STRATEGIC CONCEPTS: RETIREMENT INCOME STREAMS

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1 RETIREMENT INCOME STREAM CONCEPTS One of the key benefits of the Australian retirement system is the flexibility surrounding the methods of using your accumulated assets to provide you with income in retirement. Further, from 2007 there is no longer a requirement to cash out your super or to access it via a pension at retirement or age 65 thereby allowing your super to remain in super for your entire life the birth of the retirement accumulation account. This change has removed the requirement to remove funds from the super system meaning that your assets can continue to accumulate in the concessionally taxed super environment without you ever being forced to draw down on them (unlike under the compulsory cashing rule which applied prior to 2007) while providing a high degree of Estate Planning flexibility and control. There are a wide variety of retirement income streams that may be used, however for the purposes of this document we have focused on the key income streams that are currently able to be set up. Generally speaking, retirement income streams established under previous laws and regulations are able to continue or be converted into a currently available income stream. However, summarising all of the historically available income streams is beyond the scope of this document. We will therefore focus on the following currently available retirement income streams: 1. Account Based Pensions 2. Transition to Retirement Income Streams 3. Annuities Account Based Pension Account Based Pensions are the most common of the various superannuation pensions. Their appeal lies in the wide array of flexibility and the significant tax concessions available to superannuation when in pension phase where all investment returns, including all income and all realised capital gains, all pension payments made and all lump withdrawals made are either concessionally taxed prior to age 60 or thereafter tax free. Quite simply, the only conditions that apply under the law and regulations to Account Based Pensions are:» Annual Income Payment a pension payment must be made at least annually» Capital as with all super pensions, the capital of the pension is not able to be added to. If you wish to use additional accumulated super to provide a pension you can either: commence a new additional income stream with the additional accumulated super which would leave you with multiple pensions; or rollback an existing pension to accumulation super to add this to the additional accumulated super and then commence a new single pension with the combined amount» Minimum Pension Income the pension income must be equal to or greater than a minimum percentage of the account balance (either the balance at commencement (in which case the minimum will be pro-rated for the remaining time in the financial year) or at 1 July each year) as follows: Information correct at July 2014 Page 1

2 Age at 1 July Standard Minimum Pension Factor <65 4% % % % % % 95 or older 14% For instance, if the account balance of an Account Based Pension on 1 July was $400,000, in the financial year starting on that date, a 60-year old pensioner would be required to receive at least $16,000; whereas a 76 year old pensioner would be required to receive at least $24,000. The minimum income is recalculated each year on 1 July using the account balance on that date. Important note: It is imperative to note that if you are running a pension through a Family Super Fund (FSF) / Self Managed Super Fund (SMSF) and you fail to pay at least the minimum pension amount then the ATO will treat the FSF as if the pension did not exist at all during that financial year and therefore the tax exemption applicable to returns from assets supporting pensions will not apply. This could carry significant taxation consequences as well as render Estate Planning arrangements put in place in relation to the pension ineffective. It is therefore a high priority to ensure that you ensure that any pension you run within a FSF pays at least the minimum income amount in each financial year. Importantly, there is no maximum income payment prescribed under the law for Account Based Pensions, unless they are established as a Transition to Retirement Income Stream (see below). You could in effect withdraw the entire account balance if you wished. However, you would need to be the very sure that this is in your best interests before you did so. Investments held within Account Based Pensions may be any investment allowable under the superannuation laws, including market linked investments such as cash, fixed interest, property, Australian Shares, International Shares and alternative investments. Account Based Pensions can be run from publicly available super funds or from your Family Super Fund (SMSF). Importantly, as is the case with all super laws, they prescribe minimum standards only. Whereas the Trustee of a Family Super Fund (SMSF) is able to add more conditions to govern the operation of an Account Based Pension if they wish. This ability can be highly beneficial for Estate Planning purposes. Account Based Pensions were introduced under the Simpler Super reforms of 2007 and effectively replaced several other types of pensions, including Allocated Pensions. However please note that if you have existing pensions that were established under different rules (for instance prior to 2007), the conditions of those pensions will continue to apply. For instance, an Allocated Pension has a maximum income amount and this continues to apply unless some specific action is taken by you or the Trustee of the Fund to convert an Allocated Pension to an Account Based Pension. An Account Based Pension is a superannuation pension which benefits from significant tax concessions, Information correct at July 2014 Page 2

