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49. Tax-efficient ways to make up for the shortfall of a defined benefit pension fund

Question: I will be retiring at the end of the year. The pension fund I’m on will pay me 2% of my salary for every year’s service. I will be receiving 60% of my salary as I have 30 years’ service. 

We are comfortable that we can live on this. However, I am concerned that my wife, who is five years younger than I am, will only receive half of my pension when I die. 

We are in the process of selling a property and will have R3-million available to cover any shortfall in pension for my wife. What options should we consider?

Answer: The type of pension that you describe is called a defined benefit pension. What is nice about this pension is that you know exactly how much you’re going to get each year. Even if the stock market collapses, you will get your pension each month. But there are two drawbacks that you need to watch out for: 

Annual increases 

The annual increases on these funds do not always keep up with inflation, let alone pensioner inflation. The biggest expenses for pensioners usually include medical aid and electricity. These increases have been way higher than the consumer price index (CPI). 

Spouses pension 

Many of these funds have a clause that reduces the spouse’s pension by 50% when the pensioner dies. This can be problematic if the spouse does not have a pension of their own. I maintain that a 75% pension works better for most people, but that is not always offered as an option. 

There are a few options for you to consider when it comes to investing the proceeds of the property. 

Endowment policy 

If you are paying tax at a rate that is greater than 30%, then you should consider using an endowment policy as the vehicle for this investment. Endowments are taxed at 30%, so if your personal tax rate is higher, you can invest in the same portfolios and end up paying a lot less tax on the growth. 

You are also able to attach a beneficiary to the investment so there will be a saving on executor fees. In the case of your investment, this could be as much as R120,000. 

Your type of pension usually comes with a five-year guarantee – the full pension will be paid for at least five years, even if you should die before then. This removes the big downside of endowments, which is that they are not that liquid in their first five years. 

You can also have access to some nicely structured portfolios that are not ordinarily available elsewhere. You could, for example, invest in a portfolio that targets a return of inflation plus 5% with a lower risk profile than is usually the case for portfolios that target aggressive returns such as this. 

Once the five years have elapsed, you may make withdrawals from the investment and use it to supplement your pension or pay for unexpected expenses. 

When the time comes, your wife can also use some of the proceeds to buy a life annuity for herself. This should be more than enough to make up the 50% shortfall in her pension. 

Joint life annuity 

If you need more financial certainty, then consider taking out a joint life annuity – R3-million should provide you with an income of about R16,000 a month that increases by 5%. This will be paid until both you and your wife die.  

Annuity rates are good at the moment and, by locking them in, you will have a much more certain financial roadmap. This will be more than you need now, so you should get into the habit of investing a large percentage of it initially. I would recommend:  

  • Investing R4,000 a month into a retirement annuity. This will reduce your tax bill, provide tax-free growth and you can mature it when you find your annual pension increases are not keeping up with inflation; and
  • You and your wife each invest R3,000 a month into a tax-free investment. This will set up a tax-efficient emergency fund should you have any major or unexpected expenses.

There are several other options that you can consider, including insured annuities and discretionary income plans. Talk to a financial adviser and find the solution that best suits your needs.