Current as at July 2015 Adviser use only. Technical guide: Challenger Lifetime and Term Annuities

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1 Current as at July 2015 Adviser use only Technical guide: Challenger Lifetime and Term Annuities

2 Table of contents Introduction 1 Challenger Liquid Lifetime 2 Product features 3 Centrelink treatment 5 How a lifetime annuity is counted towards the Age Pension 5 Withdrawal guarantee reduction 6 Treatment of lump sum withdrawals 6 Benefit reduction option 6 Adviser fees 6 Taxation treatment 7 Taxation upon investment 7 Taxation of regular payments 7 Taxation upon withdrawal (death) 8 Taxation upon withdrawal (voluntary) 9 Calculating the reduced purchase price 10 Challenger Term Annuity 11 Product features 12 Centrelink treatment 13 How term annuities are counted toward the Age Pension 13 Treatment of lump sum withdrawals 14 Splitting income 14 Reversionary and joint policies 14 Adviser fees 14 Taxation treatment 15 Taxation upon investment 15 Taxation of regular payments 15 Taxation upon withdrawal (death) 16 Taxation upon withdrawal (voluntary) 17 Calculating the reduced purchase price 17 Case study 18

3 Introduction With the first wave of baby boomers now hitting retirement age, it s likely you ll have more and more clients coming to you for retirement advice. A person retiring at age 65 today can expect to live 30 years or more, so your retired clients will probably need your help to make their money last the distance. With the full Age Pension currently 1 at $22, per annum for singles and $33, per annum for couples, many of your clients will have to consider how they can best invest their accumulated savings to help meet their retirement income needs. An annuity is a source of income; one which is secure and dependable, which can complement both the Age Pension and other investments like an account-based pension. Annuities may also provide some taxation benefits and interact efficiently with social security rules, which may improve your client s financial position. Term annuities and lifetime annuities are treated differently for Centrelink and taxation purposes. In this guide, we explore the technical aspects of each, including how they are assessed for Centrelink under the Income and Assets Tests, how their income is taxed and how they re taxed on withdrawal. Challenger Tech Specialists in retirement and aged care The Challenger Tech team provides specialist technical advice, support and training to financial advisers on retirement and aged care. Have you got a question? Phone challengertech@challenger.com.au 1 From 1 July 2015 until 19 September Challenger Annuities technical guide 1

4 Liquid Lifetime Product name: Challenger Guaranteed Annuity (Liquid Lifetime) Lifetime annuities create a regular cash flow for life, regardless of how long your client lives or how investment markets perform. 2 Challenger Annuities technical guide

5 Challenger Liquid Lifetime Product features Figure 1: Challenger Guaranteed Annuity (Liquid Lifetime) at a glance Investment term Residual capital value The investor s lifetime or the lifetime of the investor and another person Nil Minimum investment $10,000 Payment indexation Payment frequency Nominating a reversionary The withdrawal period The withdrawal guarantee Voluntary withdrawals On death Choice of regular payments adjusted fully in line with changes in the Consumer Price Index (CPI), partially in line with changes in the CPI or not at all. Monthly, quarterly, half-yearly or yearly. The investor can choose for their regular payments to be made for the life of a second person after they die. That person is called the reversionary. If the investor buys a Liquid Lifetime annuity with money rolled over within the superannuation system, the reversionary must be their spouse (as defined by law). Liquid Lifetime has a withdrawal period of 15 years, so within this period Liquid Lifetime has a withdrawal value. This means that at any time within 15 years of the start of Liquid Lifetime: The investor can end Liquid Lifetime and take its voluntary withdrawal 2 value as a lump sum if the withdrawal is made at the end of the 15-year withdrawal period, the amount payable is the withdrawal guarantee amount. On death of the last annuitant, a death benefit, at least equal to the withdrawal guarantee amount, is paid as a lump sum. If the investor withdraws from Liquid Lifetime at the end of the withdrawal period, the withdrawal value will be a guaranteed percentage of their initial capital investment. If the investor is aged less than 75 when they buy Liquid Lifetime, this guarantee is up to 100%. Investors can choose to reduce the maximum withdrawal guarantee percentage, which will generally result in increased regular payments. After the end of the 15-year withdrawal period the investor s Liquid Lifetime will cease to have a withdrawal value and no lump sum will be payable on their death or voluntary withdrawal. The investor can withdraw fully from Liquid Lifetime within the first 15 years (the withdrawal period); however, they cannot make a partial withdrawal. The investor can choose not to have a right to have a withdrawal guarantee percentage at the end of the withdrawal period in return for higher regular payments. If the investor chooses the no voluntary withdrawal guarantee, they will be able to voluntarily withdraw within the first 15 years at any time; however, the withdrawal value will be calculated using the prescribed minimum surrender value. If the investor dies within 15 years of the start of their Liquid Lifetime annuity (during the withdrawal period) and they do not have a reversionary or joint owner, we will make a lump sum payment at least equal to the withdrawal guarantee to their estate. If the investor dies during the withdrawal period and the reversionary or surviving joint owner then also dies during the withdrawal period, we will make a lump sum payment at least equal to the withdrawal guarantee to the reversionary s or the joint owner s estate. If the investor dies after the withdrawal period, no lump sum or further regular payment is payable unless they have a surviving reversionary or joint owner, in which case their regular payments will continue to be made to them for the rest of their life. 2 Please refer to the product disclosure statement for full product details. Challenger Annuities technical guide 3

