HOW TO SAVE FOR RETIREMENT

From earlier posts, we now know that a person can only retire once they reach Life Phase 3. This is when you’ve built up a large enough nest egg so that the returns it generates each year can cover all your expenses after retirement. Unless you’re one of the lucky few who inherited a fortune or won the lottery, there’s really only one way to get there:

Start investing as early as possible, for as long as possible, and as much as possible every month toward your retirement!

These days, there's a lot of talk around the FIRE principle: Financial Independence, Retire Early. This idea is becoming more and more popular, especially among young people, both singles and couples. Often, both partners in a couple embrace the FIRE lifestyle independently. Simply put, this means adjusting your lifestyle to live as simply and cheaply as possible, aiming to reach the point where your monthly expenses are lower than your monthly income. The difference is then invested monthly in retirement-focused investments.

Dedicated FIRE followers can sometimes reach this goal in their 30s or 40s.

It’s important to understand that while you’re still building your retirement nest egg, through regular monthly investments, you’re still in Life Phase 2. In this phase, your investments for retirement broadly fall into two categories:

• Retirement-based investments

• Discretionary investments

RETIREMENT-BASED INVESTMENTS

These typically include employer pension or provident funds, or specific retirement annuities. These are governed by South African laws with specific pros and cons. For example, your monthly contributions to these types of investments are tax-deductible (within certain limits), but you generally can’t access the money before the age of 55. Furthermore, most of the return must be used to fund your retirement. So, you have limited control over how and when you can use this money before and after retirement.

There are four main retirement-based investment options available to people still working and wanting to invest monthly toward retirement:

Pension Fund

Most employers offer pension fund membership as a standard benefit. A portion of your salary is deducted monthly, and most employers also contribute an additional amount on your behalf.

The use of the pension fund is strictly regulated. Generally, at retirement, you can only take out one-third of the fund’s value as a lump sum (this part is taxable). The remaining two-thirds must be used to buy a retirement income product like a guaranteed or living annuity. More on this later.

Provident Fund

Similar to pension funds, many employers offer provident fund membership as a standard benefit. Again, a portion of your salary is deducted and invested monthly. Employers may match or even exceed your contributions.
You can invest up to 27.5% of your taxable income across all retirement funds, capped at R350,000 per year, and this is deductible from your taxable income.

Previously, provident funds differed from pension funds in terms of how much you could withdraw at retirement. With provident funds, you could withdraw 100% of the balance (subject to tax). Now, you can withdraw up to R550,000 tax-free, and the rest must be used to buy a retirement income product.

A new “two-pot system” has been introduced where one-third of your contributions goes into a “savings pot” (which you can access before retirement), and two-thirds into a “retirement pot” (which is locked in until retirement).

Currently pension funds are being phased out and replaced with provident funds. In both, the employer’s fund is managed by a board of trustees who ensure compliance with laws and aim to invest the money wisely. They diversify investments, locally and internationally, within government-set limits.

Funds are typically split among four major asset classes:

• Company shares (equities)

• Property

• Government bonds

• Cash

Each of these carries different levels of risk and return. Equities are the riskiest but potentially most rewarding, followed by property, bonds, and cash.

Each member can choose an investment risk profile annually, aggressive (more equities), balanced (mix of all), or conservative (less risk). Younger members can afford to take more risk, while those nearing retirement should shift to a more conservative approach to avoid big losses just before retirement. Most funds adjust this automatically based on your age, but you can request changes yourself each year.

Being required to invest monthly in your employer’s retirement fund is a big advantage as it forces you to start saving from day one. Plus, your contributions (within limits) are tax-deductible, meaning SARS (the tax office) is helping fund your retirement!

So, it’s a win-win:

• Your taxable income is reduced.

• You’re building financial independence and can potentially retire earlier.

Important: You usually can’t access these funds before age 55 without heavy tax penalties. However, if you change jobs, you can transfer your full fund value tax-free to your new employer’s fund and continue building until you reach 55.

Preservation Fund

If your new employer doesn’t offer a provident fund, or if you’re retrenched or become self-employed, your existing retirement money can be moved into a preservation fund until age 55. Some funds will even let you keep your money in the same fund and continue as a member.

• Long-term growth potential: With tax-free growth and restricted early access, your savings remain invested, potentially helping to build a substantial retirement fund.

• Flexibility in service providers: Not getting what you need from your provider? You can transfer your preservation fund between service providers, subject toSection 14 of the Pension Funds Act, at no charge to you. Moving your pension into a preservation fund is also tax-neutral since it remains within the retirement savings ecosystem.

• Competitive fees: Preservation funds, especially those on direct investment platforms provide transparent fee structures with no costs to set up the investment.

• One pre-retirement withdrawal: One significant advantage is the ability to make one full or partial withdrawal before turning 55. However, remember that withdrawals are taxed according to the withdrawal tax table. 

