A Two Pot Retirement System…The Lesser of Two Evils

South Africa is facing its own cost of living crisis and many retirement fund members are experiencing a daily battle of meeting basic needs while continuing to accumulate savings for their old age through monthly contributions to their employer’s retirement fund. This financial paradox has been causing fund members to resign from their jobs, in many cases with no prospects of alternative employment, to access their retirement savings and lessen their debt burden while trying to make ends meet.

One of the key objectives of the government’s Retirement Reform program is to encourage employees to save and provide adequately for retirement to ensure that they retire with sufficient savings and income to last them during their lives in retirement. Despite this noble objective, National Treasury recognises the financial crisis many fund members are facing and proposes a potential avenue to provide members with controlled access to their retirement savings. 

National Treasury first published its draft two-pot retirement legislation for comment on 31 July 2022, with a target implementation date of 1 March 2023, which many viewed as too optimistic. On 20 September, Treasury addressed the National Assembly’s Standing Committee on Finance, on comments relating to the 2022 Draft Revenue Laws Amendment Bill, which amends the Income Tax Act and will allow for the creation of the two-pot system. During its address, Treasury proposed amending the draft two-pot retirement legislation to clear up several grey areas identified by stakeholders in the retirement fund industry. One of these included the postponement of the implementation date of the two-pot system to 01 March 2024.

The two…. three pot system

With the introduction of the two-pot system, all existing retirement fund members will effectively end up with three retirement pots, being the vested pot, the savings pot and the retirement pot. All retirement savings accumulated up to the date when the proposed two-pot legislation takes effect will be classified as their vested benefits. The current conditions attached to these vested benefits are expected to remain unchanged with members being able to make a withdrawal from their vested benefits should the member resign, be dismissed, or be retrenched. The member will be taxed on any withdrawal made as per the retirement lump sum tax table. 

From the date the two-pot system is introduced; all retirement fund contributions will be allocated to a savings pot and a retirement pot. Fund members will be required to allocate at least one-third of their contributions to the savings pot and the rest allocated to the retirement pot. To provide fund members with emergency access to their retirement savings, they will be allowed to make one withdrawal from their savings pot in a 12-month period on a rolling 12-month basis, i.e., not based on a tax year, a financial year or a calendar year. A minimum withdrawal of R2 000 will have to be made from the savings pot and will be the gross amount, i.e., before any tax or fees. Members who leave their fund and who have less than R2 000 in their savings pot will be able to commute the amount, or the amount will automatically be transferred to their retirement pot.

Members who emigrate will not be subject to a waiting period of three years before they can withdraw their savings from the savings pot, but they will only be allowed to make one withdrawal every 12 months. A member who emigrates and who has already made a withdrawal will have to wait until the 12 months period has expired. Members and their beneficiaries may receive an annuity, not only a lump sum, from their savings pot at retirement or on death. Members will also have the option of transferring any balance in their savings pot into the retirement pot at retirement. All withdrawals from the savings pot will be taxed at a member’s marginal rate of tax.

The cost of non-preservation

The main reason for most members not retiring with sufficient savings to provide them with an income during retirement is non-preservation. What the two-pot system would introduce is an avenue for members to access their savings without having to consider the drastic measure of resigning from or changing jobs. The mere thought of providing members with greater access to their retirement savings is sending shivers down the spines of Trustees, Management Committees, employee benefit and asset consultants. However, some of the fears are misplaced, and one needs to consider the long-term implications of being able to dip into your retirement savings pool under the current retirement dispensation and the two-pot dispensation. 

Currently, retirement fund members are allowed to make a full withdrawal from their retirement savings without any restriction when they resign, are dismissed or retrenched before retirement. The only material disincentive for a full withdrawal would be the lump sum tax payable. With the introduction of the two pot system, the new generation of retirement fund members will be better protected when it comes to withdrawals. This will facilitate improved preservation of their retirement savings and result in a better retirement outcome than for many fund members from previous generations.

