In this podcast, I chat to certified financial planner Wynand Gouws, wealth manager at Gradidge Mahura Investments and author of To 100 and Beyond. He argues that a retirement strategy aimed at optimising only pre-retirement tax savings is short sighted, and that not enough time is spent on considering the post-retirement impact of investing only in retirement funds.

Conventional wisdom says that contributing to retirement funds (pension funds, provident funds, and retirement annuities) is the most prudent investment that you can make. This view is often anchored in the tax deductibility of these investments ‒ investors can deduct retirement fund contributions of up to 27.5% of their taxable income (up to maximum of R350 000).

This tax deduction reduces your taxable income before retirement and provides a “guaranteed” return in the form of a tax rebate.

Even though contributing to a retirement annuity, pension fund or provident fund, is extremely tax efficient before retirement, these products are punitive post retirement, because all the post-retirement income is taxable.

To illustrate the punitive impact of only using retirement funds as a vehicle for retirement savings, we consider two examples. In the first example we consider an investor who earns R60 000 per month, and in the second example an investor who earns R100 000 per month. In both examples the investor is 34 years old, plans to retire at age 65, and is contributing the full 27.5% to their pension savings.

We consider five scenarios in terms of how these investors can contribute towards pre-retirement savings:

Scenario 1
No retirement fund, only invests in tax-free savings and unit trusts. We assume the maximum allowable contribution to a tax-free savings account, with the balance invested in a unit trust fund.

Scenario 2
100% invested in a retirement fund

Scenario 3
Half of the contributions invested in a retirement annuity, with the other half split between tax-free savings and unit trusts. Again, we assume the maximum allowable contribution to tax-free saving with the balance invested in a unit trust fund.

Scenario 4
100% invested in a retirement fund with the tax savings reinvested, first in a tax-free savings account up to th emaximum allowed, and the rest put into a unit trust fund.

Scenario 5
Half of the contributions invested in a retirement annuity, with the other half split between tax-free savings and unit trusts, with the tax savings reinvested.

The post-retirement analysis

We then analysed what the sustainable income would be for each scenario, from retirement age to age 90. The results are shown in the chart below.

It is evident that the “best” solution (particularly for the person earning R100 000 per month) is not using a retirement fund. For those earning a lower income, using a retirement fund in combination with a tax-free savings and unit trust investment also yields a good outcome. For both investors, choosing only a retirement fund gives the worst result.

Even though the above may sound counter-intuitive the answer boils down to the fact that by only investing in retirement funds, all of your post-retirement income is fully taxable. In our examples, the investor would pay tax of 20% and 28% respectively.

By investing in only tax-free savings and unit trusts before retirement, the investor significantly reduces their tax rate after retirement ‒ to 4% (an 80% tax saving) and 12% (a 57% tax saving) respectively.

The unit trusts investment does attract capital gains tax and tax as a result of interest, but pernsioners get a large interest exemption, and capital gains are taxed at significantly lower rates than income.

In addition, tax-free savings accounts and unit trust investments are not restricted by regulation 28, which places severe restrictions on where retirement funds can invest their money. So money put into tax-free savings accounts and unit trusts can be invested much more aggressively. We have assumed a 1% higher return for these investments.

With less money going to the taxman in the 25 years after retirement, the investor can enjoy a significantly higher post-retirement income.

This analysis reinforces the importance of understanding tax both pre- and post-retirement, and implementing a retirement strategy that provides diversified income after retirement that specifically optimises for tax. This is even more relevant in a world where people are living into their 90s and 100s.

The retirement strategy needs to take into consideration the other benefits that retirement annuities provide, including the fact retirement funds are not included in your estate and therefore reduce your estate duty, and are protected against creditors. Also, there are no executors’ fees on retirement assets.