Tax-Free Savings Accounts (TFSAs): how to select the most appropriate investment portfolio

Tax-Free Savings Accounts (TFSAs): how to select the most appropriate investment portfolio

by Albert Louw

Albert Louw

In The Educator, we address a number of topics with the ultimate goal of providing a better understanding of investing clients’ money.

Executive Summary

  • A TFSA is a flexible and highly tax-efficient solution for discretionary savings • Save for the long term (use your maximum annual contribution) to maximise the tax benefits – the longer the investment is held, the greater the (tax saving) benefit
  • A TFSA is not suitable for money market / income type portfolio. The portfolio would have to deliver a return above the annual interest exemption to deliver a real benefit.
  • Investors would only benefit meaningfully once the value of the investment is sufficient to exceed the annual interest exemption
  • Be disciplined and don’t withdraw from your TFSA if you have other sources of income available

Background

In 2015 National Treasury decided to incentivise South Africans to save more to address the underlying socio-economic problems that arise from our 1 poor savings culture. It introduced tax-free savings and investment vehicles. The TFSA is an ideal discretionary investment option to supplement your existing retirement and /or discretionary savings. A TSFA is completely tax free. It reduces your taxable income while you invest. When you withdraw, you receive the full investment back, without incurring any tax on the growth.

Advantages & limitations Advantages

  • The investor’s growth is tax free: the interest, capital gains and dividends are completely tax free;
  • You can choose from a range of selected underlying funds that can meet your unique investment needs;
  • You can access your investments whenever you need them. There are no penalties for withdrawing from your investment and you can change, stop and restart your debit order whenever you wish, at no extra cost;
  • Flexibility – you can transfer savings from one provider to another, without it being seen as a new contribution. This increases competition among TSFA providers and helps to ensure that products stay competitive;
  • Liquidity – you make a long-term investment into a TSFA, intending to leave it there for the long term, at least you have the comfort of knowing that if the “wheels do fall off” and something unexpected does happen, you can access your money;
  • Saving additional CGT – When you die, the value of the TSFA will be added to your estate. After the exemption of R3.5million, it will be subject to estate duty. However, the estate will not be liable for CGT when the investments in the account are sold (deceased estates are subject to CGT). Neither you nor your estate can transfer investments in a tax-free savings account to someone else. Your heirs can inherit the savings and transfer them to their own tax-free savings accounts, but the amount transferred will be regarded as a contribution by the beneficiary to their accounts and will count towards their annual and lifetime limits;
  • Saving on executor fees – If a life assurance investment policy is an underlying investment in your tax-free savings account and you nominate a beneficiary, the proceeds from the policy can be distributed to him or her before your estate is wound up. This will save executor’s fees.
No real disadvantages – only limitations
  • The maximum amount you can currently invest is R33 000 a year or R2 750 per month with a lifetime maximum of only R500 000;
  • You will incur a penalty of 40% of any amount you invest above the maximum.

BUT what investment portfolio to consider?

When selecting a TFSA, it’s important to ensure it fits within a holistic long-term financial plan.

The (1) first step is to ensure the investor’s discretionary investment goal is mapped against the appropriate portfolio – choose the portfolio that is suited to your investment objective.

(2) Secondly, to maximize your after-tax return, you may want to consider a TFSA or what is sometimes referred to as “tax free wrappers”, to achieve medium to long-term investment goal(s).

TFSAs are NOT intended for short term savings such as money market / call account investments

If you are not already paying tax on your investments, or are not investing for the long term, the TFSA may not provide significant tax benefits. You would only benefit meaningfully from the tax-free treatment of money in the TFSAs once the value of the investment is sufficient to exceed the annual interest exemption. Consider that the current annual interest exemption for people below age 65 is R23 800 per annum and this is not going to be increased in future. If you are younger than 65 and select only interest-bearing investments earning, say, 7% a year, the investment would have to be worth 2 R340 000 before the interest exemption is exceeded.

The real value of your tax savings on a TFSA needs time to compound. So if you contribute to a TFSA and withdraws that money in two years’ time, you will have used up two years of contribution limits, but you’ve actually gained very little in the way of tax savings.

You should have a 10-year or longer investment horizon when choosing a tax-free savings account. Investors sometimes think because it’s an account, it has to be held in the form of bank or fixed deposits. It is important to consider very long-term investments, in other words things like investments in shares or listed property, or balanced unit trusts.

The longer you remain invested, the greater the (tax saving) benefit

As with all worthwhile things in life, patience and discipline are vital. The longer you remain invested, the greater the benefit from tax-free growth – so target a term of at least five to ten years or longer. The extent of the tax saving will vary significantly across the universe of portfolios available. It depends on a combination of factors, the primary two being:

  1. Your marginal tax rate, and
  2. The type and amount of income and capital gains earned from your selected portfolio.

Time horizon growth portfolios typically have most of their assets invested in equities, including listed property. Equity dividends received from shares, both locally and offshore, exempt from paying 20% dividend withholding tax (DWT). On the other hand, taxation of 3 REIT dividends are taxed at your marginal rate but in a TFSA are tax-free. 4Research shows that property as an asset class typically has the greatest tax saving regardless of your marginal tax rate. Property distributions i.e. dividends are paid from pre-tax profits and typically produce higher dividend yields than equities. The saving on DWT, and relatively high property distributions (“dividends”) in growth portfolios make them ideal long-term investments for tax free savings accounts.

The CGT saving is underestimated when the investor decides to sell all or part of a non-tax free investment

Any capital gains must be declared to SARS and if they are above the tax threshold of R40 000 you will be liable for tax on your return calculated according to your marginal income tax rate.

For instance, the current capital gains tax exclusion is R40 000 per year. If you chose investments with strong capital growth it could potentially exceed the capital gains exclusion within five years. That means you would be better off having this money in a TFSA. The tax saving (i.e. capital gains tax) when “cashing- in” your investment at the end of your savings term, should not be underestimated.

