How to choose and open a tax-free savings account
16 July 2015
Posted by: Author: Robert Laing
Author: Robert Laing (BDlive)
Writing practical how-to guides involves going step-by-step through whatever you are trying to explain. That’s what I’ll attempt to do in this and coming columns by going through the steps involved in choosing and opening a tax-free savings account (TFSA to its friends).
An advantage of writing a column for the web rather than print is you can change mistakes once they have been pointed out. I needed to do it for last week’s column because I jumped to a wrong conclusion that the new TFSAs let you reduce your taxable income. (Like Albert Einstein, I find income tax the hardest thing in the world to understand.)
It turns out government isn’t as generous as I thought with its TFSAs. The accounts let you escape taxes on interest, dividends and capital gains, but the money you put in (which is limited to R30,000 a year and R500,000 over your lifetime) comes from after-tax income.
In last week’s column I mentioned Standard Bank was pitching its TFSA offering at a brockerage of 0.25% – half of what it charges for a full featured stockbroking account. Thanks to an e-mail from Absa Stockbrokers head of digital and education Ridwaan Moolla, I subsequently discovered Absa is offering an even better deal at 0.2% brokerage.
I decided to go with Absa since I’m familiar with its online stockbroking offering. But there are a couple of problems I stumbled across which probably also apply to the other banks and financial institutions offering these accounts.
You can’t simply go to your bank and say, "could I open a TFSA account please" because they come in three broad categories.
At www.absa.co.za/Absacoza/Individual/Saving-%26-Investing/Tax-free-solutions, Absa offers you a choice of what it brands a "tax-free savings account" or a "tax-free investment account". One is a money market account and the other lets you buy a selection of unit trusts.
For the option I want — a TFSA that lets me invest in exchange-traded funds — it transpired I mustn’t go the bank’s website, but to www.absastockbrokers.co.za/. If you click on "Create an Account" it gives you the option, "I wish to open a tax-free savings account (TFSA)". The online application process if fairly painless, but I now still need to complete the Fica rigmarole of supplying the bank with a utility bill etc.
Absa Stockbrokers’ TFSA account is identical to its full-featured broking account except the menu is limited to exchange-traded funds. Interestingly, exchange-traded notes don’t seem to be included in government’s tax deal, something to explore in a future column.
Let me digress a little into money market accounts and why I think they should be avoided. One of the great mysteries of our age is known as the "equity premium puzzle". To quote from its Wikipedia entry: "The puzzle has led to an extensive research effort in both macroeconomics and finance. So far a range of useful theoretical tools and numerically plausible explanations have been presented, but no one solution is generally accepted by economists."
To put the equity premium puzzle in a South African contest, I’ll compare the total returns of the FTSE/JSE top 40 index (something Satrix along with a growing number of competing exchange-traded fund managers offer as a product) against a money market index called the "Stefi 12 month NCD rate".
If you had invested R100 on December 31, 2000 (that’s unfortunately as far back as the data goes) in an account paying the Stefi rate, by the end of last year compound interest would have grown your savings to R319.71. If you had put that R100 into the JSE top 40 and reinvested your dividends, your savings would have grown to R837.80 over the same period.
The stock market — using the top 40 as a proxy — provided an average annual interest rate of 16.4% while the money market account averaged 8.66%.
As I mentioned in a previous column, I’m a huge fan of massive open online courses and in one I did recently, Chicago Unversity’s Asset Pricing, the lecturer estimated the equity premium of the S&P 500 over interest paid by US treasury bonds was about seven percentage points a year using data going back nearly a century. So the example I’m using of the top 40 versus the Stefi is in a similar ball park even if the data set is too small to really give convincing evidence.
What puzzles economists is that considering the returns of the stock market are so much higher — around seven or eight percentage points — than interest paid by banks, why do most people put their money in banks rather than the stock market?
The most obvious answer to the equity premium puzzle is that a stock market investor is much like the person in the old joke with one foot in boiling water and one foot in icy water, and therefore statistically comfortable. Comparing the R100 a JSE top 40 investor started with in 2000 to the R837.80 at the end of 2014 glosses over a wild roller coaster ride where the investor suffered one gut-wrenching 23.58% drop in 2008 after a 11.28% dip in 2002. These falls were outweighed by a giddy 48.24% bull run in 2005 followed by another 40.9% in 2006.
Two important figures in what has come to be known as "computational finance" are the winners of the 1990 Nobel economics prize, Harry Markowitz and William Sharpe. Professor Markowitz is credited with being the first person to think of graphing different kinds of investments by plotting their average return on the vertical axis against their standard deviation on the horizontal axis.
In the case of the top 40, its standard deviation is about 19.4% (higher than its average return of 16.4%) while the Stefi index swings just 2.3% around its average return of 8.66%.
This type of graph Markowitz invented enabled economists to tackle a lot of investment problems with high-school geometry. Sharpe’s theory is built around a straight line that intersects the vertical axis at the "risk-free rate" and then rises at a gradient called the "Sharpe ratio".
Even if you don’t have the stomach for the wild ride the stock market will take your money on, before you let a bank talk you into opening a money market account, check out what government is offering at www.secure.rsaretailbonds.gov.za/. Government retail bonds are as close as you can get in the real world to Sharpe’s theoretical "risk-free" rate. Besides offering higher interest rates than banks, government is a safer bet given it can always just print money to repay its debts.
As the 10% haircut imposed on Abil bonds brought home to many bank savings account holders the hard way, money in the bank is not completely risk free. I got calls from a couple of distraught readers when the Abil haircut was imposed and people were informed by their financial institutions this meant their capital in their money market accounts would be reduced by a percentage point or so.
You can buy government bonds as exchange-traded funds these days, so you can build your own money market account if you’re worried about a stock market crash. Money market accounts are just a bad deal that give you little choice and little return after inflation is taken into account.
The debate against accounts offering unit trusts rather than exchange-traded funds is less clear cut, which I’ll save for next week’s column.
This article first appeared on bdlive.co.za.