FundsAtWork. Navigating the taxation changes

Transcription

1 FundsAtWork Navigating the taxation changes Momentum FundsAtWork Conditions for use: The contents of this document may not be changed in any way. The document is for illustrative purposes only and does not constitute advice. The user relies on the contents at his sole discretion. A person should not act in terms of the information in this document without discussing it with an authorised financial services provider. Momentum is not liable for any form of damage that may be caused by the use of this document. Momentum does not make any warranty about the contents of this document. Registration number 1904/002186/06. Momentum, a division of MMI Group Limited, an authorised financial services and credit provider. July 2014

2 Contents Section 1-3 Section 2 - income disability benefit (PHI) 4 The change 4 Tax implications on PHI premiums 4 Tax implications on PHI benefits 4 Using FlexiCovers 5 Section 3 - retirement fund contributions 6 The change 6 The impact 8 The opportunities 9 Section 4 - Provident fund post-retirement alignment 10 The de minimus threshold 10 Impact on members of a provident fund on 1 March 2015 who are younger than Impact on members of a provident fund on 1 March 2015 who are 55 and older 12 Transfers 13 Impact on employers 13 Public sector funds 14 Section 5 - of 16 long term retirement savings on umbrella funds - will umbrella funds survive? What is a retirement annuity? 16 Tax consideration 16 Membership requirements 16 Analysis of the FundsAtWork member base 17 Expenses and commission 17 Ease of registration 18 Flexibility 18 Access to money 18 Fund governance 19 Meeting members needs 19 Conclusion 20 Key Take-Outs 20

3 01: The Taxation Laws Amendment Act No. 31 of 2013 that was published in December 2013 introduces several tax changes in the employee benefits industry that will become effective on 1 March This document provides a brief summary of these changes and discusses the impact on members, employers and financial advisers. It provides a practical guide to ensure that clients make the most of the opportunities presented by the changes. 3

4 02: disability income (PHI) Read Legal Update 2 of 2014 for supporting information. The change From 1 March 2015, a member s PHI premium will be taxed, but the benefit will be tax free. The first question that comes to mind is what the impact on a member s take home pay will be. The impact will largely be determined by: The PHI premium being paid, The normal annual inflationary adjustment to the taxation tables, and The member s salary and tax rate. Tax implications on PHI premiums The graph shows various scenarios of the impact on a member s take home pay. Different salaries and premiums were used for the calculations, assuming that the tax tables will be adjusted with 6% inflation. Impact on member s take-home salary post tax change Monthly impact on member s take-home pay Members annual cost to company 25th Percentile PHI Rate 50th Percentile PHI Rate 75th Percentile PHI Rate Average PHI Rate 4 Most members will not have a reduction in take home pay. However, those members earning higher salaries and with higher PHI premiums can expect a negative impact on their take home pay. Even if there is no negative impact on a member s take home pay as such, there will be a negative impact because the real rate of tax would have increased for such a member. Tax implications on PHI benefits We also need to understand how the change impacts a member s PHI benefit. The graph shows the improvement on a member s financial wellness as a result of the benefits being tax free. PHI Insurance Replacement Ratio % of need (net pay) met 92% 80% 71% 63% 63% 64% 65% 63% 5% 15% 25% 35% Employee tax rate Before 1 March 2015 After 1 March 2015 The calculation is based on the following assumptions: The member s insurance salary is 80% of total cost to company. His PHI benefit is 75% of his insurance salary. His income disability need is 100% of net pay which means that the member needs 100% of his net pay to meet his financial needs if he becomes disabled. The graph shows that higher income members, who are currently in higher tax brackets, will be significantly better off than lower income members.

5 02: 5 Using FlexiCovers With FundsAtWork FlexiCovers, each member can increase or decrease his PHI benefit level to ensure that his needs are met on an after-tax basis. If the intention is that each member in a scheme must have the same after-tax benefit amount, it will mean that there has to be different before-tax benefit levels. The following graph assumes that members want to maintain their after-tax benefit levels and shows what the estimated before-tax benefit levels should be at the different tax rates. Benefit % Required to Maintain Existing Cover Benefit as % of Insurance Salary 75% 68% 61% 51% 5% 15% 25% 35% Employee tax rate The graph shows that a high income member, currently on an average tax rate of 30% who wants to keep his aftertax income disability benefit levels the same, should use FlexiCovers to reduce his current benefit level of 75% to around 53%.This is just an estimate. Because members tax situations are different, a more specific tax calculations should be done to see what the exact impact for the member would be. Yusuf Nanabhay Head: Product Development Momentum Employee Benefits: FundsAtWork Tel yusuf.nanabhay@momentum.co.za

