The in`s and out`s of annuity investments. This week we look at retirement annuity funds.
What is it? A retirement annuity (RA) is a personal savings plan you take out to provide for your retirement.
Self-employed people take out RAs as a tax-efficient means of retirement savings. Employees often use RAs as an additional savings tool to their company pension or provident fund.
Contributions
Contributions to an RA can be made monthly, quarterly or annually, or you can make a once-off investment (which is called a single premium policy).
You can increase or decrease your premium contributions as the need arises. If you have a monthly policy, you can make extra lump sum payments.
When do you receive the benefits?
An RA can be matured only after the policyholder has turned 55 years of age, but it must be matured before the age of 70. This flexible maturity date paves the way for some tax-saving opportunities.
There are two instances where an RA can be matured before age 55:
* On death, where it is paid into the estate; and
* On the permanent disability of the policyholder.
What growth rate can you expect?
This depends on the expertise of the company you invest with, the portfolio you choose for your investment and the costs of the policy.
You should expect a five to seven percent real rate of return (that is, the return after inflation) on your investment.
Returns are usually better on an RA than on an endowment policy because of some tax benefits.
Who sells RAs?
Life assurance companies and reputable financial institutions are licensed to administer RAs.
An RA may be sold to you either through one of the company's salespeople (called agents) or through an independent financial adviser (called brokers). An agent can sell you an RA from his or her company only, whereas a broker should offer you a wider choice.
Costs
You pay a policy fee of about R5 a month; commission; admin charges; and an annual service fee (which is a percentage of the assets in your RA fund).
All life insurers deduct administration and commission costs upfront from the policy premiums (usually, in the first two years), whereas the non-insurers gradually deduct these costs on an on-going basis.
Deducting upfront seriously affects the ultimate value of your RA because you miss out on the growth of that money for the two years or so it takes until the costs are recovered.
The commission structure on RAs is standard in the life assurance industry, and depends on the term of the RA. For a period of 25 years (the maximum), a broker will, in the first year of the policy, earn 75 percent of your contributions, and in the second year, 20 percent of the commission paid in the first year.
For single premium policies, the broker will earn two and a half percent commission. (Note: non-insurers, who have a much smaller share of the RA market, do not structure their commission on this basis.)
Paid-up policies
If the policyholder cannot afford to continue paying the premiums, the policy will become paid-up, that is, the money remains invested but can only be withdrawn after the age of 55.
A policyholder can reinstate the policy at a later date.
Tax deduction for your contributions
A major advantage of RAs is that the taxman subsidises your investment.
If you're self-employed, you can deduct your contributions up to an amount equal to 15 percent of your taxable income.
If you're an employee and a member of your company's pension or provident fund, you can deduct your contributions up to the greatest of the following three figures: R1 750, or R3 500 less your allowable pension fund contributions, or 15 percent of your taxable income from non-retirement fund sources.
You can carry forward - to be deducted in future tax years - contributions in excess of this year's tax limit.
If you reinstate your policy, such contributions can be deducted up to R1 800 a year, and any excess can again be carried forward.
What happens when your retire?
When you retire from your RA, you are legally permitted to take one-third of the accumulated benefit as a cash lump sum, with the balance being used to buy an annuity (see next week's story on annuities).
You can also use the full amount to buy an annuity.
Tax on retirement
Unfortunately, you are taxed on the benefit of your RA. Your monthly annuity will be taxed as normal taxable income.
If you take the one-third cash option, this sum will be added to the other lump sums you receive on retirement and the relevant tax formula will be applied (generally, the first R120 000 of your total lump sum will be tax-free).
But the tax laws are changing. The Katz Commission has recommended a restructure, which will probably be ushered in over the next two years.
Broadly, the commission recommends that the deductible contributions to RAs be lifted to 22,5 percent, and at retirement, the first R50 000 will be tax-free plus the next R330 000 if it buys you an annuity. The balance of the fund will be fully taxed.
The monthly annuity paid to the policyholder will be exempt from tax, because the income will be taxed in the fund itself at 17 percent.
Significantly, the commission recommended equal tax treatment between RAs, pension and provident funds.
Other advantages
* Sequestration: If you fall on hard times, your RA is a protected asset and your creditors cannot attach it.
* Emigration: After your retirement, the annuity portion can be paid out to you even if you have emigrated as it does not form part of your blocked assets.
Other disadvantages
* Locked in: Your money cannot be touched until your 55th birthday. Unlike other life assurance policies, you cannot borrow money from the insurance company on the back of your RA.
* Returns: Your investment return depends not only on the particular investment portfolio you choose, but also on the expertise of the company with whom you invest.
Some investors have in the past complained of returns below an acceptable level.
Options when buying a RA
Life or disability cover: Can be taken as part of your RA.
Investment portfolio: You choose where your money is invested.
The choice ranges from a pure equity exposure to a balanced portfolio holding different asset types.
Each portfolio produces a different return. The difference can be 10 percent or more.
Some insurers allow you to switch between portfolios, and this costs a fee.
Inflation-linked premiums: You can have an automatic rise in premiums each year to cater for inflation.