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TFSAs – helping to maximise your retirement income and minimise your estate duty liability

After 20 years, TFSA investors realise an additional 20% return due to these tax benefits.

Tax-free savings accounts (TFSAs) are a great initiative from government to encourage savings in South Africa. Jaco van Tonder,1 Advisor Services Director at Investec Asset Management, has previously discussed how to maximise the value of the TFSA tax benefits, which are well documented. You pay no tax on dividends and interest received, and no tax on capital growth. As a result, you benefit from increased compounding of returns. Jaco’s article shows that after 20 years, TFSA investors realise an additional 20% return due to these tax benefits. But little continues to be said about the potential retirement and estate planning tax benefits.

 

The first choices

Anyone retiring from a provident, pension, provident preservation, pension preservation or retirement annuity fund needs to decide what portion of their retirement benefits they would like paid out as a cash lump sum.

  • Provident and provident preservation fund members can currently2 elect to have their entire retirement benefits paid out as a cash lump sum.
  • Pension, pension preservation and retirement annuity fund members can elect to have up to a third of their retirement benefits paid out as a cash lump sum.

Where there is a balance remaining, this must be used to purchase an annuity, either a guaranteed or living annuity, which pays a monthly income that is taxable at the annuitant’s marginal tax rate.

 

How can a TFSA help reduce this potential income tax liability?

A TFSA can help a retiring member who has chosen a living annuity reduce their marginal tax rate, hence maximise their after-tax income.

A living annuity is a compulsory purchase annuity offered by insurers, retirement funds and linked investment service providers under which the income is not guaranteed but is dependent on the performance of the underlying investments. Importantly, living annuity regulations allow the annuitant to elect an income of between 2.5% and 17.5% per annum. However, research indicates that annuitants should not exceed an annual income rate of 5%, otherwise they risk ruin.3

1 TFSAs – how to maximise the value of the tax benefit? Taking Stock Spring 2017.

2 Changes to the tax treatment of provident funds, introduced as part of broader retirement reforms in 2015 by National Treasury, have been postponed. The proposal is that on retirement, members of provident funds will only be permitted to take up to a third of their retirement benefit, with the balance used to purchase an annuity, i.e. provident funds will be treated the same as pension and retirement annuity funds. The proposed changes will only apply to contributions made to a provident fund after the implementation date.

3 A sensible income strategy is critical for living annuity investors. Jaco van Tonder, Taking Stock Winter 2018.

Having established the income required in retirement, retiring members next need to determine how to access this income in a tax-efficient manner. As indicated above, a minimum income rate of 2.5% per annum must be taken from the living annuity, taxable at the individual’s marginal tax rate. Any income required in excess of this 2.5% can then be drawn from the TFSA. This income is not taxable and therefore minimises the retiring member’s marginal tax rate, as long as capital remains in the TFSA.

Drawing additional income from a TFSA means more money in your pocket for the same level of gross income drawn from the living annuity and TFSA combined.

This is best illustrated by a simplified example. Assume an investor has accumulated R1.8 million (as suggested by Jaco’s article)1 in his TFSA over the preceding 20 years and R7.5 million in his pension fund, which he then converts entirely into a living annuity. He requires an annual income of R350 000 and his only source of income is his TFSA and living annuity.

Below are two scenarios based on the 2020 income tax tables:

  1. In year 1 he takes the full R350 000 from his living annuity (a drawdown rate in year 1 of 4.67%). He will pay income tax of R77 539.50 and receive an after-tax income of R272 460.50.
  2. In year 1 he takes the minimum 2.5% from his living annuity (R187 500) and the remainder from his TFSA (R162 500). He will only pay income tax of R33 750 and receive an after-tax income of R316 250, i.e. a tax saving of almost R44 000 in year one and which, depending on the changing tax tables, is likely to escalate each year for so long as there is value in the TFSA.

