Information to help you plan your retirement years
Having an adequate income throughout your retirement years is a fundamental part of enjoying retirement. Retirement income streams are a popular investment choice for retirees as a way of producing regular income payments throughout retirement.
Gaining a good knowledge of retirement income streams involves understanding:
- what they are;
- how they work;
- what types there are;
- who provides them;
- what the risks are;
- how they are taxed; and
- how they are counted for the social security means tests.
You can then work out what retirement income stream suits your needs.
On 9 May 2006, in the context of the 2006 Budget, the Australian Government announced its intention to streamline and simplify the current arrangements that apply to peoples' superannuation benefits. These were very significant changes for retirees and retirement income streams and this information incorporates those changes.
What are Retirement Income Streams?
During working life, and certainly well before retirement, we become used to earning a regular income. For most people the regular income comes in the form of a salary or wage which is paid at least monthly.
Because of the regularity of income during our working life, we usually adapt our spending to fit in with our income patterns. We might for example, buy the groceries on payday, or pay our major bills monthly.
And for most of us, managing our tax is not a big issue as our employer will have deducted income tax instalments from our pay before we receive the net amount. At the end of the year we receive a tax summary and lodge this with our personal tax return. All in all, this is a relatively straightforward process - we get a regular income and we don't have to budget for large tax bills at the end of the year.
By the time retirement comes around we usually have our income and spending patterns well practised, although these may change a little in retirement. At retirement, or at some stage before, we also need to plan what we are going to do with our retirement savings. Usually this will involve looking at what to do with our superannuation money and any other savings that we may have accumulated along the way.
One of the things you can do with some or all of your superannuation and/or other money is to invest it in a retirement income stream. When dealing with superannuation money, this may mean nothing more than receiving an income (instead of a lump sum) from your current superannuation fund, or it may mean using that money to purchase an income stream from a new fund.
Using a retirement income stream is simply a way of dealing with many of the financial issues to which you have become accustomed before retirement.
Retirement income streams are simply investments which allow you to obtain regular income and capital payments, and thereby provide you with a basis for managing ongoing income and spending patterns. And with most income streams, they are tax exempt thereby your gross amount equals your 'take home pay'.
Retiring does not mean that your need for regular income payments suddenly stops, so it's wise to consider this form of retirement income as part of your options in retirement.
There are various types of retirement income streams that we will examine, some of which may suit you and others may not. However, the basic principle is the same - investing to obtain a regular tax paid income stream.
Is a retirement income stream suitable for you?
There are lots of things to consider in planning for retirement. The number of years we spend in retirement is increasing and this part of our life will generally be a very long period of time.
Planning anything for such a long period of time is quite difficult as many things can change along the way. Planning retirement is no different, particularly when you consider what might change in future years.
For example, there is a fair chance that the house you live in at the start of retirement will not be your place of abode in 10 to 15 years time. You may decide at a future point in time to perhaps move to a smaller residence or move to another location. And further on you may consider other types of accommodation with access to medical care.
With properties there are always ongoing maintenance costs. The property will need painting, plumbing, electrical or other repairs at some point in time. Or you may decide to do some renovations.
You may also have the prospect of receiving an inheritance at some point in time and this may impact on how you plan your retirement. And of course there are always the uncertainties that happen in life which may involve substantial expenses.
So while having a regular income in retirement is a fundamental part of retirement planning, there are lots of other things to consider also. Having access to some cash is very important to meet special needs and having some flexibility in your financial affairs is usually sound planning.
Retirement income streams are not the only option you have for investing your retirement savings, however they can cater for many retirement needs, primarily the regular income need. We have identified just a few of the things that can change throughout the retirement phase of life and having the flexibility to alter your plans may be very important. Some retirement income streams are not very flexible and you should consider the advantages and disadvantages of each type of income stream carefully. After becoming more familiar with them you may decide that other options best suit your needs.
How can you benefit from reading this?
By taking a little time to read this you should be able to:
- understand the role of retirement income streams as an option for investing accumulated retirement savings
- see that there are numerous types of income streams which cater for varying needs in retirement
- be able to compare this type of retirement investment option with other investments
- take greater control of your retirement plans
- work with case studies of similar retirement situations to yours
- see how you don't need to have a fortune to make use of income streams
- get valuable tips on retirement budgeting
- learn about taxation and social security rules which may affect you
The retirement income stream concept is not difficult - as with any investment it just takes a little time to become familiar with all the terms and understand how the products work in practice. Income Streams - What types are there? There are two main types of retirement income streams - pensions and annuities. "There are two types of retirement income streams - pensions and annuities, but for the investor there is not much difference between the two types."
Income Streams - What types are there?
There are two main types of retirement income streams - pensions and annuities.
"There are two types of retirement income streams - pensions and annuities, but for the investor there is not much difference between the two types."
A pension is the name given to income streams which are payable from superannuation funds, whereas an annuity is the name given to income streams which are generally payable from life insurance companies. There are many similarities between these two types of income streams.
There are a number of different superannuation funds which may provide pensions. For example, a public sector superannuation fund (such as for Commonwealth public servants), provides pensions to retired employees.
There are also publicly offered superannuation funds (often referred to as retail funds) which offer pensions. Usually, a person would 'rollover' their money from their superannuation fund to one of these funds and then commence to receive an income stream which happens to be called a pension.
While the funds providing the pension payments may differ, and indeed the type of pension payments may differ, their objective is still the same - to provide a regular income to people in retirement from their superannuation savings.
An annuity is a little different in that it is purchased from a limited range of organisations, mainly life insurance companies. Traditionally, the word annuity has referred to situations where a person exchanges a sum of money for a guaranteed series of income payments. However, in more recent times there has been more flexibility incorporated into arrangements involving annuities.
