By: Carmen Forster
The Income Tax Act, Act No 24 of 1981 (the ITA) indicates how retirement benefits are to be taxed when a member retires.
If the member is retiring from a provident fund, he/she may choose to receive up to one-third of his/her retirement benefit as a tax-free cash lump sum. The remaining two-thirds of the benefit may also be taken as a cash lump sum but will be taxed at the member’s marginal tax rate.
Being able to take their entire retirement benefit as a lump sum has historically been a practical solution for employees who plan to retire in remote areas where banking facilities were limited or non-existent and who intend to supplement their retirement income by subsistence farming. There is, however, a risk that the retiree might splurge their retirement savings on items that provide for short-term rather than long-term benefits and they become reliant on the Pillar 0 universal old age pension, the Basic Social Grant, within five to ten years of retirement.
The South African government, which also allows for provident fund retirement benefits to be paid as a lump sum benefit, has decided to reduce the likelihood of this occurring by commencing with the process of phasing out provident funds as of 1 March 2021. The protection of vested rights pertaining to contributions paid prior to the 1st of March 2021 has, however, been allowed for.
FIMA may also signal the end of provident funds in Namibia as it provides for full annuitisation of retirement benefits and no provision appears to have been made for vested rights.
If the member is retiring from a pension fund, he/she may take up to one-third of his/her retirement benefit as a tax-free lump sum but must use the remaining two-thirds to purchase an annuity if the retirement benefit is more than N$50 000. The monthly income sourced from the annuity is taxed at the annuitant’s marginal tax rate.
Traditionally, a retiree would use his/her retirement benefit to purchase a monthly income, that is payable for the remainder of his/her life, from an insurer. There are several variations of these guaranteed/life annuities, including the following:
- The provision for a pension to be paid to the annuitant’s spouse once the annuitant has passed away;
- The manner in which the income derived from the annuity increases on an annual basis; and
- The implementation of a guarantee period during which the annuity benefit will continue to be paid, even if the annuitant passes away during this period.
The insurer carries the longevity and investment risk related to the life annuity. This means that the insurer must continue to pay the annuitant a monthly pension until he/she passes away (even if the annuitant lives to a very old age). The benefit paid cannot be reduced and any fixed annual pension increases that were allowed for in the annuity contract must be paid even if stock markets perform poorly. When the annuitant passes away, any remaining capital remains with the insurer.
Since the late 1990s, retirees have been opting for an alternative annuity product, namely the living annuity. This type of annuity provides the annuitant with more flexibility regarding the amount of income that will be paid to him/her in a particular year. The ITA indicates that the income that is drawn in a particular year must be a percentage equal to between 5% and 20% of the capital value of the living annuity. When the annuitant passes away, the remaining capital value of the annuity is payable to his/her dependents.
Living annuities are popular due to their income flexibility and legacy benefits. It is, however, important to understand that the annuitant bears longevity and investment risk with respect to this product. This means that if the annuitant draws a high proportion of the living annuity capital in the early years of retirement, returns earned are poor and/or the annuitant lives for a long time after retirement, the living annuitant may have to rely on the Basic Social Grant or other sources of income to supplement the dwindling income sourced from the living annuity.
One area of reform that could improve the long-term outlook for living annuities would be for the ITA to be amended such that the living annuity capital withdrawal limits are reduced. For example, South Africa has reduced their living annuity withdrawal limits so that they range between 2.5% and 17.5% rather than between 5% and 20%.
Pillar 2 Retirement Reform
Since Pillar 2 plays a significant role in Namibian retirement funding, it will be a focal point in any retirement reforms that the government plans to introduce. The current system has many merits, including the tax incentives and the well managed retirement fund structures, but the lack of compulsory preservation does reduce the likelihood that a member will be able to accrue enough retirement savings to provide for a reasonable level of income after retirement.
Any change the government introduces that is perceived to reduce freedom of choice is likely to be met with opposition. Namibians are, however, more likely to be supportive of these changes if they are not deemed to be overly harsh and the vested rights of benefits accrued prior to the implementation of FIMA are acknowledged. Changes are also likely to be supported if the long-term implications of contributing very low amounts towards retirement savings and/or withdrawing retirement benefits prior to retirement are understood. This educational process is an area in which the retirement fund industry should play an active role.
Carmen Forster is the Head of Production Development & Client Retention (Corporate Segment) at Old Mutual Namibia