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ARE YOU DUE TO RETIRE?

PART 1

If you are due to retire from your employer’s retirement fund, you will be required to make some decisions that will determine the course of your life in retirement. Worse, some of your decisions may be irreversible once you have affixed your signature to paper and you may live to regret your decision for the rest of your life. So be certain that you are fully and properly informed and that you do understand the implications and the underlying principles of the choices you are required to make! Rather spend some money on expert advice!

To assist those that are about to retire, Mathinuz Fabianus, administration manager of Retirement Fund Solutions and trustee of the Benchmark Retirement Fund will offer some unbiased advice in this and further articles. You may also contact Tilman Friedrich, Mark Gustafsson or Hannes van Tonder.

Preliminary Considerations and Principles

As a member of a retirement fund it is important that you are fully appraised of the options available to you upon retirement in terms of the rules of your fund. It is therefore essential that you obtain a copy of the relevant sections of the rules that deal with retirement from your employer or your fund or that you at least obtain a summary of the benefits offered by your fund. Rules are mostly very technical documents that are difficult to understand and it would be wise to approach an expert to assist you if you feel overwhelmed by what you read.

Retirement entails a number of important consequences, most obvious being the fact that your regular monthly income will fall away. Most likely some work related regular expenditure will also fall away but it is important that you have a clear understanding of your position. Again rather call on expert assistance if you are not certain how to approach this! In addition, the death and disability benefits offered by your pension fund will fall away. Sometimes the manner in which you retire determines whether or not the employer will continue to subsidise medical aid contributions. Often ongoing employer subsidization of post retirement medical aid contributions is dependent on your continued membership of the employer’s pension fund. You need to ensure that you are aware of the arrangements in this regard. Of course the psychological effect of retirement should also not be ignored and you are well advised to ensure that you have a goal and a meaningful occupation after retirement that continue to present a challenge to you.

At the time of retirement, a fund member usually has the option to purchase a pension of his or her choice from any Namibian insurance company or other approved fund. Some funds would however require that this happens one month prior to reaching normal retirement age and stipulate that once a person has reached normal retirement age the only option left, is to arrange a pension with that fund. Please enquire in good time whether or not this applies to your fund and what the implications would be in case of leaving your fund one month prior to reaching normal retirement age in terms of continuation of any benefits and continued subsidization of medical aid contributions, as referred to in the previous paragraph.

When you reach retirement age a pension fund will allow you to have one-third of your retirement capital paid out to you in cash, tax free (provident funds allow you to take your full retirement capital in cash, but two-thirds of this amount will be subject to income tax). You will be required to purchase a pension with the remaining two-thirds of your retirement capital which will be taxed as if it were a salary. Normally it is not appropriate to use your full retirement capital to purchase a pension since you will convert the tax free lump sum (one-third) into a taxed pension.

If you do not have any need for an income from your retirement capital at the time of retirement, and provided the rules of your fund allow you to do this, the capital can be ‘warehoused’ in a preservation fund or a retirement annuity fund until the need for a regular income arises.

PART 2: How Secure is Your Pension Capital?

As a prudent investor you should ask how secure your investment in a pension fund is. Well to put your mind at ease right at the outset, you will find it very difficult to invest in a more secure environment than a pension fund. And this applies to every pension fund independent of its size. Firstly, the Pension Funds Act and various regulations made in terms of the Act are all designed to protect the interests of the public in many different ways. A special government agency, the Registrar of Pension Funds, is tasked with the job to supervise and regulate the pensions industry and to ensure that the interests of the public are properly safe guarded.

A pension fund is a legal entity with its own identity, separate from the employer and sponsor. A pension fund has to be audited and has to submit audited annual financial statements and other detailed information to the Registrar of Pension Funds every year within 6 months of the end of its financial year. Additional peace of mind is often provided by means of annual or triennial actuarial investigations into the financial position of the fund by an actuary who is a highly specialized professional in the pensions field.

The Pension Funds Act also protects members’ retirement capital against members’ own financial imprudence and protects retirement capital from attempts by creditors to secure their debt with your retirement capital whether with or against your own wishes. So whatever your or your employer’s financial position may be, your retirement capital enjoys special statutory protection. Members are often concerned about their fund’s ability to pay for large benefits often offered by funds, particularly in the event of death. Well, any benefit offered by your fund that is not based on your own accumulated retirement capital has to be secured by means of an insurance policy taken out with a local insurance company and the payment of such benefits will not impact on the fund’s financial position or its ability to meet your retirement promise. Of course, if your own accumulated retirement capital is exposed to the wild fluctuations of financial markets you will find that your capital will increase and decline in accordance with movements in these markets.

