-By Elke Zeki
“I prefer questions that cannot be answered to answers that cannot be questioned” – Richard Feynman.
How much offshore is enough? This is not an easy question to answer, because so many factors may influence the answer. In this article, I’d like to share how we approach this pressing issue with our clients – an approach we have developed through our academic training combined with decades of experience in offshore investments.
Let’s start with a reality check. South Africa is not in a good place. We face many serious structural challenges that define the long-term future of this country.
These challenges are:
- Education – we are failing to provide our children with quality education.
- Unemployment – a symptom of poor education and insufficient economic growth, it is especially prevalent amongst our youth.
- Work ethic – there is no culture of self-motivated upskilling and working hard to achieve more. Instead, there is a culture of “how can I earn more for doing the same?”
- Social unity – poverty and unemployment (especially amongst the youth) is a ticking time bomb. We have already seen an increase in social unrest and it is likely to escalate.
- Rule of law & property rights – there is a pervasive disregard for the law and consequences for breaking the law. We need to see clarity on the issue of property rights in order to move forward.
Unless we see policy shifts and strong leadership around these issues, we remain negative on the long-term future of South Africa. It is against this backdrop that we believe it is important to continue to externalise funds and invest offshore for the foreseeable future. However, we need to balance political risk with other risks such as running out of money in retirement and having access to your money.
How much is enough?
To guide us, we need to start with an important financial planning concept called “asset/liability matching”. Simply put, the currency of your assets needs to match that of your expenses. The “funding bucket” that provides for children’s education, lifestyle and ultimately your retirement needs to be predominantly invested in the country in which you live, in order to protect yourself against currency and inflation movements. In other words, you do it to protect the purchasing power of your money. As difficult as it is to currently imagine that the Rand may strengthen, history has shown us that there are long periods of currency strength and weakness in all currencies, including the Rand. If all your money is invested in US Dollars and you live here and for whatever reason, the Rand strengthens against the US Dollar, you will become poorer.
If you have a rough idea of what your future expenses will be, you can determine the size of the “funding bucket”. Then ask yourself where you see yourself living in 10 to 15 years’ time? Where do you see your major expenses? THIS is where your “funding bucket” needs to be invested!
If it is South Africa, the “funding bucket” gets invested here and within this, you need to ensure that you have a healthy offshore exposure of at least 30%. If the answer is another country, the “funding bucket” needs to be externalised and invested in a global portfolio over time, preferably in the currency of your future home country.
What to consider about retirement products?
Pre-retirement structures limit you to 30% offshore exposure. This is the most efficient exposure determined by most mathematical models. However, many South African investments within your retirement products may include offshore elements such as global companies listed in South Africa (for example, British American Tobacco, Naspers). Your actual offshore exposure may, therefore, be more than 30%.
You may retire from pre-retirement structures at the age of 55. Funds can then be transferred to a traditional life annuity or a living annuity. Many opt to “retire” as early as 55 for the following reasons:
- A living annuity, which has more flexibility, allows you to invest 100% in offshore funds.
- There is a possibility that the government may in future prescribe how you invest your assets in retirement products but living annuities would not be affected if prescribed assets had to come into play.
Before doing this, there are important factors to consider:
- Not all insurance companies offer the facility to invest 100% of your living annuity into offshore funds.
- Once you convert to a living annuity you have to draw an income between 2,5% -17,5%. This income stream is taxable.
- You may be getting global exposure through offshore funds, but you are not physically externalising your money. The best protection against political risk is to externalise discretionary funds.
- If you formally
- You may withdraw and externalise funds within pension/provident, retirement annuity and preservation funds.
- You may NOT withdraw and externalise a living annuity, but you can draw the maximum allowable limit of 17.5% per year for several years, effectively emptying your living annuity.
What about money outside of this “funding bucket”?
Any savings that fall outside of the “funding bucket” can be invested in various ways and this will differ from client to client. For any South African client with additional capital, we would aim for a holistic global exposure of at least 50% or higher.
We understand the political risks in South Africa. There is a certain probability that things may get worse but there is also a certain probability that things may get better. It’s important to have a balanced view and take all these probabilities into account when making investment decisions. Because of this, we are not of the view that all your money should be offshore.
Younger wealth accumulators struggle to determine the true size of future expenses and therefore may not know what size the “funding bucket” needs to be. What then?
Our younger generation needs to plan for a longer time horizon in which many things can change. Because of this, our approach would be as follows:
- Save towards retirement and make use of tax deductions.
- Limit your debt. It may mean limiting your property aspirations.
- Externalise (invest offshore) any additional savings.
- Aim for the 50% offshore target. Good global exposure gives you optionality in life.
- We do a GAP analysis for our younger clients to determine whether their savings towards retirement is sufficient.
How do I externalise funds?
If you have the option, avoid Rand denominated offshore funds. Physically take the funds offshore and invest in USD, EUR or GBP. South Africa has relatively relaxed exchange controls for individuals.
The following rules apply:
- Any taxpayer in good standing, over 18 years may make use of the allowance.
- R1m discretionary allowance per year.
- R10m offshore allowance per year. For this allowance, you need to apply for a tax clearance certificate from SARS.
What other factors influence our decisions?
It’s important that we understand what is driving your decision to take more funds offshore. Often the concern is driven by behavioural biases which can distort your thinking and may lead to irrational decisions. Over the past 5 years, offshore markets delivered significantly better performance whilst South African politics faced some of its biggest challenges in decades. Therefore, many South Africans are investing funds offshore, sometimes even cashing in pension funds to do so. We need to check whether these decisions are driven by sound investment and risk guidelines or whether it’s driven by emotion.
Of course, advisors also suffer from behaviour biases and the way they view the world will influence the advice given to clients. Our team frequently check in to see if we’re giving advice based on a known behavioural bias.
These are some examples of biases currently at play:
Recency bias: remembering something that happened recently and extrapolating this into the future.
The example below shows how a fund’s recent performance influences the flow to and from the fund. If the fund does well (2016) money flows into the fund, and if the fund performs poorly (2019) funds flow out of the fund.
Source: Allan Gray
The next example shows how investors move from poor-performing funds to better performing funds. Over the past 5 years, SA equity funds underperformed income funds. Because of this, SA Equity funds suffered a total outflow of R120bn in 2019 alone.
When this happens on a large scale, a bias like herding (where investors tend to mimic the crowd) could also come into play.
Confirmation bias: favouring information that confirms your existing beliefs.
This is an interesting one that affects South Africans in a big way. If you are worried and negative about the country, you will find many sources confirming this belief. It can be so convincing that even optimists start wondering if they have it wrong.
I think the risk of making big, irrational decisions that can impact your finances significantly is critically high now. We need to be honest about the long-term structural issues and build protection into our portfolios. This needs to happen is a systematic way because knee-jerk reactions can destroy capital. This is especially true when markets are particularly under or overvalued like now.
Below is a table showing past returns and expected returns for each asset class. Over the past 10 years, global equity has significantly outperformed local equity (16.6% per annum vs 11.1% per annum). Over the last 5 years, the difference has been even more dramatic (13.5% per annum vs 3.7% per annum). As discussed above, one of our biggest temptations is to extrapolate the recent past when looking to the future. Switching local equity to global equity now means you lock in years of underperformance relative to global equity AND you possibly give up on future outperformance.
At Foundation Family Wealth we want to address each client’s concerns and identify risks. Externalising money to de-risk is a priority. We, however, prefer to do this in a systematic and balanced way. We consider various biases and possible outcomes. We want to ensure that you have peace of mind, but also that you participate in future opportunities. Our goal is for your holistic portfolio to provide you and your family with optionality.
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