6 03: retirement fund contributions Read Legal Update 3 of 2014 for supporting information. The change From 1 March 2015, employer contributions to all retirement funds will be taxed in the hands of the member. At the same time, the member will get a tax deduction on the total contribution towards retirement funds, subject to an annual percentage and monetary limits. Employers will have an unlimited deduction. Summary 6 All retirement funds (pension, provident, retirement annuity) Deduction on member contribution Deduction on employer contribution Up to 27.5% of the greater of ***remuneration or taxable income, subject to an annual monetary limit of R Unlimited deduction. Employer contributions taxed as a fringe benefit in employee s hands and deemed to be employee contributions. ***Remuneration refers to the payment made to an employee (their salary). It excludes any retirement fund lump sum, lump sum withdrawal benefit or severance benefit. Taxable income is a person s total income, from all sources, less the allowable deductions and exemptions. An employee who receives a salary from his employer but also has other sources of income, can potentially have a taxable income that is higher than his remuneration. In that case, the maximum deduction will be based on his taxable income instead of just his remuneration. Employee contributions From 1 March 2015, the contributions paid by an employer for the benefit of their employee to a retirement fund will be deemed to be an employee contribution and will be taxed in the employee s hands. These contributions however, together with the member s other retirement fund contributions, will qualify for a deduction of up to 27.5% of their remuneration or taxable income, whichever is the higher, subject to an annual maximum of R The employer will allow the pension or provident fund contribution as a deduction from the member s remuneration every month in terms of proposed paragraph 2(4)(a) of the Fourth Schedule to the Income Tax Act. Under paragraph 2(4)(b), the employer will also be able to allow a deduction in respect of the member s contributions to a retirement annuity if it so chooses and provided that the member provides the necessary proof of the member contributions. Where the employer makes the contribution on behalf of the employee, the employer must take those contributions into record (refer to paragraph 2(4)(bA)). By implication, the maximum amount that can be taken into account for calculating the maximum retirement fund contributions in a specific year is R Any contribution over that amount will not qualify as a deduction in that year of assessment, but will be carried forward to future years of assessment, once again subject to the annual limits. Whatever the member is not able to claim as a deduction before leaving the fund, can be claimed as a deduction in terms of the Second Schedule to the Income Tax Act when they leave the fund or alternatively, as a reduction in taxable annuity income. This can be illustrated by way of the following example. Mark s cost to company (remuneration) is R per annum. His basic salary is R per annum. Mark s defined contribution pension fund s rules provides for an employer contribution of 15% and an employee contribution of 7.5% of his basic salary. Mark also contributes 5% of his salary towards a retirement annuity fund. CTC R1,75m Basic salary R1,5m ER cons 15%: R EE cons 7,5%: R RA cons 5%: R75 000

7 03: He also has a business from which he receives an income of R His deductible expenses in relation to this business is R Taxable income has to be calculated before the are taken into account. Mark s taxable income is R , calculated as follows: R basic salary + R employer contribution (which is now a taxable fringe benefit) + R business income R business expense = R Taxable income R (Remuneration) > R (Taxable income). For purposes of calculating the maximum tax deduction for his, Mark will use his remuneration of R Mark will be taxed on the 15% employer pension fund contribution of R as a fringe benefit. He will be deemed to have contributed this R to the pension fund, together with his own contributions to the pension fund (7.5% of R = R ) and the retirement annuity (5% of R = R75 000). In total, the contributions come to R R R R R His deductions are limited to R (27.5% of R ) or R , whichever is the lowest. His actual contributions of R are higher than the maximum allowable deduction of R He will accordingly only be able to deduct R in the year of assessment, with the balance of R rolling over until the next year of assessment. Deemed er cons EE cons to pension EE cons to RA Total cons Deduction limit: lower of R or R Actual cons = R R > R Limited to R R rolls over If Mark s taxable income remains the same and the monetary cap does not increase, it will mean that the amount to be rolled over each year will increase by the excess of the specific year of assessment. The total amount rolled over by the time the member leaves the fund, can be deducted from his lump sum before the tax paid on the lump sum is calculated. If the total amount rolled over exceeds the lump sum, the deduction can be made against the member s pension. While the deduction of employer contributions in a defined contribution fund is fairly straight forward (being equal to the value of the amount contributed by the employer for the benefit of the employee the employer contribution), that is not the case in a defined benefit fund. In the latter, the cash equivalent of the amount that the employee can deduct is the total of the value of the employer contribution to the defined contribution component of the fund and the employer contribution to the defined benefit component of the fund in accordance with the formula X = Y ((A x AF) + (L x LF)) V as set out in the newly introduced paragraph 12D of the Seventh Schedule to the Income Tax Act. Employer contributions The deduction of the employer contribution is still allowed. In fact, the employer s position as far as the deductibility of contributions towards a retirement fund will be even better from 1 March The 10% limitation in section 11(l) of the Income Tax Act has been removed. This means that the employer has an unlimited deduction; they can deduct whatever they contribute for the benefit of their employees to a pension, provident or retirement annuity fund. In the example above, Mark s employer will be able to deduct the employer contribution of 15%.

