Introduction
The two-pot retirement system addresses the financial challenges faced by many South Africans, but also aims to improve the preservation of retirement savings. It breaks from the traditional model where retirement savings are only fully accessible when members change jobs or when they retire. Instead, they will have access to a portion of their retirement savings without having to resign from their jobs and preserve the rest until retirement. This two-pot retirement system will come into effect on 1 September 2024.
Under the two-pot retirement system, retirement savings will be divided into three components.
Vested component: will be a member’s accumulated retirement savings on 31 August 2024. This amount will be reduced by a one-time transfer, known as the seeded amount. This component will continue to operate under the current retirement framework. No further contributions will be allocated to this component after the implementation date, but it will still grow with investment returns.
Savings component: one-third of a member’s retirement contributions will be allocated to this component from 1 September 2024. Existing retirement fund members will have a once-off compulsory transfer of 10% of the money in their retirement savings on 31 August 2023, or R30 000, whichever is lower to their savings component. Withdrawals from the savings component are allowed once per tax year, with a minimum withdrawal amount of R2 000, before fees and taxes. These withdrawals will be taxed at a member’s marginal tax rate.
Retirement component: the remaining two-thirds of a member’s retirement contributions will be allocated to this component from 1 September 2024. This component cannot be accessed when a member resigns, only when they retire. The money must be used to buy an annuity unless the accumulated amount falls below the legislated minimum value.
While the two-pot retirement system is designed to improve the preservation of retirement savings by restricting members’ access to their full retirement savings amount when changing jobs, it is important that they understand the long-term impact of investment decisions and savings withdrawals on their retirement outcomes.
The Impact of Pre-Retirement Withdrawals
Retirement fund members must balance their long-term investment goals against their short-term needs and risk tolerance for investment market volatility. To maintain their standard of living during retirement, members are advised to aim for a net income replacement ratio of at least 75% during retirement. The net income replacement ratio calculates the income of the member in the year after retirement, divided by the salary in the year before retirement, to measure the standard of living in retirement. A ratio between 70% and 80% of pre-retirement income is typically considered sufficient to maintain a member’s standard of living, but can vary based on their personal circumstances, including their health, debt, and lifestyle choices.
This example demonstrates the impact of savings withdrawals on a member’s net income replacement ratio: Jared, who starts saving for retirement at age 25, earns a monthly salary of R20,000. He plans to retire at age 65. Assuming his salary grows by 6,1% annually before age 45 and by 5,4% annually after age 45, with an assumed inflation rate of 5%, his income effectively increases by 1,1% and 0,4% annually in real terms during each of these periods respectively. Jared contributes 15% of his gross salary towards his retirement savings and chooses to invest these savings in a growth portfolio with a real return of 5% per annum after fees. At the start of his retirement, he plans to draw down 5% annually from a living annuity. After 10 years, the two-pot system is introduced. Jared now needs to decide how he will invest the money in his savings component. He can either continue investing in the growth portfolio or choose a more stable money market portfolio, which serves as a safety net for unexpected financial needs. The money market portfolio generates a real return of 1% per annum after fees.
Consider the following scenarios:
Scenario 1: Jared decides to continue to invest the money in his savings component in the same growth portfolio as before and does not withdraw from his savings component before retirement. By maintaining this strategy, he stays invested in a growth portfolio until he retires. At retirement, Jared can buy his desired living annuity, resulting in a replacement ratio of 78%.
Scenario 2: Jared decides to invest the money in his savings component in a money market portfolio, serving as a safeguard for unexpected financial needs. Fortunately, Jared doesn’t have a situation that requires him to withdraw money from his savings component. On retirement, Jared can buy his desired living annuity, resulting in a replacement ratio of 70%.
Scenario 3: Jared decides to invest the money in his savings component in a money market portfolio, and every tax year until retirement, withdraws the entire amount available in his savings component. On retirement, Jared can buy his desired living annuity, resulting in a replacement ratio of 61%.
By investing the money in his savings component in a money market portfolio, Jared can buy a living annuity that will result in a replacement ratio of 70% at retirement. This replacement ratio is 8% lower than if he had invested his money into a growth portfolio, highlighting the long-term impact of having less exposure to growth assets. If Jared decides to withdraw money from his savings component before retirement, the situation worsens, resulting in a net income replacement ratio that is 17% lower compared to what he could have achieved by staying invested for the long-term and benefiting from exposure to growth assets. These scenarios demonstrate how Jared’s investment choices and behaviour can materially change his income and standard of living during retirement.
In Closing
The two-pot retirement system recognises the financial challenges that many South Africans who are saving for retirement face. It also attempts to enhance the preservation of their retirement savings. In contrast to the current retirement system, which gives members the option to access all their retirement savings amount if they leave their employment, the retirement reform wants to achieve this by allowing members limited access to their retirement savings while they are still employed. It is important that members understand the consequences of withdrawing from their savings component on their long-term retirement outcomes. The scenarios show the significant impact that investment decisions and withdrawing from the savings component can have on post-retirement income. They also highlight the importance of making informed decisions and long-term financial planning to maintain an adequate standard of living during retirement. As the two-pot retirement system takes effect, members must carefully consider these factors and discuss with their financial adviser to ensure a financially secure retirement.
Disclaimer: This blog is for general information and education only. It does not constitute advice (financial or otherwise) and should not be relied upon as such. I am not licensed to provide financial advice. The content may contain errors or omissions and is provided without any guarantee of accuracy or completeness. No liability is accepted for any loss or damage arising from reliance on this content. For advice tailored to your circumstances, please consult a registered financial advisor.