Maximise the compounding growth of your retirement capital

Not only does this strategy reduce your marginal tax rate but it also ensures that your living annuity capital continues to compound faster, as your capital is eroded more slowly than it would be were you

drawing more than the minimum. Importantly, as with TFSAs, no income or dividend withholding tax is levied in the living annuity and capital gains tax is not applicable in terms of current legislation – only income paid by the living annuity attracts tax. As is the case for TFSAs, retirement capital invested in living annuities therefore benefits from increased compounding returns.

Minimise any estate duty liability

Estate duty is an important consideration for investors. On death, it would be preferable from an estate duty perspective to have depleted your TFSA (and other discretionary savings), while maximising the capital growth of your living annuity. This is because you may nominate a beneficiary or beneficiaries to receive the benefit on death, which in turn confers tax benefits on them. Beneficiaries may choose to receive the benefit as an annuity, a lump sum (subject to tax) or a combination of the two. Both lump sum and annuity benefits are free from estate duty. Bear in mind that disallowed contributions (retirement fund contributions in excess of a maximum allowable deduction) may be subject to estate duty where such contributions were made after 1 March 2015.

We encourage financial advisors and investors to carefully consider all the financial, retirement and estate planning benefits that TFSAs provide, including when used in combination with living annuities. By investing in a TFSA with Investec IMS, investors benefit from a competitive fee structure, transparent pricing and a wide range of funds from Investec Asset Management.

 

Investec IMS TFSA fast facts

These benefits are increasingly being recognised, as illustrated by the following summary data of the Investec IMS TFSA as at 31 December 2020 (31 December 2019 details in brackets):

Important information

All information provided is product related and is not intended to address the circumstances of any particular individual or entity. We are not acting and do not purport to act in any way as an advisor or in a fiduciary capacity. No one should act upon such information without appropriate professional advice after a thorough examination of a particular situation. This is not a recommendation to buy, sell or hold any particular security. Collective investment scheme funds are generally medium to long term investments and the manager, Investec Fund Managers SA (RF) (Pty) Ltd, gives no guarantee with respect to the capital or the return of the fund. Past performance is not necessarily a guide to future performance. The value of participatory interests (units) may go down as well as up. Funds are traded at ruling prices and can engage in borrowing and scrip lending. The fund may borrow up to 10% of its market value to bridge insufficient liquidity. A schedule of charges, fees and advisor fees is available on request from the manager which is registered under the Collective Investment Schemes Control Act. Additional advisor fees may be paid and if so, are subject to the relevant FAIS disclosure requirements. Performance shown is that of the fund and individual investor performance may differ as a result of initial fees, actual investment date, date of any subsequent reinvestment and any dividend withholding tax. There are different fee classes of units on the fund and the information presented is for the most expensive class. Fluctuations or movements in exchange rates may cause the value of underlying international investments to go up or down. Where the fund invests in the units of foreign collective investment schemes, these may levy additional charges which are included in the relevant Total Expense Ratio (TER). A higher TER does not necessarily imply a poor return, nor does a low TER imply a good return. The ratio does not include transaction costs. The current TER cannot be regarded as an indication of the future TERs. Additional information on the funds may be obtained, free of charge, at www.investecassetmanagement.com. The Manager, PO Box 1655, Cape Town, 8000, Tel: 0860 500 100. The scheme trustee is FirstRand Bank Limited, PO Box 7713, Johannesburg, 2000, Tel: (011) 282 1808. Investec Asset Management (Pty) Ltd (“Investec”) is an authorised financial services provider and a member of the Association for Savings and Investment SA (ASISA). A feeder fund is a fund that, apart from assets in liquid form, consists solely of units in a single fund of a collective investment scheme which levies its own charges which could then result in a higher fee structure for the feeder fund. The fund is a sub-fund in the Investec Global Strategy Fund, 49 Avenue J.F. Kennedy, L-1855 Luxembourg, Grand Duchy of Luxembourg, and is approved under the Collective Investment Schemes Control Act. This document is the copyright of Investec and its contents may not be re-used without Investec’s prior permission. Investec Investment Management Services (Pty) Ltd and Investec Asset Management (Pty) Ltd are authorised financial services providers. Issued, January 2020.

