Which investment product?

Foreigners are often surprised at the sophistication of the South African financial industry and the wide array of products available here. Don’t worry, I won’t cover them all in this post; only the three most popular ‘wrapper’ products available to individuals.

What is a wrapper? Your investment portfolio forms the heart of your investment. In other words, your choice between interest-yielding assets, shares, property and offshore assets drives the growth and volatility of your investment. The structure around your portfolio is the wrapper. Your choice of a wrapper will determine how your investment is regulated, when you may withdraw your money, how much tax you pay on income and capital gains, and many other issues that surround your investment.

1. Unit trusts

Unit trusts allow you to pool your money with many other investors, all investing in the same portfolio as you. The portfolio can consist of only interest-bearing assets, property, shares, offshore assets or any combination of asset classes. The assets are held by trustees on your behalf. You share in the growth and income of the portfolio in the same proportion as your number of units to the total number of units in the portfolio. You can access your money within 24 hours and add money to your investment at any time.

Unfortunately, you don’t get any tax-relief for your contributions and you become liable for capital gains tax when you withdraw your money (if there was any capital growth). You will also receive a certificate every year to show how much interest, rental or dividend income the portfolio earned and you have to declare this in your tax return.

Unit trusts form part of a bigger group of investment products called ‘collective investment schemes’ and they are regulated by the Association of Collective Investments. Their prices are published daily in most newspapers and you can view all the assets in the portfolio at least quarterly.

2. Retirement annuities

Technically, buying a retirement annuity actually means you become a member of a specific retirement fund. The fund’s trustees look after your interests. Sometimes the trustees buy an old-fashioned retirement policy on behalf of all members or an individual policy for each member. Often the policies contractually bind you to contribute premiums on a regular basis until a certain retirement age and penalise you if you stop contributing earlier. The life insurers issuing the policies usually appoint asset managers who choose the underlying investment portfolio.

Nowadays there’s a more modern, flexible and transparent version of the retirement annuity which allows you to choose your own investment portfolio (often a unit trust) and also allows you to contribute only when you can – without penalties. Still, neither version allows you to withdraw your money before you reach age 55. The age is determined by retirement fund legislation.

Why would anybody choose to be locked in for so long? Retirement annuities currently provide great tax benefits for the self-employed, as the government wants to encourage you to save for old age. As a tax-payer, you may therefore receive a tax rebate on your contributions, subject to certain limits. In addition, neither you nor the retirement fund pays any tax on the income earned by the investment portfolio. It’s only when you start drawing your pension, that you could pay tax on your retirement income exceeding the annual income threshold.

Unlike unit trusts and endowment policies, regulation requires the trustees to use their discretion when they decide who your dependents are and where the money should go after your death. As a result, they may overrule your beneficiary nomination.

3. Endowment policies

Like the old-fashioned retirement annuity policies, endowment policies have become unpopular because of the high penalties life insurers charge when you end the policy or stop your regular contributions before the contractual end date. Traditional endowment policies also do not allow you to select your own underlying investment portfolio and don’t always regularly disclose all assets in the portfolio they select on your behalf. Legislation effectively forces you to remain invested for five years. If you need the money earlier, you can withdraw it, but won’t receive more than your contributions plus 6% compound interest per year.

With all these restrictions, why do some people still prefer this wrapper? Unlike unit trusts, you don’t account for your investment income and capital growth in your tax return. In other words, you are not taxed directly; the fund that pools your contributions with that of other individual policyholders will pay the tax to SARS on your behalf. Currently the rate is 30% on all interest and rental income. Even though you are not taxed directly, the net effect is that you are left with only 70% of the interest and rental income earned by the portfolio. Individuals paying more than 30% tax on their annual interest and rental income may therefore benefit from the 30% tax rate of the endowment policy. Unfortunately, the policy doesn’t allow you to use your R19 000 annual interest exemption as an individual – interest earned by the portfolio is taxed from the first R1.

An endowment policy is therefore only an option if:

• You are a high income tax payer
• You expect substantial amounts of interest or rental income from your investment portfolio

Endowment policies have also evolved over the years. It is now possible to purchase policies that allow you to choose your own underlying investment portfolio, often from a wide range of unit trusts. Because the unit trust is wrapped within the policy, it follows the tax and other rules of an endowment policy, but offers the transparency of a unit trust investment.