Considerations before taking the One-Third Option in the Two-Post Retirement System: What Accountants Should Advise Their Clients
Introduction
The decision to take a portion of retirement savings as a lump sum upon retirement is a significant financial choice with long-term implications. In South Africa, retirees under the two-post retirement system are often given the option to withdraw up to one-third of their retirement savings as a lump sum, while the remaining two-thirds must be used to purchase an annuity for ongoing income. Alexander Forbes reported that they have received in excess of 560 000 online claims within five days from 1 September 2024.
As accountants, advising clients on the potential impacts of this choice requires careful consideration of their financial future, tax implications, and lifestyle needs. Statistics indicate that only 6% of people entering retirement are prepared to retire comfortable in South Africa. This early withdrawal of retirement savings will have a huge negative impact on the future of clients when they reach retirement age.
Key considerations before taking the one-third lump sum
Immediate Financial Needs vs. Long-Term Security: Clients may be tempted to take a lump sum to cover immediate financial needs, such as debt repayment, home renovations, or even leisure activities. However, this must be weighed against the long-term need for a sustainable retirement income. The more a client withdraws upfront, the less is available to grow and generate an income stream from the annuity. Accountants should help clients evaluate whether their current financial situation justifies the immediate withdrawal.
Impact on Retirement Savings and Growth: The one-third lump sum will be deducted from the total retirement savings pool, which means the two-thirds that remains for annuity purchase will be smaller. This reduction will have a direct impact on the client’s retirement income over the coming years. Accountants can help clients model the potential growth of their remaining retirement savings if they do not take the lump sum, versus the potential depletion of their savings if they opt for the withdrawal.
Tax Implications: One of the critical elements to consider is the tax treatment of the lump sum. In South Africa, the first R500,000 of a retirement lump sum is generally tax-free, while anything above this amount is taxed on a sliding scale. It’s important to advise clients on the tax implications of withdrawing large sums, as this could significantly reduce the actual cash they receive after taxes.
Early Withdrawal: A Double-Edged Sword: If clients are considering early withdrawal before their official retirement age, they need to understand that this can significantly erode their retirement savings. Early withdrawals reduce the compounding potential of the investment, meaning they will have a smaller retirement nest egg to generate income when they eventually stop working.
For example, if a client retires at age 55 instead of 65, their retirement savings will have 10 fewer years of growth. Additionally, they’ll need to stretch their remaining funds over a longer period, which could result in a lower monthly income during retirement. Encourage clients to consider whether they can postpone their retirement to maximize their savings.
Inflation and Longevity Risk: Inflation can erode the purchasing power of retirement income over time. If a client opts to take the one-third lump sum, the remaining two-thirds must be sufficient to maintain their standard of living for decades. With advances in healthcare, people are living longer, which means that retirement savings must last longer. Accountants should guide clients in projecting their retirement income needs and consider inflation-adjusted income streams.
Alternative Income Streams: For clients with multiple income streams—such as rental properties, businesses, or other investments—taking the one-third lump sum may be less risky. However, if retirement savings represent their primary source of income, the decision to withdraw a lump sum becomes more critical. Ensure that clients are aware of all their income options and how they can work together to sustain their retirement lifestyle.
How Early Withdrawals Impact the Time to Retire
Reduction in Retirement Capital
Early withdrawals mean that a significant portion of retirement capital is used before retirement, diminishing the funds available for future growth. This may result in a lower amount being available at the actual time of retirement, requiring clients to either delay retirement or adjust their lifestyle expectations.
Fewer Years of Compound Interest
Compounding is one of the most powerful forces in retirement savings. Early withdrawals reduce the capital base, which diminishes the effect of compound interest over time. Clients will likely have to save more or take on additional risk to make up for the lost compounding.
Potential Need to Supplement Income
If clients take the one-third lump sum and their annuity income falls short of their needs, they may need to find alternative income sources during retirement, such as part-time work or downsizing their living arrangements. This is something they should be prepared for, especially if early withdrawal significantly reduces their future income potential.
Before withdrawing your retirement savings, consider this
Having an emergency fund: Start building a separate emergency fund to handle unexpected expenses so that you do not have to cut down retirement trees for short-term purposes.
Exploring alternative financing: If you urgently need funds, consider speaking to your bank about a personal loan at a competitive interest rate. It means you will have to pay the money back with interest, but the long-term value of leaving your retirement savings untouched will far exceed these costs.
Setting clear financial goals: Having clear goals can help you save purposefully towards the things you need in the future without compromising your retirement plans.
Making extra contributions: Consider making additional contributions to your retirement savings as part of a recovery strategy. If you find that your financial situation improves shortly after dipping into your savings pot for emergencies, use your additional voluntary contributions to replace funds in your retirement fund. Doing so allows you to take advantage of a tax deduction at your marginal rate, capped at R350 000, with any remaining balance carried forward for use in future tax years.
Conclusion
Accountants play a vital role in helping clients make informed decisions about their retirement. Advising them to carefully consider the long-term impacts of taking the one-third lump sum from their retirement savings can help ensure that they are financially secure throughout their retirement. By discussing the trade-offs, tax implications, and potential effects of early withdrawal, accountants can provide valuable guidance that helps clients navigate this complex financial decision with confidence.