6 Figure 1: Challenger Guaranteed Annuity (Liquid Lifetime) at a glance (continued) Benefit reduction option Upfront adviser service fee Ongoing adviser service fee The benefit reduction option is only available if the investor has elected a reversionary or if they are a joint owner. With this option, when the investor buys Liquid Lifetime, they can choose that any payments due after their death (or the earliest death of a joint owner) are paid at a reduced level. They can choose to have those payments reduced by 25% or 50%. If they make this choice, the regular payments will reduce by the chosen percentage, and the withdrawal guarantee also reduces by that percentage. Up to 0.55% (including Goods and Services Tax (GST) of the capital investment multiplied by life expectancy (up to a maximum of 2.2% including GST). If an investor withdraws their annuity, or their annuity is withdrawn due to death, we may require that all or part of the upfront adviser service fee be repaid to us by you. This is because the upfront adviser service fee is calculated on the basis that the annuity is held for your client s life expectancy at commencement. Any agreed dollar amount up to the annual payment amount. 4 Challenger Annuities technical guide

7 Centrelink treatment How a lifetime annuity is counted towards the Age Pension Centrelink uses two means tests to determine eligibility for the Age Pension: the Income Test and the Assets Test. The test that produces the lowest result is the one that is used to determine entitlements. Lifetime annuities such as Challenger s Guaranteed Annuity (Liquid Lifetime) generally interact efficiently with social security rules. For example, the assessment of Liquid Lifetime may benefit from a deduction amount which is considered for social security purposes to represent the return of capital over the lifetime of the investor. Calculating the deduction amount To calculate the deduction amount for a lifetime annuity, divide the purchase price of the annuity by the investor s life expectancy at the start of the annuity (for annuities purchased from 1 January 2015, use Australian Government Actuary, Australian Life Tables ). Deduction amount = Purchase price divided by life expectancy at start of annuity For example, Bruce, a 65-year-old male has a life expectancy of years. If he invests $100,000 in a lifetime annuity, he will have an annual deduction amount of: Once you have worked out the deduction amount, you can then work out the lifetime annuity s assessable income (for the Income Test) and the asset value (for the Assets Test). The following sections summarise how a lifetime annuity is assessed under the Income and Assets Tests. It applies to lifetime annuities bought with either superannuation or non-superannuation money. Income Test: How to calculate the assessable income Assessable income = Annual payment less annual deduction amount The application of the deduction amount means that the lifetime annuity may provide a favourable outcome when compared to deemed financial assets, such as term deposits. Assets Test: How to calculate the asset value Asset value = Purchase price less (deduction amount x term elapsed) The deduction amount will reduce the lifetime annuity s asset value counted toward the Centrelink Assets Test every six months, or every 12 months where yearly payments are made. Using the same example, Bruce s lifetime annuity with a deduction amount of $5, which pays $4, in the first year will have the Centrelink asset value profile described in Figure 2. $100,000/19.22 = $5, per annum Where a lifetime annuity is established with a reversionary or a joint owner (non-superannuation money only), the deduction amount is worked out using the longer of the two life expectancies. For example, if Bruce s lifetime annuity had Wendy (Bruce s spouse who is also age 65) as the reversionary, his lifetime annuity s deduction amount will be worked out as follows: Bruce s life expectancy = (65-year-old male) Wendy s life expectancy = (65-year-old female) The deduction amount will use Wendy s life expectancy: $100,000/22.05 = $4, per annum 3 Based on a Challenger Guaranteed Annuity (Liquid Lifetime) quote as at 14 July 2015 for Bruce. The quote assumes a withdrawal guarantee of 100%, no adviser fees and regular payments are paid monthly with no indexation. Challenger Annuities technical guide 5

8 Figure 2: The asset value of a lifetime annuity reduces over time Start of year Asset value for social security purposes 1 $100, $94, $89, $84, $79, $73, $68, $63, $58, $53, $47, $42, $37, $32, $27, $21, $16, $11, $6, $1, $0.00 Withdrawal guarantee reduction The way the deduction amount is calculated or applied does not change if the lifetime annuity s withdrawal guarantee has been reduced. However, where a different guarantee amount is chosen, any change in the income payment amount may affect the assessable level of income for Centrelink purposes. Treatment of lump sum withdrawals Centrelink will treat the full withdrawal of the lifetime annuity as the return of capital, which means that the withdrawal amount will not be assessed as income under the Income Test. The manner in which the funds are subsequently invested will determine how they will be assessed under the Assets and Income Tests. For example, if the withdrawn funds are invested in a term deposit, Centrelink will assess the value of the term deposit as a financial asset and deem it under the Income Test. Benefit reduction option If the benefit reduction option has been selected for Liquid Lifetime, the regular payments (and the withdrawal guarantee) of the annuity are reduced by the reduction percentage on death of the primary owner (or the earliest death of a joint owner). The benefit reduction option does not change the Centrelink deduction amount. The asset value profile of the annuity will continue to reduce over time as detailed in Figure 2. However, as the amount of regular payments is reduced (and the deduction amount remains unchanged), the amount assessed under the Income Test is also generally reduced. Adviser fees Upfront adviser service fee Where an upfront adviser service fee has been negotiated, Liquid Lifetime s regular payments are reduced to reflect the amount of the fee. However, this fee does not reduce the purchase price. Ongoing adviser service fee With Liquid Lifetime, your client can agree to the payment of an ongoing adviser service fee, which can be deducted from their regular payments. Where an ongoing adviser service fee is charged, the regular payments are reduced by the amount of the fee and the net amount credited to the client s nominated account. Centrelink does not reduce the assessable income of the lifetime annuity by the amount of this fee. 6 Challenger Annuities technical guide

