply the net contribution concept.
You’ll notice that the “end balance” column is the same as the table above. This is because the tax refund does not come out of the retirement annuity, rather directly from SARS into your bank account. Which results in a lower net contribution to achieve the same ending balance. This results in an implicit return of 11.45% per annum.
The Effect of Reinvesting the Tax Refund
Just by contributing to an RA there is a benefit by way of the tax refund reducing the net contribution. However, you can achieve a compounding effect by reinvesting these tax refunds.
Logistically, this would occur by contributing the R10,000 at the beginning of the year plus the tax refund received for the previous year. What this means then, is you would be contributing more to the RA, which in turn increases the tax refund received.
Continuing with our example, and assuming the individual’s salary remains constant at R150,000 for simplicity. The investment schedule illustrating the effect of reinvesting the tax refund is below.
Reinvesting the previous year’s tax refund results in an increased tax refund for the current year, and subsequently larger reinvestment for the next year. This is the compounding effect of reinvesting the tax refund.
Side note: you may notice that the “tax refund” column increases at a decreasing rate until it reaches a constant refund amount. This is due to the fact that we kept the salary and tax rates constant in our example, and the tax refund needs to essentially catch up with itself in the calculation. This also illustrates how the compounding effect is greatest for money contributed at the beginning of an investment.
Now let’s consider the implicit return that’s achieved due to the reinvested tax refund further reducing each contribution. Remember, the tax refund in one specific year reduces that year’s net contribution.
So the net contribution column = Investment + Reinvestment – Tax Refund.
As you can see, the implicit return after taking the net contribution effect into account is 13.52% per annum.
The tax refund has two effects on retirement annuity returns. First, it reduces the net contribution because SARS is sponsoring some of the contribution for you. Second, if you are diligent in reinvesting the tax refund each year then you could achieve extra performance due to the compounding effect over time.
In all cases, the underlying investment vehicle actually growing the money performed at 10% per annum, and it was only the effect of the tax refund and subsequent reinvestment that resulted in superior returns.
Our example was purely for illustrative purposes to help conceptualize what it actually means for SARS to provide a tax refund for contributing to an RA. It was unrealistic in the sense of keeping salary and tax rates constant. However, hopefully this was sufficient to illustrate the point.