Retiring from your company pension fund is a major milestone, and the decisions you make at this stage are crucial to ensuring your savings last for the rest of your life. As you approach retirement, you might wonder how to navigate the process, secure a sustainable income, manage taxes, and align your investments with your risk tolerance. In this article, we will walk through the steps of formal retirement planning, using a hypothetical example of R12 million in your company pension fund to illustrate the key considerations.
1. Taking a Cash Lump Sum and Its Tax Implications
Upon retirement, you have the option to take up to one-third of your pension fund as a cash lump sum. The remaining two-thirds must be used to purchase an annuity, providing you with regular income during your retirement. For this scenario, we’ll explore two options: one where you withdraw the maximum one-third of R4 million, and another where you withdraw only the tax-free R550,000.
Option 1: Withdrawing R4 Million (One-Third)
Here’s how the tax works if you withdraw R4 million as a lump sum:
Taxable Income (R) Rate of Tax (R)
1 – 550,000 0% of taxable income
550,001 – 770,000 18% of taxable income above 550,000
770,001 – 1,155,000 39,600 + 27% of taxable income above 770,000
1,155,001 and above 143,550 + 36% of taxable income above 1,155,000
For the R4 million lump sum:
• The first R550,000 is tax-free.
• R220,000 (from R550,001 to R770,000) is taxed at 18% = R39,600.
• R385,000 (from R770,001 to R1,155,000) is taxed at 27% = R103,950.
• The remaining R2,845,000 (from R1,155,001 to R4,000,000) is taxed at 36% = R1,024,200.
Total tax owed = R1,167,750, leaving you with R2,832,250 from the R4 million lump sum after taxes.
Option 2: Withdrawing Only R550,000 (Tax-Free)
If you withdraw only R550,000, this amount falls within the tax-free bracket, meaning you pay zero tax on the lump sum.
In this case:
• The entire R550,000 will be paid out to you tax-free.
This leaves the remaining R11,450,000 in your retirement fund to purchase an annuity, which will generate your monthly income in retirement.
Comparison of Tax Implications
Option Lump Sum Withdrawn Tax Payable After-Tax Lump Sum
Option 1: Withdrawing R4 million R4,000,000 R1,167,750 R2,832,250
Option 2: Withdrawing R550,000 R550,000 R0 R550,000
By withdrawing only R550,000, you avoid paying any tax, whereas withdrawing the full one-third (R4 million) results in a tax payment of R1,167,750.
Key Takeaway: If you do not need a large immediate lump sum, withdrawing only the tax-free R550,000 could be a more tax-efficient option. This would allow more of your pension fund to remain invested for long-term income generation.
Disclaimer: Kindly note that the tax table applicable to this calculation is subject to change at the start of every tax year. In preparing the calculation above, we have assumed that you have not made any previous withdrawals from a retirement fund.
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2. Purchasing an Annuity: Living or Life?
Since you have chosen Option 2 and withdrawn only R550,000, the remaining R11,450,000 of your pension fund must be used to purchase an annuity, which will provide you with regular income throughout your retirement. You have two main options for annuities:
• Living Annuity: A living annuity gives you the flexibility to control how your money is invested and how much income you wish to draw each year (between 2.5% and 17.5% of your capital annually). However, your income will fluctuate based on investment performance, and you can leave the remaining funds to your beneficiaries.
• Life Annuity: A life annuity provides a guaranteed income for the rest of your life, no matter how long you live or how the market performs. You lose control over the investments, and there may not be any remaining capital to leave to beneficiaries.
Tax on Annuity Withdrawals
The income you draw from a living or life annuity is taxable and will be taxed at your marginal tax rate. Therefore, managing your annuity withdrawals efficiently is important to minimize tax implications while meeting your income needs.
For the purpose of this scenario, we’ll assume the person opted for a Living Annuity. The next crucial step is determining how much income you can withdraw.
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3. Income Planning: The Process and Factors to Consider
Income planning is one of the most critical aspects of retirement, as it involves determining how much you can safely withdraw from your retirement savings to maintain your lifestyle without running out of money. The 4% rule is a helpful starting point. Still, it’s essential to recognize that every retiree’s situation is unique, and several factors influence how much you can afford to withdraw each year. Let’s break down the income planning process and critical factors to consider when making this decision.
A. Current and Future Expenses
• Assessing Your Needs: The first step in income planning is understanding your monthly and annual expenses. These include essential costs (housing, utilities, groceries, medical aid) and discretionary spending (travel, hobbies, dining out). Creating a realistic budget is essential.
• Adjusting for Inflation: Inflation erodes purchasing power over time. It’s important to account for rising costs, particularly in areas such as healthcare, which typically outpace general inflation.
• Future Lifestyle Changes: Think about any significant lifestyle changes in retirement, such as moving to a new home, starting a business, or embarking on long-term travel, and how these could impact your budget in the long run.
B. Life Expectancy and Longevity Risk
• Estimating How Long You’ll Need Income: People live longer, increasing the risk of outliving savings. Consider your family history, health status, and lifestyle when estimating your life expectancy. The longer you expect to live, the more conservatively you may want to plan your withdrawals.