9 Taxation treatment This information applies to individual Australian tax residents only and is based on our understanding of current taxation legislation as at the date of this document. Taxation upon investment No tax is deducted from the initial amount invested in a lifetime annuity bought with non-superannuation money. Lifetime annuities bought using rolled over superannuation funds with an untaxed element will have the applicable tax deducted prior to commencement. Note: Liquid Lifetime can only be purchased with superannuation benefits that are classified as unrestricted non-preserved. For clients under age 60, the benefit will also need to be 100% tax free. Taxation of regular payments Non-superannuation money The regular payments are split into two components: Deductible amount The deductible amount is the amount of each annuity payment that is deemed to represent the return of part of the original investment. This amount is tax free. The deductible amount is calculated based on the gender and age of the investor at the time of investment. It is fixed for the term of the lifetime annuity. To calculate the deductible amount, divide the purchase price by the investor s life expectancy at commencement. For joint policies or policies with a reversionary beneficiary, the longest life expectancy of the two is used to calculate the deductible amount. For example, Bruce s lifetime annuity will have an annual deductible amount of: $100,000/19.22 = $5, per annum Assessable amount If annuity payments in the financial year are greater than the deductible amount, the excess amount is called the assessable amount and is assessable for tax purposes. The assessable amount is the amount (if any) of each annuity payment that notionally represents earnings. Depending on the investor s personal circumstances, this amount may be subject to Pay As You Go (PAYG) withholding tax. Note: PAYG is not a final tax, and a greater or lesser amount of tax may apply on assessment of your annual income tax return. Where income paid from the lifetime annuity is less than the deductible amount, no income is counted for taxation purposes. The excess deductible amount does not reduce other assessable income of the individual. The excess deductible amount is carried forward and may be used to offset assessable income from the lifetime annuity in future years (if any). Joint policies Challenger allows investors to select the regular payment amount to be paid to each owner. For example, one owner can be allocated 30% of the regular payments and the second owner the remaining 70%. In these cases, the deductible and assessable amounts for tax purposes will also be split in these proportions. On death of one of the owners, the full regular payment (subject to any reduction selected) will be paid and the full deductible amount will be allocated to the surviving owner. Where a benefit reduction was selected, the assessable amount may also reduce. Withdrawal guarantee reduction Reducing Liquid Lifetime s withdrawal guarantee does not change the way the deductible amount is calculated or applied when working out the assessable amount of regular income payments. However, if the higher income payment exceeds the deductible amount, the difference between the income payment and the deductible amount will be assessable for tax purposes. Reversionary Where a reversionary is nominated, regular payments will continue to be paid to the reversionary and taxed in their name. Note that the deductible amount does not get recalculated and the assessable amount (if any) will be the proportion of the income payment in excess of the deductible amount. Superannuation money Superannuation income streams such as superannuation annuities must meet specific standards in the Superannuation Industry (Supervision). One of the SIS standards requires that payments received in the first year must meet the Government s minimum payment standard. Challenger Annuities technical guide 7

