Many South Africans will look to invest in a retirement annuity (RA) before the end of February, which represents the close of the country’s tax year, in order to take advantage of the tax break. However, according to Steven Nathan, Chief Executive Officer of 10X Investments, investors often negate this benefit by paying high investment fees.
Nathan says that the tax benefit is equal to approximately a 1% fee saving, so if you pay 1% more in fees, then you offset the tax benefit. “Therefore, investors only benefit from the tax break if they pay low fees.
He says most investors do not do enough homework when investing and often end up with funds that are not optimal for their investment goals. “Pitfalls include poor fund selection, under-performing fund managers, and high fees. These mistakes can potentially halve your final pension.”
Nathan advises investors to apply five common-sense principles to all long-term investments, including RAs, to ensure a better return on investment:
1. Own well diversified portfolios
Do not put all your eggs in one basket. Your portfolio should own listed shares, listed property, bonds and cash. One quarter of your portfolio should be in international investments.
2. Time drives investment risk
People should own portfolios based upon their time horizon. The longer your time horizon, the higher your portfolio’s weighting in equity (shares), up to the maximum 75% limit. You should reduce the equity weighting as you approach retirement if you intend purchasing a pension for your retirement. If you intend remaining invested in a living annuity at retirement then you still have a long-time horizon and a high-equity portfolio may still be appropriate.
3. Invest in index funds
Index funds (tracking the market return) provide superior returns (adjusted for risk and costs) versus active funds. Invest in low-cost index funds rather than expensive active funds.
4. Minimise fees
Fees must be minimised in order to maximise your long-term returns. Don’t pay total fees of more than 1.5% of your investment balance and preferably lower. Note that each 1% in fees saved increases your final pension by approximately 30% over a working life.
5. Stay the course
Don’t be swayed by short-term investment returns that are volatile, unpredictable and irrelevant to long-term investors. Focus on maximising the size of your RA at retirement – not next week or next year.
Nathan says many high earners invest in RAs to max out their tax-free deductions, but from March 2015 the tax-free deduction (currently uncapped at 15% of your non pensionable salary) will be capped at the lower of 27.5% of your total taxable income or R350 000. “High earners have only two years to benefit from uncapped tax free contributions,” says Nathan.
While RA season encourages people to save to benefit from tax advantages, people need to get into the habit of saving consistently and as early as possible rather than waiting for RA season. “Once you have a sensible portfolio using the principles described above, then you need the discipline to save a meaningful amount each month. 10X believes you should be saving 15% of your total earnings towards your retirement. If you save early, time is your friend, as your investment benefits from compounding returns, but the opposite is also true.”