Let’s look at the following example:

The investor realizes the full extent of the cost of education once a child starts school. So he decides to invest the full annual tax-free allowance of R33 000 every year for 15 years, which means that he would have contributed a total of R495 000 over the period – this is very near the current maximum R500 000 lifetime limit. If the annual R33 000 was invested in a high growth multi-asset portfolio and achieved a 5 real return of inflation plus 6% over the 15 years it would have grown to R1 373 846 when the investor decided to sell his investment to pay for the children’s education (“he would have doubled his investment”).

The capital gains tax saving of *R150 000 is substantial by comparison with non-tax free investment portfolio. The investor would therefore have notched up an extra R150 000 for school education at the end of the 15-year investment term solely as a result of the tax-free benefits of this vehicle. This would be a substantial bonus for anyone saving for a specific goal such as education.

R1 373 846 – R495 000 = R878 846 Min annual exclusion: R40 000 Capital gains of: R838 846 CGT (6 18% x R838 846) = R150 992 ~ R150 000

A TFSA is a “no brainer” – on condition you put savings into the right vehicle and for the right reasons

TFSAs are a great solution to South African’s poor savings culture. Investors should take advantage of the opportunity to grow their savings without paying any interest, dividends or capital gains. If used wisely, TFSAs can have significant and positive long-term financial consequences. The key is to start contributing as soon as possible. It is also important to contribute the maximum allowed each year. The tax saving will compound returns in the long term. The investor’s marginal tax rate and type of portfolio should be carefully considered, as should their existing retirement and/or discretionary savings.

 

  1. According to the 2017 Old Mutual Savings and Investment Monitor, only 15% of household income is allocated towards savings
  2. R340 000 = 7%/23 800
  3. A Real Estate Investment Trust (REIT) is a listed property investment vehicle that publicly trades on the JSE board and qualifies for the REIT tax dispensation. REITs must pay at least 75% of their taxable earnings available as a distribution to their investors each year.
  4. (1) MoneyMarketing publication (February 2018) – Tax-free investing Feature (2) Nedgroup Investments (Q1 2015) – The new tax-free savings account: how much will you actually save?
  5. Assume the portfolio achieved an annual return of 12% (with inflation at 6%)
  6. Assume highest tax bracket of 45% x 40% inclusion rate



Part 3: Contributing towards your retirement fund(s) – contributing more than what is allowed for income tax deduction

Part 3: Contributing towards your retirement fund(s) – contributing more than what is allowed for income tax deduction

by Albert Louw

Albert Louw

In The Educator, we address a number of topics with the ultimate goal of providing a better understanding of investing clients’ money.

In the final part of a three-part series we briefly discuss a number of factors to consider when retirement contributions are more than the amount allowed under Section 11F of the Income Tax Act. This series of articles focuses on Section 11F of the Income Tax Act – deduction of contributions to retirement funds.

Pre-retirement

Carried forward to future years of assessment

In the 2017/2018 tax year Mrs Selinda’s retirement contributions qualified for a deduction of 27.5% of her taxable income. This amounted to R500 000. Since her deduction was capped at R350 0000, she qualified for a deduction of R350 000 in that tax year of assessment, with R150 000 rolled over to the current 2018/2019 tax year.

In the current year of assessment, the 2018/2019 tax year, her preliminary assessment shows that she qualifies for a deduction of R400 000. Since her deduction is once again capped at R350 000, the contributions rolled forward amount to R200 000 (150 000 + 50 000) i.e. R200 000 of previously disallowed contributions.

Contributing more than the amount allowed for under Section 11F allows you to rollover excess amounts

Non-discretionary savings vs discretionary savings

Mrs Selinda is contemplating whether she should continue to contribute more than the capped amount of R350 000 per year or reduce her contributions and instead, use them towards a discretionary savings vehicle such as a unit trust.

The answer will differ for investors, based on their financial needs, the amount they contribute in excess of the R350 000 cap, their term to retirement, tax brackets, appetite for risk, etc. It is therefore vital for Mrs Selinda to speak to her financial adviser and establish the best solution for her specific needs. Below are some of the options/factors that her financial adviser will bring to her attention.

Non-discretionary savings: contributing in excess of R350 000 cap

  • If Mrs Selinda continues to contribute more than the amount allowed for under Section 11F of the Income Tax Act into a retirement annuity (RA), she will not receive immediate tax relief but will get the deduction in following years of assessment
  • She will accumulate tax-free growth while invested in the RA
  • If she is not financially astute and/or has a poor savings track record, it may be worth her while to continue contributing more than the capped R350 000 towards her non-discretionary RA savings vehicle
  • Lastly, she may also decide not to take a lump sum benefit in excess of the R500 000# taxed at a nil rate, at retirement – following her inheritance from her late dad. This means she will not have to pay 36% lump sum tax as per the retirement tables, as she has adequate discretionary savings by way of her inheritance.

(#R500 000 only taxed at nil rate if previous lump sum benefits have not been taken)

Tax fee ‘build up’ allows for disciplined investing

Discretionary savings: contributing non-deductible contributions into another investment vehicle

If Mrs. Selinda decides to invest her non-deductible contributions into an investment vehicle other than an RA, such as a unit trust, all income generated from her unit trust will attract income tax as well as dividends withholding tax. Furthermore, any withdrawal would be taxed as a capital gain (excluding money market funds). While tax is a very important consideration, there are many other factors to take into account.

  • She can optimise her tax benefits by investing into a tax fee savings account. This is unfortunately limited to a maximum of only R33 000 p.a
  • Investing in a unit trust will allow her more flexibility. In contrast, Regulation 28 restricts RA’s. Her needs analysis may show a capital shortfall at retirement and in view of that, will allow her to invest 100% in an equity (growth) fund in order to potentially overcome the shortfall by the time she retires
  • Mrs. Selinda can only access her RA fund value at the age of 55 and even then, she can only access up to one third of her fund value in cash. Her discretionary savings allow her to withdraw at any stage from a unit trust account – her financial planning analysis may show the need for an ‘emergency fund’ to cater for short-term needs.

Tax benefits limited but provide full liquidity

At retirement

If Mrs Selinda elects to commute the lump sum she receives from her retirement benefit, it will be taxed in terms of the retirement tax table. However, in addition to the R500 000 taxed at a nil rate, she is allowed to deduct her previously disallowed contributions from her lump sum. Had she rather chosen to invest her nondeductible contributions into her unit trust account, then any withdrawal would be taxed as a capital gain.

