Retirement fund choices can confuse. In this the last of three Scrapbook articles on retirement funds, BRUCE CAMERON looks at defined contribution provident funds.
WHAT IS IT?
A defined contribution provident fund is similar to a defined contribution pension fund in that 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 provident fund also differs from a defined benefit pension fund, in the same way as a defined contribution pension fund, in that your pension, or benefit when you retire, is not guaranteed.
Your employer guarantees to make a contribution to your provident fund, but does not guarantee you a pension.
If the investments from your retirement fund savings perform poorly, you carry this loss. If they perform well, you pick up the benefit.
The big difference with a provident fund lies in the taxation. You cannot claim your deductions against tax every year, but you can take your entire retirement savings as a lump sum when you retire.
You are not required to buy a monthly pension with the money.
Your contributions to the fund are also not taxed at retirement.
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 employment.
The contributions of both yourself and your employer are calculated as a percentage of your pensionable salary.
This normally excludes allowances, such as those for motor vehicles.
The ratios between what you and your employer contribute can vary.
Normally, but not always, with a provident fund, your employer will make the entire contribution. This is because your employer, not you, can claim the contributions from tax.
HOW YOUR PENSION IS CALCULATED
A record is kept of exactly 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 can take the entire benefit in cash.
At retirement, your tax free portion is calculated in the same way as for a pension fund, but you can claim your own contributions, with a minimum of R24 000.
Further tax may be levied on any income generated from your investment, depending on how the income was generated .
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 go 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.
ADVANTAGES OF DEFINED CONTRIBUTION PROVIDENT FUNDS
* You may have the advantage of a higher pension than you would have had from a defined benefit retirement fund as a result of good investment performance;
* If you change jobs you are normally permitted to take your full benefit after a certain number of years. Rules vary from fund to fund;
* At retirement you have all the cash available to make greater choices, such as to buy an annuity of your choice and from any company you like; to set up a post retirement business; to invest in a wider range of investments; and to be able to control your investments yourself;
* If you live in a remote area, with little infrastructure, and where it is difficult to receive pension payments, a lump sum can be preferable; and
* As with a defined contribution pension fund, you have greater say in the investments of contributions. However, here again, you need to be cautious about how you decide on the option most suitable for you.
An example of payment on retirement:
Length of service: 30 years
Your total contributions: R200 000
Plus employer's contributions: R200 000
Plus income and capital growth: R600 000
Total: R1 million
(Tax is ignored for the purposed of this calculation)
DISADVANTAGES OF DEFINED CONTRIBUTION PROVIDENT FUNDS
* The risk of having sufficient money to see you through retirement is yours.
This risk is greatest with a provident fund.
Not only do you have the risk in the build up of the fund, where investment returns will determine what you will receive at retirement, but you also need to ensure that your money will last you through retirement.
If it is poorly invested, you may find yourself destitute, particularly if you live for a long time.
It is impossible for you to know how long your natural life will be, making it very difficult to decide how much money you will need for the rest of your life.
As a result, it is best to use at least part of the money to purchase a pension, because then you are at least assured of a certain income until you die.
* Your contributions are not tax deductible;
* Your family may not be better off if you die young, or if you have to take early retirement because of ill-health, particularly when you are younger.
The reason for this is that you or your family receive a pension based on your accumulated retirement savings at that point.
However, group life and disability benefits are normally better than for a defined benefit scheme. You need to take into account the structure of group life benefits.
If there is a shortfall, particularly when you are younger, you may need to buy additional personal 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.