If you invest in an annuity with a life insurance company you enter into a 'contract of insurance' with that company that covers the terms of the regular annuity payments. With a pension, you become entitled to receive pension payments by virtue of being a member of the superannuation fund. So legally there is a difference, but from a practical viewpoint, annuities and pensions operate in a similar way.
Pensions and annuities can have a lot of different product features and not all products offer the same features. There are two main groups of income stream products to learn about in terms of features and benefits. Some of these may be called pensions or annuities or you may find examples of both being offered by the one company. The key point to focus on first is what type of features do you want from your income stream?
Apart from the distinction between pensions and annuities, income streams also fall into two other categories, being those that are account based and those that are not account based.
Account Based Income Streams
The 'account based' variety is the most flexible type of income stream.
When you invest in an account based income stream, you have an investment account within the relevant fund.
Your investment account balance will increase as investment earnings are added to your account and decrease as you draw down regular income payments. For as long as the income stream lasts, you will have an account balance.
The most common type of account based income stream has been referred to as an allocated pension. Around 80% of all income streams are allocated pensions. More recently, market linked pensions (also called term allocated pensions) have become popular.
Non Account Based Income Streams
These are income streams which do not have an account balance. They generally have a purchase price and you exchange a lump sum of money for an income stream over either a fixed period of years, or for your lifetime. These payments are guaranteed to be payable by the organisation providing the product.
These are also referred to as fixed term pensions and annuities or lifetime pensions or annuities.
There is a mix of terminology used to describe the various types of income streams.
|Type of Income Stream||Category||Common product names used|
|Pensions||Account Based||Allocated pensions
Market linked pensions
|Pensions||Non Account Based||Lifetime pensions
Fixed Term pensions
|Annuities||Account Based||Allocated annuities
Market linked annuities
|Annuities||Non Account Based||Lifetime annuities
Fixed Term annuities
Who provides them?
Retirement income streams are provided by many different organisations and superannuation funds.
As mentioned earlier, annuities are incomes primarily provided by life insurance companies. These include allocated, lifetime and fixed term income streams. However not all life insurance companies provide all varieties.
Life insurance companies offering income streams (ie everything except allocated and market linked income streams) are subject to certain government regulations. To support the guarantees that they offer, these companies must carry a prudent level of 'capital reserves' so that they are able to withstand substantial fluctuations in investment markets without affecting the guarantees they have provided. These regulations are administered by the Australian Prudential Regulatory Authority (APRA).
On the other hand, pensions are incomes paid from superannuation funds. APRA also applies prudential controls to superannuation funds offering lifetime, life expectancy or fixed term pensions. Life insurance companies are subject to stricter requirements in terms of reserving assets to meet their payment obligations than superannuation funds. The most common types of funds providing income streams are:
Public Offer funds - the name merely indicates that the general public (subject to meeting certain conditions) are able to join the fund. Most public offer funds are operated by large institutions including banks, life insurance companies, credit unions, investment managers and financial advisory groups.
While there is a concentration towards account based income streams (allocated and market linked income streams) by this group of income providers they are also able to provide non account based income streams (lifetime and fixed term income streams).
Defined Benefit funds - these funds usually provide pension benefits to people who have been members of the fund for numerous years. The pension benefits are usually a percentage of the member's pre-retirement salary or wage and are usually payable for (at least) the lifetime of the member.
The most common examples of defined benefit funds paying pensions are funds established for State Government and Commonwealth employees.
Industry funds - a number of industry funds provide pension benefits to members. Those that pay pension benefits generally restrict their activities to allocated pensions. These funds first became popular when superannuation became part of various industry awards. Management of the fund includes employer and employee (often union) trustees.
Many of the large industry funds now have (limited) public offer status and are available to a wide range of workers.
There are many industry funds in Australia - some of the largest ones are Retail Employees Superannuation Trust (REST), Aust Super, and Health Employees Superannuation Trust of Australia (HESTA) amongst others.
Self Managed funds - these funds (which are also often referred to as DIY funds) make up a significant part of the Australian superannuation scene. Self Managed funds will have four or less members and more commonly one or two members only. While most are used by people in the pre-retirement phase of life, an increasing number are being used to provide retirement income streams.
Self managed funds can be used for the delivery of most varieties of pensions, but the vast majority are used to provide account based allocated pensions. These types of funds are subject to the same income stream rules as other types of superannuation funds, except in relation to lifetime, life expectancy and fixed term pensions where there are a few special rules.
Matching Income Stream features to your needs
There are many different income streams from which to choose; some are guaranteed, some are not, some are payable for life and others are payable for fixed terms (short, medium or long terms).
What you need to do is to match the most appropriate income stream (or streams) to your own specific circumstances.
If you want to retain the most flexibility with your financial affairs, then it is likely that an account based income stream will be the most suitable option. Alternatively, if you seek a high level of security and flexibility is not a major issue then a lifetime or life expectancy income stream may be more appropriate.
Of course, it may be that you want a bit of both - a high level of security and certainty of income for part of your money and a high degree of flexibility with the balance.
If this suits your needs then investing in more than one income stream may be the best option.
There is no limit on the number of income streams you may invest in. In fact, you may choose to invest in more than one income stream simply to spread your risk.
You should also consider how much of your available money to invest in income streams. They are not the only option available and it is always prudent to retain access to some money for emergencies or other irregular expenses such as home maintenance costs.
What are the risks?
As with any investment, retirement income streams involve some degree of risk.
Everyone views risks differently, however with income streams there are 3 main dimensions to risk:
Security - means how much risk is involved in the investments underlying the income stream.
Certainty - means how predictable the amount of the payments is from the income stream.
Outliving - means the risk that you will outlive your income stream payments. Only lifetime income streams do not have this risk.
