Sinking Funds Demystified

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In the ever-evolving landscape of personal finance and wealth management, investors are faced with an increasingly wide array of choices. In South Africa, the investment universe has many options, from unit trusts and share portfolios to retirement annuities and tax-free investment accounts. Each type of investment comes with its own set of advantages and limitations, and their effectiveness often depends on the investor’s goals, time horizon, and tax considerations. Navigating this landscape requires not only a clear understanding of each investment product but also a strategic approach to combining them in ways that support long-term wealth creation.

One of the investment choices is a sinking fund, sometimes referred to as a tax-efficient fund or a life policy wrapper. It’s a product that has often been misunderstood due to its seemingly complex structure and long-term nature. Many investors overlook them because of rigid terms, limited liquidity, and layered fees, and sometimes confuse them with an endowment, as they are similar.

Sinking funds offer a unique combination of tax efficiency, estate planning benefits, and structured liquidity for long-term investing. When used appropriately, especially for goals like legacy planning or funding future liabilities, they can be a powerful tool in a diversified wealth strategy, especially for high net-worth individuals and trusts. This article aims to unpack the key features, limitations, and strategic uses of sinking fund policies in South Africa.

What is a Sinking Fund?

A sinking fund is a life insurance-based investment product that is governed by the Long-Term Insurance Act. Even though it’s a life policy, sinking funds no longer resemble traditional life insurance products (picturing a man with a briefcase trying to sell you a product!). Besides some restrictions, it’s now very similar in look and feel to a unit trust investment, both in the range of the funds available and its wide accessibility across investment platforms like Allan Gray, Glacier, and Ninety One.

Investors can contribute either a lump sum or recurring premiums into a local or offshore portfolio of unit trusts or other instruments, with one or more nominated beneficiaries, where the policy matures after a minimum term of five years. While sinking funds are subject to certain rules and restrictions, they are considered discretionary investments and are not bound by Regulation 28 of the Pension Funds Act.

The Case for Sinking Funds

1. Tax Efficiency

Sinking funds can be used as tax-efficient vehicles for high-income earners. Unlike other discretionary investments, where returns are taxed at the investor’s marginal rate, sinking funds are taxed within the policy at a flat rate of 30%. This can result in significant tax savings for individuals in higher tax brackets.

Trusts with natural beneficiaries can also take advantage of the flat tax rate of 30% compared to their standard flat rate of 45%. Sinking funds do not offer tax advantages for companies. Companies already pay tax at a flat rate of 27%, so the internal tax structure of a sinking fund offers no benefit. Companies cannot nominate natural person beneficiaries, limiting estate planning benefits.

When you invest in a sinking fund, the life insurance company is the legal owner of the investment. Because of this, the insurer pays the tax on any income or capital gains earned inside the sinking fund on your behalf.

Why This Matters for Individual Investors

• Your investment is placed in the Individual Policyholder Fund.

• The insurer pays 30% tax on interest earned from the investment and 12% net effective CGT on your behalf.

• You don’t need to declare this income or gains on your personal tax return.

• You won’t get the R40,000 annual capital gain exclusion or annual interest exemption that you would with a direct investment, so these exemptions remain intact, which can be utilised for other investments.

This structure is especially useful if your personal marginal tax rate is higher than 30%, as it can reduce your overall tax burden.

Example

Let’s say you’re in the 45% tax bracket and you earn R100,000 in interest from your investment:

• In a direct investment, you’d pay R45,000 in tax.

• In a sinking fund, the insurer pays R30,000 in tax on your behalf.

• This results in a R15,000 tax saving, with no need to file anything with SARS.

2. Estate Planning Benefits

A sinking fund will continue into perpetuity until the investment is fully withdrawn or the individual investor dies without a nominated beneficiary. From an estate planning perspective, sinking funds allow for the nomination of beneficiaries, which enables the insurer to transfer the policy or pay out benefits directly to them. This avoids executor’s fees and ensures faster access to inherited assets, often within weeks. Capital gains tax rolls over and is therefore not triggered when the policy is transferred into the name of your beneficiary/ies after you pass away.

How Endowments Differ from Sinking Funds

• Unlike endowments, which may terminate prematurely upon the passing of the life assured, sinking funds offer greater continuity and control.

• Sinking funds do not enjoy creditor protection under Section 63 of the Long-Term Insurance Act, which is available to endowments where the policyholder or their spouse is the life assured.

3. Liquidity Considerations

Sinking funds enforce a minimum five-year restricted term, promoting disciplined investing and long-term financial planning. While this limits short-term access, it encourages investors to stay focused on their financial goals while allowing the investment to benefit from compounding growth.

During the initial five-year period, investors may make one withdrawal without repayment, and in some cases may be allowed one interest-free loan, ensuring that funds are not entirely inaccessible. Any withdrawal is limited to the amount of total contributions plus interest at a rate of 5% p.a. However, any withdrawals or surrenders beyond these allowances may incur penalty costs.

To enhance liquidity, investors can open multiple sinking fund policies, which is platform-dependent. Once the five-year restriction ends, withdrawals are unrestricted in both frequency and amount, and all other benefits remain intact. Additional contributions, within legislated limits, can be made without restarting the restricted term. A new 5-year restriction period begins if your annual contributions are 20% or more above the highest annual contribution in the previous two years.

Here is a table that shows a comparison across some of the common investment vehicles in South Africa:

Common Questions About Sinking Funds

Here are the answers to some common queries about sinking funds:

Sinking Funds are Not One-Size-Fits-All

Sinking funds may not be suitable for every investor because they come with specific constraints that limit flexibility. The fixed terms and restricted access to funds can be problematic for those who may need liquidity or want to adjust their strategy over time. Additionally, the tax advantages of sinking funds may not benefit individuals in lower tax brackets.

But for investors in higher tax brackets, those with estate planning needs, or those seeking structured long-term growth, sinking funds can be a highly effective financial planning tool. The key is understanding the tax mechanics, liquidity constraints, and how to structure the policy to maximise its benefits.