8 03: The impact On the member The impact on the average member should not be different from the current position. The combined contribution rate on the FundsAtWork schemes is in the region of 12% and most members remuneration falls below R Although all members will have to pay tax on their employer contributions from 1 March 2015, and given that these contributions are below the deduction threshold as outlined above, they are expected to qualify for a full tax deduction for those contributions. Their tax position is therefore expected to be tax neutral. 8 On the employer The contribution deductions apply to all contributions made to a fund. It therefore includes the administration costs and the costs of the insurance benefits provided by the fund (approved insurance benefits). Where members need a higher percentage of their salary to be allocated towards retirement savings and also need the maximum deduction to apply to their retirement savings, the employer might decide to rather choose insurance benefits outside of the fund (unapproved insurance benefits). This decision might also be influenced by the taxation of the unapproved insurance benefits: the premiums will be taxed, whilst the benefits will be tax free. Furthermore, unapproved insurance benefits are not subject to Section 37C of the Pension Funds Act and can potentially be paid out quicker. Where an employer does provide separate insurance benefits to their employees, and the premiums for those benefits are included in the employer contribution to a pension or provident fund (otherwise referred to as an inclusive scheme), the employer must make sure that the insurance premium portion of the contribution is taxed correctly. In these cases, the employer cannot allow the employee to claim the total employer contribution to the fund as a deduction under section 11(k) of the Income Tax Act; the portion of the employer contribution that relates to the employer-provided insurance benefit must be taxed as a fringe benefit in the hands of the employee in terms of paragraph 12C of the Seventh Schedule, with no corresponding deduction. Refer to Legal update 2/2014 for more information on the taxation of employer-provided insurance.

9 03: The opportunities Instead of taking out a separate retirement annuity to boost their retirement savings, members can decide to make additional voluntary contributions to their FundsAtWork Umbrella Pension or Provident Fund and make optimal use of the maximum tax deduction on their. Members may even find that making an additional voluntary contribution of 5% does not necessarily mean that their take-home pay will decrease by 5%. Consider the following as an example. A member with an annual salary of R with a marginal tax rate of 25% contributes 10% (R24 000) towards his pension fund. He does not have any other taxable deductions. 9 Salary R Marginal tax rate 25% Cons R His taxable income after the deduction of R is R Taxable income R The tax payable on that is R54 000, which leaves him with a net salary of R Tax R Net salary R If the member decides to increase his contribution to 15% (R36 000), his taxable income is R Increase cons to R Taxable income R The tax on that is R51 000, which leaves him with a net salary of R Tax R Net salary R Although his contribution went up by R (from R to R36 000), his take-home pay only dropped by R9 000 (from R to R ), resulting in a tax benefit of R Cons R Take home pay R9 000 Tax benefit R3 000 Another reason for rather increasing the member s contributions to his FundsAtWork Umbrella Pension or Provident Fund is that although the employer will also be able to allow a deduction in respect of the member s contributions to a retirement annuity if it so chooses, the employer is not compelled to do so. The expectation is that larger employers will be very reluctant to do so, due to the employer having to obtain proof that the member in fact did make the contributions to the retirement annuity fund. Hettie Joubert BLC LLB LLM (Labour law) Legal Adviser Momentum Employee Benefits Tel +27 (0) Cell +27 (0) HeJoubert@momentum.co.za

10 04: Provident fund post-retirement alignment The Taxation Laws Amendment Act No. 31 of 2013 inter alia deals with the alignment of annuitisation requirements between pension, provident and retirement annuity funds. Read Legal Update 4 of 2014 for supporting information. The de minimus threshold The current de minimus threshold applies to pension, pension preservation and retirement annuity funds. The new threshold of R will apply to pension, pension preservation, provident, provident preservation and retirement annuity funds. The de minimus threshold will be increased from R to R from 1 March This means that if a member s total benefit at retirement in a specific fund is less than or equal to R , he can take his whole benefit in a lump sum. It will then not be necessary for him to take 1/3 of the benefit in a lump sum and buy a pension with the rest. This rule applies per fund, in other words a member who has three fund benefits, each of which is less than R , will be able to take all three benefits in a lump sum. 10

