Business & Industry views
The Two-Pot System: A New Era for South African Retirement Funds
The opportunities and challenges of rolling out a key regulatory reform.
The Quick Take
- This is the largest reform in the history of the SA retirement fund market and aims to ensure a balance between compulsory preservation and access to emergency funds.
- The system should result in better retirement outcomes for members in the long term.
- The required changes must be carefully managed in order to meet the September deadline.
- Upholding the principle of compulsory preservation is vital to ensuring the long-term sustainability of retirement savings.
South Africa’s retirement fund system is at a critical juncture, with the imminent rollout of the two-pot system. A successful implementation promises to address key long-standing deficiencies in our current retirement framework, driving better retirement outcomes for members. In contrast, an unsuccessful or rushed implementation runs the risk of destabilizing or undermining confidence in what is a crucial sector of the economy.
WHAT IS THE TWO-POT SYSTEM?
The “two-pot” system is a proposed reform that conceptually divides future retirement fund contributions into two parts: a “retirement pot” and a “savings pot”. The retirement pot, comprising two-thirds of contributions, is strictly preserved for retirement and must be used to purchase a retirement income annuity, while the savings pot, accounting for the remaining one-third, can be accessed before retirement, with the intention that it should be used for financial emergencies. Members will be able to withdraw from the savings pot once per tax year, subject to certain conditions. The savings pot can also be understood to provide tax-disadvantaged early access opportunities to the tax-advantaged one-third retirement lump sum. The “vested” savings that members have accumulated prior to the implementation of the new system will remain subject to the rules that were previously in place.
WHY IS IT BEING IMPLEMENTED?
The two-pot system is a significant step in the National Treasury’s efforts to improve retirement outcomes. Over the past decade, reforms have been implemented to address a range of issues in the retirement savings sector, such as harmonizing the tax regime, promoting higher levels of savings, preservation and annuitisation, enhancing value for money, and improving fund governance.
Despite progress in these areas, the critical issue of compulsory preservation has remained a key challenge. Under the current system, individuals are allowed to cash in their occupational retirement savings when leaving employment, which most members do. The result is that only a small minority of individuals have sufficient savings when they reach retirement.
The Covid-19 pandemic highlighted the urgent need for a system that provides both compulsory preservation as well as access to short-term savings as a financial safety net. The financial distress caused by the pandemic brought into sharp focus the reality that, for many South Africans, there are times when immediate financial needs outweigh the need to save for retirement. This acted as a catalyst for the move toward the two-pot system, aiming to establish a balanced approach that allows for immediate financial access to a portion of retirement savings whilst also ensuring adequate preservation for retirement.
WHAT IS THE CURRENT STATUS OF THE REFORMS?
At the time of writing, parliament’s finance portfolio committee has agreed to an implementation date of 1 September 2024, after having previously resolved that the system should be implemented on 1 March 2024. While this six-month reprieve does provide industry stakeholders with additional time to prepare for the change, the deadline remains challenging due to several key issues that must be resolved, including:
- A raft of regulatory changes is required to give legal effect to this new system and to provide clarity about the changes that are required. This includes changes to the Income Tax Act and Pension Fund Act. This enabling legislation must still be finalized and promulgated.
- SARS must adjust its systems and processes to accommodate the tax requirements.
- The FSCA must approve enabling rule amendments for all of the retirement funds affected by the new system.
- Administrators must make necessary system upgrades and adjustments to meet the requirements of the new system.
- Funds must make necessary preparations, such as ensuring that they have the correct bank details for all members.
- Member education about the new system is crucial. This involves helping members understand how the new two-pot system works, dispel many myths and clarify what will happen to their accumulated (“vested”) savings pots.
WHAT ARE THE KEY BENEFITS AND RISKS OF THIS CHANGE?
The two-pot design provides an elegant way of addressing the unique challenges faced by the South African retirement industry. If it is implemented successfully, then it will result in materially better retirement outcomes for savers.
Even if we assume that most members withdraw the entire one-third from their savings pots before retirement, the beneficial effects of compounding on the two-thirds in the retirement pot over time should lead to substantially better retirement outcomes for the average member. Of course, those members who are able to keep their savings pots invested will be in an even better financial position at retirement.
Improved retirement outcomes will, in turn, improve the overall health of the retirement system, increasing the amount of capital available for investment, and providing long-term benefits to the economy.
