South Africa is changing its pension laws. The new system is designed to give individuals the opportunity to access only a portion of their retirement funds before they retire in the case of dire need - or even in case of desire. To an extent, this makes sense, given the low savings rate in the country.
It forces individuals to save at least some of what they have in their pension fund instead of being able to spend it all when they change jobs, but also allows them to spend some of what they couldn't save by other means or on their own.
It puts retirement savings into two "pots": one to keep for retirement and one to spend sooner if needed.
It strengthens the country's retirement system and grows long-term savings.
But the changes also present a number of challenges. Research suggests that a contribution of at least 15% of income is necessary from the age of 25 to achieve an acceptable pension.
South Africa already falls woefully short on this measure, and while the new system takes the country in the right direction, there is more to be done.
South Africa is an environment in which consumers have been financially strained over an extended period as a result of elevated rates of consumer price inflation, and associated high interest rates. This strain comes on top of the fact that the economy has grown below the population growth rate for almost 15 years, unemployment rates are high, and grossly skewed inequality is deeply entrenched.
Under the new system, the temptation to withdraw funds, and the need to withdraw funds, will be high.
Fully respecting that financial circumstances might leave a person with few options, I would point to a few guidelines that could help people decide what to do about their retirement savings.
The most effective application of the money that's withdrawn would be to pay down personal debt, pay down a mortgage, pay down loans on other assets, or use it to acquire capital assets, such as property or an investment. In other words, people should use the cash to bolster their balance sheets either by paying off debt or by investing into assets that grow in value or produce income, not to spend on consumption as if it were a windfall.
But mostly, if you can possibly avoid it, don't cash out your retirement savings at all, because, in doing this, you eliminate compounding the growth on your investments over time - which is the single most powerful fuel of the investment engine.
Four guidelines
First, keep withdrawals to an absolute minimum. Only extract whatever is essential. You are robbing your future self by making an early withdrawal.
Second, if possible, consider allocating the retirement component of your pension to assets that will achieve the best possible growth rate over time, thereby providing greater capital for your retirement.
Third, if you do withdraw funds, use those funds to pay down debt, and first pay down debt that carries the highest interest rate. Don't use withdrawals to fund consumption.
Also, be aware that you will be taxed on withdrawals from the accessible pot at your marginal tax rate. And, depending on what you earn and how much you intend to withdraw, you could nudge yourself into a higher tax bracket. In essence, the South African Revenue Service will treat your withdrawals as a boost to your income, and so these withdrawals will be subject to income tax.
Fourth, if you are in debt, speak to your bank about renegotiating your loan conditions or look around among different banks. One of South Africa's banks recently announced that as many as 60% of home loans charged interest rates that were too high.
Critically, even modest reductions of interest rates on long-term debt can have a material effect on your financial welfare. This could mean that a repricing of your home loan could bring about a reduction in monthly bond payments. In turn this would make it less necessary for you to need to withdraw funds early.
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This would be a positive double whammy for your financial wellbeing.
More can be done
Saving creates a path to prosperity - and retirement saving is a big part of it. And there are additional ways the government and the private sector can bring further improvements.
A number of countries offer good ideas. For example, Singapore's pension fund system is designed to help people in lifestyle decisions, including investing in their homes and their health.
Chile's Pensión Básica Solidaria and Aporte Previsional Solidario set out to provide a basic pension to individuals with no or low savings. This ensured a minimum level of income in retirement.
For people saving for retirement, South Africa's two pot system is a step in the right direction.
This is the second of four articles on South Africa's changing pension rules.
Adrian Saville, Professor of Economics, Finance & Strategy at the Gordon Institute of Business Science, University of Pretoria