10 Generally, where these requirements are met, income from the income stream for those aged 60 and above is tax free. For those younger than 60, and at least preservation age, only the taxable component of the income payment is taxable (with tax reduced by a 15% tax offset). On death of the original owner, the income paid to the reversionary (if applicable) will also be tax free if the original owner or the reversionary was aged 60 or over at the time of death. Challenger s quote facility equote, available on our AdviserOnline site provides quotes that meet the SIS payment standards to ensure that payments made to those 60 and above are tax free. Note: Challenger currently only offers superannuation annuities to people with unrestricted non-preserved benefits who are entitled to receive tax-free payments. Taxation upon withdrawal (death) Non-superannuation money Upon death, any amount payable to the investor s estate will comprise an amount that represents a return of remaining capital (called the reduced purchase price) and income. The reduced purchase price is worked out by reducing the purchase price by the deductible amount used each year. If the regular payments were less than the deductible amount, the purchase price is reduced by the income paid. The taxation of death benefits generally depends on the tax circumstances of the estate. Under current rules, the estate will generally be taxed on the income component at the same marginal tax rates as an individual (including being eligible for the tax-free threshold, but excluding Medicare levy). The tax-free threshold will not be available where the deceased died more than three years before the end of the income year. In Bruce s case, if his lifetime annuity (with a withdrawal guarantee of 100%) was purchased using nonsuperannuation money (for $100,000) and in the event that he died within the withdrawal period, his estate will have the following assessable income upon receiving the withdrawal payment. This amount is included in the tax return of the estate in the tax year it is received. The components are shown in Figure 3. Figure 3: The estate s assessable income upon receiving the withdrawal payment (100% withdrawal guarantee) End of year Withdrawal value Reduced purchase price Income component (assessable) 1 $100, $95, $4, $100, $90, $9, $100, $85, $14, $100, $80, $19, $100, $76, $23, $100, $71, $28, $100, $66, $33, $100, $61, $38, $100, $57, $42, $100, $52, $47, $100, $47, $52, $100, $42, $57, $100, $37, $62, $100, $33, $66, $100, $28, $71, If Bruce chose to reduce his withdrawal guarantee to 85% (increasing his regular income payments from $4, per annum 4 to $5, ), his estate will instead have assessable income in the event of his death inside the withdrawal period as shown in Figure 4. 4 Based on a Challenger Guaranteed Annuity (Liquid Lifetime) quote as at 14 July 2015 for Bruce. The quote assumes a withdrawal guarantee of 100%, no adviser fees and regular payments are paid monthly with no indexation. 5 Based on a Challenger Guaranteed Annuity (Liquid Lifetime) quote as at 14 July 2015 for Bruce. The quote assumes a withdrawal guarantee of 85%, no adviser fees and regular payments are paid monthly with no indexation. 8 Challenger Annuities technical guide

11 Figure 4: The estate s assessable income upon receiving the withdrawal payment (85% withdrawal guarantee) End of year Withdrawal value Reduced purchase price Income component (assessable) 1 $99, $94, $4, $98, $89, $8, $97, $84, $12, $96, $79, $16, $95, $73, $21, $94, $68, $25, $93, $63, $29, $92, $58, $33, $91, $53, $37, $90, $47, $42, $89, $42, $46, $88, $37, $50, $87, $32, $54, $86, $27, $58, $85, $21, $63, Superannuation money Lifetime annuities bought with superannuation money are generally made up of a taxable and a tax-free component. The proportion of these components is set at the start of the lifetime annuity and remains fixed for the life of the lifetime annuity. On death and where a withdrawal value applies, a lump sum is paid to the estate. If the estate pays the benefit to tax dependants, the amount paid is not subject to tax regardless of the components. However, if the benefit was paid to a non-tax dependant, the taxable component is subject to tax at a maximum rate of 15% (Government levies may also apply). In summary, tax dependants are: a spouse or ex-spouse a child under the age of 18 (or otherwise a financial dependant) someone who is a financial dependant someone with whom an interdependency relationship existed. Taxation upon withdrawal (voluntary) Non-superannuation money If a lifetime annuity is withdrawn before or at the end of the withdrawal period, the withdrawal value will comprise an amount that represents a return of remaining capital (called the reduced purchase price see the following section) and income. The income component of the withdrawal will be assessable to the investor and, depending on personal tax circumstances, subject to tax. Using the same example above, if Bruce decided to withdraw his lifetime annuity in full, his annuity would have the components as shown in Figure 5: Figure 5: Bruce s income component on withdrawal (100% withdrawal guarantee) End of year Withdrawal value 6 Reduced purchase price Income component (assessable) 1 $97, $95, $2, $97, $90, $6, $95, $85, $10, $94, $80, $14, $94, $76, $17, $93, $71, $22, $94, $66, $27, $94, $61, $32, $94, $57, $37, $95, $52, $43, $96, $47, $48, $97, $42, $54, $98, $37, $60, $98, $33, $65, $100, $28, $71, If Bruce chose to reduce his withdrawal guarantee to 85% (increasing his regular income payments from $4, per annum 7 to $5, per annum 8 ), 6 Based on Challenger Guaranteed Annuity (Liquid Lifetime) and bank bill swap rates effective 14 July Based on a Challenger Guaranteed Annuity (Liquid Lifetime) quote as at 14 July 2015 for Bruce. The quote assumes a withdrawal guarantee of 100%, no adviser fees and regular payments are paid monthly with no indexation. 8 Based on a Challenger Guaranteed Annuity (Liquid Lifetime) quote as at 14 July 2015 for Bruce. The quote assumes a withdrawal guarantee of 85%, no adviser fees and regular payments are paid monthly with no indexation. Challenger Annuities technical guide 9

