Don’t let the default option lead you to a false sense of security
A default plan doesn’t consider a retiree’s personal circumstances, and there’s a risk that it’ll severely under-perform your growth.
Every independent financial planner has stories to share of being approached by meeting new clients who have a few months to go before retirement. They usually have a worried look and a lot of questions about how to invest their life savings. Could the new default option change that?
The new default option came into effect at the start of the new tax year (March 1 2019) and states that every pension fund should have a default investment portfolio that contributing members could belong to if they do not want to make personal choices about how to invest their funds.
For this to make sense to people who aren’t close to retirement, you should remember that on retirement you are required to make a decision on how you will further invest your pension to make sure it can look after you during retirement.
This decision is the result of changes to the way in which a pension fund provides income after retirement. This has changed from defined benefits to defined contributions.
Over the past three decades, South Africa has moved from a defined benefit system to a defined contribution model. The former required the retirement funds, or their insurers, to pay pensions to individuals for life. The latter moves the focus to the individual and requires them to use the accumulated balance of their savings to provide and income for themselves when they retire.
In the case of defined contributions, the Income Tax Act (1962, as amended) compels the pension fund and its holders to use at least two-thirds of their accumulated fund balances to buy annuities. This is referred to as mandatory annuitisation.
The mandatory annuitisation and the overall decision on how to use your accumulated funds is usually done in partnership with a financial advisor. In partnership, you will decide how to invest your funds, which annuities to purchase, if you should use some of your funds for other uses, such as cleaning up some debt, and how much you will earn on a monthly basis.
This process can be daunting, because many people on the cusp of retirement feel overwhelmed with the options and with the prospect of making their savings last for the rest of their lives. There is also a question of trust, as many people have found that their advisor had limited knowledge of retirement planning and simply sold them a standard, off-the-shelf investment product that could not sustain them through retirement.
Indeed, this feeling of being overwhelmed by the number of options and by the responsibility of caring for yourself and your family after retirement is part of the reason why, based on research by Just SA, over 86% of people between the age of 55 and 85 prefer a guaranteed income for life, rather than to more actively manage their funds. Yet, recent research by the Association for Savings South Africa (ASISA) show that in contrast to these wishes, over 90% of retirees purchase living annuities.
With this in mind, the Finance Ministry introduced the new Default Regulations. These regulations state that every single retirement fund should have a default option that is reasonably well priced, offers acceptable value for money and is communicated well to all members.
There are some additional regulations on how funds can levy fees and how trustees should monitor the portfolios in which the pension fund invests, but the ultimate decision on how to structure the default pension option is in the hands of each pension fund.
Keep in mind that to make use of this default option, you are still required to make a decision and communicate it to your pension fund. The pension fund cannot simply transfer your savings into this option if it does not hear from you or you do not make a decision.
While the default option may be the saving grace of pensioners who in the past fell prey to unscrupulous ‘advisors’ who simply regarded them as customers for his or her standard pension products, it should not be seen as the best or only option. As with any one-size-fits-all option, it does not consider individual life-stages, personal preferences or your own financial needs.
Not only does a default plan not consider a retiree’s personal circumstances, there is also a risk that it will severely underperform your growth when you make wise financial planning decisions.
For instance, research from the independent research analysts Morningstar, show that sound financial planning that focus on asset allocation, the withdraw strategy, guaranteed income products, tax-efficient allocation and portfolio optimisation will generate as much as 29% more, on average, for a retiree.
So, when it comes to planning for retirement and deciding how to invest your pension, consider the default option alongside all the other available options with the help of an independent Certified Financial Planner (CFP®), who is held to high ethical and professional standards, and if he/she is truly independent, you will receive sound advice and access to a variety of available options in the market.
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