How you should be blowing your year-end bonus

Regard Budler from Momentum explains how much of your year-end bonus you can add to your company retirement fund for maximum tax benefit.

year-end bonusFor those fortunate enough to receive a year-end bonus, the burning question is: “How do I spend this money?” Shopping spree, Christmas presents, family holiday, paying off debt… the possibilities seem endless (and tempting). One option that not many people think about is using their bonus as an additional voluntary contribution (AVC) to their retirement fund.

An additional voluntary contribution is exactly what the name implies: a contribution over and above the normal monthly contributions that you make to your retirement fund to build up your retirement benefit.

What are the benefits of investing my bonus as an AVC?

Many people across the globe – including South Africa – are experiencing financial difficulty and struggling to make ends meet. Most people spend more than what they earn on a monthly basis and then use their annual bonuses to pay back debt. This results in a global savings ratio that is very low. Most people do not fully understand the risks of not saving enough towards retirement, or the benefits of investing relatively small amounts – like an annual bonus – over the long term.

An AVC is one of the most tax-efficient ways to use your annual bonus. Currently, as a member of a pension fund, you are allowed to deduct a contribution of 7.5% from your taxable income. If, for example your normal contribution is 5%, you will be allowed to deduct a further 2.5% if you make an additional contribution. Any contribution more than that will qualify as a deduction when you leave the fund.

Member contributions made to a provident fund cannot currently be deducted at the time of the contribution; you can however also deduct these contributions from tax when you leave the fund. From 1 March 2016, however, this will change. A member of a pension fund and a provident fund will be taxed on both their own and their employer’s contribution, but will at the same time qualify for a tax deduction of up to 27.5%, limited to R350 000. If for example your employer contribution is 15% and your contribution is 5%, and you also make an AVC of 5%, you will be taxed on the total contribution of 25%, but will at the same time get a deduction of 25%, as long as it is not more than R350 000.

Although there are various other ways to invest the portion of your bonus that does not fall within the thresholds referred to above, it makes sense to also invest this portion in your retirement fund if the rules of the fund allow it.

Occupational retirement fund assets are normally considered “institutional” in nature and not “retail”, which results in lower investment management fees.

Certain trustees or advisory bodies select appropriate portfolios (often referred to as default portfolios) on behalf of members. In most cases, these portfolios are monitored and reviewed on an ongoing basis to ensure that they meet and/or exceed their objectives. Changes are made where the investment returns of these portfolios do not meet the expected levels or where they do not behave as expected.

Other retirement funds, such as retirement annuities (RAs), also offer some tax benefits. There is, however, limited flexibility with these funds and they are not always suitable if only a lump sum, like a bonus, needs to be invested. Certain RAs also penalise members if the same amount is not contributed the following year. You should request all the facts from your financial advisor before making an AVC to your RA.

As a member of an RA, you will be unable to withdraw the money before you retire. With most other types of retirement funds, you will have access to your benefit if you leave your employer when you change jobs – although we encourage members to preserve.

Should I only invest my bonus if it’s a really big amount?

You may have heard the saying: “It’s about time in the market and not timing the market”. The same goes for savings. People often don’t want to invest small amounts because they believe that it is insignificant and won’t make a difference in the long run. This, however, is not true.

The reality is that over time these accumulated ‘small amounts’ add up as long as there is some consistency in saving patterns, and the assets are invested in appropriate portfolios.

There are various studies that show how investors have benefitted from investing over the long term. Compound interest also needs to be taken into account, as this significantly impacts investments.

How do I know if I’m on track?

One way to ascertain whether you are saving adequately for retirement is by calculating an expected replacement ratio. A ‘replacement ratio’ refers to the percentage of your net salary you will be paid every month when you retire. For example, if your net monthly income is R10 000 and your replacement ratio is set at 80%, upon retirement you can expect to receive R8 000 in monthly pay-outs.

You can calculate your replacement ratio percentage by dividing the expected annual income stream after retirement by your last annual salary before retirement, and multiplying it by 100.

Aim towards a replacement ratio of at least 75%. For example, if your salary is R20 000 per month by the time you retire, the pension that you should aim for should not be less than R15 000 per month. Review this on a yearly basis, as your salary and living standard are likely to change over time.

Let’s for example look at an individual  who starts working at age 25 and retires at age 65 (40 years of contributions) with a salary of R20 000 per month (R240 000 per annum) and who invests in a portfolio that targets inflation + 5% annually (a nominal return of 11% if we assume inflation is 6%). If she contributes 10% per annum towards her retirement savings, if all the assumptions hold, she can assume an expected replacement ratio in the region of 57%.

If this person invests one year-end bonus of R20 000 in the exact same portfolio at age 25, the expected replacement ratio will increase to 60%. If this member invests her bonus every year, it will have a remarkable effect on the outcome at retirement.