Disallowed contributions can be deducted from lump sum amount taxable at retirement

In retirement

Any income derived from Mrs Selinda’ s compulsory annuity will be taxed as income at her marginal tax rate. Though Section 10C of the Income Tax Act provides that any previously disallowed contributions that have also not been set off against a lump sum taken, may then be applied towards exempting annuity income received from compulsory annuities.

Example:

Over the years, Mrs Selinda continued contributing more than the amount allowed for under Section 11F and built up previously disallowed contributions of R1 200 000. On retirement she elected to take only R1 000 000 of her retirement annuity as a lump sum and used the remaining amount to purchase an annuity. She will earn an annuity income of R600 000 in her first year of retirement.

An exemption will be applied under Section 10C for disallowed contributions not set off against lump sums

Upon your death

Non-deductible contributions included in estate

Mrs Selinda’s previously disallowed contributions would be property in her deceased estate and are subject to estate duty tax. This will be for all deaths occurring on or after 1 January 2016 and for all non-deductible contributions to retirement funds made on or after 1 March 2015. However, it is important to note that although her previously disallowed contributions are subject to estate duty, they do not create additional estate duty tax. The money was voluntary money to start off with and regardless of how the money was invested; it would be subject to estate duty in any case.

Disallowed contributions do not create additional estate duty cost

Mrs Selinda’s wishes vs that of the trustees

Mrs Selinda’s non-deductible contributions will be subject to Section 37C of the Pensions Fund Act, which specifies that trustees must apply their discretion as to who the dependants of the deceased member are and to distribute equitably among them.

If, however, she decides to invest her non-deductible contributions into a discretionary savings vehicle, the investment will be dealt with in terms of her will. In her will, Mrs Selinda may instruct how the proceeds of her unit trust account should be dealt with. This is not the case, however, with retirement funds.

In summary

  • The reality is that the question of whether there is still rationale for making excess contributions to a retirement fund, will not impact the average salaried employee since their existing contributions will more than likely fall comfortably within the 27.5% deduction and the R350 000 cap.
  • The question is whether you should contribute in excess of the amount you are entitled to as a tax deduction. If this is the case, deciding how to invest is not a simple decision as there is no right or wrong answer. And if you are in this fortunate predicament, there are many factors to consider. It is therefore important to engage with your financial adviser to help you make the decision.



Part 2: Contributing towards your retirement fund(s) – the impact of CGT on your retirement savings deduction

Part 2: Contributing towards your retirement fund(s) – the impact of CGT on your retirement savings deduction

by Albert Louw

Albert Louw

In The Educator, we address a number of topics with the ultimate goal of providing a better understanding of investing clients’ money.

In part two of a three-part series we discuss the impact of Capital Gains Tax (CGT) when calculating the amount you can deduct for tax purposes. The series of articles focuses on section 11F of the Income Tax Act, which relates to the deduction of contributions to retirement funds.

Review – three limitations to be considered

The amount of the deduction in a particular year of assessment is limited by Section 11F to the lesser (smaller) of A, B and C below:

A: R350 000

B: 27.5% of the greater of:

Remuneration, excluding retirement lump sum benefits and severance benefits; or

Taxable income including a taxable capital gain but before allowing this deduction and the section 18A donations deduction. It also excludes any retirement lump sum benefits and severance benefits

C: Taxable income before the section 11F deduction and before the inclusion of the taxable capital gains

‘Taxable income’ vs. taxable income – be mindful of the context in which the words are used

Taxable income is used to determine the maximum amount you can deduct for tax purposes for retirement contributions. However, you need to be cautious when applying Section 11F as SARS uses the words taxable income in two instances, which can create confusion. (1) For determining the maximum amount you can deduct for tax purposes for retirement contributions, and (2) to determine your final tax liability.

The following examples illustrate the above application

The calculation is a three-step process:

  • Calculate your retirement fund deduction by applying Section 11F
  • Add your taxable capital gain to calculate your taxable income
  • Apply the tax tables to determine your tax liability.

Example 1: R50 000 contribution

  • Mrs Selinda earns an annual salary of R250 000
  • Her employer contributed 20% (i.e. R50 000) to a pension fund on her behalf
  • She also earned rental income of R20 000 (no expenses incurred)
  • She incurred a taxable capital gain of R2 500 000 after selling shares from the portfolio she inherited from her late father.

Step 1:

The maximum deduction that she can make is limited to the lesser of:

A: R350 000

B: The greater of:

27.5% x R300 000 (remuneration ) = R82 500 or

27.5% x R2 820 000 = R775 500 [R2 820 000 = R320 000 + R2 500 000]

C: R2 820 000 (taxable income) – R2 500 000 (taxable capital gain) = R320 000

The deduction will be limited to the lesser of the three amounts in bold, which is R320 000. Mrs Selinda only contributed R50 000 and therefore can deduct the full amount of R50 000 for tax purposes.

To the extent that a taxable capital gain is included in taxable income, it will increase the potential deduction and ‘saving more tax’ for that year of tax assessment.

Step 2:

The following applies under the tax table:

Step 3:

Example 2: Retirement fund contribution of R350 000

Mrs Selinda decided to increase her pension contribution to R350 000 for this year of tax assessment in order to ‘get the full tax benefit’ now that she has incurred a taxable capital gain of R2 500 000. She used R300 000 from the sale of shares from her equity portfolio to make a voluntary contribution towards a retirement annuity (RA). The total contribution is therefore R350 000 (R50 000 contribution from her employer and R300 000 voluntary contribution).

Step 1:

The maximum deduction that she can make is limited to the lesser of:

A: R350 000

B: The greater of:

27.5% x R300 000 (remuneration) = R82 500 or

27.5% x R2 820 000 = R775 500 [R2 820 000 = R320 000 + R2 500 000]

C: R2 820 000 (taxable income) – R2 500 000 (taxable capital gain) = R320 000 The deduction will be limited to the lesser of the three amounts in bold, which is R320 000. Mrs. Selinda contributed R350 000 BUT is now limited to deducting only R320 000 for tax purposes.