Make 2020 your start to becoming a millionaire

When asked who wants to be a millionaire, anyone would undoubtedly answer yes! However, the belief is often that this is impossible – unless through some stroke of luck or good fortune you get a windfall of money. We would like to disprove this theory and show you that it is indeed possible to become a millionaire through diligent saving.

What it requires are a few simple, but not easy, habits.

1) Start and stick to the habit of saving
2) Be patient

At Morningstar, we did some work to look at the amount of time it would take for your investment to grow to R1 million based on two factors –

 

Factor 1: The amount of money saved each month.

We looked at realistic contributions starting at R200 per month. R200 per month is equal to sacrificing roughly two coffees per week. A small sacrifice in the quest to become a millionaire. The monthly contributions used in our analysis ranged from R200 per month to R10,000 per month.

Factor 2: The return generated from your portfolio.

As investors, we naturally want the best performing portfolio and believe this is what will make the difference in our journey to wealth creation. (Park this thought for a moment as we are going to show you something very interesting in our analysis and return to the focus on performance.) The analysis used a range of return outcomes varying from the current return investors can achieve by putting their money in a bank account up to a maximum of 17% per annum. Realistically, many investments can deliver higher returns in short periods of time, but 17% per annum was considered a large annual return and a prudent maximum, as delivering such a strong outcome would require some meaningful risk-taking.

The table below shows the number of years it takes for your investment to reach R1 million based on the two variables above – your monthly contribution and the annual return thereof. Please note, it is a broad simplification and does not account for inflation and assumes a constant return and a constant contribution.

There are two interesting observations from this exercise. The first is that even with a mere R200 monthly saving into a savings account at the bank and generating a return of 6% per annum, if you start early enough, you can build your wealth up to R1 million. It may take you 55 years, but it proves that starting the habit of saving and being patient works.

The second observation is that if you look at the far right-hand column, you can see that by saving R10,000 a month, you reach that R1 million goal quickly and the return from your portfolio (on the left-hand axis) did not materially affect the time taken to become a millionaire. The power of compounding and the large contributions made all the difference.

This brings us back to the point raised earlier about focusing purely on performance. Yes, performance is important, particularly when monthly contributions are small, but what this exercise shows is that, more important than performance, is a consistent contribution and the size of the monthly contribution. I will agree with those who say R10,000 per month is a lot to invest, but even if you scale down to R1,000 per month, the goal of becoming a millionaire ranges from 17 to 33 years.

It is, of course, also important to remain mindful of the risk associated with investments. The above analysis assumes that your returns are achieved in a straight line, which is seldom the case. To achieve more than cash, it is likely you’ll have to absorb at least one setback in your wealth journey, which can distort the outcome. With that said, remember to focus on the long-term goal and not to be deterred by short-term market movements.

In the words of Elizabeth Gilbert – “There’s a wonderful old Italian joke about a poor man who goes to church every day and prays before the statue of a great saint, begging, “Dear saint-please, please, please…give me the grace to win the lottery.” This lament goes on for months. Finally, the exasperated statue comes to life, looks down at the begging man and says in weary disgust, “My son-please, please, please…buy a ticket.” The same goes for saving!

Bottom line, it is both possible and plausible to generate R1 million in savings by changing our behaviour. It starts with the decision to save on a monthly basis with no immediate gain in sight. The second behavioural change is practising the discipline of delayed gratification. Waiting. Patiently. And letting the eighth wonder of the world, compound interest, work its magic.

Victoria Reuvers

Senior Portfolio Manager

Morningstar Investment Management South Africa

Risk Warnings
This commentary does not constitute investment, legal, tax or other advice and is supplied for information purposes only. Past performance is not a guide to future returns. The value of investments may go down as well as up and an investor may not get back the amount invested. Reference to any specific security is not a recommendation to buy or sell that security. The information, data, analyses, and opinions presented herein are provided as of the date written and are subject to change without notice. Every effort has been made to ensure the accuracy of the information provided, but Morningstar Investment Management South Africa (Pty) Ltd makes no warranty, express or implied regarding such information. The information presented herein will be deemed to be superseded by any subsequent versions of this commentary. Except as otherwise required by law, Morningstar Investment Management South Africa (Pty) Ltd shall not be responsible for any trading decisions, damages or losses resulting from, or related to, the information, data, analyses or opinions or their use.
This document may contain certain forward-looking statements. We use words such as “expects”, “anticipates”, “believes”, “estimates”, “forecasts”, and similar expressions to identify forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason.