• Tax efficiency: As an approved retirement fund, preservation funds are exempt from local dividend tax and tax on interest. And switching between unit trusts within your fund does not trigger capital gains tax.

• Customisable portfolio: If invested through a direct platform, you can select funds from a range of portfolios within the limits set by Regulation 28 of the Pension Funds Act.

• One-third lump sum withdrawal at retirement: Up to a third of the fund can be withdrawn at retirement, offering liquidity for settling debts or funding major expenses. Unlike pre-retirement withdrawals, the first R500 000 of this amount is tax-free (assuming you have not made anyother tax-free retirement withdrawals. If you have, this amount could be less)

• Excluded from estate duties: Assets in a preservation fund fall outside your estate, exempting them from estate duties and executor’s fees (but if you have not named beneficiaries, funds could potentially fall into the estate).

• Creditor protection: Funds in a preservation fund are safeguarded from creditors under Section 37B of the Pension Funds Act, with exceptions for debts owed to the South African Revenue Service (Sars) and amounts due under the Divorce and Maintenance acts.

• No mandatory retirement age: Investors are not required to retire from their preservation fund when they formally retire from employment, allowing flexibility based on their financial needs.

• Annuity income at retirement: At retirement, at least two-thirds of your preservation fund must be used to purchase an annuity to ensure financial security.

Retirement Annuity (RA)

If you’re not part of an employer pension or provident fund, for example if you’re self-employed or a freelancer, you’ll need to rely on your own discretionary retirement investments. One great option is to open your own retirement annuity (RA).

These are available from most financial institutions. The same rules and benefits that apply to employer funds usually also apply to RAs, like limited access before 55, tax deductions, and the one-third/two-thirds split at retirement.

If you’re not earning a salary from an employer, you can create your own retirement fund via an RA. You just won’t have the benefit of employer contributions. You’re responsible for the full amount you want to invest.

RAs are tightly regulated. Again, you can’t withdraw funds before 55 without serious tax penalties. Many institutions offer RAs and compete based on fees and performance. You can search for “retirement annuities” online and compare.

Why a retirement annuity is a good idea:

• It provides a kickstart to your retirement savings plan. Whether you are a full-time employee, or self-employed, an RA can propel you on your retirement savings journey, either as a standalone solution or as part of a broader retirement savings plan.

• It offers flexibility. You can pause or reduce your RA contributions if you need to do so.

• You can enjoy tax benefits. A portion of your contributions is tax-deductible, and you also don’t pay tax on interest or capital gains within an RA.

• It ticks many retirement savings boxes. An RA potentially offers you the opportunity for investment in a wide range of funds, risk-profiled solutions and share portfolios, customised to suit your individual needs and risk profile.

• It’s affordable. Even a small monthly contribution can make a big difference in your retirement savings outcome years from now.

• Your savings are protected from creditors. Your retirement annuity investment is protected from creditors – they won’t be able to take from your savings. This ensures that your savings will be available when it is most needed and for what it is intended, funding your retirement.

• You can’t touch it. Well, at least not the bulk of it – until you’re 55. Once you invest in an RA, it’s for the long haul. Years from now, you’ll be so thankful for committing to an RA until you reach retirement age.

• It’s all about you. The underlying investment options in your RA should be selected based on your particular risk profile. Every investor has different needs, lifestyles and risk appetites that can change over time. Understanding your risk profile, based on your life stage and financial goals, is a critical first step on your retirement savings journey.

Remember, fees are more important than past returns.
While investment returns vary with the market and can’t be guaranteed, fees are guaranteed—and they eat into your returns. Shop around and negotiate.

Active vs Passive Funds

When investing in an RA, your money can be managed in two ways:

• Actively managed by a fund manager who regularly adjusts your portfolio to try and outperform the market.

• Passively managed in an index fund that simply follows a market index (like the JSE Top 40 or S&P 500).

Active funds have higher fees (sometimes 3–4% per year) and no guarantee they’ll beat the market. Passive funds have much lower fees (as low as 0.5% per year). In a 5% inflation environment, an active fund must return 9%+ to grow your money, while a passive fund needs only about 5.5%.

You can invest in multiple RAs at different institutions to diversify. And you can have an RA even if you’re already part of an employer’s fund.

And Finally...

If your employer doesn’t offer a pension or provident fund, or if you're self-employed, a retirement annuity is an excellent alternative. These can be in the form of insurance policies or unit trusts (more on unit trusts in the chapter on discretionary investing).

Unit trusts are often preferred because they give you more visible investment options and don’t require monthly contributions. You can invest monthly, quarterly, annually, or even just when you have spare funds.

As with employer funds, you can invest up to 27.5% of your taxable income in an RA and deduct contributions up to R350,000 per year from your payable income tax.

Access is only allowed after age 55, and the same withdrawal rules (one-third lump sum, two-thirds annuity) apply.