However, within the range of income streams available there are ways in which you can reduce risks to a low level. Here are 8 key tips to get you started:
|Tip 1||You can always invest in more than one income stream and they may be offered by more than one institution or fund - a tried and true way of not putting all your eggs in the one basket. Remember that there is no limit on the number of income streams you can invest in. However having too many may start to increase the costs of investing, particularly if your affairs get too complicated.|
|Tip 2||Be aware that there are very low risk income streams - such as those payable for lifetime and fixed terms - where an institution has usually provided a guarantee that they will continue to pay you an income at a specified level for a fixed number of years or for life.|
|Tip 3||With most income streams, particularly the guaranteed income streams, you may elect to have your annual income payments indexed to the Consumer Price Index (CPI) or some other set annual increase. By doing this you have some protection against losing the purchasing power of your money.|
|Tip 4||Within the income streams that carry the most risk (the account based varieties) there are usually numerous investment choices available. Some of them are quite low risk, and some products may even provide a guaranteed investment return for set periods of time.|
|Tip 5||When evaluating investment choices within account based income streams (allocated and market linked income streams), remember that there are choices available from quite low risk through to those that have higher risk. It is a case of matching the investment choices to the risk you are prepared to take (ie. how averse are you to receiving variable or even negative investment returns in short term periods?).|
|Tip 6||When considering the risk in account based income streams you should be aware that options offering some exposure to sharemarkets and property markets will generally, over the long term, produce higher investment returns than those that simply invest in fixed interest and cash.|
|Tip 7||Be aware that some income streams (the 'allocated' variety) allow you access to your capital, whereas other types of income streams either do not allow access or have restrictions on doing so. Capital needs must be considered carefully.|
|Tip 8||When considering investments in income streams, consider the risks that you may be taking in the context of all of your investments. For example, if you are investing only 25% of your money in an income stream which carries some investment risk, this may be quite appropriate if your other investments are invested securely (eg. term deposits).|
Budgeting for Retirement
Developing a retirement income budget
To successfully plan your financial future, start by doing a stocktake of your current position. This involves documenting your current assets and debts. It also involves working out a budget of expenses, so that you can clearly see how much income you need to meet essential living expenses and optional expenses.
A simple worksheet for documenting your financial position and your income needs follows. Take time to complete this as it will make your planning so much easier.
|Your Assets||$ Value|
|Jewellery and other valuables
|Investments in managed funds
Bank, Building Society or Credit Union accounts
Payment for unused annual leave
|Payment for unused long service leave
Insurance policies Other
|Your Debts||$ Value|
|Home improvement loan
Personal loan for other purposes
Credit card balance
Store charge accounts
Investment property loan
|Total Debts (B)||Â|
Your Net Worth (A-B)
|Weekly Living Expenses||$ per week||Other Expenses||$ per annum|
|Food Council rates
Clothing Water rates
|Health insurance||Â||Travel costs||Â|
|Newspapers and magazines||Â||Other loan expenses||Â|
|Total Weekly Expenses||Â||Â||Â|
|Multiply by 52||Â||Â||Â|
|Annual Living Costs (C)||Â||Total Other Expenses (D)||Â|
If you add columns C and D together you will have your annual income stream budget. This budget may vary a little from year to year as your circumstances and needs change. Retain this version, so you can simply review it and update it from year to year.
Now that you have worked out your essential living expenses, prepare a short list of the items of expenditure that are not essential, but which you would like to do or feel you will have to do, either now or at some time over the next few years.
|Your Optional Expenditure||$ Value|
|Total Optional Expenditure||Â|
Armed with your 'financial stocktake', we can now move on to resolving some of the other key financial questions.
How long will you need an income stream for?
It would make planning our finances so much easier if we knew exactly how long we were going to live. So how can we estimate how long we need our money to last?
The best way is to work from average life expectancies. The Government produces details of average life expectancies based on historical information. These are updated from time to time, and the good news is that average life expectancies are getting longer. While this is great news in one sense, it also means that our retirement money generally needs to last longer.
Australian Life Tables, 2000-2002, Government Actuary
By way of example, a male and female who are both age 65, would be expected to live over 17 and 21 years respectively. Life expectancies in 5 to 10 years time may be significantly longer, but this should provide some guide for planning your income stream needs into the future.
Will your needs change?
There is a very high probability that your financial needs will change over time. It is very unlikely that you will need the same amount of income over a long period of time for a variety of reasons:
Inflation - while Australia has been experiencing comparatively low levels of inflation for a number of years, there is still some inflation and there is always the possibility that it could increase. Inflation is an important factor to consider, and some income streams allow you to select an indexation option, where your income level increases with movements in the Consumer Price Index. Alternatively you can have it indexed by a certain percentage each year. For example, you could have your income increased by 3% per annum, to cope with increasing costs.
Spending changes - at various stages in retirement our income needs will change simply because our spending patterns change. This might include specific holiday costs which may not be part of our normal budget. There may be other items of expenditure such as house maintenance costs which are unforeseen. There are lots of reasons why our income needs will change from time to time.
Capital needs - similarly the need to have access to capital may change over time. There is a strong chance that at some stage in retirement there will be issues such as major car repairs, upgrading a car or moving house to deal with. There may also be significant costs later in life associated with health matters, nursing care and using other services as we become less capable of doing all the things we used to do. Having access to money for key larger items of expense is sound planning.
As such it is necessary to consider these aspects when you invest in an income stream. If you refer to the detailed information on the different types of income streams you will be able to see that these needs can be catered for in different ways.
How long will your money last?
This is the big question. How long your retirement savings will last depends on many things.
If you decide to invest money in a lifetime income stream you will know that the income will continue for life. So it is not a case of how long it will last but rather, will the income you receive be enough? You should consider whether or not you will be entitled to any age pension or social security allowance, and any other investment or employment income you may receive. We examine the age pension issue in more detail later.
Where you invest in an income stream which is payable for a fixed number of years you have the comfort of knowing that the income payments will continue for the period of years you select.
