Preservation funds: Specialised pre-retirement investment vehicles

Preservation funds are specifically designed to preserve accumulated capital which is intended for retirement, and make an attractive option for those leaving employment through retrenchment, resignation, or dismissal. However, preservation funds have some unique features and it is therefore important to fully understand how they work before opting for one.

Firstly, all preservation fund product providers are subject to the same regulatory framework, with the Pension Funds Act and Income Tax Act being the most notable. Upon leaving employment prior to retirement, one of the options available to retirement fund members is to transfer their retirement money to a preservation fund. Other options include leaving your money in the default investment option of your employer’s retirement fund, transferring to your new employer’s retirement fund, taking the funds in cash subject to tax, or investing the capital into a retirement annuity in your own name, although it is important to understand the implications of doing so (see below). Transfers to a preservation fund, whether pension or provident, are tax-neutral, as is the case should you transfer the funds to your new employer’s fund or an RA. However, before making a final decision, it is important to consider whether or not to make a withdrawal from the fund.

Once you have made decisions regarding your withdrawal, the next step is to choose an appropriate strategy for your preservation fund – and this will depend on a number of factors including when you plan to retire, your propensity for risk, and the likelihood of needing to make a full or partial withdrawal from your investment at some stage before retirement. If you’re close to retirement, your priority is likely to be more weighted toward capital preservation whereas if you have a longer investment horizon, you would probably be in a position to take more investment risk. When investing in unit trusts, you will have the flexibility to choose your underlying assets, although keep in mind that preservation funds fall within the ambit of Regulation 28 of the Pension Funds Act which will in turn affect the amount of risk you will be able to take. This piece of legislation is designed to limit exposure to higher risk assets with a view to ensuring that retirement fund money is not exposed to excessive levels of risk. However, these restrictions can also serve to limit the returns that investors require in order to achieve their investment goals and is, therefore, somewhat contentious.

Generally speaking, you may not make additional contributions to your preservation fund except if the money originates from another retirement fund. Also, if you have been awarded a share of your ex-spouse’s pension interest in terms of Section 7(8) of the Divorce Act, you are able to add these funds to your preservation fund. As in the case of other retirement funds, no local dividend tax or tax on interest will be charged to your preservation fund account. Similarly, switches between unit trusts within your fund will not trigger a capital gains tax event. Prior to the age of 55, you are able to make one full or partial withdrawal for each contribution transferred to the fund. If you make a partial withdrawal, keep in mind that you will not be allowed to make another withdrawal related to that contribution, and the remaining money will have to remain invested until retirement or death. Remember, you are free to set up as many preservation funds as you like.

It is important to fully understand the tax implications before making a withdrawal, so ideally ask your product provider to prepare a tax simulation before making the withdrawal. Once you have given the withdrawal instruction, your service provider will apply to SARS for a tax directive on your behalf and will pay out the balance of the funds to you. Remember, in the case of a provident preservation fund, an early withdrawal will have the effect of proportionately reducing the vested and unvested portions related to the contribution.

When it comes to formal retirement, you are permitted to retire from any of your preservation funds at any time from age 55 onwards, although the timing of your retirement should form part of your overall retirement plan. Upon retirement, you will need to make critical decisions with regard to choosing a suitable life or living annuity. When retiring from your preservation fund, you have the option of using the full amount to purchase a life or living annuity. Remember, in the case of a provident preservation fund, you can elect to take the full or part of the vested portion of the benefit as a lump sum, and purchase an annuity with the balance. With regard to the unvested portion, you can take a maximum of one-third lump sum withdrawal, with the remaining two-thirds to be used to purchase an annuity. However, where the pre-tax value of your unvested portion is less than R247 500 at the date of retirement, you are permitted to access the full amount in cash subject to tax.

Because preservation funds are flexible investment vehicles, investors are free to transfer a fund from one provider to another for whatever reason, and this process is strictly governed by Section 14 of the Pension Funds Act, although keep in mind that the funds will need to remain in a preservation fund wrapper.

While the funds invested in your preservation fund are protected by your creditors, it is important to bear in mind that your spouse may be entitled to claim a share of your benefits as part of a divorce settlement, although this will depend largely on the nature of your marriage contract. If you are married in community of property, you will be entitled to 50% of your spouse’s pension interest, whereas if you are married with the accrual system, any retirement funds held by either spouse will form part of the accrual calculation. Further, keep in mind that the right to claim a share of a member spouse’s pension interest only applies to couples who are married or in a civil union. If a couple is living together as ‘husband and wife’ but is not married under a legal act of parliament, there is effectively no marriage capable of dissolution and therefore no transfer of pension interest benefit. In respect of preservation funds, the pension interest is calculated as the total benefit to which the member would have been entitled to in terms of the fund rules if their membership had terminated due to resignation at the date of divorce.

In the event that you die prior to retirement, the money in your preservation fund will be distributed in accordance with Section 37C of the Pension Funds Act which makes provision for the fund trustees to use their discretion when allocating your retirement benefits between your dependants and your nominees (i.e. those people nominated on your policy) based on their financial needs. Remember, your retirement fund benefits fall outside of your estate, and you therefore cannot deal with them in terms of your Will. The fund trustees are obliged to undertake an in-depth investigation to determine who your financial dependents where at the time of your death and proportionally allocate the retirement fund death benefit. Your beneficiary nominations are included in this decision process but are simply a guide to the trustees to understand your intentions, they are not legally bound to these nominations.  The death benefit is the market value of your investment once all applicable fees and charges have been deducted.

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