Morningstar Investment Management South Africa Disclosure
The Morningstar Investment Management group comprises Morningstar Inc.’s registered entities worldwide, including South Africa. Morningstar Investment Management South Africa (Pty) Ltd is an authorised financial services provider (FSP 45679) regulated by the Financial Sector Conduct Authority and is the entity providing the advisory/discretionary management services.

Doctor with a stethoscope in the hands and hospital background

Coronavirus: An Investment Perspective

The Impact of Coronavirus for Investors

Public health outbreaks and epidemics like the recent coronavirus can quickly scare investors and, eventually, affect economies and businesses. The recent coronavirus outbreak has shut down airports, halted trade, and led to the rapid construction of new hospitals in China. The effects of the outbreak may push China’s economy into a period of slower growth, with stocks trading lower as investors seek protection.

 

So, what does that mean for the portfolios we run?

Key Takeaways

  • At Morningstar Investment Management, we are watchful. We continually monitor over 250+ markets, looking at everything from fundamental risks to contrarian opportunities.

  • Looking at nine major outbreaks since 1998, there is little evidence linking global epidemics with long-term investment fundamentals.

  • The Chinese economy may slow, perhaps even meaningfully, but that is not a reason to invest or divest. Long-term investing is often best disconnected from short-term economic reactions, so we implore investors to maintain their focus on what matters.

  • Across the portfolios we run, we do have a relatively small exposure to Chinese assets (both directly and indirectly) but remain confident these holdings will deliver positive outcomes for long-term investors.

 

Epidemics and Investing

To understand the potential impacts of an outbreak, we must make a forecast—formally or casually. This is a complex task if done correctly, and outside the scope of this piece. But it’s important to acknowledge that we’re trying to peer into the future, which is wrought with intellectual danger. No one can predict the future, but plenty of research suggest ways that forecasts can be improved.1

 

One way to improve the accuracy of a forecast is to start with base rates. How often do outbreaks become epidemics? What effect do epidemics have on economies or markets? For this latter question, we look to Exhibit 1 to provide a sense of base rates—market returns following major epidemics in recent history.

 

Exhibit 1 Investors Tend to React to Epidemics, But the Long-Term Picture is Positive

As depicted, market participants tend to react to such unforeseen outbreaks, but markets tend to recover by the six-month mark. This suggests that sentiment drives early losses, but sustained economic impacts are less than perhaps investors feared at the onset.

Another way to improve forecasts is through humility—especially knowing what you don’t and can’t know. Expert epidemiologists might be able to produce base rates on spread rates, mortality rates, and so on, but no one can predict how unknowable factors might affect the spread of this or any outbreak. That’s not to mention knowing how fear might affect markets.

 

So how can we make a reasonable assessment of the potential impact of the coronavirus? As long-term, valuation-driven, fundamentally based investors, our concern is any potential impact to businesses’ cash flows.2 For example, will the collective impact of the outbreak (fewer flights, less trade, loss of productivity, etc.) affect a few businesses, a few industries, or entire markets? That’s the question we’re asking.

 

Our answer is that, at this stage, we have to assume the outbreak will take a similar path to other recent epidemics, and thus we feel there’s no reason for investors to be alarmed. Note that there’s no “safe” approach for investors—for example, exiting stocks in favor of cash has its own risk, namely crystalizing any losses suffered to sentiment while almost surely missing out on a rebound if the virus were to be contained quickly. So we want to proceed by assuming what we consider to be the most likely scenario, while taking other possible outcomes into account.