With an account based income stream, your income payments stop when your investment account runs out. So the key with these type of income streams is to maximise the investment return on your account to make your money last longer. This doesn't mean that you should take big risks with your investments - it's just that the better you manage your money, the longer it will be able to provide you with an income.
We'll look at this issue in more depth later, but consider the following example.
Charlie and Grace invested $150,000 in an account based income stream. When they chose the fund they were given some investment choices. They were both aged 64 and knew that their average life expectancies were over 18 and 22 years respectively. They were both enjoying good health and they decided that they should think of this as a very long term investment. They chose the 'Managed' option, which meant that indirectly they had about 50% of their money invested in the share and property markets. Over the 20 years, they were able to earn 7% per annum on their money. When they first invested in the account based income stream, they needed to draw $10,000 of income per annum. Each year they increased their income payments by 3% per annum.
With this level of income payments and the 7% per annum investment earnings their money lasted for 24 years.
*Note that in this example we assume that the investment earnings rate is the same for each of the 24 years. This is unlikely to occur as investment earnings will vary from year to year.
The following table provides you with some idea about how long your money will last. The table shows different investment earning rates, ranging from 4% to 8% per annum. The table also shows the level of income that may be drawn, expressed as a percentage of the starting capital. In each case these income figures are assumed to increase each year with inflation, which is assumed to be 3% per annum.
To help you use this table - consider 6% per annum investment earnings and an income rate which is also 6%. This means in the first year, your investment account would remain constant, because the money coming out of the account is the same as the earnings. In the second year, the income payments go up by 3% and as such the investment account balance will start to reduce. The table shows that the investment account will be exhausted after 25 years.
The table is designed as a guide only to how long your money may last and does not represent an actual allocated pension or allocated annuity account. Later on there is an actual example of an account based pension.
Income Payment Level (% of Capital)
Investment Earnings - 4% per annum
Investment Earnings -6% per annum
Investment Earnings - 8% per annum
|5%||24 years||32 years||35+ years|
|6%||19 years||25 years||35 years|
|7%||16 years||20 years||27 years|
|8%||14 years||17 years||21 years|
In the above table it is assumed for simplicity that income payments are drawn annually in arrears and that investment earnings are added to the account annually in arrears also. The investment earnings are net of any fees which may be charged. The income levels do not take into account the minimum payments each year that may apply for an account based income stream. This means that the actual income from an allocated pension or allocated annuity may vary from that calculated in the above table.
Other income sources
How long your money will last depends on many things, as can be seen from the above example. The impact of income from other sources will be very important. If for example, you earn some money from part-time employment in your early retirement years, you will be able to keep more of your capital intact, or perhaps actually build on it for a while.
If you are entitled to a full or part age pension then this will assist in providing for your income needs. If you are entitled to a part age pension, you may not need to draw down your retirement capital as quickly and be able to spread your retirement savings out over a longer time frame.
Types of Income Streams - Account Based
Account based income streams are the most flexible type of income stream.
When you invest in an account based income stream you have an investment account within the relevant fund. Your investment account balance will increase as investment earnings are added to your account and decrease as you draw down regular income payments. For as long as the income stream lasts, you will have an account balance.
The most popular types of account based income streams have been referred to as allocated pensions and allocated annuities. An allocated pension is provided from a superannuation fund, whereas an allocated annuity is an annuity contract issued by a life insurance company. Apart from this difference they are almost identical.
When you are considering account based income streams, you should be aware that you can only use 'superannuation money' to invest in them. 'Superannuation money' means any money that is within a superannuation fund and certain types of superannuation lump sum payments.
So any savings that you have outside superannuation would need to be contributed to a superannuation fund prior to investing in an account based income stream. Anyone can contribute to superannuation prior to age 65 without satisfying eligibility rules. After age 65, eligibility conditions need to be met. To contribute to a fund you need to have worked at least 40 hours within a consecutive 30 day period in the financial year in which the contribution is made.
Access to your money
Account based income streams offer you the most flexible option as far as having access to your money is concerned. You are generally able to withdraw all or part of your money at any time.
For example, if an unforeseen expense arose a few years after your account based income stream commenced you would be normally able to access money from your investment account. Generally, there are no limits placed on how often you may make these types of withdrawals. You are also able to switch your money from one account based income stream to another if for any reason you want to change providers.
There is also some flexibility to match the income payments to your needs. At the beginning of each financial year you may select the level of income that you wish to draw, although the income selected must meet the minimum required level. The income payments will continue to be made to you until either you withdraw your money completely, or your investment account is exhausted.
The investment earnings added to your account will depend on the type of investment choices you make. Most account based income streams offer you a range of investment choices, some of which involve more risks than others.
One important point to note about account based income streams is that in most cases there are no guarantees given that you will have an income for your lifetime. The longevity of your income stream will depend on a number of factors, the most important being how much you draw out annually and what investment earnings you receive.
Account based income streams are very popular investments, with investments in the allocated pension variety representing around 80% of all money invested in income streams.
Income Payment Rules
There are a few rules associated with account based income streams and the income payments you receive. Each year the total annual payments (income and/or capital) must be above a minimum limit.
A set of factors, called Percentage Factors (or PFs), are used to work out the minimum annual payment limit each year.
To calculate the minimum level, your investment account balance at 1 July each year is multiplied by the appropriate PFs, and the result is rounded to the nearest $10.
This calculation then sets a lower limit to the annual payments for that financial year. Subject to this limit, you are free to choose the preferred level and frequency of income payments for the year, and there is no maximum level.
|Age at 1 July||
|65 to 74||5%|
|75 to 79||6%|
|80 to 84||7%|
|85 to 89||9%|
|90 to 94||11%|
|95 and over||14%|
Extract of schedule 7 of the SIS Regulations (1994)
Unlike life expectancies, PFs are the same for males and females of the same age.
Let's see how they work in practice.