Taxable capital gain included BUT your deduction is limited to ‘taxable income’ only

Step 2:

The following applies under the tax table:

Step 3:

The result is almost a 50%* tax saving with the additional R300 000 voluntary contribution

(*R1 666 459 – R 1 517 959)

Dispelling the myth that your retirement contributions can reduce your tax on capital gains

Confusion exists among investors because taxable income, as defined in Section 11F, includes taxable capital gains. However, if you look at the limitations i.e. part C, the retirement savings deduction is reduced to taxable income before the taxable capital gain is added. In other words, your taxable capital gain is therefore still fully taxable – as illustrated per the above examples – and does not reduce the tax on capital gains.

Your taxable capital gain (and the eventual tax arising from it) cannot be eliminated or reduced by the deduction under Section 11F for retirement contributions

Summary

  • SARS uses the words ‘taxable income’ in two instances. This can create misunderstanding and ultimately, the miscalculation of deductible contributions – ‘taxable income’ for retirement contribution deductions and taxable income to calculate your final tax payable
  • The inclusion of the taxable capital gain in Section 11F of the Income Tax Act, presents the opportunity to allocate a larger contribution to retirement funds for that year of assessment. The additional tax saving is clearly illustrated in the two examples
  • The taxable capital gain is included in Section 11F, BUT your deduction limited to ‘taxable income’ only. Therefore, if you wish to make a larger retirement contribution in a year where you also have a large taxable capital gain, first apply Section 11F to assess the maximum amount you can deduct, before deciding on what your voluntary contribution should be in order to achieve the maximum tax saving
  • Your taxable capital gain cannot be eliminated or reduced by the deduction under Section 11F for retirement contributions

STANLIB Multi-Manager is not a tax professional. Please seek the appropriate assistance/advice from a qualified financial or tax adviser.

In the next issue: Deductible contributions – Part 3: The advantages and disadvantages of your retirement contributions being more than the amount allowed for under Section 11F of the Income Tax Act, carried forward to future years of assessment.



Part 1: More savings, less tax – take advantage by contributing more to your retirement fund(s)

Part 1: More savings, less tax – take advantage by contributing more to your retirement fund(s)

by Albert Louw

Albert Louw

In The Educator, we address a number of topics with the ultimate goal of providing a better understanding of investing clients’ money.

In the first of a three-part series, we discuss how you can save on tax by starting to contribute or contributing more to your current retirement fund(s). The series focuses on section 11F of the Income Tax Act – the deduction of contributions to retirement funds.

Background – new Section 11F

You may be aware that as from 1 March 2016, total contributions to retirement funds – pension funds, provident funds and retirement annuities – are tax deductible. Thus, as the tax year-end approaches on the 28 February 2019, you can benefit from a tax deduction when filing your tax return for the year of assessment. The amount of the deduction in a particular year of assessment is limited by Section 11F to the lesser (smaller) of A, B and C below:

A: R350 000

B: 27.5% of the greater of: Remuneration, excluding retirement lump sum benefits and severance benefits; or Taxable income including a taxable capital gain but before allowing this deduction and the section 18A donations deduction. It also excludes any retirement lump sum benefits and severance benefits

C: Taxable income before the section 11F deduction and before the inclusion of the taxable capital gains Any contribution over (the smaller of A, B and C above) that does not qualify as a deduction in the year of assessment, will be carried forward to future years of assessment, subject to the annual limit.

The following examples illustrate the application of these limits

Example 1: Tax saving on current contributions

  • Mrs Selinda earns an annual salary of R250 000
  • Her employer contributed 10% (i.e. R25 000) to a pension fund on her behalf
  • She also earned a well-deserved bonus of R50 000
  • She earned rental income of R35 000 (no expenses incurred)

The maximum deduction that Mrs Selinda can make is limited to the lesser of: A: R350 000

B: The greater of:

27.5% x R325 000 (remuneration ) = R89 375 or

27.5% x R360 000 (taxable income ) = R99 000

C: R360 000 (taxable income) – R0 (no taxable capital gain) = R360 000

The deduction will be limited to the lesser of the three amounts in bold, which is R99 000. Mrs Selinda only contributed R25 000 and therefore can deduct the full amount of R25 000 for tax purposes.

The following applies under the tax table:

In the example above, for every R1 invested (retirement fund contributions) by Mrs Selinda, SARS will provide tax relief and ‘refund’ her with not less than 31 cents. Her R25 000 annual contribution effectively resulted in a tax saving of R7 750 p.a.

Save more and SARS will provide you with tax relief

Example 2: Tax saving when increasing contributions

  • Mrs Selinda understood the major tax saving and decided to increase her annual retirement contributions from R25 000 to R50 000. After meeting with her financial adviser, her monthly cash flow analysis indicated that she could afford to save an additional R25 000 per year.
  • She decided to increase her contribution within her employer’s pension fund by R10 000 (i.e. an additional voluntary contribution) and to contribute the balance of R15 000 annually (before the February tax year-end) towards a retirement annuity from a reputable service provider.

The maximum deduction that she can make is limited to the lesser of:

A: R350 000

B: The greater of:

27.5% x R325 000 (remuneration) = R89 375 or

27.5% x R360 000 (taxable income) = R99 000

C: 360 000 (taxable income) – R0 (no taxable capital gain) = R360 000

The deduction will be limited to the lesser of the three amounts in bold, which is R99 000. Mrs Selinda contributed R50 000 and can therefore still deduct the full amount of R50 000 for tax purposes.

The following applies under the tax table:

Although Mrs Selinda’s contribution doubled from R25 000 to R50 000 per annum, her take-home pay only dropped by R34 500 per annum (from R279 360 to R244 860) or R2 875 per month. This resulted in overall tax relief of R15 500 per annum or R1 292 per month.

