Over the past few weeks, I have found myself embroiled in multiple conversations around investment options with friends, family and clients. There are various options to choose from. In the compulsory space resides Retirement Annuities (RA), Preservation Plans, Provident Funds and Pension Funds. In the voluntary space - Tax Free Savings Accounts, Share Portfolios and Discretionary Investment Vehicles (to name a few).
Allow me to focus an RA’s and Discretionary Investments. This is a seemingly contentious issue amongst many. Which is better? Which makes the most sense? How do I choose?
Let us take a closer look at an RA.
As most of you know, an RA is a long-term investment product available to almost anyone wanting to save towards a comfortable retirement. For young individuals specifically, an RA is a fantastic, forced means of saving, as you are only permitted to access your money from the age of 55.
RA’s provide various tax benefits:
- Investors are permitted to invest up to 27.5% of their annual taxable income (subject to a R350 000 p.a. maximum).
- No income tax, dividend withholding tax or capital gains tax is charged on the investment returns.
- Funds housed in your RA do not form part of your estate, meaning no estate duty or executor fees are payable.
- Section 10C of the Income Tax Act makes provision for Disallowed Contributions (DC) to be taken as a tax-free income or lump sum at retirement.
- At retirement (age 55 and onward), investors are permitted to withdraw up to one-third of the value of their RA, of which the first R500 000 of the total withdrawal is tax-free (this is a once-off lifetime cession and applies across all of an individual’s retirement funds). The other two-thirds must be invested in a Living Annuity from which an income is drawn.
- When emigrating, opting for financial emigration allows one to withdraw their RA savings before the age of 55 and transfer the post-tax capital offshore. You are then able to reinvest or spend those funds in the country to which you have relocated.
NB: While writing this, there is discussion that this rule could change and that you would be required to wait three years before withdrawing your retirement savings.
If an RA has all these compelling reasons to invest, why the current (and ongoing) debate around them? Why are so many individuals and financial advisors looking for alternatives, seemingly now more than ever?
Regulation 28!
What is Regulation 28 (herein referred to as Reg 28)? Reg 28 of the Pension Funds Act sets limits to where investors should invest their retirement savings. It ensures that one invests in different types of assets so as to not take on unnecessary investment risks. It applies specifically to retirement funds: Retirement Annuities, Pension/Provident funds and Preservation funds. Currently, Reg 28 has the following investment limits:
- Maximum of 75% in equities
- Maximum of 25% in listed property
- Maximum of 30% in international assets excluding Africa (40% in international assets including Africa),
- Maximum of 15% in alternative assets – hedge funds, private equity and any other investment not mentioned (Reg 28 funds may not invest more than 10% in hedge funds or private equity funds, with a maximum of 5% per single fund of hedge funds and 2.5% per single hedge fund or private equity fund).
These limits were put in place to provide investors with guidance and to ensure no unnecessary risks are taken whilst saving for retirement. BUT. What is risk? Some would define risk as losing capital. For others, risk is not achieving an above inflation return - perceivably losing value of your investment over time. Does the above Reg 28 guideline really help achieve either of these?
What if you decided that investing in an RA and being restricted in terms of how you invest was not for you. What is the alternative?
There are many alternatives as mentioned in the first paragraph. Enter discretionary/voluntary investment products. These products are not restricted in terms of the types of assets you can hold. If you have conviction in a specific asset class, region or sector and want to place 100% of your investment in any one of these, you could do so. However, these product wrappers are not as tax efficient as an RA. Returns earned within a typical voluntary product are taxable – income, capital and dividends. You do however have the flexibility, if you choose to emigrate, to withdraw and take the money offshore (within the permitted offshore allowance). The crucial factor for each individual to look at is whether the potential for higher returns, the increased flexibility and the ability to exit before age 55 outweigh the tax saving benefit (case-by-case guidance from your tax practitioner or financial adviser is recommended).
Another consideration when deciding between an RA and a voluntary product is diversification.
In a recent article in which experts from the pension fund industry discussed their investable universe and in particular, how the restrictions of Reg 28 affect their clients, they noted the following with respect to alternative assets: globally, the average allocation to alternative assets is close to 20%, whereas in SA this is closer to 1%. They concluded that the need for alternative assets in SA is not only to diversify a portfolio, but equally so to reduce the risk for an investor. It is along these thoughts that there is a current proposal seeking to increase the allowable allocation in Reg 28 to alternative assets.
Perhaps the argument does not need to be against Reg 28 itself, but rather how to construct a portfolio within a Reg 28 environment? How to maximise your portfolio for growth and longevity?
A typical way to invest within these guidelines is to use one, or a blend of, balanced portfolios. These balanced portfolios are managed within the Reg 28 guidelines. In the past, it was much easier to choose from one or more of over 500 balanced funds and it was commonplace to achieve above inflation returns. As the environment has become more competitive in terms of the funds on offer, as well as a low growth and low return reality, a fair amount of these funds have unfortunately failed to deliver reasonable returns for investors over a medium-long term basis. Although these funds are managed within the Reg 28 guidelines, it is still the fund managers discretion as to how close they invest to the maximums allowed. Even though they can allocate up to 75% in equities, many managers in a bear market will have closer to half this allocation. There is a plethora of highly skilled and experienced balanced fund managers in this category and I believe in their abilities to read the market and therefore allocate as mentioned above. It is possible however, to build a portfolio on what is known as a building block approach. This infers that individual funds are chosen to make up the optimal asset allocation required to suit a specific risk appetite and return expectation. This carries the risk that you and/or your financial adviser will need to make the asset allocation decisions. It also means you have the power to choose.
To illustrate how some of these balanced funds are positioned, I have selected three of the largest SA - Multi Asset - High Equity Balanced funds and equally weighted them. All three of these portfolios are managed within the Reg 28 guidelines.
The average asset allocation of this blend is:
- South African Equities: 40%
- International Equities: 30%
- Money Market and Fixed Interest: 28%
- Listed Property: 2%
- Alternative Assets: 0%
Despite these managers allocating the full weighting to offshore (30%), the remaining growth assets are by no means near the allowed maximum allocation.
In addition to the above, when utilising a building block approach, an allocation to alternative assets should be given serious consideration. The addition of a hedge fund will provide further diversification and return benefits for investors. Our 36ONE SNN QIF Hedge Fund has returned 14.01% p.a. over the last 10 years, importantly, at half the volatility of the FTSE/JSE Africa All Share Index. For more information as to why you should consider including a hedge fund in your portfolio, please refer to the other article in this month’s newsletter titled The 36ONE Hedge Funds – An Alternative Strategy in Building Resilient Portfolios.
In summation, there is no one size fits all solution to this conundrum. Each individual needs to consider various factors for their unique situation – for example risk appetite, age and time horizon. Perhaps a young investor with an investment horizon of 30+ years will prefer to take on more risk. Others nearing retirement age might determine that the above allocation is sufficient and within their risk parameters.
Ultimately, you would need to consult your financial adviser who will guide you in making a tailor-made decision. In partnership with 36ONE, one of our unit trusts or hedge funds could be the DEGREE of Difference in your portfolio.
Disclaimer:
The information presented here is not intended to be relied upon for investment advice. Various assumptions were made. See our full disclaimer here.