11 04: Impact on members of a provident fund on 1 March 2015 who are younger than 55 A member will no longer be able to take his whole retirement benefit in a lump sum. The Fund will have two records for that member. The first record (record 1) will be his pre-1 March 2015 record. His benefit as at 1 March 2015, plus the growth thereon, will be kept in this record. When he retires, he will be able to take the benefit in record 1 in a lump sum. The de minimus threshold will not apply to this record. The second record (record 2) will be his post-1 March 2015 record. All contributions made by or on his behalf from 1 March 2015 will be kept in this record. When he retires, he can only take 1/3 of his benefit in record 2 in a lump sum, subject to the de minimus threshold. In other words, if his benefit in record 2 is less than R , he will be able to also take the benefit in record 2 in a lump sum. If the benefit in record 2 is more than R , he will have to buy a pension with at least 2/3 of the amount in record 2. The following will apply in respect of the two different records: Investment strategy: The member will be able to have different investment strategies for each record. Divorce order divisions: If he divorces and his spouse becomes entitled to a portion on his pension interest in the fund, he might want the fund to make a deduction from only one or both of these records. Housing loans: If the fund provides a housing loan or a housing loan guarantee, the maximum amount available to the member for this purpose might be different for each record. Generally, funds limit the housing loan exposure to the member s lump sum retirement benefit, less tax thereon. Because a member in a pension fund can only take 1/3 of his retirement benefit in a lump sum, the amount 11 available for housing loan purposes in a pension fund will be significantly lower than in a provident fund, where the member can take his whole retirement benefit in a lump sum. The same principles will apply on the member s two records; record 1 will have the same restrictions applying to a provident fund, while record 2 will have the pension fund restrictions. In the FundsAtWork Umbrella Provident Fund, the maximum amount available for housing loan guarantee purposes is 64% of the member s withdrawal benefit at the time of applying for the housing loan guarantee. The same restriction applies to a member of the FundsAtWork Umbrella Pension Fund if he is younger than 50 years. If however the member is 50 years or older, the maximum housing loan amount in FundsAtWork Umbrella Pension Fund is restricted to 64% of 1/3 of the member s withdrawal benefit at the time of applying for the housing loan guarantee. A member of the FundsAtWork Umbrella Provident Fund who was a member on 1 March 2015 will therefore be entitled to a maximum housing loan guarantee of 64% of his withdrawal benefit at the date of applying for the guarantee is he is younger than 50 years. If he is 50 years or older, he will be entitled to a housing loan guarantee equal to 64% of his benefit in record 1 plus 64% of 1/3 of record 2 at the date of applying for the guarantee.

12 04: These impacts can be illustrated graphically: 12 Impact: Member <55 Before 1 March 2015 From 1 March 2015 Benefit + growth in lump sum 1/3 restriction De minimus N/A R de minimus Housing loan limit Housing loan limit Investment instruction Investment instruction Divorce order split Divorce order split The protection of the member s vested rights will apply even if he transfers to another fund. The following example illustrates this. Example: Mark is a member of P Provident Fund on 1 March Mark s benefit on 1 March 2015 is R The growth on this is R per year. Mark continues to contribute R to his benefit every year. The annual growth on this is also R per year. On 1 March 2017 Mark transfers to T Pension Fund. On 29 February 2020 Mark retires from T Pension Fund. Result: P Provident Fund has to maintain two records for Mark one for the R benefit that Mark accrued before 1 March 2015, plus the growth (record 1), and one for the benefit that accrued after 1 March 2015, with the growth (record 2). On 1 March 2017 the amount in record 1 is R (R [R x 2]). On that same date, the amount in record 2 is R ([R x 2] + [R x 2]). When P Provident Fund transfers Mark s benefit to T Pension Fund, P Provident Fund must indicate the value of the two records. T Pension Fund in turn must also have the same two records for Mark. T Pension Fund will put the R transferred from Mark s record 1 in P Provident Fund to Mark s record 1 in T Pension Fund and the R transferred from Mark s record 2 in P Provident Fund to Mark s record 2 in T Pension Fund. When Mark retires on 29 February 2020, the amount in his record 1 will be R (R [R x 3]). Mark can take this benefit in a lump sum. The amount in his record 2 will be R (R ([R x 3] + [R x 3]). Mark will only be able to take R of his benefit in record 2 in a lump sum and will have to buy a pension with the remaining R Impact on members of a provident fund on 1 March 2015 who are 55 and older The 1/3 restriction will not apply to a person who is a member of a provident fund and who is 55 years or older on 1 March 2015, as long as that member stays in the same fund. If this member stays in the same provident fund, he will be able to take his whole benefit at retirement in a lump sum. It will not be necessary to have two records for that member for as long as he stays in that provident fund. If the member transfers to another fund, that other fund must have two records for him. The first record (record 1) will be his transfer amount record. His benefit accrued in the provident fund of which he was a member on 1 March 2015, plus the growth thereon, will be kept in this record. When he retires, he will be able to take the benefit in record 1 in a lump sum. The de minimus threshold will not apply to this record. The second record (record 2) will be his post-transfer record. All contributions made by or on his behalf to the new fund will be kept in this record. When he retires, he can only take 1/3 of his benefit in record 2 in a lump sum,