Jack is aged 64 and is single. He invests $100,000 in an account based income stream on 1 July. From the above table we can see that his minimum PF is 4%.
When Jack works out his minimum annual payment he will multiply $100,000 by 4%:
$100,000 X 4% = $4,000
So Jack can draw an income of anywhere above $4,000. This limit applies for that financial year.
So what happens each year?
Each year the provider of Jack's account based income stream will do a similar calculation and let Jack know what his new limit is.
Assume that a year has gone by and Jack, now age 65, has $99,000 in his account. At age 65 his PFs is 5%.
The new calculation will be:
Minimum payment $99,000 X 5% = $4,950
Jack can make a new income nomination at or above this limit for the financial year and this procedure is repeated each year.
How does my investment account value change?
Your account value will vary regularly. It will go down in value when you draw an income payment and increase when investment earnings are added to your account. The following example will provide an insight into what happens over time.
Let's revisit Jack from the previous example. He was 64 when he started his account based income stream.
We'll assume Jack received an income of $7,000 in his first year (which was above his minimum). Each year Jack increases the income amount by 3% per annum. We'll assume that Jack is able to earn 6.5% per annum on his money after fees.
The following table shows Jack's annual income, his annual minimum payment and the movement in his investment account over time. Remember that investment returns can vary significantly from time to time and may even be negative.
Jack's investment account balance at start of year
Investment earnings at 6.5% per annum
Jack's income payment each year
Minimum income each year
Jack's investment account balance at end of year
So let's have a look at the typical investment choices which you may encounter within allocated income streams.
The term "capital guaranteed" generally means that 100% of the money you invest is guaranteed by the provider to be returned to you at a future date together with any earnings. The guarantee may not cover fees which are deducted from your initial investment. The term is often confused with investments where the interest rate on the investment is guaranteed but the capital isn't. In many cases, both the capital and the interest are guaranteed. You need to establish what the guarantee refers to - it's not something you can make assumptions about.
This choice is usually for short term or very security conscious investors. This investment choice generally does not involve the giving of guarantees in relation to your capital. It also generally does not involve any guarantees in relation to the interest or investment earnings on your money. Instead, this choice usually refers to a conservative style of investing. A capital secure investment will generally hold a high proportion of its money in cash, short term money market securities, government and bank-backed securities.
The investment return on a capital secure choice will generally track short term interest rates. While the investments held within this investment choice are highly secure, you are not usually immune from losing part of your capital as a result of adverse investment markets - although it is highly unlikely that this would occur.
This choice is for investors who are looking for a relatively stable investment and who are comfortable accepting short term fluctuations in investment returns.
There is no set definition of a capital stable investment choice. When investment managers refer to short term fluctuations in returns they usually mean that there may be some short periods where returns are negative. However, they generally would not expect to have a negative return over any 12 month period. This doesn't mean that it can't happen, it is simply not usual or expected.
The investments held in capital stable choices vary depending on the views of each manager. As a rule of thumb you would not expect to see more than 25% - 30% of the total investments in shares (Australian or International) and property. These investments' aim is to produce a relatively stable pattern of returns by limiting the exposure to investments which fluctuate more in value.
Managed or Balanced
This choice is suited to investors who want higher returns over the medium to long term. To use this investment choice you must be prepared to accept moderate fluctuations in returns over the shorter term.
With this choice, it is possible that you may experience negative returns over a 12 month period. The chance of having two consecutive years of negative returns is however quite slim. If you are considering this choice, you should not be a short term investor. As a guide, you should be looking at your investment over a 3 to 7 year time frame.
The underlying investments are generally spread over the full range of assets, including Australian Shares, fixed interest investments, cash, property and overseas investments. The percentages allocated to each area vary considerably between investment managers. Usually you would not expect to see more than 60% of the total investments in the areas of shares and property.
This choice has many similarities to the managed choice in that investments are usually spread over all types of investments. It is also similar in that you would need to have an investment time frame of 3 to 7 years. It is not the choice for short term investors or investors who are not tolerant to market fluctuations.
The main difference is that 'growth' choices may have more invested in the growth areas of shares and property than 'managed' choices.
Some allocated income streams have a wide range of choices, which include investing in single investment categories such as Australian shares.
If you were to select a category such as Australian shares, you would have that part of your money exposed to the Australian sharemarket. With this exposure comes the volatility associated with investing in shares and the possibility of significant fluctuations in your investment returns.
As with the growth and managed choices you need to have a minimum investment time frame of at least 3 years, but more probably 5 years.
This is similar to the Australian share choice except that the investments are shares in overseas companies. Most international share choices will have shares in most economic regions. You may see the total investments split between North America, Europe, Japan and South East Asia. The proportion allocated to each region will depend on the manager's views on how that region will fare in the future. It may also depend on the level of opportunities the manager sees in companies within that region. With international share investments, there is an added risk of currency fluctuation. This risk must be considered before making investments in this sector.
As with the Australian shares choice, you should have a minimum time frame of 3 to 5 years and be prepared to accept a higher level of volatility with your investments.
Some allocated income streams offer a specialist property choice. The underlying investments of this choice are usually listed property trusts, which are involved in the residential, office and industrial property markets. These trusts own the properties, lease them to a variety of tenants, and pass the income (less costs) from the buildings back to the investor.
This choice carries risk in that this part of your money would be fully exposed to the property markets. You should therefore look at this option on the basis of a long term investment and have a minimum 3 to 5 year time frame.
Australian Fixed Interest
Just as you can invest in shares or property, you can also invest in a specialist fixed interest choice. The underlying investments are usually government and semi- government bonds, and other high quality fixed interest securities issued by Australian companies.
Most of the choices available are outlined above. There are others which do not fit the descriptions above and some which go by a different name, but are very similar to the choices previously described.
