TRANSITION TO RETIREMENT INCOME STREAMS: THE STATE OF PLAY

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1 1 Chris Chow, Rainmaker Information Chris is the Technical Services Manager at Rainmaker. He is responsible for researching and producing educational content regarding all areas of financial advice, with expertise in areas including SMSF, superannuation, income streams, social security, aged care, personal taxation and estate planning. Chris is also responsible for managing the Financial Standard CPD program for subscribers and the ongoing education of internal staff. Chris has 7 years experience in the financial services industry and previously worked as a Technical Services Analyst within Colonial First State s technical services team, FirstTech. Chris holds a BBus (Fin Plan) and BA (German) from the University of Technology, Sydney. TRANSITION TO RETIREMENT INCOME STREAMS: THE STATE OF PLAY Chris Chow Introduction Once seen as a cornerstone tax minimisation strategy for wealthy baby boomers, the changes to the concessional tax treatment of transition to retirement income streams (TRIS) has significantly changed the landscape of financial advice. The changes occurred as the Government took the view that TRIS were intended to be used to assist with the transition into retirement by supplementing income as a result of working fewer hours. However, due to the significant tax concessions, the reality was that they were used purely to minimise tax without a reduction in working hours. As a result, these concessions have been tightened to rein in their use as a tax minimisation tool. The impact to the viability of TRIS has been further exacerbated by the reduction of the concessional contribution cap, reducing the pre-tax amounts that can be contributed into superannuation. While the changes do not necessarily spell the end of TRIS strategies, it does limit the scenarios where it would benefit clients to utilise a TRIS while making deductible concessional contributions. This is dependent on a number of factors including: age of the client, income levels, available cash flow, and tax components of the TRIS. The exclusion of TRIS from being in retirement phase has also had some unintended consequences, including the emergence of the view (taken by the Government and the ATO) that a TRIS is a completely separate type of income stream from an account-based pension (ABP). This view is incongruent to historical industry practice and has significant implications when converting a TRIS to an ABP and also for estate planning purposes. This paper will delve into the impact of consequences of all of these changes and examine the overall viability of TRIS now and into the future. What s changed? Since 1 July 2017, TRIS is no longer considered a retirement phase income stream and will be subject to the same tax rates superannuation in accumulation phase, i.e. up to 15%. Prior to this, investments earnings in a TRIS (including capital gains) were considered exempt current pension income (ECPI) and exempt from income tax. Note The taxation of TRIS pension payments has not changed, which is a common misconception. For a person aged 56-59, the taxable component of pension payments will continue to be taxed at marginal tax rates with a 15% tax offset. Pension payments for those aged 60 and over are still exempt from tax. Removing this exemption raises the question of their efficacy when used in tandem with a concessional contributions strategy, especially where TRIS payments are used to maintain net income. Furthermore, coupled with the reduction in the concessional (pre-tax) contribution cap for people of all ages back to $25,000 p.a., the overall effectiveness of TRIS has been significantly hampered.