12 his lifetime annuity would instead have the following assessable income on withdrawal inside the guaranteed period. Figure 6: Bruce s income component on withdrawal (85% withdrawal guarantee) End of year Withdrawal value 9 Reduced purchase price Income component (assessable) 1 $91, $94, $ $89, $89, $ $88, $84, $4, $88, $79, $8, $87, $73, $13, $86, $68, $18, $86, $63, $23, $86, $58, $28, $86, $53, $33, $86, $47, $38, $86, $42, $43, $85, $37, $48, $85, $32, $53, $85, $27, $58, $85, $21, $63, Calculating the reduced purchase price The reduced purchase price of an annuity for taxation purposes is calculated by deducting the total of the deductible amounts used (which includes any excess deductible amounts carried forward and used in a later year) from the amount invested. For example, Bruce, who invests $100,000 in a lifetime annuity, will have the following reduced purchase price at the end of the first year: Deductible amount: $5, (see page 7 for calculation) Annuity payment received: $4, Deductible amount used each year: $4, End of year one reduced purchase price = $95, ($100,000 $4,769.28). This is the methodology used when calculating the reduced purchase prices shown within the tables in Figures 3-6. Superannuation money Where a lifetime annuity purchased with superannuation money is withdrawn within the withdrawal period, the amount withdrawn can be paid as a lump sum or rolled over to another superannuation fund. Amounts taken as a lump sum are generally tax free for people aged 60 and over. 9 Based on Challenger Guaranteed Annuity (Liquid Lifetime) and bank bill swap rates effective 14 July Based on a Challenger Guaranteed Annuity (Liquid Lifetime) quote as at 14 July 2015 for a lifetime annuity with a 100% withdrawal guarantee, nil adviser fees and income paid monthly with no indexation. 10 Challenger Annuities technical guide

13 Term Annuity Product name: Challenger Guaranteed Annuity A Challenger Guaranteed Annuity is also referred to as a Term Annuity. Term annuities create regular, guaranteed cash flow for your client s desired term, regardless of how investment markets perform. Challenger Annuities technical guide 11

14 Challenger Term Annuity Product features Figure 7: Challenger Guaranteed Annuity at a glance Investment term 1 to 50 years (in whole years) Minimum investment $10,000 Capital repayment Payment indexation Payment frequency Voluntary withdrawals Nominating beneficiaries Upfront adviser service fee Ongoing adviser service fee The investor can choose to have all of their capital repaid at the end of the investment term, or they can choose to have some or all of their capital repaid (as part of their regular payments) throughout the investment term. Any capital that remains at the end of the term is called the residual capital value (RCV). If: the investor s chosen investment term is at least two years, and they choose to have all their capital returned to them as part of their regular payments throughout the term, then they can choose to have their regular payments increased annually. The annual increase can be in line with increases in the Consumer Price Index (CPI) or a fixed whole percentage rate of up to 5%. Monthly, quarterly, half-yearly or yearly. The investor can withdraw before the end of the investment term (in part or in full). However, the Term Annuity is designed to be held until the end of the investment term and so they might not receive the benefits they would have, had they not withdrawn, and they might receive back less than they invested. Generally, an investor can elect for an individual (or individuals) to receive the remaining benefit of their Term Annuity if they die. If the Term Annuity is bought with money rolled over within the superannuation system, and the beneficiary is not the investor s dependant at the time of the investor s death, the benefit will be paid to their estate. Up to 0.55% (including GST) of the capital investment multiplied by the term (up to a maximum of 2.2% including GST). Any agreed dollar amount up to the annual payment amount. Please refer to the product disclosure statement for full product details. 12 Challenger Annuities technical guide

15 Centrelink treatment How term annuities are counted toward the Age Pension Unlike a lifetime annuity, the Centrelink assessment of Challenger s Guaranteed Annuity (Term Annuity) will depend on the actual term of the annuity. Terms of five years or less A term annuity with a term of five years or less (unless the term is equal to or greater than the person s life expectancy) will be classified as a short-term income stream and treated as a financial investment. Centrelink s income and asset assessments of short-term income streams are as follows: Income Test Deemed (refer to Challenger Fast Facts) Assets Test Asset value = Purchase price less (deduction amount multiplied by term elapsed) Terms greater than five years A term annuity with a term of six years or more will be classified as a long-term income stream and will be assessed under Centrelink s Assets Test and Income Test as follows: Income Test Assessable income = Annual payment less annual deduction amount It is important to note that: Assets Test Asset value = Purchase price less (deduction amount multiplied by term elapsed) the above applies to annuities bought with either superannuation or non-superannuation money, and the purchase price is reduced by any withdrawals. Calculating the deduction amount The deduction amount generally represents the return of capital over the term of the annuity. To calculate the deduction amount for a term annuity, divide the purchase price (less withdrawals and residual capital value) by the nominated term at commencement. For example, Bruce and Wendy also bought a term annuity for $100,000 as part of their retirement plan. The term annuity has a 10-year term with no residual capital value. Bruce and Wendy s term annuity will have a deduction amount of: $100,000/10 = $10,000 per annum Income Test: How to calculate the assessable income The deduction amount is the proportion of each annuity payment that is not counted for Centrelink purposes. This means that where income paid from the annuity exceeds the deduction amount, then only the difference between income paid and the deduction amount is counted for Centrelink purposes. Assets Test: How to calculate the asset value The amount of the purchase price counted as an asset for Centrelink will reduce by the deduction amount over the term of the annuity. Where regular payments are paid more frequently than yearly (e.g. monthly), the purchase price will reduce every six months. If regular payments are paid yearly, the purchase price will reduce every 12 months. Assuming Bruce and Wendy do not make any withdrawals from their term annuity, the assessable asset value of their term annuity will reduce uniformly as follows: Figure 8: Bruce and Wendy s reducing assessable asset value Start Asset value for Centrelink purposes of year 1 $100, $90, $80, $70, $60, $50, $40, $30, $20, $10, $0.00 Challenger Annuities technical guide 13

