Retire before Retirement

Retire before Retirement

by Ankie Engelbrecht

Upon reaching retirement age most people tend to retire from all their retirement funds simultaneously – be it from their employers’ retirement funds and/or from their retirement annuities (RAs). However, it might often be more beneficial to retire from your RAs a few years before leaving office at the end of your formal working life. Let me explain this strategy below. Also see video:

Firstly, limit your contributions towards your employer’s retirement fund to the bare minimum allowed by the rules of your employment contract. The funds released in this way should rather go towards new and/or existing RAs. Any extras you want to invest in your retirement funds should also go to your RAs instead of your employer’s retirement fund. These and other contributions to tax incentivised retirement funds reduce your gross income for income tax purposes. They could result in significant income tax savings, hence the concept of a tax incentivised contribution or saving. Current legislation in South Africa allows you to contribute up to 27,5% of your total annual taxable income to a range of tax incentivised retirement products including RAs, subject to an annual limit of R350 000. This means your retirement contributions could reduce your taxable income by up to R350 000 per annum if you are in a certain income category. Budget constraints, however, might hamper you to invest such a large proportion of your income in tax incentivised retirement funds. To retire before retirement might enable you to fully exploit the generous tax kick-backs on offer.

The above contributions should be in the “new” generation investment RAs – not in insurance (or policy) RAs. Both of these products enjoy exactly the same tax benefits but investment RAs have no maturity date, are more flexible and carry no penalties – in sharp contrast to insurance RAs which gave RAs a bad name. From the age 55 onwards, a South African RA investor has an option, but not the obligation to retire from his RAs. In other words, you are still fully employed, but you have the opportunity to retire from your RAs. Hence the logic of the above heading, “Retire before retirement”.

Why would someone do that? To answer this question, some background on RAs is needed.

To access the capital (fund credit) in your RA at any stage after the age of 55 years, the relevant law forces you to purchase a monthly pension (compulsory annuity), in the form of either a living or life annuity. A minimum of 2/3 of your fund credit must be used for this purpose. This implies that up to a maximum of 1/3 of the fund credit can be paid out to the investor to be spent on anything. Note that only a certain portion (currently R500 000) of this 1/3 withdrawal is tax free. For example, if your RA is worth R3 million you may withdraw R1 million (which is 1/3 of your capital) but any amount in excess of R500 000 will be taxed at predetermined rates. The remainder of the fund capital, that is, 2/3 or more, has to buy a “pension” in the form of either a life or a living annuity. The extra income from the “pre-mature” pension will obviously cause additional income tax to kick in going forward. All this boils down to the fact that the corporate employee now has an additional income stream while still in formal employment after the age of 55 years.

It could be a potent wealth creation strategy to access your RA credits at the earliest possible opportunity. The lump sum that you have drawn can be invested in new RAs. On the surface it might appear like a zero sum game - money is just moved from one investment to the other. However, extra tax kick-backs are generated in the process. They must be invested with the lump sum in the new RAs to get the real benefit from this move. Now what do you do with the remainder of the capital, i.e. the balance left after you received the lump sum? As mentioned above you are forced to purchase a monthly pension. A living annuity is one of the two vehicles for this purpose. The advantage of selecting a living annuity is that you now move away from the restrictions of Regulation 28 which governs RAs but not living annuities. This regulation, amongst other, limits your exposure to equity (listed shares) to a maximum of 75%. In other words, your living annuity is allowed to have a 100% exposure to equity. But is this good or bad? The good part is that, historically, equity has been the best performing investment class in the long run compared to bonds, properties and cash. (The downside is that equities carry more market risk.) Therefore the earlier one starts getting additional exposure to equity, the longer you make the “long run” and the smaller will be the impact of any short term negative performances. Thus, time in equity and not timing equity investment is the password towards real wealth creation. In investment jargon, you diversify your investment over time by having a long term exposure to equity. Since we tend to live longer it could be a sensible strategy to be aggressive for longer in order to grow your capital faster. This might compensate for your longer life expectancy. Research has shown that for every four years that pass, progress in medical science could add one year to your life expectancy. So, if you are now 45 years old and assume that you will live until 75, you will have roughly seven blocks of four years each over the next 30 years. This means your life expectancy is going to extend by about seven years, taking you from 75 to 82 years. Earlier exposure to equity could be the vehicle to take you over the longer distance in life expectancy.

Legislation requires that you must draw a minimum income of 2.5% of your capital in a living annuity, on a monthly basis. The maximum is 17.5%. As mentioned above, this extra income stream will increase your taxable income, causing you to pay more income tax. This could, however, be offset by re-investing this income in new RAs.

Another private use of the lump sum at the age of 55 is to settle all the debt at that stage. Some of this debt could be a hangover from your children’s tertiary education. Thus, a way to save for children’s tertiary education is to invest in RAs and use the lump sum to pay for their studies or debt associated with that. Money that previously went towards servicing of debt, now goes towards retirement savings in RAs.

On the other hand, the lump sum could be used for the long awaited overseas trip. Why should you wait until you are 60 or 75 years to access your money from your RAs. You might be still alive by then, but your health might prevent you from fully enjoying the wealth you have created. Rather do it earlier, at 55. Your tax incentivised investments are anyhow going to work harder via a larger allocation towards equity inside the living annuity after 55. Taste a bit of the retirement life at the age of 55 - before you really retire later!

General disclaimer from the author:

  • The above article is not meant be advice. It was merely an attempt to share interesting information. There are still too many missing pieces of the puzzle to use the above as a blanket solution to everyone. Everyone’s circumstances differ. The reader should visit his/her financial advisor, giving the latter all the relevant personal info to enable the advisor to compile a financial plan that serves the particular needs of the reader.
  • Ziets Botha is thanked for his inputs.

More about the author: Ankie Engelbrecht works for the Academy of Financial Markets (AFM) since 1998. Over the years, Ankie has lectured on various investment and wealth management topics at premier and blue chip institutions in South and Southern Africa. He has also written some chapters in prescribed investment text books. He continues to conduct research to keep the AFM training materials relevant for its various FAIS accredited qualifications and customised programmes. Readers are welcome to contact him at ankie@academyfm.co.za.