2 2 This is especially the case for high income earners, as much of their concessional contributions cap (CC cap) will already be depleted by their compulsory superannuation guarantee (SG), which means they have less room to make deductible concessional contributions. The reduction in Division 293 income threshold to $250,000 also leaves little room for very high income earners to benefit from such strategies, as any concessional contributions subject to Division 293 is effectively taxed at 30%. The analysis examines outcomes of three scenarios of using a TRIS while salary sacrificing up to the relevant CC cap at varying levels of income. The three scenarios compared are: Base case: Do nothing - No TRIS or salary sacrifice strategy (i.e. only SG paid into super) Old rules: Pre-1 July 2017 rules (i.e. $35,000 CC cap and 0% tax on TRIS earnings) New rules: Post-1 July 2017 rules (i.e. $25,000 CC cap and 15% tax on TRIS earnings) Assumptions In all of the scenarios, the following assumptions have been used: Earnings of 7% within TRIS and accumulation, all taxable where applicable 15% tax on earnings at end of income year where applicable TRIS commenced upon reaching 56 and have not met a condition of release SG contributions based on income before salary sacrifice Salary sacrifice up to CC cap and pension payments used to maintain net income All tax rates, caps and projections are not indexed or adjusted for CPI There is no untaxed element, i.e. assumes interest in taxed super fund only Contributions and pension payments made monthly at end of period All figures compounded monthly where relevant All figures have been rounded to nearest dollar Individual tax benefit As a result of the reforms, the potential individual tax benefit of the strategy has been diminished and will impact some more than others. The tax benefit analysis will compare tax payable in the base case to the tax payable (including contributions tax) in the other two scenarios where salary sacrifice contributions are made up to the CC cap and using TRIS payments to maintain net income. Where TRIS payments include a taxable component, the taxable portion is taxed at individual marginal tax rates with a 15% tax offset on the taxable component, while the tax-free component is exempt from tax. For people aged 60 and over, TRIS payments are exempt from tax regardless of tax components (this analysis assumes there is no untaxed element). Table 1: Individual tax benefit in first year of TRIS at varying income and tax components: Old rules vs. New rules 100%* 75% 50% 25% 0% : $60,000 Old rules $5,822 $5,497 $4,105 $2,647 $1,168 New rules $4,221 $3,546 $2,792 $1,944 $983 Reduction in benefit $1,601 $1,951 $1,313 $703 $185 Old rules $5,293 $4,412 $3,436 $2,348 $1,129 New rules $3,343 $2,797 $2,193 $1,520 $765 Reduction in benefit $1,950 $1,615 $1,243 $828 $364 Old rules $5,664 $4,745 $3,701 $2,504 $1,118 New rules $3,264 $2,734 $2,133 $1,443 $644 Reduction in benefit $2,400 $2,011 $1,568 $1,061 $474 Old rules $4,296 $3,599 $2,807 $1,899 $848 New rules $1,896 $1,588 $1,239 $838 $374 Reduction in benefit $2,400 $2,011 $1,568 $1,061 $474 *The tax benefit for people aged 60 or over is the same for people under 60 with a TRIS with 100% tax-free component. As shown in table 1, there is still a fairly significant personal tax benefit of a TRIS strategy with salary sacrifice under the new rules, though the benefit has been significantly reduced especially for higher income earners due to the reduced CC cap. However, to gain an overall picture of the impact of the reforms, the reduction in the tax benefit also needs to be looked at in conjunction with the impact to the overall retirement after a certain period, as well as considering the impact of any advice fees. Total superannuation after reaching 60 The reforms will also have a negative impact to a person s total superannuation (TSB) in retirement given they will be taxed in a TRIS and cannot contribute as much into super while getting a tax deduction. The following analysis looks at people who reach preservation age (currently 56) with $500,000 in accumulation and what their TSB (includes both accumulation and TRIS) will be after 4 years upon reaching age 60. The analysis only goes to age 60 since all TRIS pension payments become tax-free regardless of tax components. The amount that is used to commence a TRIS will vary due to the minimum 4% drawdown requirement. Before the changes, it was beneficial to maximise a TRIS given TRIS earnings were tax exempt and this is also done in the analysis. This is achieved by looking at the smallest pension payment required at each income level and equating it to 4% of the starting, rounded down to nearest $10,000. For the purposes of illustrating the potential benefits lost after the reforms, the TRIS starting s will vary between income levels and under the old and new rules scenarios, which are detailed in tables 2 and 3.

