Compulsory versus discretionary investing, and why you probably need both

Deciding whether to use a compulsory investment, such as a retirement fund, or a discretionary investment, depends on a number of factors, including your investment goals, availability of funds, tax-efficiency, and the returns you are looking for on your investment. While compulsory investments provide ongoing tax benefits, investors have limited access to their money which can be restrictive and impact on cashflow. On the other hand, discretionary investments provide ease of access to the funds and greater investment flexibility, but with significantly reduced tax benefits. That said, it is likely that your investment portfolio will require a blend of both types of investments.

Compulsory investments, which include pension, provident and retirement annuity funds governed by the Pension Funds Act, are enormously tax-efficient vehicles, with investors able to invest up to 27.5% of their annual taxable income on a tax-deductible basis, with the annual limit of R350 000 being based on the cumulative total of all contributions to an investor’s retirement funds. In addition to this, investors do not pay tax on the growth earned in respect of interest, dividends or capital gains, and the proceeds do not form part of an investor’s deceased estate which means that the funds are exempt from estate duty and executor’s fees. A perceived drawback when it comes to investing through a compulsory fund – keeping in mind the long-term nature of the vehicle – is that such vehicles are subject to Regulation 28 of the Pension Funds Act which restricts the extent to which investors can enjoy offshore exposure, although this must of course be weighed against the ongoing tax benefits afforded by such funds. The purpose of Regulation 28 is to protect investors against poorly diversified investment portfolios and to ensure that funds intended for retirement are not overly-exposed to high-risk assets. As it currently stands, the regulation currently limits equity exposure in retirement funds to 75% whether local or offshore. Further, exposure to local or international property is limited to 25%, while foreign investment exposure is limited to 30%. There are also additional sub limits for alternative investments and the percentage of a portfolio that can be held in offshore, among others.

In the years leading up to retirement, a person invested in an individual retirement annuity cannot access their funds until age 55, whereas members of pension and provident funds have limited access to their money prior to age 55 or before the formal retirement age as determined by the fund rules. On resignation or retrenchment, a pension/provident fund member is able to make a full withdrawal of his retirement benefits although the withdrawal will be taxed subject to the withdrawal benefit tax table which is a higher tax rate than on retirement. Other than in the case of leaving one’s employment, investors are able to access up to one-third of their retirement fund at formal retirement, and are required to use the remaining two-thirds to purchase an annuity income, either in the form of a living or life annuity – whichever is post appropriate for their needs. Where an investor lacks adequate discretionary money, taking a one-third withdrawal at retirement can be a useful way to protect against future cashflow difficulties. This is in line with the recent retirement fund harmonisation, so bear in mind that member contributions to provident funds that were made pre-March 2021 are still 100% accessible, and only those contributions that were made after this date are subject to the one-third withdrawal limitation.

A significant advantage of purchasing a living annuity is that funds held in such a structure are not subject to Regulation 28 of the Pension Funds Act which means that an investor can invest more aggressively and obtain more offshore exposure for his funds should this be appropriate. Living annuity investors are not restricted in their exposure to offshore assets and can choose to invest 100% of their capital offshore, although this will need to be done using a Rand-denominated feeder fund, keeping in mind that direct offshore investing is not permitted through a living annuity structure.

Another benefit of a living annuity is that an investor can nominate beneficiaries to the policy, and the distribution of the funds in the event of his death are not subject to Section 37C of the Pension Funds Act. As such, in the event of his death, the proceeds of the living annuity will bypass the investor’s estate and will be almost immediately accessible by his nominated beneficiaries, at which point they can choose between making a full withdrawal, purchasing a living annuity in their own names, or implementing a combination of both. On the other hand, bear in mind that a life annuity is effectively a long-term insurance policy and, in the event of the policyholder’s death, the policy dies as well, meaning no capital will be available to bequeath to his heirs.

Because the aim of a living annuity is to provide the policyholder with a regular income throughout retirement, limits are placed on the level at which investors can draw down from their investment. As it currently stands, investors can select a draw down rate of between 2.5% and 17.5% of the value of the fund per year, with the option to adjust this level on the policy’s anniversary each year. If the drawdown is greater than the growth achieved in the living annuity, the capital will diminish over time, resulting in a decreasing value of the investor’s draw down which, in turn, can create liquidity problems later on in retirement. Further, because living annuities make no allowance for lump sum withdrawals – and in the absence of adequate discretionary funding – an investor may experience funding problems if he needs access to capital at some point, for instance to pay for a wedding, overseas travel, or for costly medical care. As such, discretionary investments can play an important role in one’s overall investment strategy, although it is important to understand the tax implications of investing through a discretionary investment such as a collective investment scheme, and to ensure that your investment portfolio finds a workable balance between the tax-efficiency of compulsory investments and the flexibility of discretionary investments.

Unlike compulsory investments, your contributions to a unit trust portfolio are made with after-tax money, and you are liable for tax on interest, dividends and capital gains. Interest earned, whether locally or offshore, is taxed at your marginal tax rate, while both local and foreign dividends are taxed at an effective rate of 20%. If you are under the age of 65, up to R23 800 of local interest is exempt from tax, whereas after the age of 65 the first R34 500 is tax exempt. In addition to this, any switching between units or withdrawal of units can trigger a capital gain. The first R40 000 of gain made in a tax-year is exempt from CGT and thereafter 40% of any gain made will be taxed at your marginal rate. Remember, where you are invested in a Rand-denominated offshore unit trust, you are liable for tax on all gains, whether achieved as a result of capital growth or currency movement. That said, while the tax benefits of a discretionary investment may be limited, there are significant advantages to be achieved by housing funds in a discretionary portfolio, including more investment flexibility and the ability to gain more offshore exposure. Without the restrictions of Regulation 28, investors in discretionary portfolios are able to take on as much offshore risk as they deem appropriate for their needs.

In the event of an investor’s death, funds held in a discretionary unit trust portfolio will form part of his deceased estate and will be liable for estate duty and executor’s fees. Investors do not nominate beneficiaries to such investments but rather deal with the distribution of such assets in terms of their Will. Because the funds are subject to estate administration, the intended heirs may have to wait to months, or even years, before they have access to their inheritance. Remember, because these funds fall into the estate, they can be used by the executor to settle the estate’s liabilities and, as such, are not protected from creditors, and the heirs are not guaranteed to receive these funds. However, regardless of these disadvantages, a discretionary portfolio – if optimally structured to achieve a set of pre-determined investment goals – can play a critical role in working alongside your life and/or living annuity to provide accessibility of funds and emergency capital when required, to supplement income, and to protect against future liquidity risks.

Have a super day.

Sue