13 04: subject to the de minimus threshold. In other words, if his benefit in record 2 is less than R , he will also be able to take the benefit in record 2 in a lump sum. If the benefit in record 2 is more than R , he will have to buy a pension with at least 2/3 of the amount in record 2. For example, if Mark in the example under paragraph 2 above was 55 years old on 1 March 2015, he would be able to take the R that was transferred to T Pension Fund on 1 March 2017, plus growth, in a lump sum when he retires in The balance of his benefit must be used to buy a pension, subject to the de minimus exemption. T Pension Fund will have to maintain two records for Mark record 1 for the amount that was transferred from P Provident Fund on 1 March 2017, plus growth, and record 2 for the contributions made to T Pension Fund after the transfer, plus growth. The same principles applying with regard to investment strategy, divorce order divisions and housing loans for a member younger than 55 on 1 March 2015, as discussed under paragraph 2 above, will also apply to a member over 55, except that this will only be applicable if the member transfers to another fund. The dividing line between the two records for this member will also not be 1 March 2015, but the date of transfer to the new fund. This can be illustrated graphically: 13 Impact: Member 55 In 1/3/2015 provident fund Lump sum De minimus N/A Housing loan limit Investment instruction Divorce order split From date transferred to new fund 1/3 restriction R de minimus Housing loan limit Investment instruction Divorce order split Transfers The general rule for fund-to-fund transfers is that if the member transfers from a fund that is less restrictive to a fund that is more restrictive, the transfer will be tax free. Following the post-retirement alignment from 1 March 2015, transfers between all occupational retirement funds (pension, pension preservation, provident and provident preservation funds) and transfers from any occupational fund to a retirement annuity fund will be tax free. A member in a retirement annuity fund will still only be able to transfer to another retirement annuity fund. The reason for this restriction is that a retirement annuity fund has a restriction that no other retirement fund has a member in this fund cannot withdraw from the fund before retirement. Impact on employers An employer often participates in a hybrid arrangement where its employees belong to both a pension and a provident fund. The employee contributions are then paid into the pension fund so that the member can get the tax deduction on those contributions, with the employer contribution going into a provident fund. Following the changes with regard to the taxation of contributions with effect from 1 March 2015, Refer to Legal Update 3 of 2014, a member will be able to claim a tax deduction on his contributions irrespective of whether it is paid to a pension or a provident fund. The member will also be taxed on the contributions paid by his employer for his benefit, irrespective of whether it is paid to a pension or a provident fund, with a concurrent deduction for those contributions of up to 27.5% of his remuneration or taxable income, whichever is the higher, subject to an annual maximum of R

14 04: From 1 March 2015, it will therefore not make sense from a tax perspective for an employer to participate in both a pension and a provident fund. Since each scheme has its own administration costs, having two schemes may have a negative cost implication. It also causes more work on the employer s side when it has to submit two contributions statements. It is therefore expected that the employer will terminate its participation in one of these two schemes. The question is which one. If the employer has employees who are 55 or older who are members of the provident fund on 1 March 2015, it would not be to the advantage of these members if the employer terminates its participation in the provident fund and these members are transferred to the pension fund. If that happens, these members will lose their entitlement to take their whole retirement benefit in a lump sum. If they have done their retirement planning based on the assumption that their retirement benefits from the fund would be paid in a lump sum, this change might have unplanned negative consequences. If the employer terminates its participation in the pension fund and those members are transferred to the provident fund after 1 March 2015, the pension fund members position will remain unchanged they will still be restricted to only taking 1/3 of their retirement benefit in a lump sum. Furthermore, the transfer will be tax free. Even if the employer does not have employees who are 55 or older who are members of the provident fund on 1 March 2015, he might still decide to rather terminate his participation in the pension fund in favour of participation in the provident fund. The determining factor will then probably be costs. Generally, where a service provider has both a pension and a provident fund, there are more members in the provident fund. Based on economies of scale, the fund expenses should then be lower in the provident fund. 14 An employer that does participate in a pension or a provident and wants to do so after 1 March 2015 will in all probability opt for the cheaper of the two options, since all else will be equal the taxation of contributions in both funds is the same and both will have the 1/3 restriction on retirement. Public sector funds The definition of pension fund in the Income Tax Act distinguishes between 3 types of pension funds: (a) pension, provident or dependants funds or pension schemes established by law or for the benefit of the employees of municipalities this includes for instance the Government Employees Pension Fund (GEPF), the Associated Institutions Pension Fund and all municipal funds; (b) a pension fund established for the benefit of employees of a control board as defined in the Marketing of Agricultural Products Act and the Development Bank of Southern Africa, if their rules are similar to those of the GEPF, and (c) the Municipal Councillors Pension Fund and all other pension funds approved by SARS, subject to the requirements listed under this paragraph (c) of the definition of pension fund. 1/3 restriction One of the requirements listed in paragraph (ii)(dd) under paragraph (c) is that not more than 1/3 of the total value of the retirement interest may be commuted for a single payment, and that the remainder must be paid in the form of an annuity (including a living annuity) except where 2/3 of the total value does not exceed R or where the employee is deceased (the 1/3 restriction). The 1/3 restriction does not apply to pension funds referred to in paragraphs (a) and (b), known as public sector funds. (These funds are included under the definition of provident fund in the Second Schedule to the Income Tax Act). Unless their fund rules impose this restriction such as in the case of the GEPF, members of these funds can take their whole retirement benefit in a lump sum.

