By: Luke Meiklejohn
A bird in the hand is worth two in the bush, but a buck in the bank is worth more than five at retirement
On 1 September 2024, South Africa will implement the two-pot retirement system, which has been designed to enhance retirement savings and financial stability for individuals. This new system divides retirement savings into two distinct pots: a "retirement pot" and a "savings pot". While the new system offers advantages to investors in the form of easier access to savings in times of economic stress, it is vital to emphasise the importance of long-term investing and the potential opportunity costs of withdrawing funds early.
Understanding the system
The two-pot retirement system is a strategic approach that aims to address both immediate financial needs and long-term retirement goals. It involves structuring retirement savings into two portions:
Benefits of the two-pot system
The two-pot system aims to strike a balance between ensuring long-term retirement security and providing immediate financial flexibility. By safeguarding a substantial portion of retirement savings in the retirement pot, including requiring the preservation of these funds after leaving an employer, individuals are more likely to have a stable and secure financial base when they retire. This long-term protection is crucial for financial peace of mind in the later stages of life and serves as an improvement to the current system where investors might be motivated to withdraw all their pension savings when in need of funds.
The savings pot provides flexibility, allowing individuals to access funds when necessary, without necessarily jeopardising their long-term retirement savings. This can be particularly beneficial in times of financial hardship. However, it's essential to use this flexibility wisely to avoid compromising future financial security.
With the ability to access part of their retirement savings, individuals may feel more encouraged to contribute regularly to their retirement funds knowing that they have a safety net if needed. This can foster a culture of consistent saving and financial discipline, which is important in South Africa where savings rates are significantly lower than the global average.
Importance of long-term investing
While the flexibility of the savings pot is advantageous, it's critical to maintain a long-term perspective on retirement savings. The 2024 FNB Retirement Insights Survey highlights the human tendency to prioritise shorter term gains over longer term goals, because of a bias called temporal discounting. While we rationally know we should be preparing for retirement, because this happens so far in the future and preparation feels so challenging and uncertain, we discount the value of it, in favour of more immediate gains. This mindset, focusing on the here and now while avoiding thinking about the uncertain future, can lead to inadequate savings and financial insecurity in later years.
Investing in the retirement pot allows for savings to grow through compounding of returns, which can significantly increase fund values over the long term. Consider a scenario where you invest R1,000 a month from age 25 to 65 with an average annual return of 9%. By retirement age you could accumulate over R4.6 million. However, delaying your investment by even ten years could reduce this amount by more than half, illustrating the power of compounding returns and the importance of starting early and staying invested.
The opportunity cost of early withdrawals
While accessing funds from the savings pot might seem tempting, especially in challenging financial situations, it is crucial to consider the opportunity cost of withdrawing these funds early. When money is withdrawn prematurely, it misses out on the potential growth that would have occurred had it remained invested.
The FNB Retirement Insights Survey findings indicate that premature cashing out of retirement funds can derail well-crafted retirement plans and reduce overall financial security. For instance, consider the scenario above where you started saving for retirement at age 25. At age 35, suppose you withdraw a third of your accumulated savings, depleting your savings pot by a total of around R64,000, before being subject to income tax at your marginal tax rate. If your marginal tax rate is 36%, you're left with around R41,000 to spend. Over the next 30 years that R64,000 would have grown to over R800,000, and your savings at retirement is worse off for it. You've not only lost the principal amount, but also the future gains it could have earned over the years, leaving your retirement savings a shocking 24% lower. Adjusting for inflation, each rand withdrawn early loses you over R5 available to cash out in retirement.
While the savings pot provides a valuable option for accessing funds - and there may be scenarios where it is unavoidable, or scenarios where those savings can be deployed to a worthwhile investment, like furthering your education on the expectation that this will increase your future earnings, we can't stress enough that it should be used judiciously to avoid compromising long-term financial goals. To retire with the same amount, adjusted for inflation, and make up for those funds withdrawn at age 35, you might be forced to end up delaying your golden years, working and saving for an additional 6 years.
Conclusion
The two-pot retirement system is, in essence, a forward-thinking initiative that offers a balanced approach to managing retirement savings in South Africa by ensuring that a significant portion of savings is protected for retirement while providing flexibility for immediate needs. This system can enhance financial security for individuals; however, it is vital to remember the importance of long-term investing and the potential costs of early withdrawals. Adopting a disciplined approach to retirement planning from an early stage can help you secure a financially stable and fulfilling retirement.
The choices you make today will shape your financial future. Start planning, start saving, and stay invested.
