Keeping pot full for workers before and after retirement

Recent amendments to regulation 28 which governs how pension funds invest retirement savings of working South Africans, when combined with the draft proposals commonly called the two-pot system, is a structural positive change for the retirement landscape, investments and the economy over the long term.

These reforms demonstrate that bold decisions to make the economy fit for purpose are being made, and they must be supported by all stakeholders.

There are three historical policy contentions related to these two regulations.

The first aspect related to low economic growth due to low investment is prescribed assets, which was hotly debated in 2017. The argument was pension funds must be forced by law to invest in infrastructure to boost economic growth and job creation.

The challenge was infrastructure that was not receiving investment funds was not investible, hence employees would likely experience negative returns from their investments. The historical experience with prescribed assets is that investment returns were negative.   

The second aspect related to the two-pot system is low preservation rates for workers contributing to pension funds.

Alexforbes Member Insights data shows that only 9% of members of retirement funds preserved their retirement savings when changing jobs or resigning from jobs. Of those who preserved, 48% of the assets were preserved.

The result of this is that workers can replace only 31.5% of their income in post-retirement. This will necessitate an abrupt adjustment in lifestyle, having to move from a life financed by 100% income during working life to a lifestyle based on 31.5% in post-retirement.

It’s an adjustment that few will be able to make, without reducing their quality of life. Of all workers contributing to pension funds, only 6% can expect to retire with more than 75% of their pensionable salaries.

In a properly designed and efficient pension fund system, workers who contribute funds must retire with sufficient income, closer to 75% of their pre-retirement income, and must never need to be on the state’s old-age grant system.

The third aspect is the vulnerability that workers have to economic shocks such as the Covid-19 pandemic or huge loss of income in the family due to  life eventualities such as death, retrenchments or permanent disability of breadwinners.

In such instances, there is often a need for short-term access to funds, which most workers would not have. The majority of workers do not have sufficient emergency funds readily available, which leave retirement savings as the only funds that can be accessible.

Workers resort to resigning from their jobs to cash in their retirement savings to deal with these shocks in their lives. They lose all the tax benefits of retirement contributions and most likely use all the funds beyond what they need to deal with the economic shocks, ending up with too little for their retirement.

This is what the two-pot system tries to solve by creating a new structure for pension fund contributions. All the retirement fund contributions made until February 28 2023, the last day before the two-pot system comes into effect, will be ring-fenced for a vested pot.

Existing rules of access will continue to apply for this pot where workers can choose to cash in their retirement savings when they change or resign from jobs, but will attract the associated tax obligations.

From March 1 2023, all contributions will be split into two pots, a savings pot and a retirement pot. Up to one third of the contributions will be directed into the savings pot, which workers can access once in a 12-month cycle, provided the balance is a minimum of R2,000, and will be taxed at their marginal tax rates as this amount will be classified as income within that tax year.

This provides a solution for workers who experience shocks and need access to funds without having to resign or change jobs. This is not intended to be a normal savings vehicle, it is a retirement savings instrument that responds to a section of workers who cannot put in place usual emergency savings.

The second pot, the retirement pot, is where a minimum of two-thirds of contributions will be made. This pot will not be accessible until retirement and all the savings in it will be annuitised, that is, converted into a monthly income while in retirement.

If a worker withdraws all the income in their savings pot throughout their working life, the income replacement doubles when compared with the current 31.5%, which means that the worker will be closer to the 75% ideal income ratio at retirement, which now only 6% are achieving. This is a game-changer for individual retirement incomes.

 There is more upside from an investment perspective. Part of the reason there is low investment in infrastructure is the need for liquidity. As workers can withdraw their pension savings before retirement when they resign or change jobs, there is a greater need for liquidity in the investments that can be made.

However, with a minimum of two-thirds of retirement contributions saved into the retirement pot preserved over the entire working life, for instance 40 years, the need for high liquidity reduces. This mean that pension funds can now invest in infrastructure that boosts economic growth and jobs for those outside the labour market.

 Overall, the amendment in regulation 28 of the Pension Fund Act and the proposed draft legislation for retirement savings are a structural positive change for individual retirement income goals and for broader economic development goals.

Workers will retire with at least double the income replacement ratios compared with existing arrangements and will have access to 30% of their retirement income to help in times of economic shocks.

Pension funds have access to patient capital with which to make long-term investments into infrastructure without higher liquidity requirements. 

A social compact under discussion must embrace and support these changes, which are positive, especially when marginal short-term benefits are compared to the significant long-term impact.