3 3 TSB: Base case For the base case, the TSB is purely a person s accumulation interest when only adding SG contributions to their starting accumulation of $500,000. As shown in table 4, s can still grow quite significantly after 4 years of only making SG contributions. The base case will be used to compare against the other two scenarios, where SG and salary sacrifice contributions (up to the CC cap) are made into accumulation phase while payments are drawn down from the TRIS. Impact to TSB: Before and after the reforms Table 5 compares the TSB under the old and new rules when salary sacrificing up to the concessional and using a TRIS to maintain net income. To state the obvious, the s are lower under the new rules due to the reduction in the concessional cap and the loss of the tax exemption on earnings in a TRIS. However, it also shows that people with higher tax-free components when commencing a TRIS are impacted the most. This is mainly due to: people with higher tax-free components need smaller pension payments to maintain net income, and given the smaller drawdowns, they would have had more tax-free earnings pre-1 July When you also include the reduced tax benefit from each of the four years, the reduction in the efficacy of the strategy is very significant. The combined loss in benefit of four years worth of tax benefit and reduction in when comparing the old rules and new rules is shown in table 6, and illustrates the major impact that the reforms will have over such a short period. Impact to TSB: Looking forward from 1 July 2017 While it is interesting to compare what could have been had the superannuation reforms not occurred, it is more pertinent to look forward and compare the benefits of using a TRIS in the post-1 July landscape. Table 7 compares the overall benefit (including the personal tax benefit and also the impact to TSB) of using a TRIS with salary sacrifice under the new rules compared with the base case. As shown in the table, the benefits can still be very significant (despite table 6 showing how significant the benefits actually were under the old rules) and shows that a TRIS strategy with salary sacrifice can still be extremely effective in certain circumstances while being less so in others. However, this should be taken with a grain of salt especially because we are looking at the future of TRIS strategies from the financial advice perspective. For TRIS to continue to be a viable strategy for financial advisers, we will need to look at the impact if clients are being charged fees for the advice. Impact of advice fees If we assume fairly conservative advice fees - $2,000 upfront and $2,400 p.a. ongoing fees ($200 deducted monthly at end of month) - the outcomes in table 8 do not look anywhere near as rosy. Once advice fees are taken into account, the reality is that the efficacy of TRIS strategies is greatly impacted. The individual tax benefit that a person receives is also included when considering the benefit of the strategy to show the total benefit after advice fees. Table 2: TRIS starting s: Old rules Smallest pension payment required in scenarios TRIS starting Accumulation $60,000 $19,083 $470,000 $30,000 $90,000 $17,190 $420,000 $80,000 $120,000 $14,396 $350,000 $150,000 $180,000 $10,919 $270,000 $230,000 Table 3: TRIS starting : New rules Smallest pension payment required in scenarios TRIS starting Accumulation $60,000 $12,184 $300,000 $200,000 $90,000 $10,640 $260,000 $240,000 $120,000 $8,296 $200,000 $300,000 $180,000 $4,819 $120,000 $380,000 Table 4: TSB at age 60: Base case Super at age 60 (SG only) $60,000 $656,631 $90,000 $667,601 $120,000 $678,571 $180,000 $700,511 Table 5: TSB at age 60: Old rules vs. New rules : $60, % 75% 50% 25% 0% Old rules $705,857 $704,354 $697,914 $691,167 $684,322 New rules $675,437 $672,363 $668,928 $665,065 $660,689 Reduction in $30,420 $31,991 $28,986 $26,102 $23,633 Old rules $711,985 $707,908 $703,391 $698,358 $692,716 New rules $682,467 $679,984 $677,233 $674,167 $670,731 Reduction in $29,518 $27,924 $26,158 $24,191 $21,985 Old rules $721,226 $716,974 $712,142 $706,603 $700,189 New rules $693,141 $690,729 $687,989 $684,848 $681,210 Reduction in $28,085 $26,245 $24,153 $21,755 $18,979 Old rules $733,103 $729,878 $726,213 $722,011 $717,146 New rules $708,974 $707,574 $705,982 $704,157 $702,044 Reduction in $24,129 $22,304 $20,231 $17,854 $15,102 Table 6: Combined reduction in tax benefit and impact to TSB over 4 years after the reforms (old rules vs. new rules). 100% 75% 50% 25% 0% $60,000 $36,824 $39,795 $34,238 $28,914 $24,373 $90,000 $37,318 $34,384 $31,130 $27,503 $23,441 $120,000 $37,685 $34,289 $30,425 $25,999 $20,875 $180,000 $33,729 $30,348 $26,503 $22,098 $16,998