Pension fund assets are by law required to be invested fairly conservatively as a result of which the risk to which your capital is exposed, is relatively moderate, even in the most risky market linked portfolios. This is evidenced by the fact that most investment managers in this category invest in anything between 25 and 70 different, generally only the more prominent and well known shares, with a maximum exposure to any single share of 15% of the fund’s capital. The total invested in equities by any fund is limited to 75% of its assets in terms of the Pension Funds Act, the balance being required to be invested in property, bonds, treasury bills, cash and other assets. Similarly to the limitation of an investment in one specific share, investment in a single property or bank is limited to a certain maximum. So your retirement capital is spread widely between different asset classes and between different investments. Compliance with these prescribed limits is typically managed by the fund’s investment manager, verified by the fund’s auditor and supervised by the Registrar of Pension Funds.

PART 3: How is Your Pension Capital Invested And Taxed?

The Income Tax Act provides for a uniquely favourable tax regime for pension funds. You will be aware that your contributions to your pension fund are deducted from your income before determining the taxable portion of your income. Similarly, your employer’s contributions are offset against its income before determining the taxable portion thereof. Once invested in the pension fund all investment returns earned by your fund accumulate tax free, since pension funds are tax exempt entities. Lastly when benefits become due, the Income Tax Act provides for very favourable tax treatment of the benefits.

Pensions purchased from a registered long-term insurer or another approved fund in Namibia will remain a Namibia domiciled and Namibia Dollar denominated pension. Current legislation allows a maximum investment outside Namibia of 65% of the fund’s total capital, including a maximum of 20% of total capital that may be invested offshore. Most insurers do make use of this concession. Pension funds are currently not taxed in Namibia and should thus achieve superior returns compared to South African funds. This is not the case in the RSA where retirement funds are subject to Retirement Funds Tax. The effect of Retirement Funds Tax in the RSA is typically between 1% and 2% of capital invested. South Africa recently introduced capital gains tax which should also have a negative impact on investment returns. These disadvantages of a South Africa sourced pension must be tempered by the generally higher inflation and lower interest rates prevailing in Namibia though.

How is the Level of Your Pension Determined

As a layman you might believe that insurance companies use some fancy but secret formula to determine the level of pension that will be paid to you. This is actually not the case and it is in fact a pretty simple amortization calculation. The simple principle is that you lend your capital to the insurance company, which will repay the capital to you over the remainder of your life. Of course no one knows how long you will live nor what investment returns your capital will earn. The insurance company will therefore have to place reliance on statistics as regards life expectancy and will have to make assumptions as regards future investment returns. With these inputs and a financial calculator it is then fairly simple to calculate the rate at which your loan to the insurance company will be amortised (or repaid). Since every insurer maintains its own life expectancy statistics and makes its own assumptions concerning future investment returns you will find that every insurer will quote a different pension.

PART 4: The Pooled Pension (part 1)

Firstly the more common arrangement, often referred to as ‘pooled pension’, provides either for a guaranteed income for your life whatever happens, or alternatively for a guaranteed income for your life and the life of another nominated person who would continue to receive an income for his or her life, whatever happens, once the pensioner has passed away. The ‘pooled pension’ is only offered by insurance companies. The pensioner’s retirement capital is paid into a pensioners’ pool and loses its identity. The income can usually provide for an annual increase of 5%, 10% or 15% as desired and this increase will also be applicable to the dependant or spouse that is nominated to continue receiving a pension after the death of the pensioner. Where provision is made for another nominated person to receive a pension for life following the death of the pensioner, the spouse’s or dependant’s pension needs to be determined as a fixed percentage (normally 50%, 66%, 75% or 100%) of the pensioner’s pension upon death of the pensioner, before retirement. The pooled pension furthermore offers a choice of a so-called ‘guarantee period’ of 5, 10 and up to 15 years, following date of retirement. This means that in the event of death of everyone that was provided for to receive a pension for life prior to the expiry of the ‘guarantee period’, the pension will continue to be paid up to expiry of the ‘guarantee period’. Once the last pension has been paid in terms of the original arrangement, the insurer’s obligations are extinguished and no further capital will be paid out by the relevant insurance company.

The principle of this arrangement is that the insurance company commits itself contractually to the pension agreed between it and the pensioner at date of retirement, whatever may happen. The risk the insurer is taking upon itself (with regard to the ‘whatever may happen’) is, firstly, that the income earned on the pensioner’s capital is lower than expected and, secondly, that the pensioner and/or his spouse/dependant live longer than expected. Conversely, if the pensioner and/or his wife/dependant died sooner than expected and the investment income was higher than expected, the benefit would accrue to the insurance company at the expense of the pensioner. Obviously, the pensioner loses where the insurance company gains and vice versa. This alternative is the more appropriate alternative for a pensioner who is wholly or mainly dependent on his/her pension income, and whose spouse/dependant is likely to be so, with few or no other sources of post retirement income. It is also recommended for persons with a low risk threshold. This arrangement fixes the contractual conditions of the retiree, for as long as the pensioner and his or her nominated ‘pension successor’ live. We expressly caution the prospective retiree not to enter into this arrangement under abnormally unfavourable market conditions (historically low interest rates), as is currently the case. When such conditions prevail it is advisable to postpone retirement or to initially enter into a ‘living annuity’ arrangement until conditions have normalized, where after one may consider moving into the ‘pooled pension’ arrangement.

