In early 2022 we hosted a webinar to provide financial advisers with early context and information on the two pot proposals. We have been following these developments closely, with the aim of helping advisers understand how the implementation of two pot may impact their clients.

Background

• As far back as 2012, the South African government announced various reforms to South Africa’s retirement system in a paper called “Enabling a better income in retirement”. Included in that announcement was a version of what has now become known as the “two pot retirement system”.
• In 2016, the first of the retirement reforms was implemented, being the standardisation of the tax deductibility of retirement fund contributions across the different types of retirement funds.
• The forced annuitisation of two-thirds of provident fund benefits at retirement, known as “T-day”, was delayed several times due to the extensive consultation required with organized labour and other parties. This was finally implemented on 1 March 2021, along with other changes to allow for greater tax-free transferability between retirement funds.

Why we need the two pot retirement system

• The two pot retirement system is the last of the retirement reform measures that has not yet been implemented.
• The intention of the two pot legislation is to enforce a level of retirement savings preservation and thereby ensure that retirement savings are retained for the purposes of retirement, even when someone leaves an employer. This intervention is desperately needed, with only a small portion of members currently preserving retirement savings, typically resulting in a replacement ratio in retirement which falls far short of the 75% generally required.
• The two pot regime endeavours to address this issue, but also recognises that many households require occasional access to savings to cater for emergencies and unforeseen circumstances. The sad reality is that currently many people resign from employment to access their pension benefit as this is their only source of savings. This increases their future financial risk as they will most likely still experience financial hardship and will also now be unemployed.
• The aim of the two pot system is to balance the opposing forces of long-term retirement saving with short term financial distress, in a manner that optimizes outcomes for retirement fund members. It does so by creating by creating two new “pots” of retirement savings – a ‘savings pot’ which members can access prior to retirement, and a ‘retirement pot’, which must be preserved until retirement and cannot be accessed as a cash withdrawal at all before or at retirement.
• The two pot system is estimated to result in a new member accumulating more than DOUBLE the value of their savings at retirement compared to the current system, while providing them with access to some savings annually.

The latest updates on the two pot regulation

Two draft versions of the legislative changes have been released since the initial discussion paper was published. Based on these we can expect the two pot system to work as follows:

Retirement funds to which the two pot regulation will apply

Pension and provident funds, preservation funds, and retirement annuity funds are required to comply with the two pot regulations. This includes both defined benefit and defined contribution funds, and most notably public sector funds, including the Government Employee Pension Fund (GEPF). The GEPF is a defined benefit fund which manages pensions and related benefits on behalf of government employees in South Africa. Established in 1996, it is the largest pension fund in South Africa, managing over 1.2 million members from more than 325 government departments, with over R2 trillion in benefits under management. Whilst some of the prior retirement reforms have not applied to the GEPF, these changes will align the treatment of GEPF members with members in private sector funds.

Certain legacy retirement annuity policies will be exempt from the two pot requirements, including:

• Pre-universal life policies and/or conventional policies with or without profits;
• Universal life policies with life and/or lump-sum disability cover; and
• Reversionary bonus or universal life policies as defined or referenced in the insurance legislation.

“Pots” are now “Components”

• In the latest draft released in July of this year, the regulation now refers to the “pots” as “components”.

The Vested Component

Any retirement savings which have already accumulated prior to 1 March 2024 are classified as a member’s Vested Component. This may consist of a member’s ‘vested benefits’ resulting from provident fund contributions prior to 1 March 2021 (“T-day”) plus growth, and ‘non-vested benefits’. The member will retain all his/her current rights of access to those benefits after 1 March 2024, namely:

• A full withdrawal may be taken on resignation or retrenchment from an employer pension or provident fund.
• The member may make one full or partial withdrawal from a benefit preserved in a preservation fund.
• On retirement, the entire value of the T-day ‘vested benefit’ (Provident Fund contributions made prior to 1 March 2024, plus growth) may be withdrawn in cash, and a maximum of 1/3rd of the T-day non-vested benefit may be withdrawn in cash.

Provident fund members who were 55 on 1 March 2021 (‘T-Day’) and who have remained in their original provident fund and who have only accumulated ‘vested benefits’ will be able to elect to continue making contributions to the Vested Component from 1 March 2024 onwards.  If they don’t make such an election, their contributions from 1 March 2024 will be invested into the Savings and Retirement Components as per the new rules.

