Monthly Archives: March 2017

Put money into your bond

Q: I have R100 000 in a unit trust. At the same time I have an outstanding bond. Would it be better to remove the funds from the Investment and offset part of the home loan?

Advisors are frequently asked this question. This often has more to do with personal risk preference than with economic rationality. To answer this question, however, certain assumptions must be made, and I specifically won’t look at tax to keep the answer succinct.

The rational answer

Let us assume that the interest rate on the bond is at the prime lending rate. That is currently 10.50%

The second assumption we need to make is about what the risk level of the unit trust in question is. A money market unit trust has a very different risk and associated return goal than an equity unit trust.

A low-risk money market or income fund aims to beat inflation and offer a real return of 1% per annum. Thus, if the R100 000 is in an income unit trust only yielding 7% to 8%, it would be rational to secure the higher guaranteed return of 10.5% and transfer the funds into the bond.

However, if the money is in a balanced fund which generally targets a 5% real return, it would be more rational to remain invested as the real return is in excess of the bond interest rate.

It is also important not to fall into the trap of looking at the short-term underperformance of equity linked funds in a time like now and compare this to a resilient prime rate. This may result in the wrong decision to sell out at the wrong time. Every situation is unique and the best course of action is to get advice from a financial advisor who will look at the big picture and your individual circumstances.

The subjective answer

The other way I would advise a client on this is a more subjective approach – the sleep test. Quite simply, what makes you sleep better at night? Would that be a bond balance of R100 000 lower than it is now with no funds invested, or the same outstanding bond balance but R100 000 invested?

The answer will be different for each individual and there are a lot of factors that influence one’s financial decision making such as your view of debt as either toxic or as an enabler. For some people having R100 000 invested offshore, for example, gives them comfort. Therefore, because the economic rationality argument is often such a close contest, considering the subjective approach may help make the final decision easier.

Save up for retirement

Q: I am 56 years old, healthy, have a reasonable job and presume I can work for the next 10 years.

I have a home which is worth about R2.5 million, with a relatively small bond. However, apart from an annuity worth about R300 000 I have no other savings.

My youngest child is almost independent, and in a couple of months time I will be able to save R10 000 per month. This amount can increase to R20 000 in the next 18 months.

How should I invest this money and how much trouble am I in?

The really important question here is the last one. In our view, any investor currently requires approximately R1 million for every R4 200 of monthly income they want before tax and after costs.

This yield is specifically constructed to provide an escalating income that keeps up with inflation. We are aware that an investor can source a fixed yield that is higher, but that would mean that it doesn’t increase in the future and progressively becomes worth less.

This also assumes that your capital will be maintained and over occasional periods will grow faster than inflation. This is important, because if you don’t have to use up your capital, how long you live and how long you need an income for become inconsequential. You could live beyond 100 and still have a secure income.

This is obviously the optimum position.

The next important question is then what to invest in to give you the best chance of building a retirement pot. The table below will demonstrate a value in today’s money of what your savings could be worth in ten years’ time. This is based on 18 months of investing R10 000 and then 102 months of putting aside R20 000 per month.

When looking at this table you have to consider that there are two key drivers that affect the investment return.

The first is cost. It may seem intuitive but it is amazing how investors are so easily duped. Costs reduce returns, and the higher the costs, the bigger their impact.

Where investors are usually fooled is that they are led to believe that their provider is somehow 25% to 30% better than the rest over a longer period. We are not so sure anyone can consistently claim that. There are good value options out there, so be cost conscious.

The second consideration is your choice of asset class. Investors hate volatility, but growth assets come with volatility. As a result, most dilute their returns with stabilising asset classes that have no track record of beating inflation over longer periods.

If you want to achieve returns of well above inflation, you therefore have to be prepared to live with short-term volatility. That means investing in products that predominantly hold growth assets such as equity and listed property.

Finally, something the reader has not specified is their expectations in retirement. Probably the biggest hurdle we face with individuals about to retire, is that they want to continue their current lifestyle with very limited resources.

In this particular instance, you should consider the possibility of downscaling and modifying your lifestyle to unlock the capital in your home. This will both provide more capital and potentially lower your required income.

If we use the example above and assume that you do successfully build up R3.2 million, your retirement fund grows to R425 000 (in today’s money), and that you downsize and release a sum of R500 000 from the property, then your wealth pool would be around R4.125 million. We could therefore advise taking an income of R17 325 per month before tax as prudent.

The options at retirement

Q: I will retire at the end of October 2016 from government service. I have the option of a retirement gratuity of R1.2 million plus a monthly pension of R 27 414 for life, or a resignation benefit of R5 047 648.