The key question whether to opt for the ‘pooled pension’ or for the ‘living annuity pension’, as will be referred to in our next article is whether the pensioner is more concerned about his or her own financial survival, a situation that would favour the ‘pooled pension’ or about the preservation of surplus capital for the heirs, a situation that would require adding a ‘capital preservation’ option as referred to in the next paragraph, or choosing the ‘living annuity’ pension as will be referred to in our next article.

PART 5: The ‘Pooled Pension’ (part 2)

The ‘pooled pension’ also offers a ‘capital preservation’ option, in terms of which the pensioner takes out a life insurance policy that secures repayment of the original pension capital, in the event of death of the pensioner at any time after retirement, at the cost of an insurance premium. Clearly, the risk to the insurance company only increases gradually from date of retirement in accordance with the erosion of the pensioner’s capital as a result of the payment of pensions. Therefore the longer the pensioner survives the less of the original capital will be left and the larger the amount to be borne by the insurance company, and vise versa. In times of high inflation, the real value of a pay-out of the original capital in the event of the death of the pensioner will obviously decline rapidly. The rationale for this option is usually to leave something behind for the pensioner’s heirs and can only be realized through the pensioner sacrificing a portion of his or her pension for the benefit of the heirs, as insurance cover is provided for the gap between the original pension capital received by the insurer and the amortised capital left at date of death of the pensioner.

A distinct disadvantage of the ‘pooled’ pension is the fact that it is not a transparent arrangement and the pensioner will not be appraised of the actual investment returns earned by, or costs recovered from his or her investment in the pool.

The key question whether to opt for the ‘capital preservation’ option in preference to the ‘living annuity pension’ is essentially how risk averse the pensioner is and whether he or she wants to be rid of all future management decisions concerning the retirement capital, where the ‘living annuity pension’ requires a higher level of risk acceptance, and requires ongoing involvement in managing the retirement capital.

Some pooled pension arrangements offer a variation concerning future pension increases. This arrangement may also be considered at times of unusually low interest and inflation rates, as we currently experience. Instead of a contractually fixed annual rate of increase as referred to above, the arrangement offers participation in investment returns in excess of the assumed future investment return that was applied to calculate your initial pension. You will also be able to select amongst a predetermined range of future investment returns that the insurer is to apply when calculating your initial pension. By way of example: If you set 5% as the future investment return to be used, the insurer will apply its statistical assumptions concerning the survival period of every person due to receive a pension in respect of your retirement. Let’s assume this survival period is 10 years, you have retirement capital of N$ 1 million and there are no costs to be taken into account (admittedly a very unrealistic assumption!). With a financial calculator you will be able to confirm a pension of around N$ 10 600 per month and a theoretical capital of N$ 920 000 at the end of the first year. If the actual return for the first year was in fact 10% and not 5%, the capital to be amortised over the remaining survival period of 9 years will now be around N$ 971 400. Your calculator will now give you a pension of around N$ 11 200 as from the start of year 2, some 5.5% higher than your initial pension. If the actual return for the second year is then only 5%, your pension for year 3 will remain unchanged, and so on.

If you want to be given quotes from insurance companies on the basis of a pooled pension, you need to be aware that these quotes are only valid for a maximum of seven days. Should your retirement capital not be received by the insurance company within these seven days, the quote will no longer be valid and your may find that your pension is either less or more than the amount quoted. For this reason there is no purpose in obtaining quotes at an early stage other than to give you a rough indication of the pension you can expect to receive. We therefore suggest that official quotes be obtained, based on your particular needs, around actual retirement or a week thereafter.