Dispelling the myth that an additional contribution of say 10% will result in your take-home pay also decreasing 10%

Retirement savings vehicles – pension plans and/or retirement annuities (RAs)

Mrs Selinda had the option to increase her contribution (refer example 2) within her occupational fund (pension fund) and/or via a retirement annuity (RA). She opted to contribute towards both retirement vehicles. The main reasons for this are:

  1. Additional diversification – the pension fund follows a specialist investment approach and invests with a single manager. The RA offers more investment choices, allowing her the opportunity to diversify between
  2. Staggering her retirement needs – when she retires from her pension fund no further contributions can be made. In contrast, you can mature your RA any time after the age of 55. She realises the cost of medical expenses and plans to continue contributing towards her RA once she retires from her occupational fund in order to build up additional savings for post-retirement medical expenses. In this way, making use of an RA to continue saving after retirement for medical expenses.

Retirement annuities: No real disadvantages, only limitation(s)

It is not possible to withdraw from a RA other than on early retirement due to ill health, divorce orders and formal emigration. Whist this may be considered a ‘disadvantage’, it ensures you do not interfere with savings. Only if your fund benefit is below R247 500, can you can withdraw the full amount. In addition, with all investment vehicles there are a variety of RAs, costs and fees to consider when making your final selection.

Major benefits when contributing more towards retirement

  • No tax (income, dividend or capital gains) is paid on the growth of your retirement savings. Tax is only payable when accessing your savings.
  • Retirement contributions are tax deductible, subject to section 11F of the Income Tax Act. Based on the examples provided, SARS will provide tax relief and ‘refund’ you for contributions made towards your retirement fund savings.
  • Flexibility – you can contribute to your existing employer retirement fund and/or via a retirement annuity (RA) or if selfemployed, 100% into an RA.
  • In the unfortunate event of death prior to retirement, RA benefits are not subject to estate duty#, thus saving 20% estate duty tax or 25% if your estate is greater than or equal to R30 million. # Any contribution amount to a retirement fund that was not income tax deductible in the year it was made will be property in the deceased estate. This will be for all deaths occurring on or after 1 January 2016 and for all nondeductible contributions to retirement funds made on or after 1 March 2015
  • Discipline – many may disagree that this is an actual advantage, but the fact remains that South Africans are not doing enough to ensure a comfortable retirement. For those less disciplined who may succumb to the temptation of withdrawing from their investments to fund impulsive purchases, a retirement plan (occupational fund and/or RA) is an ideal investment vehicle.

South Africa has several tax initiatives to encourage a savings culture. You should consider taking full advantage of the current legislation if you wish to save more towards retirement. In addition to the annual tax-free amount of R33 000 in an appropriate taxfree savings account, making additional contributions towards retirement savings is a no-brainer.

In the next issue: Deductible contributions – Part 2: The impact of Capital Gains Tax (CGT) when calculating the amount you can deduct for tax purposes.



The pitfalls of emotional investing

The pitfalls of emotional investing

Time in the market, rather than timing the market is far more valuable to investors

by Albert Louw

Albert Louw

In The Educator, we address a number of topics with the ultimate goal of providing a better understanding of investing clients’ money.

Emotional potholes

Since investors rarely behave according to financial and economic theory, behavioural finance has grown over the past twenty years. Most investors know that emotion affects the way in which investment decisions are made – and that greed and fear play a large role in driving investment markets. The actions of many investors are based on feelings rather than facts. They may make decisions based on a host of emotional biases that, unfortunately, undermine the chance of meeting the desired investment outcomes. Admittedly, it is difficult to escape the influence of emotions on investment decisionmaking and that influence, is more than likely the main reason many investors do not achieve the results they want.

Our brains regularly set little traps for us – and these ‘emotional potholes’ may have very real costs associated with them. Crucial in overcoming this risk is awareness of how emotions can affect decisions, which may make you a better investor in the process. In order to improve decision-making and investment results, it certainly helps to be aware of:

1. Some of the most common biases;

2.How to avoid/mitigate these costly investment mistakes; and

3. Focusing on your goals.

Some of the most common biases

Herd mentality

Our emotions may be influenced by the prevailing investment climate – such as a fear of standing out from the crowd or missing out on a trend. Herd behavior/mentality can amplify the market upswings and down turns and a prominent example was the dotcom bubble in the late 1990s. Venture capitalists and private investors made frantic moves to invest huge amounts of money into internet companies, despite the fact that many of those dotcoms not having financially sound business models. Many investors more than likely moved their money in this way, on the reassurance they received from seeing so many other investors do the same thing. They did not want to miss out and followed the ‘herd of sheep’ rather than their logic.

Greed and fear

This relates to an old Wall Street saying that financial markets are driven by two powerful emotions – greed and fear. Succumbing to these emotions can have a profound and detrimental effect on investment outcomes, as too often, investors enter (on greed) or exit (on fear) the market at precisely the wrong time.

Overconfidence

Overconfidence may cause investors to overestimate the quality of their judgment or information. Some investors believe they can successfully predict market downturns and rallies. Others perceive themselves to have a knowledge advantage when they get a tip from someone in finance or read information from a publication or research report. In reality, several studies have shown that overconfidence bias leads investors to trade more frequently in effort to align their positions with current market conditions. The cost of frequent trading erodes returns and returns earned are rarely sufficient to make up the difference. Investors are very susceptible to forgetting the times they were incorrect or recognizing the role that luck played in positive outcomes.

If you ever find yourself saying things such as ‘nothing could ever go wrong,’ ‘I believe it will go forever,’ or ‘I know the risks,’ it may be time to check yourself. It is important to remember that every investment carries some risk and the potential for loss.

Loss aversion

The basic concept behind loss aversion is that investors feel losses much more than they feel gains. Investors would rather avoid losses than reap rewards. Loss aversion is often seen in financial markets – stock market investors hold their positions with paper losses too long and sell their investment holding paper gains too early.

Consider an investment bought for R1 000 that rises quickly to R1 500. Investors would be tempted to sell it in order to lockin the profit. In contrast, if the investment dropped to R500, investors would tend to hold it, in order to avoid locking in the loss. The idea of a loss is so painful that investors tend to delay recognizing it. More generally, investors with losing positions show a strong desire to get back to the break-even point. This means that investors generally show highly risk-averse behaviour when facing a profit – selling and locking in the sure gain – and more risk tolerant or risk seeking behaviour when facing a loss – continuing to hold the investment in the hope the price rises again.