16 Treatment of lump sum withdrawals Centrelink/Department of Veterans Affairs (DVA) treats full and partial withdrawals of the term annuity as a return of capital, and does not currently assess them under the Centrelink Income Test. How the funds are subsequently invested will determine how they will be assessed under the Assets and Income Tests. For example, if the withdrawn funds are invested in a term deposit, Centrelink/DVA will assess the value of the term deposit as a financial asset and deem it under the Income Test. Where a partial withdraw is made, Centrelink will recalculate the assessable asset value of the term annuity based on a purchase price and deduction amount that reflects the withdrawal. For example, if Bruce and Wendy withdrew $10,000 from their term annuity at the end of the second year, the deduction amount going forward would be: = Purchase price (less withdrawals and residual capital value) divided by the nominated term at commencement = ($100,000 $10,000)/10 = $9,000 per annum Their assessable asset value after the withdrawal would be: = Purchase price less (deduction amount multiplied by term elapsed) = ($100,000 $10,000) ($9,000 x 2) Reversionary and joint policies On death of the primary owner, payments will continue to the reversionary or remaining owner (joint policies). For Centrelink purposes, the reversionary beneficiary will inherit the deduction amount and assessable asset value of the primary owner. For joint policies, the full deduction amount and asset value are applied to the surviving owner s Income and Assets Test assessments (that is, the income split proportion is no longer applied). Adviser fees Upfront adviser fees Where an upfront adviser service fee has been negotiated, the Term Annuity s regular payments are reduced to reflect the amount of the fee. However, this fee does not reduce the purchase price used to calculate the deduction amount. Ongoing adviser service fee With the Term Annuity, your client can agree to the payment of an ongoing adviser service fee, which can be deducted from their regular payments. Annuities that pay an ongoing adviser service fee have their regular payments reduced by the amount of the fee and the net amount credited to the client s nominated account. Centrelink does not reduce the assessable income of the Term Annuity by the amount of this fee. = $72,000 Splitting income Where the term annuity is owned jointly by two investors (non-superannuation money only), the regular payment can be split according to a nominated proportion. This proportion will also be used to split the deduction amount and assessable asset value across the two investors for Centrelink purposes. 14 Challenger Annuities technical guide

17 Taxation treatment This information applies to individual Australian tax residents only and is based on our understanding of current taxation legislation as at the date of this document. Taxation upon investment No tax is deducted from the initial amount invested in a term annuity using non-superannuation money. Term annuities purchased using rolled over superannuation funds with an untaxed element will have the applicable tax deducted prior to commencement. Note: The Term Annuity can only be purchased with superannuation benefits that are classified as unrestricted non-preserved. For clients under age 60, the benefit will also need to be 100% tax free. Taxation of regular payments The tax treatment of the term annuity s regular payments is different for annuities purchased with non-superannuation and superannuation money. Non-superannuation money For term annuities purchased with non-superannuation money, the regular payments are split into two components: Deductible amount The deductible amount is the amount of each annuity payment that is deemed to represent the return of part of the original investment. This amount is tax free. The deductible amount is calculated in the same way as the deductible amount used for Centrelink purposes, that is: [Purchase price (less withdrawals) less the residual capital value]/term of the annuity Assessable amount If annuity payments in the financial year are greater than the deductible amount, then the excess amount is called the assessable amount and is assessable for tax purposes. The assessable amount is the amount of each annuity payment that notionally represents earnings. Depending on the investor s personal circumstances, this amount may be subject to Pay As You Go (PAYG) withholding tax. Note: PAYG is not a final tax and a greater or lesser amount of the tax may apply on assessment of your annual income tax return. Where income paid from the term annuity is less than the deductible amount, no income is counted for taxation purposes. The excess deductible amount does not reduce other assessable income of the individual. The excess deductible amount is carried forward and may be used to offset assessable income from the term annuity in future years (if any). Joint policies Challenger allows policy owners to select the amount to be paid to each owner. For example, one owner can be allocated 30% of the regular payments and the second owner the remaining 70%. In these cases, the deductible and assessable amounts for tax purposes will also be split using these proportions. On death of one of the owners, the full regular payment will be paid, and the full deductible amount will be allocated, to the surviving owner. Reversionary beneficiaries Where a reversionary beneficiary is nominated, regular payments will continue to be paid to the reversionary and taxed in their name. Note that the deductible amount does not get recalculated and the assessable amount will be the proportion of the regular payment in excess of the deductible amount. Superannuation money Superannuation income streams, such as superannuation annuities, must meet specific SIS standards. Generally, where those requirements are met, income from the income stream for those aged 60 and above is tax free. For those younger than 60 and at least preservation age, only the taxable component of the income payment is taxable (with tax reduced by a 15% tax offset). On death of the original owner, the income paid to the reversionary (if applicable) will also be tax free if the original owner or the reversionary was aged 60 or over at the time of death. One of the SIS standards requires minimum income payments to be paid from the annuity. If the term annuity has an RCV, the term annuity s regular payments will need to meet minimum standards each year. If the term annuity has no RCV, a minimum payment requirement must only be met in the first year, which is similar to the lifetime annuity. Challenger Annuities technical guide 15