3 including tax free investment returns (income and capital gains) for pensioners of all ages, as well as concessionally taxed pension income payments and lump sums for those under age 60 and tax free pension income payments and lump sums for those aged 60 or over. Consequently the amounts invested into an Account Based Pension must come from a superannuation account, and therefore if you wish to use nonsuper assets, these must be contributed to super in the first place. This requires compliance with the super contribution laws and contribution caps (limits). Transition to Retirement Income Streams (TTRIS) Transition to Retirement (TTR) refers to rules than enable you to access your super once you reach your Preservation Age but before you retire. Preservation age is shown in the table below: Date of Birth From Date of Birth To Preservation age 30 June 1960 and earlier 55 1 July June July June July June July June July 1964 and later 65 Please refer to the Mammoth Financial website Case Studies section for further details on this popular and frequently highly beneficial strategy. A pension used to implement a Transition to Retirement strategy (a TTRIS ) may be one of several types of super pensions however the most common is a Non-Commutable Account Based Pension, which is an Account Based Pension with the following additional rules:» Non-Commutable this means that lump sum withdrawals (known as commutations) may not be made. That is, the only amounts that can be withdrawn from the pension are the income payments» Maximum Pension the amount of pension income payable is limited to 10% of the account balance at commencement or at 1 July each year Depending on the specific Governing Rules of the Fund and the rules of the specific pension, upon satisfaction of a Condition of Release (for example reaching age 65, changing jobs after age 60 or permanent retirement), the process to change a TTRIS to an Account Based Pension with no limit on access to funds and no maximum income amount can be a relatively straight forward one (depending on the Governing Rules of your super fund). TTRIS s are most commonly used in one of two ways: 1. Supplementary Income for those who wish to reduce their working hours without retiring completely (which is a Condition of Release that allows you to access your super without these conditions) but who would be unable to meet their living expenses from their reduced employment income, the income from the TTRIS supplements their employment income 2. Wealth Creation Strategy for a large number of people, continuing to work while combining a TTRIS with salary sacrifice to super can create further wealth in the lead up to retirement. Please refer to the Case Studies section of the Mammoth Financial website for further details Information correct at July 2014 Page 3

4 A TTRIS is a superannuation pension which benefits from the same tax concessions as explained above for an Account Based Pension. TTRIS s may be obtained from a publicly available super fund or they may be operated from a Family Super Fund (SMSF). Annuities An annuity is a retirement income stream whereby an initial amount is invested that is then used to pay an income stream. The income payments are guaranteed for the life of the annuity. To safeguard the guaranteed payments the initial investment is invested into a tightly regulated set of investments, known as a Statutory Fund, which is generally comprised predominantly of cash and fixed interest investments however may also include other investments including property. Consequently, in return for the certainty of a guaranteed return, annuities generally pay low rates of return, although this will depend on the general level of interest rates available at the time of the initial investment. Annuities have the following features:» Term: this may be either a set term in years, or payable for the remaining life of the annuitant (investor)» Residual Capital Value (RCV): this is the amount that will be returned to the investor at the end of the term. It may be anything from nil to 100%. Generally, when considering using annuities for generating retirement income streams, the RCV will be nil as most retirees will need to use their capital to meet living expenses.» Indexation: income payments can be kept level or indexed each year to keep pace with the everrising cost of living» Payment Frequency: payments are generally able to be made monthly, quarterly, half yearly or annually» Initial Investment Source: may be funded from super or non-super investments and therefore may be established at an age when you can no longer contribute to super, such as after age 65 and not working or after age 75 As the return is known at the time of the initial investment, the amount to be invested will be determined by the income that you require and the portion of your initial investment that you wish to receive back at the end of the term (the RCV). CASH PLUS INVESTMENT OPTION STRATEGY MANAGING TIMING RISK Account Based, Allocated and Transition to Retirement Pensions all provide the opportunity to invest in growth assets that will rise and fall in value over short periods. Each income payment from a pension requires the sale of some kind of asset to fund the payment of cash to the pensioner. Pension payments are generally made regularly (eg monthly) and the amount is typically constant irrespective of the state of investment markets (unless you elect to change the income amount). It is generally advantageous to reduce pension income payments in times when investment returns are weak or negative to reduce the amount that is sold at temporarily low prices. However for many that may not be possible given the need to meet fixed living expenses. Information correct at July 2014 Page 4