Mitigating biases

How does one go about avoiding ‘emotional traps?’ Financial markets without volatility would be unnatural, like an ocean without waves. Like the open ocean, the market is constantly churning and the degree of market volatility varies from small ripples, to rolling waves, to a financial crisis sized tsunami. Despite any negative connotations, volatility simply refers to a change in prices. It is normal and happens over time. It is not necessarily a cause for panic and is something that needs to be considered when investing. By understanding that prices of stocks and bonds will go up and down, there are things that can be achieved with that in mind. Many investors are uncomfortable with the large amplitudes swings inherent in a volatile investment and thus shun this risk – and the associated return – for less-swingy, lower returning investments. Avoiding more volatile investments simply leaves a lot of potential return on the table and may shave thousands and possibly hundreds of thousands off one’s wealth at retirement. Paradoxically, avoiding risk in long-term investing typically leads to a smaller pool of wealth, feeling far “less safe” in retirement than if one had assumed more risk along the way.

How to respond to market volatility

It might sound counterintuitive but during periods of market volatility, the correct course of action might be to take no action. This is difficult to do because volatility can leave investors feeling vulnerable and concerned that they have to react. That means that investors who jump ship after a ‘big wave’ may break the cardinal rule of investing by ‘selling low.’ Consider this – if you own a home and its value went down this year, would you panic and sell? Most likely, you would not. You bought your house because you knew you would be there a while and so its day-to-day price movement is not as important. The chances are that your home’s value will rise over time and that is what you are focused on.

Be disiplined and stay invested

There might be many investors who have made money by seemingly timing the market correctly – in other words, predicting market movements and selling or buying shares accordingly – but it is likely that this was due more to luck than skill. For the average investor it is not only difficult to foresee market upswings and downswings, but also challenging to make decisions that are not marked by emotion.

The golden rule that it’s about time in the market and not timing the market is valuable to investors. We know that markets do not move up in a straight line and that volatility is inherent in equities as an asset class. Checking a portfolio too frequently can make investors more susceptible to loss aversion, since the probability of seeing a loss in a short time period is much greater than over longer time periods. As a result, investors that frequently check their portfolios tend to take a less than optimal amount of risk. True long-term investors are more willing to allocate towards risky assets because they do not care about the short-term ups and downs. Holding a portfolio for long enough increases the probability of a positive return. Research from Putnam Investments on investing offshore in the S&P 500, shows that by remaining fully invested over the past 15 years, would have earned investors $20 460 more than those who missed the market’s 10 best days – more than double!

A goal without a plan is just a wish

Acting on emotion may lead to irrational decisions — and difficult lessons. If you develop a sound investment game plan and stick to it, you will more than likely be in a better position to pursue financial goals. A game plan can help remove emotions from the equation, enable investors to make the most of potential market opportunities; and help preserve assets during periods of volatility. Investors who are not saving for a goal and/or do not have the discipline to remain invested during the time saving for a goal, are more likely to realise the waves of volatility that occur over their period of investing. In contrast, investors with clearly defined goals, that are able to shift their focus on the potential of meeting their needs and requirements, have the luxury of realising infrequent negative market returns. There is unfortunately no assurance that an investment strategy will be successful but investing with a clear plan provides a higher probability of meeting your goals/needs.

Conclusion

The industry is learning more and more about emotional biases and the effect on individual investors. But it seems that adhering to a sound investment plan may be one of the best ways to avoid the pitfalls set by our brains.



Fund names and benchmark changes

Fund names and benchmark changes

Keeps you updated with news and changes within STANLIB Multi-Manager.

We have recently completed a review of the STANLIB Multi-Manager Equity Fund and the STANLIB Multi-Manager All Stars Equity Fund of Funds’ mandates and have determined that there is a need to change the current fund names and benchmark to better align with the funds’ respective mandates.

Current fund name
STANLIB Multi-Manager
Equity Fund

New fund name
STANLIB Multi-Manager
SA Equity Fund

The current name could be misinterpreted to imply that the fund may also invest in direct offshore assets, which is not the case. The name change will provide clarity that the fund may only invest in South African domiciled assets. This includes inward listed securities and secondary listings of global companies on the JSE.

The benchmark will change from the South African Equity General Sector average to FTSE/JSE Capped Shareholders Weighted All Share Index (FTSE/JSE Capped SWIX). The fund’s current benchmark restricts its holdings to 10% of any single stock which may result in sub-optimal portfolio construction. Changing the benchmark to an index will enable the fund to hold more optimal exposure to specific stocks when market conditions are favourable.

Current fund name
STANLIB Multi-Manager
All Stars Equity Fund of Funds

New fund name
STANLIB Multi-Manager
Diversified Equity Fund of Funds

The current name could be misinterpreted to imply that the fund may only invest in certain underlying funds. The fund’s construction has evolved to the point where it has become a diversified fund of domestic equity, offshore equity and domestic property.

Fund manager changes – effective 30 June 2017

In addition, we completed a review of the STANLIB Multi-Manager Defensive Balanced Fund and STANLIB Multi-Manager Real Return Fund, and we have decided to terminate our mandate with ABSA and move these allocations to the STANLIB Asset Management and Investec Asset Management, respectively.

STANLIB Multi-Manager Defensive Balanced Fund

Current fund manager
ABSA

New fund manager
STANLIB Asset Management

Following the recent departure of Errol Shear from ABSA (the incumbent portfolio manager to our mandate), we decided to terminate our mandate with ABSA. We have subsequently replaced the ABSA allocation in the fund with the STANLIB Absolute Plus Fund managed by Marius Oberholzer and Peter van der Ross, the fund managers for the STANLIB Absolute Return team.

The STANLIB Absolute Plus Fund brings a different dimension to the overall portfolio with its flexible approach, exploring areas of the market often overlooked. The manager is innovative and cost efficient in achieving the fund’s CPI+4% target and has used various strategies to protect capital in the short-term.