To illustrate this, we can take the example of retirement fund member X who has accumulated R200 000 of retirement savings. For this exercise, we will assume that Member X currently contributes R1 000 a month to his retirement fund and that this amount increases by 5% every year based on expected average annual salary adjustments. Member X is 40 years old and still has 25 years to contribute towards retirement at age 65, assuming the member remains employed during this time. The capital growth portfolio that Member X is invested in as part of the fund’s default investment strategy is expected to deliver a return of 9% per annum, net of fees.

Let us consider a few withdrawal scenarios under the current dispensation and compare them to the outcome or results at retirement under the proposed two pot system should Member X resign from the current employer. Under Scenario A, Member X accumulates all retirement benefits under the current retirement savings dispensation and in Scenario B accumulates all retirement benefits under the proposed two pot dispensation. To keep things simple, we look at three scenarios. Member X withdraws the full R200 000 at age 40, withdraws only 33%, or full preservation (no withdrawal).

Note: Taxes and costs have been ignored as they would not materially influence the conclusion of case study

Under Scenario A, Member X would have to increase current contributions from R1 000 per month to R2 050 per month under a full withdrawal scenario to accumulate the same amount of capital at retirement at 65 (R 3 359 430) if there was full preservation with no withdrawal at age 40. This is more than double the current contribution. Member X would have to increase current contributions from R1 000 per month to R1 350 per month under the 33,3% withdrawal scenario to accumulate the same amount of capital at retirement at 65. 

The worst case for Member X under the two-pot dispensation would be to increase the current contributions from R1 000 per month to R1 350 per month to still achieve the best-case scenario (no withdrawal) outcome at retirement. Member X would also have R1 146 870, or 70%, more savings at retirement in the 33,3% withdrawal scenario under a two-pot dispensation than under a full withdrawal scenario that is allowed under the current dispensation. The chances are therefore much better for Member X to still have a reasonably good outcome at retirement under the two-pot dispensation.

Reviewing the default investment strategy

The implementation of the two-pot system has various implications for the default investment strategies of retirement funds. Most funds currently have a default strategy that invest a member’s retirement savings based on how long they still have before the member reaches normal retirement age as per the rules of the fund. Some funds allow the member to opt out of the default investment strategy and to select a different portfolio that may be available as a member choice. With the introduction of the two-pot system all retirement funds, with the assistance of their investment consultant, will have to review their default investment strategy and what options they allow members going forward. The investment strategy will have to clearly differentiate between the various pots as the timeframes for each pot could be different depending on what the member decides to do.

The retirement benefits pot would typically follow the same default investment strategy as the vested pot as members are not supposed to touch these benefits before retirement for preservation purposes. However, there is a great likelihood that the savings pot may be accessed by members prior to retirement and careful thought will have to be given to the type of investment mandate that would be most suited for these benefits from a risk and liquidity perspective. The implications of Regulation 28 compliance, whether at a pot or a fund level, would also have to be considered. This will add additional complexity from a fund rule, governance, investment performance monitoring, compliance, reporting and administrative perspective.

Key concessions made by Treasury

In the latest draft legislation, National Treasury made a few key concessions to proposals made by Cosatu. As a first concession, Treasury will “consider” allowing members to make a once-off transfer, into their savings pot, from the vested benefits that they have accumulated prior to the implementation of the two-pot system. However, seeding the savings pot with vested benefit pot savings would be on condition that doing so did not have any adverse implications for a retirement fund from a liquidity perspective.

A second partial concession was made by Treasury that will allow fund members to withdraw savings from their retirement pot when they are retrenched or “forced” to resign. Members will be allowed to make limited income-based withdrawals from their retirement pot based on various conditions that has to be met, such as a member must have depleted all their savings in their savings and vested pots and must have exhausted their Unemployment Insurance Fund benefits.

Finally, Treasury said that under the revised legislation the two-pot system will be mandatory for all retirement funds and that employers would not be able to opt-out. Cosatu felt very strong about making the two-pot system compulsory for all employers to avoid a situation where members are denied access to their savings and then resort to resigning from their jobs.

