Financial trade-offs: Retirement fund vs. discretionary investments

We are continuing our series on financial trade-offs most investors will face at some point during their financial journey. In this week’s article, we will take a look at what investors need to consider when deciding to invest new capital. All investments broadly fall within one of two categories, which are subject to different laws and regulations. On the one hand, there are retirement products and on the other is all discretionary investments. Let us start by first unpacking each of these two categories after which we will discuss the considerations investors needs to make when deciding how to invest new capital.

Understanding retirement funds

Retirement funds, which include retirement annuities (RAs) as well as employer-sponsored pension and provident funds, are governed by the Pension Funds Act and regulated under Regulation 28. These regulations aim to safeguard investments ensuring that they are well diversified, by outlining the asset allocation the funds need to be invested according to.

One of the most attractive features of retirement funds is their tax efficiency. Contributions are tax-deductible up to 27.5% of your taxable income (with an annual cap of R350,000), which can significantly reduce your immediate tax burden. Additionally, investment growth within the fund, whether through interest, dividends, or capital gains, is entirely tax-free. For estate planning, retirement funds offer further advantages, as savings are excluded from your estate, avoiding estate duty and simplifying the transfer of benefits to your beneficiaries.

However, these benefits come with trade-offs as retirement funds have limited accessibility. Withdrawals are generally restricted until age 55, except under specific circumstances such as permanent disability or emigration under qualifying rules. Recent changes to legislation have seen the introduction of the Two-pot System allowing members to also withdraw small portions of their funds before retirement, but most of your retirement investment will still not be fully accessible until retirement.

Furthermore, the prescribed asset allocation outlined by Regulation 28 limits investors’ exposure to higher-risk asset classes, such as equity and offshore investments. Restrictions to risks will ultimately lead to lower returns which is an important consideration when deciding on how to allocate new capital.

Understanding discretionary investments

Discretionary investments, including unit trusts, exchange-traded funds (ETFs), shares, and other non-retirement savings products, provide flexibility and control unmatched by retirement funds. These investments are not subject to the same regulations, allowing you to tailor your portfolio to your preferences.

The most significant advantage of discretionary investments is their unrestricted accessibility. Funds can be withdrawn at any time, making them ideal for shorter-term goals or unexpected expenses. Additionally, they offer complete freedom in asset allocation, enabling you to pursue higher-risk investments or full offshore exposure without regulatory constraints.

Despite their flexibility, discretionary investments lack the tax benefits associated with retirement funds. Investment growth, whether from interest, dividends, or capital gains, is subject to annual taxation or taxes upon disposal, potentially reducing long-term returns. Moreover, these investments do not offer protection from creditors, unlike retirement funds, which can be a concern for those in financial difficulty.

Key considerations when deciding between retirement products or in discretionary investments

Your time horizon is a crucial factor in determining whether to invest in either retirement product or in discretionary investments. For long-term goals like retirement, the tax advantages and disciplined savings structure of a retirement fund often outweigh its limitations. On the other hand, discretionary investments are better suited to medium- or short-term goals, where liquidity and flexibility are more critical.

Tax implications also play a significant role. If you are in a high-income tax bracket, the immediate tax savings from retirement fund contributions can be particularly advantageous. However, once you exceed the annual deductible limit, excess contributions may be carried forward, diluting their short-term benefits.

Your investment objectives and risk appetite are equally important. Retirement funds, constrained by Regulation 28, are designed for conservative to moderate risk profiles, which may not align with the goals of more aggressive investors. A discretionary portfolio offers greater freedom to pursue alternative investments or higher offshore allocations, which could be more suitable for those seeking elevated returns.

Lastly, lifestyle needs should guide your decision. If you require liquidity for expenses such as education or travel, discretionary investments are the better choice. Conversely, if your focus is solely on long-term financial security, the tax efficiency and creditor protection offered by retirement funds are highly advantageous.

Choosing between a retirement fund and a discretionary investment is not always an either/or decision. A balanced approach often proves most effective. For example, you could maximise your allowable tax-deductible contributions to a retirement fund each year and channel additional savings into discretionary investments to maintain flexibility and accessibility.

Ultimately, the best strategy often involves a combination of both vehicles, allowing you to optimise tax efficiency while maintaining liquidity for unforeseen needs. By understanding the trade-offs and aligning your investments with your financial goals, you can create a strategy that supports both your immediate and long-term financial well-being.