However, if the system is not implemented properly, then there is a risk of member discontent, which could undermine confidence in the retirement industry. There are three key risks that need to be carefully managed:
1) Execution risk:
The two-pot system is the largest reform of the South African retirement system in its history, and the aggressive timeline introduces the risk of delays, errors, and a lack of member understanding about the benefits to which they are entitled under the new system.
The practical challenges of implementing a reform as substantial as this means that the revised deadline of 1 September 2024 will still be tight but much more manageable than the initial 1 March 2024 target. In order to ensure a smooth transition to the new system, clear and effective communication with members about the upcoming changes is vital, alongside operational changes that are required for industry stakeholders to be able to deliver on their respective obligations under the new system.
2) Risks relating to the initial seed capital payment:
There is a very real risk of significant member unhappiness in relation to an initial “seed capital” lump sum that will be available to members when the two-pot system is introduced.
The first area of possible discontent is around how much members will be able to receive when the new system is implemented. Throughout the two-pot deliberations, there has been a strong push for an initial lump sum payment to be made to members at inception of the system in the form of a seed capital payment. While this is technically classified as a seed transfer from their vested pots (existing savings) into the new savings pot (which can then be accessed immediately), it will practically be seen as an initial once-off lump sum withdrawal that members will be allowed to take from their current retirement savings.
Advocates for the payment of seed capital emphasize the urgent need for members to access a portion of their capital, highlighting the financial hardships many are facing in the aftermath of Covid-19 and the ongoing economic challenges in South Africa.
The amount of seed capital is expected to be set at 10% of a member’s retirement balance, subject to a maximum of R30,000. This is a gross amount, and the actual amount that members will receive will be lower than this, because they will be reduced by tax and administration costs. There is a risk that some members may not have a full understanding of the actual amount that they will receive when their seed capital is paid out.
Secondly, some members are likely to expect that they will receive their initial seed payments on, or shortly after, the implementation date of 1 September 2024, whereas there is a risk that it may take longer for all stakeholders to have the necessary processes in place so that funds are able to make these payments to all their members. In the current system, most funds only need to make payments to a small percentage of their member base for life events such as retirement or resignation. In contrast, all members of retirement funds will be entitled to a seed capital withdrawal at inception, putting a huge administrative burden on funds, their administrators and other industry stakeholders such as SARS and the FSCA.
This risk of the seed capital payouts not meeting member expectations is compounded by the significant financial difficulties faced by many South Africans, coupled with the fact that funds have limited time to educate members about the new system.
3) Retirement savings sustainability risk:
While the immediate focus is understandably on meeting the September deadline, a more significant long-term risk relates to the expectations that may be created following the payout of the initial seed capital lump sums. It is critical to the long-term sustainability of the retirement system that this initial seed payment is only allowed once, and that additional lump sum withdrawals from members’ retirement pots and vested pots are not allowed. After the seeding has taken place, the only amounts that should be accessible to members should be the balances available in their savings pots.
The potential risks of creating an expectation for recurring lump sum withdrawals are highlighted by what happened in the Chilean retirement market during the Covid-19 pandemic. Prior to the pandemic, Chile’s pension system was generally well regarded. However, the retirement system was decimated following a series of Covid-19 related withdrawals, with over $50 billion flowing out of the system.
In contrast, Australia also allowed emergency withdrawals from Superannuation funds during Covid, but only under very specific and limited means-tested conditions. This protected the integrity of the Australian system, allowing it to recover once the immediate needs of the pandemic had passed.
To avoid a fate similar to Chile’s, it is essential for South Africa's shift to the two-pot system to clearly establish that no further rounds of seeding will be permitted. Such discipline is crucial to protect the industry and avert severe harm to retirement savers and to the broader economy over the long term.
WHERE TO FROM HERE?
The retirement industry is at a crucial point, with a lot of work required to meet the tight timelines for rolling out the two-pot system, especially considering the extent of these changes, the need for coordination amongst stakeholders to implement this properly, and the importance of ensuring that members are properly educated about the upcoming changes.
While the stakes are high, we are optimistic that the end result can be a retirement system that finally provides the much-needed adjustments like compulsory preservation alongside a clear framework for access, in order to improve retirement outcomes for members. As we navigate these challenges, we are committed to working closely with clients and industry bodies to manage these risks and proactively prepare for this significant change.