Big implementation hurdles remain

There also remain concerns about how realistic the government's new deadline of 1 March 2024 is. Implementation hurdles for the two-pot system exist from a regulatory, tax legislation, administrative and educational perspective. First, the Pension Funds Act will have to be amended. With the adoption of the two-pot system compulsory for all retirement funds, all registered retirement funds in South Africa will have to amend and get their fund rules approved by 01 March 2024.

Fund member administrators will have to adapt their administration systems to effectively and accurately allocate, account for and report on all contributions and withdrawals across the three retirement fund pots of every fund member. This will also involve keeping track of all provident fund members who were 55 or older on 1 March 2021 and will have the option to either continue contributing to their vested benefit pot or join the two pot system. ASISA suggests that fund administrators be granted a minimum period of 18 months from the date of the final legislation being adopted to make the necessary provisions and changes on their systems and processes. The increased administrative complexity will come at an additional cost to the retirement fund industry.

The South African Revenue Service (SARS) will need to create sufficient system and human capacity to cater for the new retirement pots and track all member contributions and withdrawals. Finally, retirement funds will need to communicate with and train and educate all fund members about the two-pot system and its potential implications. Employers will also have to provide the necessary resources to guide members who considers accessing their retirement savings and assist them in making informed decisions.

Some unfinished business

In addition to the implementation hurdles, many aspects still need to be clarified for the proposed legislation to be finalised and adopted as a formal policy by the retirement fund industry. The first relates to defined benefit schemes and how the two-pot system will be applied to these retirement funds, which includes the Government Employees Pension Fund (GEPF). Treasury will be consulting with the relevant stakeholders and explore some protective mechanisms, which could include an increase in future contributions for members making withdrawals before retirement. Treasury is also engaging with the FSCA on how to deal with the two-pot system when it comes to deductions permitted in terms of Section 37D of the Pension Funds Act. These deductions include divorce-order settlements, maintenance orders, amount owed by the member to the employer and pension-backed housing loan arrangements. Current thinking is that deductions will be made from the retirement pot and the vested pot when a member leaves a fund or when divorce order settlements become payable.

Treasury still needs to consult with the FSCA and industry stakeholders on how to best deal with legacy retirement annuity products. Including these products as part of the two-pot system will require a complete review of all historically acquired insurance policies and their terms and conditions. Another practical challenge to resolve involves excess contributions to retirement funds that exceed the annual tax-threshold. ASISA is of the view that to administer this provision, a member’s taxable income will have to be known when the contributions are received as this will ensure a proper division between the savings pot and the retirement pot. However, the administrator of a particular fund will not know whether a member has contributed more than the maximum, because the member could belong to another fund or other funds.

When it comes to the deduction of costs, the draft bill states that retirement funds must deduct costs from contributions, whereas retirement funds currently deduct costs from contributions and fund values. This raise the question of how funds that receive transfers but not contributions would be able to deduct their costs. Treasure will have to amend the legislation and clarify the nature and scope of costs that can be deducted from contributions or fund values. It will also have to provide more certainty around these costs not including subsequent transaction and administration fees. Specific guidance is also required from the FSCA regarding Regulation 28 and how it would apply across the various savings pots, i.e., is compliance required per pot or across all the pots?

Speed it up…with caution

The preservation of retirement savings and the power of compound growth are crucial elements to ensure sufficient savings to live off in retirement. But preservation and compounding cannot put bread on the table today, which is the immediate need of the most vulnerable retirement fund members in our society. The two-pot system, if implemented with care and consideration of the input received from all stakeholders, could be a good compromise in addressing the existing need for access to savings and maintaining a member’s dignity during retirement. 

Members who need to access their savings will require education and guidance around withdrawals and a clear understanding of the challenges they may face once they retire. Measures will also have to be implemented for members not in dire need of financial relief and who will seek to abuse the right of access to their savings pot for lifestyle purposes.

Until such time as the two-pot system is introduced the risk of members resigning from their jobs and accessing all their accumulated savings remain. Finalising the proposed legislation, mapping a realistic process and timeframe, and getting traction on implementation needs to be a matter of great urgency and priority for the government, retirement funds, investment administrators and fund consultants.