Account Based Market Linked Income Streams
Another type of account based income stream is a Market linked pension or annuity. They are sometimes referred to as 'term allocated pensions' or (TAPs).
When you are considering a market linked income stream you should be aware that you can only use 'superannuation money' to invest in them.
Selecting the term for your income
With a market linked income stream the income payments are paid for a fixed term. The duration of the term depends on when the income stream commences and your age at that time.
For a market linked income stream that commences before 20 September 2007, the term may be determined broadly by reference to your life expectancy at the commencement of the income stream. A table of current average life expectancies is shown earlier. You can choose a term anywhere between the following minimum and maximum terms:
Minimum Term - the income stream must be payable for a minimum fixed term equal to your life expectancy (rounded up). For a male of 65 the life expectancy is 17.7 years and hence an 18 year term would be relevant.
Maximum Term - the income stream must be payable for a term equal to the period from the commencement day of the income stream until the primary beneficiary reaches age 100. For a male of 65 that is 35 years.
As you can see there is a wide range between the minimum and maximum terms in this case.
In some less common circumstances it might be possible to use a different method of working out the term. This only applies where the income stream is set up so that on death the income payments must revert automatically to a spouse and the spouse has a longer life expectancy. This is referred to as a 'reversionary' income stream.
The term can be between the following ranges:
- a minimum term equal to the longer life expectancy of the reversionary spouse at commencement; and
- a maximum term equal to the period from the commencement day of the income stream until the spouse reaches age 100.
This option can only be used to provide access to a longer term.
Term Example - Selecting your term
James is age 65 and his wife Helen is aged 60. If James wants to acquire a Term Allocated Pension that reverts to Helen on his death, he can select a term for his pension of between:
- 18 and 35 years (based on the term for a 65 year old male); or
- 26 and 40 years (based on the longest term for a 60 year old female).
If James does not want to nominate Helen as a reversionary pensioner he can only choose a term between 18 and 35 years.
Access to your money
Unlike other Account Based income streams, market linked income streams are a lot less flexible when it comes to accessing your capital investment.
Generally, most market linked income streams are 'non-commutable'. This simply means that, except in very limited circumstances, the capital you invest in them is not accessible at any time. Because of this restriction on accessing your money you should not, as a general rule, invest all of your money in them. You should keep part of your money in other investments where you have access or you could use some part of your money to purchase an allocated income stream. By doing so you will have the ability to meet unexpected lump sum expenses.
If you select a term based on your spouse's life expectancy, in the event of your death the market linked income stream must be paid to your spouse for the remaining term. Your spouse cannot convert the pension into a cash lump sum at your death.
Market Linked Income Streams commencing on or after 20 September 2007
In some cases, after 20 September 2007 you can purchase a market linked income stream still provided the fixed term is chosen such that the minimum annual payment (as determined by applying the relevant percentage factor) is met each year. The factors are the same as those listed for other account based income streams.
A market linked income stream can only be purchased under these rules with the rollover of a superannuation benefit from an existing complying lifetime, fixed term or market linked income stream.
Income Payment Rules
So once you have chosen your term between the minimum and maximum, the income level for a market linked product can be determined for the first year. To work this out you take the purchase price of the income stream and divide it by a factor. The pension factors used are as follows:
So for the male of 65 who had a maximum term of 35 years and who chose to use the maximum term, you would take the purchase price of say $100,000 and divide it by 20.00. The income stream payment in the first year would be $5,000.
To allow some flexibility in the payments from a market linked pension you can select an actual annual income payment which is within 10% either side of the calculated figure. In this case it would be: $4,500 (90% of $5,000) or $5,500 (110% of $5,000).
What happens each year?
Each year, the account balance is divided by the factor applicable to the remaining term. So if the account had remained at the same value in 12 months, the new income stream would be calculated by dividing $100,000 by 19.70, giving an income for the next year of $5,076
And to find the limits:
Minimum Income Limit
Maximum Income Limit
|(0.9 x $100,000) Ã· 19.70||(1.1 x $100,000) Ã· 19.7|
|=$5,076 x 0.9||=$5,076 x 1.1|
|= $4,570||= $5,580|
(Minimum income figures are rounded to the nearest $10)
How does my investment account value change?
Your market linked investment account value will vary regularly. It will go down in value when you draw an income payment and increase when investment earnings are added to your account. The following example will provide an insight into what happens over time.
Let's take Louise and Jon. Louise is age 71 and Jon is 65. They are both enjoying good health. Louise has $250,000 of superannuation money and invests this in a market linked pension on 1 July. They have other investments which can be cashed for any lump sum needs they may have.
Jon has a life expectancy of 17.7 years and Louise 16.29 years. Louise could therefore choose a term of between 17 and 29 years based on her life expectancy only. As Jon has the longer life expectancy, the pension may be set up on a reversionary basis (i.e. the income payments are automatically directed to Jon upon Louise's death). As Jon is 65 the maximum term could be extended to 35 years.
We'll assume that Louise selected a 30 year term. The factor for a 30 year term is 18.39. The income is $250,000 divided by 18.39, or $13,594. The income range for year 1 is as follows:
Minimum Income Limit
Maximum Income Limit
|(0.9 x $250,000) Ã· 18.39||(1.1 x $250,000) Ã· 18.39|
|=$13,594 x 0.9||=$13,594 x 1.1|
|= $12,230||= $14,950|
Louise selects $13,594 as the starting point and each year expects to use the calculated income amount without adjustment. We'll assume that Louise is able to earn 6.5% on her money after fees.
Louise's account balance at start of year
Investment earnings at 6.5% per annum
Minimum income each year
Louise's income each year
Maximum income each year
Louise's account balance at end of year
From the table you will note that Louise's account balance increases each year until age 79, when the pension then being drawn is greater than the investment earnings. After age 79 the income is increasing and the account balance is decreasing. In the last year, the balance of Louise's account balance is drawn out.