15 04: To achieve the post-retirement alignment of provident funds with pension funds and retirement annuity funds, the definition of provident fund was amended with effect from 1 March 2015 to provide that the rules of a provident fund must contain provisions similar in all respects to those required to be contained in the rules of a pension fund under paragraph (ii) of the proviso to paragraph (c) of the definition of pension fund, with a proviso that deals with the protection of the rights of a member who is 55 or older. The result of this amendment is that the 1/3 restriction will also apply to provident funds from 1 March Paragraphs (a) and (b) pension funds were not included in this alignment Accordingly, after the provident fund alignment on 1 March 2015, members of these funds would still be able to take their whole retirement benefit in a lump sum if the fund rules permit it. When such a member transfers to another fund after 1 March 2015, the receiving fund will have to treat him the same as a member aged 55 and over, as explained in paragraph 3 above. Pre-1998 benefit protection Up to 1 March 1998, the benefits of private sector funds were not taxed. Members vested non-taxable benefits prior to 1 March 1998 are protected under paragraph 2A of the Second Schedule to the Income Tax Act. When a member of a public sector fund withdraws from that public sector fund, the formula under paragraph 2A (generally known as Formula C) has to be applied to the member s lump sum benefit first to determine what portion of his benefit is taxable. Once that is done, the member contributions that didn t previously qualify for a deduction (if any) must be deducted from the taxable benefit, and only then will the applicable tax table be applied. If a public sector member transfers to another fund, Formula C will be carried over to that fund. The receiving fund must therefore keep record of the member s completed years of service prior to 1 March 1998 to ensure the correct application of Formula C. When the member withdraws from the receiving fund, he will qualify for a deduction under paragraphs 5(e) (if he resigns) or 6(b)(v) (if 15 he retires) of the Second Schedule to the Income Tax Act, which allows for a deduction for... amounts in respect of which the formula in paragraph 2A applies, which have been paid into a pension fund, pension preservation fund, provident fund, provident preservation fund or retirement annuity fund for the taxpayer s benefit by a pension fund contemplated in paragraph (a) or (b) of the definition of pension fund in section 1, less the amount represented by symbol A when applying that formula,...as has not previously been allowed to the taxpayer as a deduction in terms of this Schedule in determining any amount to be included in that taxpayer s gross income. In order to qualify for the deduction, the amount had to be paid into the receiving fund by a private sector fund. If the former public sector member wants to transfer to a second fund, the transferring fund (which was the receiving fund when the member first transferred out of the public sector fund) must caution the member on the potential negative tax consequence of such a transfer. This subsequent transfer will cause the member to lose his pre-1998 vested rights protection. The reason for this is that the amount transferred to the second receiving fund will not qualify for the deduction referred to in paragraphs 5(e) and 6(b)(v) referred to above, because it is not an amount paid into the fund from a public sector fund. This can be graphically illustrated as follows (where green indicates the retention of Formula C and red means Formula C falls away). Public sector fund Transfer to Fund A Hettie Joubert BLC LLB LLM (Labour law) Legal Adviser Momentum Employee Benefits Tel +27 (0) Cell +27 (0) HeJoubert@momentum.co.za Transfer to Fund B

16 05: of long term retirement savings on umbrella funds - will umbrella funds survive? Retirement annuities have long been the retail retirement savings vehicle of choice for affluent members looking for a tax efficient manner to save for their retirement. However, with the imminent tax changes set to change the retirement landscape of South Africa, group retirement annuities are gaining momentum with many employers and advisors opting to choose them over traditional umbrella pension and provident funds. Many new-generation group retirement annuities are now being offered and marketed very strongly to financial advisers and employers as a cost effective alternative to save for retirement. While there is undoubtedly a place for group retirement annuities within the South African retirement landscape under certain circumstances, employers and financial advisors alike should consider all the factors before determining what the best vehicle is to enable their members to retire comfortably. This section focuses on some of the factors to be considered when deciding between a group retirement annuity and an umbrella fund. We look at one of the most marketed group retirement annuities and analyse how it compares to the Momentum FundsAtWork Pension and Provident Umbrella Fund. What is a retirement annuity? A retirement annuity offers individuals, usually selfemployed, the opportunity to save for their retirement. It allows them to take up to a third of the value of the retirement annuity as a lump sum at retirement. The retirement benefit is taxed on the retirement tax table. The rest of the benefit must be used to buy a pension. The pension is then taxed as income in the member s hands. 16 Tax consideration Currently the maximum tax-free contribution that members can make to a retirement annuity is 15% of non-pensionable income. In the FundsAtWork Umbrella Funds, the maximum tax deductible contribution that can be made on behalf on an employee is 27.5% of a member s pensionable income. This is comprised of a 7.5% employee contribution deduction and 20% employer contribution deduction. The employer contribution deduction includes other employer costs such as medical aid premiums. From 1 March 2015 the tax treatment of long term retirement savings will change and the distinction between pensionable and non-pensionable income will fall away. Members will thereafter be able to make a maximum tax deductible contribution of 27.5% of all income (both pensionable and non-pensionable) to all retirement products. A member in an occupational pension or provident fund will therefore be able to rather increase his contribution towards that fund by making an additional voluntary contribution (or AVC as it is generally called) than starting up a retirement annuity. Membership requirements Group retirement annuities are essentially individual policies administered on a group basis. Most providers thus have minimum membership requirements, often of 5 employees. In addition, there is often a minimum contribution amount which can be as high as R1 000 per member per month. This differs from FundsAtWork Umbrella Funds where there is no minimum number of employees per scheme. The minimum contribution on average must be higher than

