Personal-Finance

The ins and outs of a retirement annuity

2019-07-02 15:17

It’s important to understand which RA will suit your lifestyle, writes Mapalu Makhu.

A retirement annuity (RA) is a pension plan designed for individuals to build up and accumulate money for retirement in a tax efficient way. It is a vehicle to save towards retirement.

Some benefits of an RA

  • You don’t pay tax on RA investment returns, such as interest income, dividends and capital gains.
  • The maximum tax-beneficial contribution is up to 27.5% of the greater remuneration or taxable income, with an overall annual limit of R350 000 (this includes RAs, pension funds and provident funds).
  • One of the rules is that you cannot access your RA funds before the age of 55. This prevents premature cashing out.
  • Unlike a pension or provident fund, where the ultimate decision rests with the trustees on how the funds will be paid out on death, with an RA, your appointed beneficiaries are paid out directly.
  • If you leave your employer, you can transfer your pension or provident fund into an RA without paying any tax.
  • To a large extent, your RA is safeguarded against creditors, meaning that creditors cannot touch or come after it.

Saving in an RA is a long-term investment and your fund choice should reflect the life stage you are in.

Although you do have access to all the different asset classes, there is an asset allocation limitation. This is called regulation 28, which limits equity exposure to 75% of a portfolio – 30% can be held offshore, with an additional 10% in the rest of Africa.

Not all RA’s are made equal.

While they are one of the best ways to save for retirement, they can sometimes be riddled with costs, which is counterproductive.

The high costs can rob you of potential good returns in the long run.

For example, a couple of weeks ago, I received an email from one of my readers asking for a second opinion on a quote he had received for a RA.

The gentleman was 15 years from reaching the age of 55 and wanted to top up his pension fund by saving in an RA.

RA
Retirement Annuities annual cost. Graphics24

It goes without saying that it was exorbitant. It is also designed to have a penalty cost if you cancel because the fees only reduce over time.

That said, even a fee of 2.8% a year is too high and would erode your total return by as much as 40% over a 30-year period. There are many RAs that have fees as low as 1% a year, but, at the very least, aim for the fee to be less than 2%.

It is important to go through a quote thoroughly before you sign on the dotted line.

If you have an existing RA that perhaps you are not happy with, you can transfer it from one service provider to another without being taxed. This is called a section 14 transfer.

However, you can incur penalties, depending on your service provider. For RAs with life insurance companies, you could incur early termination fees, whereas with a unit trust retirement annuity, there are no penalties.

When deciding to move your RA from one provider to the next, it is important to do a detailed analysis of the financial impact before and after the move.

What happens at retirement?

When you retire, you are allowed to take one third in cash (this is subject to the R500 000 limit for all your retirement funds) and invest the remaining two thirds.

The two thirds is meant for you to purchase an annuity. You have the option to either invest in a living annuity or a guaranteed life annuity. The living annuity is an investment-type product, while the guaranteed annuity is an insurance-type product.

With the living annuity, you have the flexibility to choose your income drawdown between 2.5% and 17.5%. Each year, on the anniversary of your investment, you can change your income percentage.

Although this is a great feature of the living annuity, most people draw the maximum, which means they may well run out of money during retirement.

Another advantage of a living annuity is that any remaining capital on death will go to your beneficiaries. However, in exchange for this flexibility of having beneficiaries, you take on the risk that the income may not last for 25 or 30 years, and there is also the risk that the investment returns may be poor.

Unlike with a living annuity, where there is potential to outlive your retirement savings, a guaranteed annuity will ensure you have a secure, pre-determined income for the rest of your life. This is the biggest distinction between a living annuity and a life annuity.

The disadvantage, however, is that your heirs will not be able to inherit any capital that might be left over when you die.

When considering an RA, it is essential to go through your documents thoroughly and do not be afraid to ask lots of questions.

Makhu is a financial adviser

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September 15 2019