Louise could have elected to take a slightly lower income each year (using the 90% rule) however this generally has the effect of increasing the income in later years.
If Louise was able to generate better than a 6.5% per annum return, then this would have the effect of producing higher income for her over the 30 year term. Another option for Louise would be to examine all of the investment options her market linked pension offered to see whether she was using the most suitable option to boost her investment earnings.
Are there fees and charges?
There are charges that usually apply to account based income stream investments. These may include initial fees which apply to your investment and ongoing fees. Ongoing fees are usually a percentage of your investment account balance each year.
The best way to evaluate the ongoing fees that apply to your investment account is to refer to the providers Product Disclosure Statement (PDS). In the PDS the provider must show worked examples of the total costs that apply in certain circumstances. The PDS will also detail all fees, commissions and brokerage payable to a financial adviser.
What happens when you die with an account based income stream?
A key part of retirement planning is estate planning. When you deal with account based income streams, there are several estate planning options which you need to consider before you invest.
If your affairs are complicated you may also need some legal advice.
There are generally three estate planning options available but not all providers or super funds provide all of the options.
It is possible to set up an account based income stream so that, on death of the purchaser, an income will continue automatically to a spouse or child (in certain cases). This does not generally prevent a spouse or child from converting the income into a lump sum (by using the cash out option) at a later date.
If you purchase a reversionary market linked pension, then upon your death the pension will continue to be paid to your spouse for the remaining term. Your spouse cannot convert the pension into a cash lump sum when you die.
The account based income stream can be set up so that, on death of the purchaser, a spouse or child would receive the balance of the investment account as a lump sum.
With this option, on death of the purchaser, a spouse or child has the choice of whether to continue to receive an income stream or take a lump sum.
The choice of option depends on your personal circumstances and how you want your estate to be dealt with. There can be different taxation outcomes for each option, depending on your circumstances.
Advantages and disadvantages
As with any investment there are advantages and disadvantages. Some of the major ones for account based income streams are shown in the following table.
Types of Income Streams - Non Account Based
All other income streams are categorised as being non account based which simply means that you don't have an account balance in the fund. Instead what you do is exchange an amount of money for a regular income which is usually guaranteed to be payable to you.
The features of these income streams can vary considerably and they are commonly referred to as 'lifetime income streams' or 'fixed term income streams'.
Lifetime Income Streams
Lifetime income streams are the most secure and certain variety of income stream available.
There are two types of these - lifetime pensions and lifetime annuities. A lifetime pension is provided from a superannuation fund, whereas a lifetime annuity is an annuity contract issued by a life insurance company. Apart from this difference they are almost identical in features.
You can only use 'superannuation money' to invest in lifetime pensions. Any savings you have outside superannuation would need to be contributed to a superannuation fund prior to investing in a lifetime income stream. Anyone can contribute to superannuation prior to age 65 without satisfying any eligibility rules. After age 65, eligibility conditions need to be met. To contribute to a fund you need to have worked at least 40 hours within a consecutive 30 day period in the financial year in which the contribution is made.
On the other hand, lifetime annuities can accept any type of savings - superannuation or non-superannuation based, including for example, deposits directly from your own bank account.
How do they work?
Lifetime income streams, as the name suggests, are payable for the investor's lifetime regardless of the age of the person. This means that you would be paid income payments, at least annually, for the rest of your life. So there is no risk of outliving this type of income stream.
In some cases it may also be possible to have income payments made for the lifetime of another person, usually a spouse. This is commonly referred to as a 'reversionary' income stream.
Where the lifetime income stream is purchased (as distinct from simply receiving the payments from your superannuation fund) you exchange a sum of money for a guaranteed series of future income payments. By doing so, you transfer the investment risk to the provider.
Before you purchase a lifetime income stream, you will receive a quotation of the payments that you would expect to receive in the future. In this way you are able to know where you stand before you commit your retirement savings. You simply nominate the features that you want and then the provider will tell you how much they will pay you each year after taking into account your selections.
The annual amount of income offered will vary between providers. You, or your financial adviser can compare what is on offer through quotations. You can also look at tables in financial magazines and journals, which are prepared by independent sources.
What are the features?
Payments - you get to choose how often you want your payments. They must be at least annually and you can usually choose from monthly, quarterly or half yearly.
Income increases - as this type of income stream may continue for what you hope is a very long period of time, you may also set up the income so that it increases annually with movements in inflation or some other fixed rate of increase. In this way your income can move with general price increases.
Reversionary income and percentage - when you invest in a lifetime income stream you may want an income to continue to a spouse on your death. If the income stream was purchased with 'superannuation money', the reversionary can generally only be your spouse or a dependant child. The income which becomes payable to that person is referred to as a 'reversionary' income. Usually the reversionary income will be lower than the original income that was supporting, or assisting to support, two people. When the income reduces on death, the amount of the reversionary income is referred to as the reversionary percentage. This can be up to 100% of the income which was payable before death but is often is set around 60 - 70%. If this option is selected a spouse, for example, could receive 60% of the income that was paid at the time of death and this would then be payable for the remaining lifetime of the spouse. Any indexation will continue on the reversionary income.
Guarantee periods - you can also consider some form of income protection by selecting what is generally referred to as a 'guarantee period' with your lifetime pension or annuity. Should you (and your spouse if the income has been set up to be payable to both of you) die within the guarantee period, income payments may continue to another beneficiary until the end of the guarantee period. The most common guarantee period selected in the past has been 10 years. Where the income stream is reversionary, you can select a guarantee period which is the longer of your life expectancy or your spouse's life expectancy but not greater than 20 years.
Are there fees and charges?
Generally, no separate fees are charged. You should be aware that fees and commissions are usually factored into the annual amount of income offered. If a commission or fee is payable for your purchase of a particular income stream, such as to a financial planner, this should be disclosed to you.
in Real life...