17 05: R200 per member per month; therefore some members may contribute less than that, making umbrella funds more inclusive, specifically for lower contributing employees. Analysis of the FundsAtWork member base Retirement annuities were traditionally intended as a tax efficient product for affluent members looking to save for retirement, with many providers having relatively high minimum contributions of R1 000 per month. Some retirement annuities have now reduced their minimum contribution to R500, with a particular provider reducing the minimum contribution to R250 per month if the average contribution is above R1 000 per month. Applying these criteria to the FundsAtWork Umbrella member base, only 49% of the total number of members would be eligible for a group retirement annuity with a minimum contribution of R500, reduced to R250 if the average contribution is above R That leaves 51% of the member base unable to make the minimum contribution for the group retirement annuity. Expenses and commission The old saying about reading the fine print holds true for fees, and the complicated nature of investment fees doesn t help much either. While the marketing message of no administration fees by some retirement annuity providers looks attractive, a fee breakdown needs to be done to gain a comprehensive view. Let s consider the fees that are applicable to a retirement annuity member: Commission Commission is generally not included in fees quoted and is payable on an in-out basis negotiated between the member/employer and the financial adviser. This means that commission will be added to the fees and taken off the member s contributions. Thus unless an employer is taking out a group retirement annuity without a financial advisor, the commission payable must be included for a meaningful comparison. 17 Administration fees Administration fees are only waived when an internal investment portfolio is selected. Where the investment portfolio is managed by an external investment portfolio manager, administration fees are payable. The administration platform fees for an externally managed portfolio for one of the retirement annuity providers range from between 0.11% to 0.48% per annum, depending on the portfolio selected. Asset management fees While asset management fees differ between different portfolios, due consideration must be given to ensure that they remain competitive against those offered within umbrella funds. Asset management fees in a retirement annuity can differ by up to 0.77% compared to a similar portfolio in an umbrella fund. FundsAtWork Umbrella Fund members pay product fees ranging from R15 to R75 per member per month for an employer with between 11 and 40 employees, depending on the product option selected. The members also have access to externally managed investment portfolios on the Entrepreneur product option and are charged an asset based fee ranging from 0% to 0.55%, excluding VAT, based on their choice of investment portfolio. When considering the underlying asset management charges, on average the charges measured by the TER (total expense ratio) tend to be higher on some unit trusts than those under comparable Momentum investment portfolios. The total expense ratio measures the total costs as a percentage of the total assets. For example, the Momentum Enhanced Factor 7 has an asset management charge of 1.50%. A comparable equity fund of a retirement annuity provider has an asset management charge of 2.27%, targeting a similar benchmark. Let us consider the impact of these fees on a typical member with an annual salary of R , contributing 12% of that salary towards retirement for 30 years. Using the same growth assumption and contribution assumptions,