Given that the new STANLIB mandate typically invests in more growth assets, including offshore, we have had to make additional adjustments to the fund structure to ensure we remain comfortable with the overall balance of the portfolio.

These adjustments comprise:

  • Prudential remains our core position, with its relative value approach. We have increased its allocation to 25%.
  • Coronation’s mandate has a medium-equity risk profile with an absolute return focus. The new STANLIB mandate increases the portfolio’s exposure to growth assets and we therefore slightly reduced Coronation’s weighting to obtain the required balance to growth assets within the portfolio.
  • The STANLIB Multi-Manager global allocation has been marginally reduced to accommodate the global mandate allotted to STANLIB Absolute Return.

The table below provides a breakdown of the old and new *strategic (manager) allocations.

Underlying ManagersFund ManagersNew Strategic AllocationChange in Allocation
STANLIB Absolute ReturnMarius Oberholzer17%New
Investec (Global Balanced)Clyde Rossouw20%-
Coronation (Domestic only)Charles de Kock17%(3%)
Prudential (Domestic only)Charles de Kock25%(5%)
STANLIB Multi-Manager (Global only)Kent Grobbelaar21%(4%)

The strategic allocations are a construction guideline to achieve the fund’s long-term return and risk objectives. In the short-term the manager allocations may differ from the strategic allocations.

STANLIB Multi-Manager Real Return Fund

Current fund manager
ABSA

New fund manager
Investec Asset Management

We have decided to terminate our mandate with ABSA. We have replaced the ABSA allocation in the Fund with Investec Asset Management – a segregated mandate with Clyde Rossouw built on the same portfolio guidelines as the Investec Strategic Opportunity Fund.

Given that Investec’s mandate typically invests in more growth assets over time compared to ABSA (in that it takes on more risk), we had to make additional adjustments to the Fund structure to ensure we remain comfortable with the overall balance of the portfolio. These adjustments comprise:

  • Investec will also be responsible for a global mandate (i.e. global balanced mandate). As a result, the strategic allocation to the STANLIB Multi-Manager global funds was reduced to remain within its foreign limits. The new Investec mandate takes on moderate risk on a relative basis and invests in high quality shares that have long-term sustainable return on invested capital. The focus on quality is more pronounced with Investec and provides additional diversification to the overall fund. Clyde Rossouw and Sumesh Chetty are the fund managers and have a reputable long term track record;
  • Prescient’s allocation was increased from 15% to 20%. Prescient uses various techniques to protect capital and is a key mandate as part of the fund’s overall risk management budget;
  • Following our decision to change the Coronation mandate (i.e. from Coronation Domestic Absolute to Coronation Domestic Balanced) at the end of last year we further reduced the Coronation weighting down to 15%; and
  • The Prudential (i.e. relative value) strategic allocation remains unchanged and together with the Coronation mandate (i.e. valuation based) provides the fund with the required growth assets necessary to achieve its long-term return objectives.

The table below provides a breakdown of the old and new *strategic (manager) allocations. The transition process commenced this month (May 2017) and is expected to be completed during the month of June 2017.

Underlying ManagersFund ManagersNew Strategic AllocationChange in Allocation
Investec (Global Balanced)Clyde Rossouw20% domestic + 5% globalNew
Prescient (Domestic only)Guy Toms20%5%
Coronation (Domestic only)Charles de Kock15%(10%)
Prudential (Domestic only)Michael Moyle20%-
STANLIB Multi-Manager (Global only)Kent Grobbelaar20%(5%)

The strategic allocations are a construction guideline to achieve the fund’s long-term return and risk objectives. In the short-term the manager allocations may differ from the strategic allocations.



Embracing a new financial planning landscape

Embracing a new financial planning landscape

The financial advisory landscape has changed remarkably over the past decade.

Increased regulation

The financial advisory landscape has changed remarkably over the past decade. The start of this new “era” came in 2002 with the publication of the FAIS Act which set minimum standards of qualifications and professionalism for financial advisers.

The Retail Distribution Review (RDR) discussion paper released in South Africa in November 2014 and the planned change to a “Twin Peaks” model of financial sector regulation further aim to enhance professionalism and improve investor outcomes. The “Twin Peaks” model of financial sector regulation will see the creation of a prudential regulator – the Prudential Authority – housed in the South African Reserve Bank (SARB), while the Financial Services Board (FSB) will be transformed into a dedicated market conduct regulator known as the Financial Sector Conduct Authority.

The financial advisory landscape looks significantly different now than it did even five years ago. Financial advisers looking to build a successful business for the future should aim to find opportunities among this ever-changing regulatory landscape.

Too much regulation or not – Embrace the opportunity

The South African financial planning industry is one of the most established in the world. Highly skilled financial advisers have spent decades building successful businesses based on robust investment advice, processes, trust and reputation. For these advisers increasing regulation has required minimal changes to their business models.

Over the past 10 years, there has been a natural tightening of standards across the broader advice fraternity. This has resulted in more comprehensive financial planning and improved advice to investors. However, the final outcome of the RDR proposals is still expected to have a profound impact, specifically on financial advisers who have yet to make the paradigm shift in how they execute their advice models and reposition their businesses for this new era.

There is a lot to consider when RDR is finally implemented. Will there be a big drop in adviser numbers? Will clients be reluctant to embrace the concept of advice fees? How can clients be persuaded to pay for advice? How will financial advisers build a profitable business? Will there be an increasing gap between clients able to pay for advice, and those who aren not able to?

Despite the uncertainty and challenges, one thing is certain, financial advisers with strong relationships and the willingness to adapt and improve will remain relevant to clients.

Opportunities – The need for financial advice is greater than ever

There remain several primary challenges to clients’ financial security in the context of today’s economic and demographic environment. These reinforce the importance of the role of the financial adviser and the need for suitable financial planning.

The key challenges that clients are facing include but are not limited to:

Increasing longevity – Average life expectancy has increased significantly since most retirement systems 

were first established. Today, life expectancy in South Africa is close to 70, and more than one in three South Africans who are 65 today will live past 80 years old. Meanwhile, only 6%1 of South Africans save enough for retirement, according to the World Bank.