The Savings Component

• 1/3 of a member’s retirement fund contributions (net of charges and risk premiums) will be allocated to the Savings Component, which can be accessed before retirement. The Savings Component is intended to address the need for those retirement fund members in financial stress to access their benefits in the Savings Component on an annual basis, and thereby prevent them from having to resign from employment or completely withdraw from the retirement fund.
• A member can make a single withdrawal from their Savings Component every tax year, of a minimum of R2 000 and up to 100% of the value in the Savings Component. Practically this means that many members may request savings component withdrawals annually at the start of every tax year, placing a significant burden on the Retirement Fund industry at this time, particularly for administrators of large employer funds. It may be prudent to expect longer processing times for such withdrawals if your clients plan on accessing their Savings Components at this time of the year.
• Savings Component withdrawals will be processed at an account level, meaning if the client has multiple accounts/contracts with a fund they can withdraw from each separately. Savings withdrawal benefits will be taxed at a member’s marginal tax rate.
• Any balance remaining in the Savings Component when a member retires may be withdrawn in full, partially withdrawn or transferred to the Retirement Component and used to purchase an annuity to provide an income in retirement. Withdrawals from the Savings Component at retirement will be taxed using the lump sum retirement tax tables. Assuming that these rates are lower than many members’ marginal tax rates and keeping in mind that the first R550 000 of the lump sum at retirement is tax free, this tax treatment provides incentive for members to preserve their Savings Component investments pending a cash-out at retirement.

The Retirement Component

• Effective 1 March 2024, 2/3 of a member’s Retirement Fund contributions (net of charges and risk premiums) will be allocated to the Retirement Component, which can only be accessed as an annuity at retirement. The Retirement Component is intended to address the need for all Retirement Fund members to save more for retirement.
• The Retirement Component may only be accessed as a cash lump sum before retirement in the event of the member’s emigration or the cessation of South African tax residence as per the current “3-year rule” or, if the member is a non-resident, on the expiry of a South African work or visitor’s visa.
• When a member retires, they cannot access any part of this component in cash but must use the full value to purchase an annuity. If however, at retirement, the value of the member’s Vested Component together with the value of the member’s Retirement Component jointly falls below R247,500, the member may take the full value of these two components in cash.

Seeding

Seeding has been included in the draft regulations despite being strongly opposed by both the Retirement Fund industry and National Treasury.  As of 29 February 2024, Retirement Funds will be required to “seed” a portion of 10% (up to a maximum of R25 000) of the member’s accumulated retirement savings at that date, into the member’s Savings Component.  This will be available for members to withdraw immediately following the Two-Pot implementation on 1 March 2024. There are concerns that many members may withdraw this portion of their retirement savings without understanding the long-term consequences of their actions on their ability to receive a sustainable income in retirement. This problem is exacerbated by the expedited implementation of the Two-Pot system which does not afford Retirement Funds sufficient time to educate members on the changes.

Tax Treatment

The principles regarding taxation of retirement fund savings will remain in place, namely:

• Retirement fund contributions will continue to be tax deductible up to the current limits.
• The investment returns on a member’s benefits in the three components will be exempt from tax; and
• Withdrawals taken from the three components are subject to tax.

This method of deferred taxation is intended to incentivize retirement savings.

The draft legislation states that savings withdrawal benefits taken from the Savings Component will be taxed at the member’s marginal tax rate, by way of retirement fund administrators applying for a tax directive from SARS for each withdrawal. Given that millions of savings component withdrawal requests are expected on 1 March of each year, the proposed tax directive mechanism is expected to place a significant burden on both retirement fund administrators and SARS themselves.

What challenges should we expect in the two pot rollout?

The two pot legislation is still in draft, with discussions still underway between National Treasury and various industry bodies regarding many aspects of the regulation. As draft legislation is subject to change, fundamental aspects of the two pot retirement fund system may be amended in the final regulations, which we are unlikely to have sight of with sufficient lead time to adjust before 1 March 2024.

If the two pot system does indeed go ahead as proposed on 1 March 2024, it is likely that some parties in the retirement fund ecosystem may not be fully ready for the changes. The scale of the implementation is significant for all retirement funds and most notably SARS, which will need to make substantial adjustments in various areas to cater for the two pot requirements. It may be prudent to anticipate and prepare for some bumps in the road in the early days post the two pot implementation as the industry adjusts to the changes. One should also anticipate an impact on service levels of many retirement funds around 1 March of next year, as they endeavor to manage the many millions of savings pot withdrawal requests that they are expected to receive.

Member education and communication is a vital component of the rollout, which makes the financial advice offered to members even more important at this time. The industry is beginning with this exercise now as the effectiveness of education initiatives may suffer if rushed, to the detriment of good long-term outcomes for many members.

In 1961, American Astronaut Alan Shephard coined the term “all systems go” during his launch of the Freedom 7 spacecraft. “Cabin pressure go. Fuel system go. Oxygen goes. All systems go”. The dictionary defines this as meaning an event or activity can now begin because everything is ready. One can certainly argue that the task of fundamentally changing how we manage members’ retirement savings is as important an endeavour as a space launch. Taking into consideration the short time given for implementation, it may not be “all systems go” on 1 March 2024, but we hope the two pot rollout is managed in such a way as to retain the faith which members have placed in our retirement system. Watch this space, and we will keep you updated.