The downsides of taking the annuity option are that when I die the monthly pension that will go to my wife will halve; and that when she dies, the pension stops altogether and nothing will go to our children. I’m also worried by the current political landscape in South Africa whether I can have peace of mind with regard to how the GEPF will be managed in future.

My question is this: If I rather take the resignation benefit of R5 047 648, can I obtain a monthly income comparable to the monthly pension of R27 000 plus the yield on the investment of the R1.2 million gratuity through investing this amount?

The reader belongs to the Government Employees Pension Fund (GEPF), which is what is called a defined benefit fund. The retirement benefits are therefore defined with regard to the reader’s salary at retirement and the length of service at their employer.

Let us consider the two options that the reader has presented in more detail:

Receiving an annuity for life

The reader will receive an annuity, for life, which begins at R27 414 per month. On death, the spouse would continue to receive 50% of this annuity for the remainder of her life.

Pension increases are also usually granted annually by the GEPF in line with their policy which targets 100% of CPI. The reader is also entitled to a gratuity lump sum at retirement of R1.2 million.

Under this scenario, the GEPF, assumes the investment risk. In other words, the member will continue to receive their pension, irrespective of how the underlying investments perform.

The GEPF also assumes the longevity risk, or the risk of the member and their spouse living longer than expected. As an extreme example, if they both lived to 120 years, they will continue to receive their pension. On the other side of the coin though, if they both pass away shortly after retirement, no further payments will be made and any children dependants will not receive any lump sum payment.

Taking the lump sum and investing it

The reader states that they are entitled to R5 047 648 as a resignation benefit. For purposes of this comparison, the impact of tax on this amount has not been considered as this could vary by individual.

Let us assume that this money will be invested into a living annuity-type structure in order to provide a retirement pension. Under this scenario, the lump sum is invested and a pension is drawn from this balance for as long as the balance is positive.

To put it simply, this operates similar to a bank account. The account increases with investment returns and reduces by any amount that the reader withdraws in the form of a pension.

It is important to realise that the reader will be assuming both the investment and longevity risk under this scenario. Poor investment performance will impact on the amount of pension that the reader may be able to withdraw. Additionally, if the capital is fully eroded while the reader is alive, no further pension will be payable. However, on death, the balance of the account can be paid out to the spouse or other dependants.

Withdraw your retirement benefit

Q: I am 39 years old and have worked for the public service for just over 11 years. I am considering resigning because I want to further my studies for the next three years.

My current retirement fund value is R947 113.

How much will they tax me if I take this out and how best can I invest it?

The short answer to your question is that you will be paying R191 820.51 tax on a retirement fund value of R947 113. In other words, 20.25% of your retirement benefit will be paid to the South African Revenue Service (Sars).

How this is calculated is that your capital will be taxed on a sliding scale. The first R25 000 is tax free, the next R635 000 will be taxed at 18% and the balance will be taxed at 27%. Although not relevant in this instance, any amount over R990 000 would be taxed at 36%.

However, you can avoid this tax entirely by transferring the benefit to a preservation fund. This is an option you should seriously consider.

A preservation fund works in the same way as a retirement fund, except that you don’t have to keep contributing to it. You will be able to make one withdrawal from this fund before your retirement date, but otherwise you won’t be able to access the money until you turn 55.

Once you retire from the fund, the first R500 000, less any amount you have already withdrawn, will be paid out tax free. At this point you can withdraw up to one third of the capital as a lump sum if you like, but the rest must be used to arrange a monthly income during retirement. You will be taxed on your monthly income according to Sars income tax tables.

Why this is particularly important is because if you withdraw your retirement capital now, the R500 000 tax-free benefit that you would receive when you actually retire will fall away. So you will be suffering a double tax penalty.

Apart from the tax you will have to pay now, you should also consider the important differences between putting the money into a preservation fund and taking it out to invest yourself.

  1. Income tax paid on your investment

In any retirement product, no annual taxes are paid on interest or dividends. When it comes to discretionary investments, however, the interest you receive on your investment during any tax year will be taxed and you will liable for dividend withholding tax. You will also pay capital gains tax should you withdraw money from your discretionary investment for any reason, including switching funds.

  1. Liquidity

If you withdraw the funds now and invest the after tax amount, you will have easy access to your money. However, if you transfer it to a preservation fund, you could only make one withdrawal from the fund before retirement.

  1. Underlying investment funds

The Pension Funds Act has prescribed limits for different asset classes which are the building blocks of the underlying investments funds. The purpose of the limits is to contain the investment risk of the underlying investment funds.

However, by doing this, the Act also limits the potential upside of your investment. A discretionary investment can be 100% invested in equities (shares) and also 100% offshore, whereas any investment that falls under the Pension Funds Act can have a maximum of 75% in equities and 25% offshore.