18 For example, let s assume Bruce and Wendy s term annuity had a 15-year term, a 100% RCV and was purchased using superannuation money rolled over from Bruce s accumulation fund. The term annuity will need to meet minimum payments of 5% per annum for the first 10 years (when Bruce is below 75) and then 6% per annum for the remaining five years when Bruce is 75 and over. Where minimum regular payments cannot be met in each year, Challenger s quote software equote will require a reduced residual capital value to be selected so that each year s regular payment can be increased by an additional capital return. Note: Challenger currently only offers superannuation annuities to people with unrestricted non-preserved benefits who are entitled to receive tax-free payments. On death, if there is a nominated reversionary beneficiary, regular payments will continue to be paid to the beneficiary. Taxation upon withdrawal (death) Non-superannuation money Upon death, lump sum amounts payable to the annuitant s estate or beneficiaries will comprise an amount that represents a return of remaining capital (called the reduced purchase price) and income. The reduced purchase price is worked out by reducing the purchase price by the deductible amount used each year (if the regular payments are less than the deductible amount, then the purchase price is reduced by the income paid). The taxation of death benefits is generally dependent on the tax circumstances of the estate and the beneficiary. Payments made to the estate Under current rules, the estate will generally be taxed on the income component at the same marginal tax rates as an individual (including being eligible for the tax-free threshold, but excluding Medicare levy). The tax-free threshold will not be available where the deceased died more than three years before the end of the income year. Where a death benefit is payable to the estate, any assessable income component of the lump sum is included in the tax return of the estate in the income year it is received. Payments made to beneficiaries Beneficiaries are taxed on the income component at their marginal tax rate plus applicable Government levies. In Bruce and Wendy s case, if their term annuity of $100,000 was purchased using non-superannuation money and in the event that both died, the estate of the last surviving partner to pass away will have the following assessable income upon receiving the withdrawal payment. The income component is calculated the same way if a beneficiary is to receive the payment, however, it may be split if there are multiple beneficiaries. Figure 9: Assessable income to Bruce and Wendy s estate upon their deaths End of year Withdrawal value 11 Reduced purchase price 12 Income component (assessable) 1 $87, $90, $ $79, $80, $ $71, $70, $1, $62, $60, $2, $53, $50, $3, $43, $40, $3, $33, $30, $3, $22, $20, $2, $11, $10, $1, $0.00 $0.00 $0.00 Superannuation money Term annuities that are commenced using superannuation money are generally made up of a taxable and a tax-free component. The proportion of these components is set at the commencement of the term annuity and remains fixed for the term of the annuity. On death, lump sum amounts paid to tax dependants (directly or through the estate) are tax free regardless of the components. However, if the lump sum is paid to a non-tax dependant, the taxable component is subject to tax at a maximum rate of 15% (Government levies may also apply). 11 Based on Challenger Guaranteed Annuity and bank bill swap rates effective 14 July Based on a Challenger Guaranteed Annuity quote as at 14 July 2015 for a 10-year term annuity with no residual capital value, nil adviser fees and income paid monthly with no indexation. 16 Challenger Annuities technical guide

19 In summary, tax dependants are: a spouse or ex-spouse a child under age 18 (or otherwise a financial dependant) someone who is a financial depandant someone with whom an interdependency relationship existed. Taxation upon withdrawal (voluntary) Non-superannuation money If the term annuity is withdrawn in full, the withdrawn amount will be comprised of a return of remaining capital (called the reduced purchase price) and income. The income component of the withdrawal will be assessable to the investor and, depending on personal tax circumstances, subject to tax. For example, Bruce and Wendy s term annuity will have the following assessable income component upon a voluntary full withdrawal: Figure 10: Bruce and Wendy s assessable income upon full withdrawal End of year Withdrawal value 13 Reduced purchase price 14 Income component (assessable) 1 $80, $90, $ $73, $80, $ $65, $70, $ $58, $60, $ $49, $50, $ $40, $40, $ $31, $30, $1, $21, $20, $1, $11, $10, $1, $0.00 $0.00 $0.00 With a partial withdrawal, the withdrawn amount will generally be classified as a return of capital and will not be taxed. The deductible amount applied to future regular payments will be recalculated to reflect the partial withdrawal. For example, if Bruce and Wendy withdrew $10,000 at the end of the second year, the deductible amount that would apply going forward would be: [Purchase price (less withdraws) less the residual capital value] / term of the annuity = ($100,000 $10,000)/10 = $9,000 per annum. Superannuation money Where a Term Annuity purchased with superannuation money is withdrawn, the withdrawn amount can be paid as a lump sum or rolled over to another superannuation fund. The tax free and taxable components of the withdrawal are in proportion to the amounts locked in at commencement. Amounts taken as a lump sum are generally tax free for people aged 60 and over. Calculating the reduced purchase price The reduced purchase price of a term annuity for taxation purposes is calculated by deducting the total of the deductible amounts used (which includes any excess deductible amounts carried forward and used in a later year) from the amount invested. For example, Bruce and Wendy s 10-year term annuity will have the following reduced purchase price at the end of the first year: Deductible amount: $10,000 (see page 15 for formula) Annuity payment received: $11, Deductible amount used each year: $10,000 End of year 1 reduced purchase price = $90,000 ($100,000 $10,000). This is the methodology used when calculating the reduced purchase prices shown within the tables in the previous sections. 13 Based on Challenger Guaranteed Annuity and bank bill swap rates effective 14 July Based on a Challenger Guaranteed Annuity quote as at 14 July 2015 for a 10-year term annuity with no residual capital value, nil adviser fees and income paid monthly with no indexation. Challenger Annuities technical guide 17