4 4 Table 7: Tax benefit plus impact to TSB at age 60: Base case (SG only) vs. New rules 100%* 75% 50% 25% 0% : $60,000 Base case (SG only) $656,631 New rules $675,437 $672,363 $668,928 $665,065 $660,689 Tax benefit $16,886 $14,185 $11,168 $7,775 $3,931 Benefit of strategy $35,692 $29,917 $23,465 $16,209 $7,989 Base case (SG only) $667,601 New rules $682,467 $679,984 $677,233 $674,167 $670,731 Tax benefit $13,371 $11,190 $8,773 $6,081 $3,062 Benefit of strategy $28,237 $23,573 $18,405 $12,647 $6,192 Base case (SG only) $678,571 New rules $693,141 $690,729 $687,989 $684,848 $681,210 Tax benefit $13,056 $10,938 $8,531 $5,772 $2,577 Benefit of strategy $27,626 $23,096 $17,949 $12,049 $5,216 Base case (SG only) $700,511 New rules $708,974 $707,574 $705,982 $704,157 $702,044 Tax benefit $7,584 $6,354 $4,955 $3,353 $1,497 Benefit of strategy $16,047 $13,417 $10,426 $6,999 $3,030 *The TSB for people who are aged 60 or over when they commence a TRIS would have the same outcome as people under 60 commencing a TRIS with 100% tax-free component. Table 8: TSB at age 60: Advice fees with tax benefit 100%* 75% 50% 25% 0% : $60,000 Base case (SG only) $656,631 New rules $662,030 $658,956 $655,521 $651,658 $647,282 Tax benefit $16,886 $14,185 $11,168 $7,775 $3,931 Benefit of strategy $22,284 $16,510 $10,058 $2,802 -$5,419 Base case (SG only) $667,601 New rules $669,695 $667,212 $664,461 $661,395 $657,958 Tax benefit $13,371 $11,190 $8,773 $6,081 $3,062 Benefit of strategy $15,465 $10,801 $5,633 -$125 -$6,581 Base case (SG only) $678,571 New rules $680,368 $677,957 $675,217 $672,075 $668,438 Tax benefit $13,056 $10,938 $8,531 $5,772 $2,577 Benefit of strategy $14,853 $10,324 $5,176 -$724 -$7,556 Base case (SG only) $700,511 New rules $696,202 $694,801 $693,210 $691,385 $689,272 Tax benefit $7,584 $6,354 $4,955 $3,353 $1,497 Benefit of strategy $3,275 $644 -$2,346 -$5,774 -$9,742 *Also applies for people who are aged 60 or over. As table 8 shows, the benefits of a TRIS strategy with salary sacrifice are really only clear for people on lower incomes, people with a higher tax-free component and also for people who are aged 60 and over. The benefits are no longer present if you have no tax-free component after advice fees are taken into account. Given the level of fees chosen are quite modest, the strategy loses even more allure once higher fees are being paid. Key points from analysis Higher tax-free component As expected, the higher the tax-free component, the greater the benefit of the strategy. This is due to paying less or no tax at all and requiring lower pension payments to maintain net income, meaning their s are not being eroded as much as people with lower tax-free components. More effective for low income earners Those on lower incomes actually benefit more from the strategy because of lower SG contributions giving them more room to salary sacrifice. The taxable portions of pension payments are taxed at lower tax rates while those on $60,000 income also get some access to the benefit of the low income tax offset after salary sacrificing, further reducing the amount of pension payment they require. High income earners most impacted In contrast, as the income levels increase, the benefit continues to reduce to the point where those on $180,000 with no tax-free component would almost be better off doing nothing and only receiving SG contributions given the marginal benefit. Furthermore, as mentioned, people with very high income (in excess of $250,000) may also be required to pay an additional 15% tax on some or all of their non-excessive concessional contributions due to Division 293 tax being applicable. This may effectively mean that TRIS strategies are no longer a viable option at all under the new rules for those on very high income. TRIS retains efficacy for age 60 or over TRIS strategies are still very effective if you are over age 60, which is akin to having a TRIS with 100% tax-free component given the pension payments will be tax-free. As such, people aged 60 to 64 will get the maximum potential benefit of a TRIS strategy, regardless of the taxable component of their TRIS. Advice fees limits efficacy of TRIS When someone has 100% taxable component, they will be better off doing absolutely nothing if they have to pay modest advice fees to commence a TRIS and salary sacrifice strategy, and is also the case for a person with only 75% taxable component unless they are on lower income. As discussed, high income earners are not likely to pursue a TRIS strategy unless they can start a TRIS with a majority tax-free component. Other points to consider Greater potential for self-employed People who do not receive SG, e.g. self-employed, will benefit more from a TRIS strategy and making personal deductible contributions