High debt levels at retirement In South Africa only 33%2 of retirees are debt-free once they stop working. The country’s national savings makes up just 15.5% of GDP. The fact that people are not saving enough is highlighted in the latest Momentum/Unisa Household Liabilities index3 that shows the real value of household assets continue to fall because of lower contributions towards savings and a lack of investment growth on savings.

Lack of preservation In addition to South Africans not saving for retirement at all, there are many who aren’t saving enough or who don’t preserve their retirement benefits between jobs. Many South Africans have been tempted to access their retirement savings when changing jobs so they go back to a zero base in terms of retirement savings and, significantly, wipe out the years of compound interest they had previously earned.

Lack of engagement and financial literacyAt a time when the need for financial advice is so great for so many, levels of engagement with financial advisers are disappointingly low. According to BlackRock’s September 2016 Viewpoint4, only 17% of individuals in the United Kingdom (UK) and Germany, and only 14% in the Netherlands, use the services of a financial adviser. The levels of adviser engagement in South Africa is expected to be even lower due to our high unemployment rate and lower levels of financial literacy.

If anything, the above highlights the significant opportunity for financial advisers, as many people need professional financial advice. However, some of the new challenges facing financial advisers include:

  • The arrival of a new competitor – the digital wealth manager
  • Clients questioning the quality of advice as they struggle to link the value of advice given with their needs and outcomes.

The arrival of the digital wealth manager

Financial advisers are competing against the newest player in the market, the robo-adviser. The term robo- adviser implies that an element of advice is included in the process. However, it is provided without the intervention of a traditional (human) financial adviser.

Two factors are likely to drive consumer use of robo-advisers. Regulatory changes will be too onerous for some financial advisers to continue in business, leading to a likely contraction in the number of financial advisers operating in the sector. Quality advice comes at a price, one that the South African investor is not used to paying for. A large portion of customers could be priced out of the market due to a reluctance to pay for advice.

Since 2008, nearly 140 digital advisory firms have been founded in the US, with over 80 of those started in the past two years alone5 . A robo-adviser, in its uncontaminated form, provides a certain degree of advice, although on a more limited basis. Younger generation Y and millennial customers are likely to be attracted to the new digital wealth manager because of the anytime, anywhere opportunity to transact. This poses a further challenge to financial advisers who are trying to diversify their client base beyond its current predominantly aging customer profile.

According to the Investor Pulse Survey6 clients are contemplating robo-advice for convenience (42%), the appearance of simplicity (33%) and because there is no deliberate product push (31%).

Although the model may simplify the investing process, clients overestimate the effectiveness of robo-advisers in replacing the holistic advice given by traditional financial advisers. Non-comprehensive financial needs analyses and single-needs selling can result in detrimental financial planning shortfalls, which a client may only discover many years later.

Many clients in the 2015 Accenture7 report indicated their preference for continued access to traditional advisers. Despite this, financial advisers need to consider new ways of reaching, engaging, and connecting with clients through digital technology.

A hybrid business model that combines digital-user interfaces and client-relevant digital content (i.e. knowledge sharing), with face-to-face financial adviser interactions provides a far more compelling offering and a way to remain relevant to clients’ needs.

Quality of advice centred on holistic financial planning

Many financial advisers have adopted a “wait-and-see” approach to the new RDR legislation. Based on changes in the post-RDR UK market, there is likely to be a move away from investment planning (i.e. product pushing) to a more clearly defined focus on financial planning.

In the post-RDR era of increased scrutiny and higher professional requirements, financial advisers cannot afford to provide investment advice without rigorous and up-to-date investment research and analysis. The costs of setting up and maintaining a quality in-house research team are simply too high for many advisory businesses. In addition, advisers will want to mitigate the risks involved in defending, explaining and taking responsibility for all investment decisions. As a result, outsourcing investment research and portfolio construction to an independent provider has become an increasingly attractive solution for adviser businesses that want to focus on providing high-level financial planning and demonstrate value-add through quality advice.

Robust financial advice (i.e. a well-designed strategy) is based on an individual or family’s clearly defined financial and life goals. These could include education funding, buying a larger home, starting a business, providing for retirement or creating a legacy. The power of a goal-based approach to financial planning lies in its ability to highlight how realistic a goal is relative to a client’s risk preferences and the investment opportunities available.

As the ethos of goal-based investing gains traction with financial advisers and clients, it makes the principle of investing more tangible and relatable. It also helps to prevent rash investment decisions by providing a clear process for identifying goals and choosing investment strategies to match those goals.

Financial advisers looking to enhance and differentiate their value proposition as well as better equip themselves to deal with sometimes irrational and counter-productive investor behaviour will do well to adopt a goal-based approach. Key to the approach is shifting the focus from generating the highest possible portfolio return or beating the market, to investing with the objective of attaining specific life goals. Measuring investment performance is important, but measuring up to the goals set by a client as part of their financial plan is a more effective measure of financial success.

Conclusion

More stringent regulation, together with the outcome of RDR, will change the face of the financial adviser in what is seen as “a new era”. Financial advisers have an opportunity to embrace the changes despite current uncertainty. The need for financial advice is greater than ever but increased competition from robo–advisers along with increased scrutiny of the quality of advice, presents many challenges for financial advisers.

To succeed will require a focus on the real needs of clients to help them achieve their life goals. Helping clients invest according to their unique needs, objectives and time horizons encourages them not to view risk as something to fear and avoid, but rather as a barrier not to fully achieve their goals. By remaining highly relevant to clients’ investment and financial planning needs, financial advisers can truly differentiate themselves and strengthen client trust at the same time – There is no substitute for the trusted financial adviser.

Footnotes:  1   www.enca.com   2   www.enca.com  3   www.businesslive.co.za – South Africans do not have enough saved to see them through an emergency (23 January 2017)  4   BlackRock – Viewpoint (September 2016)  5   Tracxn Report – RoboAdvisers (Feb 2016) 6  BlackRock – Viewpoint (September 2016)  7  Accenture – The Rise of Robo-Advice: Changing the Concept of Wealth Management (2015)

By Albert Louw,

Head of Business Development,
STANLIB Multi-Manager