 

Ultimately, we are very watchful but aren’t taking any action. Our core ambition is to help investors reach their goals, which requires a measured and repeatable process to investing. Across our portfolio range, we may hold exposure to Chinese stocks, emerging-markets stocks, emerging-markets debt, and companies that sell into China to varying degrees depending on the portfolio mandate. Even so, we are still expecting that these holdings will deliver positive outcomes over the long term, and it would require a clear impact to fundamentals for our view to change.

 

Note that once the facts change, we would expect to change our minds. If we were to see a clear and significant potential impact to investment fundamentals, we would carefully study the situation, conduct rigorous scenario analysis, and try to incorporate the new information into our portfolios. Until then, we remain vigilant.

 

Final Thought

With lives at stake, it would be uncaring to call the coronavirus “noise.” Yet, if we focus on the investor’s perspective, we believe it is not time to act. Moreover, we remain confident in our portfolio holdings because they reflect a solid base of research and resemble a well-reasoned way to invest. We certainly won’t be hitting the panic button and we hope you won’t either.

 

Further information

If you have questions on discussions in this piece or want to propose a pressing question for our investment staff, please contact your financial advisor.

 

Since its original publication, this piece may have been edited to reflect the regulatory requirements of regions outside of the country it was originally published in.

 

About Morningstar, Inc.

Morningstar, Inc. is a leading provider of independent investment research in North America, Europe, Australia, and Asia. The company offers an extensive line of products and services for individual investors, financial advisors, asset managers, retirement plan providers and sponsors, and institutional investors in the private capital markets. Morningstar provides data and research insights on a wide range of investment offerings, including managed investment products, publicly listed companies, private capital markets, and real-time global market data. The company has operations in 27 countries.

About the Morningstar Investment Management Group

Morningstar’s Investment Management group, through its investment advisory units, creates investment solutions that combine award-winning research and global resources with proprietary Morningstar data. With more than USD$220bn in assets under advisement and management as of 30 September 2019, Morningstar’s Investment Management group provides comprehensive retirement, investment advisory, and portfolio management services for financial institutions, plan sponsors, and advisers around the world.

Morningstar’s Investment Management group comprises Morningstar Inc.’s registered entities worldwide including: Morningstar Investment Management LLC; Morningstar Investment Management Europe Limited; Morningstar Investment Management South Africa (Pty) Ltd; Morningstar Investment Consulting France; Ibbotson Associates Japan, Inc; Morningstar Investment Adviser India Private Limited; Morningstar Investment Management Asia Ltd; Morningstar Investment Services LLC; Morningstar Associates, Inc.; and Morningstar Investment Management Australia Ltd.

 

Important information

The opinions, information, data, and analyses presented herein do not constitute investment advice; are provided as of the date written; and are subject to change without notice. Every effort has been made to ensure the accuracy of the information provided, but Morningstar makes no warranty, express or implied regarding such information. The information presented herein will be deemed to be superseded by any subsequent versions of this document. Except as otherwise required by law, Morningstar, Inc or its subsidiaries shall not be responsible for any trading decisions, damages or losses resulting from, or related to, the information, data, analyses or opinions or their use. Past performance is not a guide to future returns. The value of investments may go down as well as up and an investor may not get back the amount invested. Reference to any specific security is not a recommendation to buy or sell that security. There is no guarantee that a diversified portfolio will enhance overall returns or will outperform a non-diversified portfolio. Neither diversification nor asset allocation ensure a profit or guarantee against loss. It is important to note that investments in securities involve risk, including as a result of market and general economic conditions, and will not always be profitable. Indexes are unmanaged and not available for direct investment. Tax treatment depends on the individual circumstances of each client and may be subject to change in the future.

This commentary may contain certain forward-looking statements. We use words such as “expects”, “anticipates”, “believes”, “estimates”, “forecasts”, and similar expressions to identify forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason.

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1 – See Superforecasting: The Art and Science of Prediction by Philip E. Tetlock and Dan Gardner. The Notes section cites numerous studies, including those done by Tetlock and his partner, Barbara Mellers.

2 – Note that as investors have a particular focus on fundamentals. As humans, we care deeply about the loss, suffering, and fear brought by this or any outbreak. But we mustn’t let our emotions drive investment decisions—now or in any circumstance.