PART 6: The ‘Living Annuity’

The less common alternative for arranging a pension in retirement is where a pensioner’s capital is invested in the pensioner’s personal pensions account, often referred to as ‘living annuity’. The capital is thus not paid into a pool where it loses its identity as your retirement capital. In this case, the companies you appoint purely administer the pension payments on the one part and the investment of the retirement capital on the other part, on your behalf. These companies do not carry any risk regarding investment income or your and/or your spouse’s/dependant’s survival. This risk is borne by you. Negative experience in this regard is consequently at your expense while positive experience is to your benefit. You usually have a choice of the level of income to be drawn, between a minimum of 5% and a maximum of 20% of your capital in the pensions account, which can be changed from time to time. In other words, if your retirement capital is N$ 60 000, your minimum pension you may draw in year one will be N$ 12 000 (5% of N$ 60 000), or N$ 1 000 per month, while the maximum pension you may draw in year one will be N$ 48 000 (20% of N$ 60 000) or N$ 4 000 per month. The pension capital remains your property, whatever happens. Should investment returns be lower than the rate of pension drawn by the pensioner or should the pensioner survive beyond his/her statistical life expectancy, the pensioner’s pension may decline rapidly over time, while the converse also holds true. This alternative is the more appropriate alternative for a pensioner who himself, and his spouse/dependant, is not dependent and is unlikely to be dependent, on his/her pension income because of access to other sources of post retirement income. It is also recommended only for persons with a medium to high risk threshold.

Pensioners under this system usually have a choice with regard to the investment portfolio or portfolios within which the capital is to be invested. Future investment returns will essentially be a function of the level or risk you take in terms of the investment portfolios you choose, the skills of the appointed manager/s from time to time and prevailing economic conditions. These products usually offer no guarantees for future investment returns. Risk in the context of the management of pension fund investment portfolios, is usually viewed as the level of volatility of the investment. In this regard a money market portfolio presents no volatility and lowest prospective returns in the long-term. The smoothed bonus portfolio (sometimes also inappropriately referred to as ‘guaranteed portfolio’) offers slightly higher volatility but also potentially higher returns in the long-term. These portfolios declare bonuses annually or biannually in arrears based on the returns generated by the underlying assets. The underlying assets are usually not much different from standard market linked pension fund portfolios but the insurer maintains a reserve from past investment returns to buffer the volatility in financial markets.

An inflation linked portfolio is quite suitable for risk averse pensioners as it also achieves a lower volatility similar to the smoothed bonus portfolio but offers no capital guarantee. Again these portfolios are invested in typical retirement fund assets such as cash, bills, bonds, property and equities. They usually have an investment objective of outpacing inflation by a target percentage, typically between 2% and 6%. Out performance of inflation is usually achieved by adding an increasing proportion of equities to the portfolio in accordance with the targeted higher rate of out performance. Its returns in the long-term, are more directly linked to inflation and should thus be more attractive for the pensioner whose income needs are also usually linked to prevailing inflation, rather than the status of the general economy and investment markets.

In terms of risk/volatility, this portfolio is followed by the multi-manager with yet again higher volatility and potentially higher returns. The multi manager attempts to find the best combination of different managers in one portfolio at all times thereby reducing volatility and leveraging performance above that of the average manager into consistent upper quartile performance, which individual managers will find difficult to achieve consistently.

Comparatively highest volatility and potential returns in the long-term are offered by market linked prudential portfolios. As pointed out in our first article, pension fund assets are by law required to be invested fairly conservatively and the risk referred to, is therefore still relatively moderate, even in the most risky market linked portfolios.

A distinct advantage of the ‘living annuity’ pension, is the fact that it is a totally transparent arrangement and the pensioner should at all times be fully aware of the actual investment returns earned by and costs recovered from his or her investment in the fund.

Living annuities can currently in Namibia be purchased from most pension fund administrators.

PART 7: Conclusion

As a rule of thumb, the pensioner should not risk that portion of your retirement capital on which you depend for your survival and should not invest that portion in the ‘Living Annuity’ but rather in a ‘Pooled Pension’ arrangement. However, it is important to be aware of the prevailing economic conditions at time of retirement since the ‘Pooled Pension’ arrangement will lock you in under prevailing conditions for the rest of your and your survivor’s life. Surplus capital however is probably better invested in the ‘Living Annuity’ arrangement as it is more flexible and any unspent balance is left behind for the benefit of your heirs to be paid out in taxable installments over not less than 5 years, upon your death.

Current long-term interest rates typically applied by insurance companies to determine your initial pension in the ‘Pooled Pension’ arrangement, are around 7% per annum and even lower. This is exceptionally low in historic context and results in exceptionally low pensions for people who are now retiring. It also illustrates the risk inherent in the ‘pooled pension’ arrangement. Should the inflation rate that is currently on a historical low of 6% per annum, increase in future the real value of the pensioner’s pension would decrease very rapidly and is likely to leave the pensioner, whose main source of income is the pension arranged at retirement, destitute within a very short time. Under current conditions we would generally not recommend entering into the ‘pooled pension’ arrangement that locks you in at current interest rate levels and you should either postpone retirement or transfer the capital into a ‘living annuity’ arrangement, at least until the market conditions have normalized, to then consider transferring the remaining capital to the ‘pooled pension’ arrangement at that stage only. Fortunately the ‘living annuity’ arrangement normally offers this flexibility but be sure that your preferred alternative does indeed offer this flexibility.