Retirement fund choices can confuse. In this the second of three Scrapbook articles on retirement funds, Bruce Cameron looks at defined contribution pension funds.
WHAT IS IT?
A defined contribution pension fund (also known as a money purchase scheme) is what the title suggests. The contributions made to the fund are set down or defined in your employment contract and by the rules of the fund.
A defined contribution pension fund is similar to a defined benefit pension fund, with one significant difference: your pension or benefit when you retire is not guaranteed.
Your employer guarantees to make a contribution to your retirement fund, but does not guarantee you a pension.
If the investments from your retirement fund savings perform poorly, you carry the loss. If they perform well, you benefit.
HOW MUCH DOES IT COST?
The contributions to the fund, both by your employer and yourself, are fixed when you join the fund, or when you start work. The contributions of both yourself and your employer are calculated as a percentage of your pensionable salary. This normally excludes allowances. The ratios of what you and your employer contribute can vary. Normally you pay about six percent, your employer an equal amount.
HOW IS YOUR PENSION CALCULATED?
A record is kept of how much you and your employer have paid into the fund, as well as the capital and income growth of the investment from the contributions.
When you retire, you are obliged by law to purchase a pension with at least two thirds of the accumulated savings. Up to one third of the benefit may be taken in cash.
However, because you cannot predict how much capital you have when you retire, you cannot predict ahead of time what your pension will be. Because you have to take the investment risk, you are normally given at least two investment choices.
The most usual ones are:
* Market linked: Here your retirement fund savings are worth exactly the same as the underlying investments. If the value of the underlying investments goes up by 40 percent, so will your retirement savings. But if there is a market crash, so will your retirement savings diminish in value; and
* Guaranteed: Here your capital is guaranteed as well as some growth. You get additional growth by way of bonuses, which are based on the market performance. Bonuses come in two forms: vesting (which cannot be taken away once given); and non vesting (which can be taken away if the life assurance company giving the guarantees has an extremely bad time in investing).
It is normally best to switch to a guaranteed fund when markets are high and you are nearing retirement.
When you retire you will have to purchase a pension. This again may be problematic, as you will not always receive (or buy) the same pension with the same amount of capital. The reason being that pensions (called compulsory annuities in the industry) are based on interest rates.
If long-term interest rates are high, you will receive a better pension; but if interest rates are low, then your pension will also be lower. In making a decision on where to buy the annuity, and in cases where a pension is bought for you individually from a life assurance company, you should ask your fund to provide you with quotations from various firms.
As with a defined benefit scheme, you are allowed to take one third of your accumulated retirement funds as a lump sum. So if you have accumulated R1 million in retirement capital, you are allowed R333 333 as a lump sum. The lump sum is subject to tax.
An example of payment on retirement:
Length of service: 30 years
Your total contributions: R200 000
Plus employer's contributions: R200 000
Plus income, capital growth: R600 000
Total: R1 million
One third lump sum: R333 333
Pension purchased with remaining: R666 000
(Tax is ignored for the purposes of this calculation.)
ADVANTAGES OF A DEFINED CONTRIBUTION PENSION SCHEME
* You may have the advantage of a higher pension than you would have received from a defined benefit retirement fund as a result of good investments;
* If you change jobs you are normally permitted to take your full benefit after a certain number of years. But fund rules vary;
* You have a greater say in the investment of your funds, with increasing choices being given to members.
Normally, as a minimum choice, you get to pick between a market-linked fund, where your investments move up and down in relation to the value of the instruments in which your money is invested; or a guaranteed smoothed portfolio, where the asset management company takes out the ups and downs of investment, giving you the average growth.
These choices should be carefully considered. For example, if you chose the market-linked option and the markets collapse the day before you retire, you could be in dire straits, as you would be paid out your retirement capital on the ruling prices or values. If you were in the smoothed category, the bump would have been taken out, as you would have got the average growth of the past years.
As a general rule, you should consider swapping into the smoothed bonus fund some years before retirement, particularly if you are considering early retirement, such as for reasons of poor health, or even if you are considering resigning. Normally, you are allowed to make this choice on an annual basis. You need to the check the rules of your fund. This requires early planning; and
* Your contributions are tax deductible. Tax is deferred until benefits are received, with the lump sum taxed (after an initial tax free amount) at your beneficial average rate of tax, rather than the harsher marginal rate. The monthly pension is taxed at your marginal rate.
DISADVANTAGES OF A DEFINED CONTRIBUTION PENSION SCHEME
* You take the investment risk. In other words, you do not know what you will receive when you go on pension. If the markets collapse, you have to find the extra money to make up any shortfall required for a pension. However, if markets continue to perform the way they have in recent years, then you might very well have a better pension than you would have received from a defined benefit pension scheme. Remember, however, that the recent strong growth in equity markets came off a very low base in the seventies;
* There are seldom guarantees that your pension payments will keep up with inflation. If guarantees are provided, particularly when an individual pension is bought from an assurer, it comes at the cost of a lower benefit, that is: your pension will start at a lower point, but will increase in line with inflation. In the case where the employer provides the pension directly, increases are normally dependent on the excess investment income of the fund. The decision on whether to increase pensions is taken by the board of trustees of the fund;
* Your family may not be better off if you die or have to take early retirement because of ill-health while still employed, particularly when you are younger.
The reason for this is that you and your family receive a pension based on what you have accumulated - not on what you may have received at retirement age.
However, group life and disability benefits are normally better than for a defined benefit scheme. Take into account the structure of the group life benefits. If there is a shortfall, particularly when you are younger you may need to buy additional disability and life assurance for a limited period; and
* Aids could have a significant impact if your employer is forced to increase payments for group life cover and reduce payments towards your retirement funding.