18 05: A member in the Provider option under FundsAtWork would have accumulated R12.3m of retirement savings after 30 years, compared to R11m if they were to use a group retirement annuity with an asset management charge of 2.27%. This represents an 11% difference in retirement savings. Ease of registration Umbrella funds allow employers to enrol their staff as fund members without the need to FICA all members. FICA stands for Financial Intelligence Centre Act and requires that every individual has to provide proof of residence that cannot be disputed to the institution requesting it. This differs from a group retirement annuity where the employer must FICA every member. This is a cumbersome task, especially where employees do not have the necessary documents and have to get it from a third party. Flexibility Members can transfer their between retirement annuity funds without any tax being paid. Most retirement annuity funds also allow transfers to another retirement annuity fund without incurring any penalties or exit fees. The disadvantage of traditional retirement annuities was the lack of flexibility. This has been overcome to some extent with the new generation product which allows members to stop and start contributions, make the annuity paid up or vary the contribution amount, without incurring any penalties. Members in umbrella funds are allowed to transfer their withdrawal benefits to their new employer s occupational fund, to a preservation fund or to a retirement annuity fund. Insurance benefits Retirement annuity funds do not offer insurance benefits. Therefore an employer who wants to provide his employees with group insurance benefits will have to be take those benefits on a self-standing (unapproved) basis. This has tax implications for members, with some being better off and others worse off. Under umbrella funds, both insurance 18 benefits provided by the fund (approved) and self-standing (unapproved) insurance benefits are allowed. The employer, with the assistance of a financial adviser, can choose a structure to optimise the tax efficiency for their members. Access to money The main disadvantage of a retirement annuity is that members do not have access to their benefits before retirement. Members can only access their benefits on ill-health retirement, approved emigration or after age 55. A member who stops contributing to the fund before retirement will only have access to their retirement benefit if the fund value is less than R7 000 or if the member is emigrating. This also means that a member who has lost their job, for example due to the employer being liquidated, would not have immediate access to their benefit in a retirement annuity, irrespective of what sort of life crises the member might be going through. This could lead to a member being unable to support themselves and their families when they can t earn an income or while they are between jobs. Employees tend to change employers every 3 to 8 years depending on their age. It often happens with group retirement annuities that not all members fully understand why they cannot get their money from the retirement annuity when changing jobs. Under a pension or provident fund, a member has access to their benefit when they leave their employer. Supporters of retirement annuities often quote portability as one of the most attractive features of the retirement annuity. They say that the member can stay in the same fund when they change employers, which can often not be done if the member was in a pension or provident fund. While this is to some extent true currently, this will change from 1 March 2015, when members who leave their employer s fund when their employment terminates will be able to transfer between pension, provident and preservation funds with no tax being paid on the transfer. Currently if a member transfers their benefit from a pension to a provident they will be taxed on their pension benefit. A member can even transfer from a pension or provident fund to a retirement

19 05: annuity, but not the other way around. This has implications for the member if they are forced to join the new employer s pension or provident fund. In this case, the retirement annuity will become paid up, which may result in penalty fees being incurred. In as far as transferability is concerned, from March next year a member in a pension or provident fund will have a bigger choice as to which fund he wants to transfer upon his exit from his occupational fund than a member in a retirement annuity fund. Fund governance An umbrella fund s board of trustees includes independent professional trustees. Trustees are appointed to ensure that the management of the funds are in line with the best interests of members. Umbrella funds often also have a second tier of management, called an advisory body or a management committee, consisting of member and employer representatives. The trustees and the advisory bodies play an important role in guiding the investment choices of members that are not financially astute. Under a retirement annuity fund, where there is no employer involvement, members will be required to take full responsibility for their own investment decisions. Some low income earners at the employer might find it difficult to understand the investment opportunities and make their own investment decisions. 19 Meeting members needs Employees have various needs ranging from food, health, education and long-term savings. However, their level of affordability determines their ability to meet these needs. When considering a typical employer group, a large number of the employees would be classified as mass market clients. Momentum s research has shown that members in this market segment value funeral, education and health benefits over long-term savings. Thus, even if a member can contribute R250 towards their retirement annuity, the perceived value of this in the member s eyes is relatively low. Members with insurance and retirement benefits under FundsAtWork qualify for Family Protector, which provides members with funeral, education and health benefits depending on their insurance benefits. In addition, members can increase these benefits depending on their needs and affordability. Mass market members under FundsAtWork with retirement contributions of R250, or less, therefore have most of their funeral, education, health and long-term retirement needs met.

20 05: 20 Conclusion In conclusion, the tax changes due for implementation in March 2015 will certainly change the South African retirement landscape. In particular, it might make group retirement annuities more attractive for certain groups of members. However, it is important that employers and their financial advisers take careful consideration of all the issues at hand before making a decision. While a group retirement annuity fund may make sense to a small employer with high earning, financially astute members, the umbrella fund should not be tossed away as something from the past, as it still has an important place in the provision of retirement and insurance benefits for all members. Key Take-Outs The different tax treatment between retirement annuities and pension/provident funds will fall away after March % of the FundsAtWork member base does not meet the minimum criteria of a group retirement annuity fund with a minimum contribution of R500. The unit trust fees under most retirement annuity providers are generally higher than those under Momentum and can lead to a significant difference in retirement savings. FundsAtWork provides insurance benefits, either through the fund or on a self-standing basis. FundsAtWork offers members Family Protector on bundled schemes, which gives all members access to funeral, education and health benefits. Members leaving FundsAtWork can receive their withdrawal benefit in cash a day after they leave employment. Yusuf Nanabhay Head: Product Development Momentum Employee Benefits: FundsAtWork Tel yusuf.nanabhay@momentum.co.za