5 5 to super. This is because they can claim a deduction on the full concessional cap whereas employees cannot claim the SG amount they receive. Hence, this should be taken into consideration when dealing with clients who do not receive SG as the strategy may be more suitable for these clients. Catch-up concessional contributions From 1 July 2018, clients will start accruing unused cap amounts for catch-up concessional contributions and be eligible if they have TSBs of less than $500,000. If the clients start to accrue unused concessional cap, then there is potential for them to salary sacrifice or make personal deductible contributions greater than the concessional cap, which would again make a TRIS strategy potentially more appealing again given the larger amounts that could be potentially deducted, which generally makes TRIS strategies more viable. Future of TRIS strategies Under 60 with taxable components While the client s personal tax benefit of the TRIS has only slightly reduced under the new rules, the removal of the TRIS earnings tax exemption means that is the only tax benefit they receive as having a TRIS is now akin to having money sit in accumulation phase, except there is no drawdown requirement in accumulation. After taking into account any advice fees, it is actually detrimental to use a TRIS with a 100% taxable component as part of a salary sacrifice strategy. This is also generally true for those with 25% tax-free component except for those with lower incomes. If the advice fees were higher, which could very well be the case given the modest fee structure used, this would also erode the benefit and put the viability of the strategy for those with 50% or even 75% tax-free components into question. For people under 60 with less than 25% tax-free component, a TRIS might only be used in future if they purely require additional cash flow and are not looking to make pre-tax contributions. If a client has sufficient surplus cash flow to make deductible concessional contributions, there is no need to recommend a TRIS at all as they can access the individual tax benefit without drawing down their superannuation. Making an NCC to commence a TRIS If a client has surplus cash available and can commence a TRIS after making a non-concessional contribution (NCC), this will significantly improve the benefits of such a strategy, as the pension payments are tax-free and smaller pension payments are required to maintain net income. However, under the old rules, there were still merits of a TRIS strategy where making an NCC was not an option. Clients that commenced a TRIS with minimal or no tax-free component also enjoyed the benefit of tax exempt earnings within the TRIS, and it was generally accepted that a TRIS with salary sacrifice provided benefits for the majority of people who paid some tax, regardless of tax components. This is no longer the case in the current environment and advisers need to take into account the variety of factors discussed before they recommend using a TRIS. 60 and over or 100% tax-free component For people aged 60 and over or aged but with a TRIS with 100% tax-free component (from making an NCC to commence a TRIS), pension payments from a TRIS are exempt from tax and using these payments to maintain income still provides a significant personal tax benefit each year. However, due to the lower CC cap, the tax benefit has diminished much more sharply compared to those with large taxable components. As shown in the analysis, it is evident that there are still overall benefits to such a combined strategy. For these people, the tax benefit and overall increase to TSB are large enough to warrant using a TRIS to minimise tax compared to doing nothing, even after advice fees and would still be viable if fees were higher than the fee structure used. As such, the future of TRIS for people under 60 will largely depend on people having an accumulation fund with significant taxfree component or surplus cash to make an NCC to commence a TRIS, while the use of TRIS for those aged 60 should not change given the benefits that it still provides. Other Practical TRIS issues Conversion to retirement phase income stream In initial legislation, it was stipulated that TRIS could only convert to a retirement phase income stream by ceasing and recommencing a new income stream, even after meeting a condition of release. Furthermore, the Government and ATO appeared to take the view that a TRIS is not an account-based pension (ABP) with additional restrictions, but that it was in itself a type of income stream separate from an ABP. This went against industry practice before the super reforms, where a TRIS has always been treated as an ABP with additional restrictions that no longer applied once the trustee was satisfied that a full condition of release had been met. Amending legislation After receiving much feedback from industry regarding this change of tact, the Government partly addressed this issue in the Treasury Laws Amendment (2017 Measures No 2) Act 2017 (TLA 2017/2). In the explanatory memorandum (EM) to TLA 2017/2, it is stated that a TRIS enters into the retirement phase where the person in receipt of the TRIS meets a condition of release with a nil cashing restriction. Specifically, the applicable conditions of release included the following: Permanent incapacity 3. Terminal illness, and 4. Attaining age 65. The only automatic conversion of a TRIS to a retirement phase income stream occurs when age 65 is attained. For the remaining conditions, a TRIS is only converted to a retirement phase income stream when the member notifies the trustee that they have satisfied the condition of release. Therefore, members should inform the trustee as soon as possible to take advantage of the earnings tax exemptions afforded to retirement phase income streams.