• Planning for Longevity Risk: To mitigate the risk of outliving your money, you may want to be more conservative with your withdrawal rate, especially in the early retirement years.
The Role of the 4% Rule
While the 4% rule provides a general guideline for sustainable withdrawals, it’s not a one-size-fits-all solution. Here’s why it’s useful, but also why it needs to be tailored to your specific circumstances:
• R11,450,000 Example: Using the 4% rule, 4% of R11,450,000 = R458,000 per year, or about R38,166 per month. Under normal market conditions, this withdrawal rate should allow your capital to last for 30 years or more.
However, factors like higher-than-expected inflation, lower-than-expected investment returns, or unexpected healthcare costs could require adjusting this rate.
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4. Risk Profiling and Asset Allocation: Making Your Money Work for You
When investing your retirement savings, it's crucial to understand how much risk you're comfortable with and how to spread your investments across different assets. This is called risk profiling, and it helps determine how to divide your money between various types of investments, including property and geographic regions.
What is Risk Profiling?
Your risk profile measures how much risk you're willing to take with your investments. Some people are comfortable taking bigger risks for higher potential returns, while others prefer safer options that provide stability, even if it means lower growth.
• Low Risk (Conservative): You prefer safer investments that protect your savings. Your portfolio will mainly include low-risk assets like bonds or cash. These investments grow slowly but are less likely to lose value.
• Moderate Risk (Balanced): You’re okay with some risk for the chance of more growth. A balanced portfolio includes a mix of bonds, stocks, and maybe some property, balancing safety and growth.
• High Risk (Aggressive): You’re comfortable taking bigger risks, like investing heavily in stocks or property. These have the potential for higher returns but come with more volatility.
What is Asset Allocation?
Once you understand your risk profile, the next step is asset allocation—deciding how to split your money between different types of investments. Common asset types include:
• Stocks (Equities): Higher-risk investments that offer the potential for substantial growth over time.
• Bonds: Safer, providing a steady return but with lower growth potential.
• Cash: The safest option but offers the lowest returns, mainly used to cover short-term needs or emergencies.
• Property: Depending on the type, investing in property offers medium-to-high risk, but it can generate rental income and long-term capital growth.
For example:
• A conservative portfolio might have 70% in bonds, 20% in stocks, and 10% in cash.
• A balanced portfolio might include 50% stocks, 30% bonds, and 20% property.
• An aggressive portfolio could consist of 60% stocks, 20% property, and 20% bonds.
Geographic Allocation: Diversifying Across Regions
Another crucial part of asset allocation is spreading your investments across different geographic regions. By diversifying where your investments are located, you reduce the risk of being too dependent on the economic conditions of one country or region.
• Local Investments: Investing in South African stocks, bonds, or property can feel familiar, but it ties your returns to the local economy. If South Africa faces economic struggles, your portfolio might be at risk.
• International Investments: Investing in international markets—like stocks in the US, Europe, or Asia—allows you to benefit from global growth and spread risk across different economies.
For instance, a conservative investor might allocate 80% of their portfolio to South African assets and 20% internationally. A more aggressive investor could have 50% locally and 50% internationally, taking advantage of growth opportunities in global markets.
Why This Matters
Finding the right balance between risk and reward is essential for making your money last through retirement. If you take on too much risk, you could lose a significant portion of your savings in a market downturn. On the other hand, if you’re too conservative, your money might not grow fast enough to keep up with inflation, meaning your savings lose value over time.
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5. The Formal Retirement Process: Step-by-Step
Once you’ve decided on how much of your pension to withdraw, selected an annuity, and decided on your asset allocation and where you will invest, the next step is the formal retirement process. Your financial advisor will coordinate this with your retirement fund service provider. Here’s how the process works:
• Tax Simulation: Your financial advisor will request a tax simulation to confirm that no tax will be owed on your R550,000 lump sum withdrawal. This ensures there are no unexpected surprises when the funds are disbursed.
• Submit Application: Once the tax simulation is complete, you’ll need to formally apply to retire from your pension fund. This includes specifying how much of your pension you want to withdraw and where the remaining funds will be allocated (i.e., the living or life annuity).
• Tax Clearance: Your retirement fund provider will request a tax clearance certificate from SARS (South African Revenue Service). This step should proceed smoothly since you’re taking only the tax-free R550,000.
• Final Payment and Transfer: Once tax clearance is granted, your lump sum (R550,000) will be paid into your bank account, and the remaining R11,450,000 will be transferred to your chosen annuity provider.
The entire retirement process, including payments and transfers, can take four to six weeks.
To avoid any cash flow issues during this period, ensure you have enough liquid funds available to cover your living expenses until your lump sum and annuity payments come through.
Conclusion
While it’s possible to navigate the retirement process on your own, there are many moving parts to consider—managing taxes, choosing the right annuity, setting up a sustainable withdrawal plan, and deciding on your risk profile and asset allocation. These decisions can significantly impact your financial security throughout retirement. To ensure you make the best choices tailored to your needs, it’s advisable to consult a professional financial planner who can guide you through this process, help you avoid costly mistakes, and provide a strategy that maximizes your retirement savings for the long term.
Family Wealth Custodians (Pty) Ltd is an authorized financial services provider FSP no 52843.
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