5 If investment markets fall, the unit price of investments investing in those markets will also fall. Therefore if a pension payment falls due at a time when the unit price has fallen, a higher number of units or investments need to be sold at these lower prices to provide the same level of cash to pay the pension payment. Having pension payments drawn or funded from investment options that include growth assets therefore carries the risk of selling more investments at lower prices and therefore of owning fewer investments to benefit when investment markets and investment prices start to rise again. Effectively it compounds your loses. Here is an example of how this can work against you with an initial investment of $300,000 invested in an investment option with a variable unit price that is used to pay pension payments: $ Unit Price Units Value Starting Position $300, Month Pension Payment $ $ Unit Price Units Sold Cumulative Units January February March April May June July August September October November December $ Unit Price Units Value Ending Position $ $285, In the example above, drawing investments from an investment option or options with variable unit prices has resulted in the need to sell investments initially valued at $14, to provide the $12,000 of pension payments throughout the year as a result of the temporary fall in value of the investments throughout the year. So even though the unit price in the above example started and finished the year at the same value ($1.00), the value of the investments was reduced by more than the amount of income received. Cash Plus Investment Option Strategy Fortunately there is another way the Cash Plus Investment Option strategy. In this strategy, the pensioner separates their investments into two sections - those that will be drawn down to fund income payments and those that will be invested with a longer term view to benefit from market movements. Generally and depending on personal circumstances, the amount invested to provide for income payments should be sufficient to fund a reasonable period of pension payments (for instance, 2 years of payments). Information correct at July 2014 Page 5

6 This amount is then invested in a stable investment option, such as cash, for which the unit price can be expected to stay steady. Pension payments are then funded by drawing only from this stable investment option. The remaining funds are then invested into market linked investments and won t need to be drawn down on for the 2-year period. This then mitigates the timing risk that investments need to be sold when prices are low to fund fixed pension payments. As the investments in the first section are reduced over time by the income payments, the pensioner chooses to re-build the balance in that section of their portfolio by selling other investments to rebuild the cash balance. The key difference is that the decision regarding that sale to rebuild the cash balance is at the pensioners discretion and can be made in the context of the prevailing market conditions. So, in the example above, with an initial investment of $300,000 and pension income of $12,000 pa, the Cash Plus Investment Option Strategy for this pensioner would involve investing: Investment Option Initial Investment Unit Price Start Unit Price End Value at Year End Type Cash $24,000 $1.00 $1.00 $12,000 Market Linked* $276,000 $1.00 $1.00 $276,000 Total $300,000 $288,000 * this is the same investment option as in the previous example where the value falls during the year but ends the year at the same value as it started the year. In this example, the Cash Plus Investment Option Strategy has saved this client $2, in investments that have not needed to be sold in the first year. The benefits grow over time as the magic of compound investment returns act on the larger number of investments. The Cash Plus Investment Option Strategy is a risk reduction strategy and like most strategies there is a trade-off between risk and return. If investment returns from the market-linked investments increase during the timeframe the Cash Plus Investment Option Strategy will detract from returns (however it will continue to assist with controlling risk) empowering your financial evolution TM Need more information? If you wish to discuss how this strategic concept summary could benefit you, please feel welcome to contact Mammoth Financial on: p e alex@mammothfinancial.com.au General Advice Warning: The advice may not be suitable to you because it contains general advice that has not been tailored to your personal circumstances. Please seek personal financial advice prior to acting on the information. Tax Agent Warning: We are not registered tax agents under the Tax Agent Services Act If you intend to rely on the advice to satisfy liabilities or obligations or claim entitlements that arise, or could arise, under a taxation law, you should request advice from a registered tax agent. Opt Out Clause: Mammoth Financial respects your privacy. Should you wish not to receive further publications please contact our office. Information correct at July 2014 Page 6