6 6 Uncertainty remains on death While this has partly rectified the issue of not requiring members to cease a TRIS to have a retirement phase income stream, it only deals with a TRIS entering retirement phase for tax purposes and does not address the issue regarding a TRIS being paid on death to a reversionary beneficiary who has not met a condition of release. Paying TRIS to reversionary beneficiaries The EM to TLA 2017/2 also intimated that a superannuation income stream that is established as a TRIS will always retain its character as a TRIS, which means that a TRIS will never permanently convert to a retirement phase income stream even if the deceased had met a condition of release. Whether a TRIS paid to a reversionary is in retirement phase will depend on whether the reversionary has also met a condition of release. The reforms also amended regulation 6.21 of Superannuation Industry (Supervision) Regulations 1994, which deals with the manner and forms that death benefits can be paid to beneficiaries from regulated super funds, to require the payment of death benefits via one or more pensions to be from a superannuation income stream that is in the retirement phase. A reversionary income stream does not actually cease and continues to be paid to the reversionary beneficiary. Because of this, a TRIS cannot be paid to a reversionary beneficiary unless the reversionary meets one of the conditions of release stipulated as it would not be considered a retirement phase income stream (this issue does not apply if the client made a binding/non-lapsing death benefit nomination or had no nomination in place because the deceased s income stream ceases on death). Invalid nomination? If this is the case, this raises the question of whether the nomination is even valid and may lead to death benefits being distributed in a manner incongruous with the wishes of the deceased, as super benefits with invalid nominations are generally distributed in accordance with the super fund s trust deed. The deed may stipulate payment to certain beneficiaries, payment to the deceased s estate (opening up potential legal challenges) or give the trustee full discretion. Conclusion: Where to from here? The Government set out to ensure that a TRIS is used in future as it was initially intended, i.e. to supplement income as people reduce employment hours / income and transition into retirement. It is fair to say that they have effectively done that and gone are the days recommending TRIS to every person who reaches preservation age. However, this certainly does not spell the end of TRIS and whether it is recommended will depend much on the many client variables discussed including age, income, cash flow and tax components. Although the benefits of a TRIS have diminished, it still very obviously provides a way to reduce tax and increase your TSB for people of preservation age with higher tax-free components and also for those aged 60 and over. TRIS will also continue to be used by clients with cash flow deficits who need to supplement income by accessing their super, even though reforms do no favours for these people given the earnings in TRIS are no longer exempt from tax. Apart from these people, each TRIS recommendation will need to be viewed on its own merit to see if there is any benefit for the client given the greater likelihood it would actually not benefit the client, especially if advice fees wipe out any benefit. The current stance of the Government and ATO that a TRIS is a separate type of income stream from an ABP has further complicated the issue and any further legislative changes may ultimately see TRIS go the way of market-linked / term-allocated pensions. Given that preservation age is slowly moving to age 60, the use of TRIS would have slowly declined regardless to those aged 60 to 64 and still in the workforce. The Government s reforms appear to be fasttracking the inevitable. fs More clarity required The ATO recently released a draft update to LCG 2016/9 that appears to reinforce the stance taken, where paragraph 15 clearly identifies that a reversionary beneficiary with a TRIS would also need to meet a condition of release to be in retirement phase (submissions close on 27/10/2017). While it is yet to be fully clarified as industry tries to persuade the Government to change this stance, there are ways to get around such a scenario until further clarification, which include: if the member has met a full condition of release, to cease the TRIS and commence an ABP with a reversionary nomination, changing reversionary nominations to binding/non-lapsing nominations where permitted, and If neither is an option, ceasing the TRIS and making a binding/ non-lapsing nomination after either starting a new TRIS or retaining the money in accumulation. Until then, one can only hope that common sense prevails where a TRIS will not be treated as a separate type of income stream and be allowed to convert to a retirement phase income stream on death.