HOW SHOULD YOU TREAT YOUR MATURING RETIREMENT ANNUITY?
Must you extend the term or ‘cash it in’?
If we consider the structure and all the pros and cons of retirement annuities, then it is difficult to argue against them. However, extending the term of an existing retirement annuity (RA) may not always be the right thing to do. However, investing in retirement annuities beyond retirement age is not a bad strategy at all. Why do I say this?
Before I answer my own question, I would like to distinguish between different types of retirement annuities. Many older folk will remember the traditional retirement annuities once offered by all the life assurance companies. Although they were criticised — sometimes unfairly, but mostly not — many provided significant wealth accumulation for individuals over the years. Their drawback was (and still is) that many were inflexible in design, with limited investment options and penalties imposed when retirement ages and premiums were reduced.
These penalties exist because such retirement annuities paid commissions and fees upfront (referred to as pre-funded commission), based on the contract’s term multiplied by the premiums. The youngest retirement age you could initially nominate was 55. Many contracts were set to end at age 65, prompting the question: Why? Did higher commissions for longer terms motivate this recommendation? Although it is possible to amend the term of the RA contract to an earlier maturity date and reduce or stop premiums, it is subject to an often hefty penalty. If you want to restart or increase premiums, all premiums that are in breach of the contractual term (considered arrear premiums) must be repaid first before the contract can be reinstated.
Unfortunately, life assurance companies still offer retirement annuities as described above. Fortunately, through their investment subsidiaries, they have also started offering new-generation retirement annuities, similar to those offered by investment houses and linked investment service providers (LISPs). It’s a pity that agents tied to life assurance companies do not receive the same recognition for sales of investment-based retirement annuities as they do for life underwritten retirement annuities. Clearly, life assurance companies still prefer their life underwritten retirement annuities to be marketed in favour of LISP-type retirement annuities. I can only assume that this is because they are more profitable for the life companies.
In the early 2000s, one of the major LISPs pioneered unit trust-based retirement annuities that do not pre-fund fees, nor do they impose penalties if premium patterns are changed. Today, most investment houses and LISPs offer retirement annuities that are priced the same as voluntary investments. Although the Pension Funds Act also governs them, meaning you cannot retire before age 55 and the investment portfolio must be invested according to Regulation 28, they are more cost-effective and flexible, generally offering more investment choices than those available under life licenses. As I mentioned, fortunately, life assurance companies also started offering similarly structured retirement annuities, mainly through their LISPs.
So, when does it make sense to extend the maturity date of your retirement annuity, and when not?
In short, if the retirement annuity is an old-fashioned life underwritten product, do not extend the retirement term. Remember, commission and fees are determined by premium x term. A term extension may be viewed as a new contract with a new term. Some life assurers allow a matured retirement annuity to become “open-ended”, in which case you can continue to contribute to a future date, but without incurring additional fees. Be careful of the advice you receive when it comes to extending a life underwritten product. If in doubt, it is better to obtain a new LISP-based RA, where fees are determined on a monthly basis.
Since LISP-based RAs are not term-linked, there is no retirement date noted on the contract, even though the earliest retirement age remains 55, which means you can contribute indefinitely without incurring additional costs. The question is, is it the right thing to do? In my opinion, it depends on the capital amount of the RA. If the capital is less than, say R 1 million, then by all means contribute until retirement. But read on…
There is an important factor that can be considered a motivator to retire from a retirement annuity as early as possible. The motivator is the difference in how RA’s and living annuities are treated at death. RAs are governed by the Pension Funds Act while living annuities are governed primarily by the Long-Term Insurance Act (for rules) and Income Tax Act (defines them and regulates their tax treatment). When a member dies, the following applies:
Retirement Annuity: The Pension Funds Act determines that trustees are responsible for establishing who all the financial dependents are of the deceased. They then have the legal responsibility to ensure that all financial dependents receive a portion of the retirement annuity in a fair and equitable manner. This has two implications. Firstly, it takes a long time (at least a year) for distributions to take place, and secondly, distributions may be made to individuals whom the deceased did not necessarily want to benefit. This happens irrespective of nominating beneficiaries.
Living Annuity: There is no trustee involvement. Administrators will distribute the living annuity as stipulated by the living annuity owner’s beneficiary nominations. The distribution will either be in the form of a capital distribution (subject to taxes) or continuing with a living annuity in the name of the beneficiary. The beneficiary has the choice. The owner can also nominate a trust as a beneficiary. Payout is swift, and where a beneficiary nominates to receive a living annuity, income will continue almost uninterrupted.
Both products fall outside the deceased’s estate. It therefore makes sense to have at least one of the products, if not both.
Consider the following strategy to optimise distribution, estate planning and wealth creation:
Keep your RA until 55 and retire from it. Invest the proceeds in a living annuity and draw the minimum income of 2.5%. Nominate beneficiaries for the living annuity proceeds. If you are concerned about beneficiaries mismanaging the proceeds, nominate a trust or a testamentary trust as the beneficiary.
If you do not require the living annuity income, start a new RA. The tax deduction of the contributions will ensure that the living annuity income will be tax-neutral.
When the new RA reaches a critical amount, say R 2 million, retire from it and repeat the above.
The above will mean that you may end up with three or four living annuities by the time you reach full-time retirement. This is not necessarily a bad thing. Each living annuity can have different beneficiaries, which is handy where complicated family structures are evident.
The more funds you allocate to living annuities, the less estate duty will be payable (living annuities are not subject to estate duty).
Living annuities are exempt from Regulation 28 investment restrictions, including those related to offshore and equity exposure limits.
The above should only serve as a guideline. It is advisable to consult a properly qualified financial planner for a detailed analysis to identify the strategy that best fits your personal circumstances and needs.
Happy investing and keep on building your retirement portfolio.