20 Challenger Term Annuities Case study Joe and Tina Clients Joe and Tina Age 65 and retiring Assets $400,000 superannuation in Joe s name Goals To always have money to pay for basic costs of living, have enough income to live comfortably, make sure their savings last the rest of their lives and protect them from share market risk. 18 Challenger Annuities technical guide

21 Case study Case study Joe and Tina Joe and Tina are 65 years old and retiring. Joe is a store manager and Tina is a stay-at-home mum. They have $400,000 in superannuation, all in Joe s name. They own their home and have $20,000 in personal assets. They have no other financial assets or debts. Joe and Tina estimate they ll need minimum income of $37,000 per year to meet their basic living expenses in retirement. However, they would prefer a more comfortable retirement and believe they would need approximately $58,000 per year to achieve that. They also would like to spend $5,000 per year on travel over the next 10 years. Joe and Tina will receive some secure income from the Age Pension. This is currently $28, per annum based on their level of assets. Over time, they expect their pension entitlement to approach the maximum rate 15 as they draw down on their assets to fund their retirement. However, this is still $3,283 per annum below their basic needs (in today s dollars). Joe and Tina s life expectancies are and years respectively 16. This is an average only they are in good health, so could expect to live well past 90. Like many Australians, Joe and Tina fear that they will outlive their savings and are worried that they won t be able to afford their basic expenses once their savings have run out. Joe and Tina would therefore like to find an additional source of secure income to cover the difference between their basic expenses and the maximum rate of Age Pension. Joe and Tina are also concerned about share market volatility and therefore prefer only a moderate exposure to growth assets (50% in growth assets, 50% in defensive assets). The first income stream is a Challenger Guaranteed Annuity (Liquid Lifetime). Liquid Lifetime is a secure investment that can provide a series of regular payments for the rest of their lives. The Liquid Lifetime annuity will cost $64,439 and will provide them with an income of $3, per annum. This secure source of income will help them meet their basic living expenses even if they spend the remaining balance of their savings in the future. The next recommended income stream is a 10-year Challenger Guaranteed Annuity (Term Annuity) with no remaining capital at the end of the term. The Term Annuity can provide regular, known payments for a fixed period of time (assuming they don t withdraw early). This will cost $46,539 and lock in income of $5,000 per year for 10 years, allowing Joe and Tina to fund their planned travels. Their adviser also recommends that they set up an accountbased pension with Joe s remaining superannuation balance of $289,022. With an account-based pension, they can choose from a range of investments and select the income they draw, subject to minimum payment requirements. Their adviser recommends that they draw $21,012 from their account-based pension in year one. The account-based pension will be invested in a mix of 70% growth and 30% defensive assets to meet Joe and Tina s preferred overall asset allocation of 50% growth, 50% defensive 18. The account-based pension is designed to provide them with an income stream that helps give them the lifestyle they desire until it runs out. With this strategy, Joe and Tina are matching income from different sources to different expenses. The secure income from the Age Pension and the lifetime annuity provides They visit their financial adviser to find a solution. The financial adviser s recommendation Joe and Tina s financial adviser recommends they convert their superannuation into a combination of income streams. This strategy is designed to give Joe and Tina not only their preferred level of income, but also the flexibility and certainty that they desire. 15 Based on Centrelink rates and thresholds as at 14 July The maximum rate of Age Pension for a couple combined is $33, per annum. 16 Based on Life Expectancy Tables from Australian Government Actuary 17 Based on applicable Challenger annuity rates for Joe as at 14 July 2015 and assumes no adviser fees. Income is paid monthly indexed to inflation for the Term Annuity and partially indexed to inflation for the lifetime annuity. A withdrawal guarantee of 50% was chosen for the Liquid Lifetime (single lifetime) annuity. Challenger annuity rates are subject to change. 18 The annuities form part of the defensive proportion of the portfolio. Challenger Annuities technical guide 19