Ross is aged 66 and Sheila is aged 67. They have $80,000 to invest, and after takiadvice, decide to invest in a lifetime income stream. They go through the optioavailable and decide as follows:
Income Payments - to be received monthly
Income increases - all income payments to be indexed each year by 2% per annum.
Reversionary income and percentage - in the event of Ross's death, payments will continue to Sheila (assuming she is still alive) for her lifetime. If Ross were to pdecease Sheila, they think that she would need 70% of the income they were receiving as a couple given that many of their normal living expenses are fixed.
Guarantee Period - they decide on a 10 year guarantee period so that if they both died within the first 10 years of the income payments commencing, payments for the balance of the 10 year period would be available to a beneficiary or estate.
When they commence the income stream they receive $5,443 per annum. This amount increases each year by 2% per annum. The income payments continue foyears, at which stage the payments are $6,130 per annum. Then unfortunately Ross dies. Sheila starts to receive income payments of $4,291, being 70% of the payments they were receiving at the time of Ross's death.
The income payments continue to Sheila for her lifetime and she lives to age 86. Alond the way, her income payments have been indexed each year by 2%.
Access to cash
Unlike the account based variety of income streams, lifetime income streams are a lot less flexible when it comes to accessing your capital investment.
Generally, most lifetime income streams are 'non -commutable'. This simply means that, except in very limited circumstances, the capital you invest in them is not accessible at any time. If you need some money, for example to carry out house repairs, you cannot generally ask your lifetime income stream provider for this money.
Because of this restriction on accessing your money you should not, as a general rule, invest all of your money in them. You should keep part of your money in other investments which allow for access to your capital, or also invest some of your money in more flexible account based income streams where you can access your capital. By doing so you will have the ability to meet unexpected lump sum expenses.
Advantages and Disadvantages
Let's look at the major advantages and disadvantages of this variety of income stream.
Fixed Term Income Streams
The 'fixed term' variety of non account based income streams offer security and certainty and also provide you with more options than other guaranteed income streams.
A fixed term income stream is simply one that is payable for a set period of time. Typically, this can be for any period of time, from 1 year to around 35 years. Unlike lifetime income streams, they will not continue to be paid for your lifetime or the lifetime of anyone else.
When you purchase this variety you exchange a sum of money for a guaranteed series of future income payments.
There are two types of fixed term income streams - fixed term pensions and fixed term annuities. A fixed term pension is provided from a superannuation fund, whereas a fixed term annuity is an annuity contract issued by a life insurance company. Apart from this difference they are almost identical in features.
As with other types of pensions, you can only use 'superannuation money' to invest in a fixed term pension whereas a fixed term annuity can be purchased either with superannuation or ordinary savings.
As for lifetime income streams, before you purchase a fixed term income stream the payments you would receive into the future will be quoted to you. In this way you know where you stand before you commit your retirement savings. Also, there are a number of options that are available at the time of investing.
The annual amount of income offered will vary between providers. You, or your financial adviser, can compare what is on offer through quotations.
in Real life...
Margaret had recently been made redundant from her employment at the age of 58. She had accumulated a reasonable amount in the way of super benefits over her working career and was in a position to be able to keep these in a super fund for at least the next five years.
She was due to receive a redundancy package from her employer and thought that it would be good idea if she could invest this money to produce an income for a few years, as she was uncertain of her employment prospects. She had secured a part-time job adn was hoping that it would continue for about the next five years but was not sure. She wanted to supplement this income over the same period.
She decided to invest her after tax retrenchment package in a 5 year fixed term annuity. She chose the option of not receiving her capital back at the end of the term and with her $50,000 she received an income of $11,260* per annum over the 5 year period. She anticipated that with the part-time work she would have an adequateincome for the next 5 years. She would then review her options and decide how best tinvest her accumulated super money.
* Note that fixed term income stream rates will vary from time to time with movements in interest rates and investment markets.
What are the options?
Payments - you get to choose how often you want your payments. Thye must be made at least annually and you can also usually choose from monthly, quarterly or half yearly.
Income increases - as this type of income stream may continue for any set period of time, you can also set up the income so that it increases annually with some fixed rate of increase. Usually fixed term incomes do not provide direct links to inflation increases.
Residual Capital Value - this is a technical name that simply refers to the amount of money you get back at the end of the term. Fixed term income streams, unlike most othvarieties, commonly pay part of your investment back at the end of the fixed term. The repayment can be as high as 100% of your original investment, or you may choose to have none(ie. 0%) of your investment returned at the end of the fixed term.
Access to cash
Fixed term income streams are inflexiable when it comes to accessing your invested capital on an ongoing basis.
While generally most fixed term income streams are commutable (ie. accessible) to soextent, there may be penalties involved for early cashing of benefits. This means that except in very limited circumstances, it is preferred not to plan to access youir capital at any time prior to the end of the term.
Because of this restriction on immediate access to your money, you should not, as a general rule invest all of your money in them. An exception to this may be where yoinvesting for a short period of time and at the end of the period, you receive all or a substantial part of your original investment back ( by way of a residual capital value).
What happens when you die?
With these types of income streams you have the comfort of knowing that the income stream will be payable for the fixed period. If you die within the fixed period, the payments can continue to a beneficiary or your estate, or a lump sum may be payable.
These types of income streams ensure that there is no loss of the agreed income payments on death.
You can set up a fixed term income stream so that on your death, the income may continue to your spouse. This income is referred to as a reversionary income. The reversionary income would then be payable for the remaining original term. Alternatively, the income can be cashed in and a lump sum paid to a beneficiary or your estate.
Are there fees and charges?
Generally, no separate fees are charged. You should be aware that fees and commissions are usually factored into the annual amount of income offered. If a commission or fee is payable for your purchase of a particular income stream, such as to a financial planner, this should be disclosed to you.
Advantages and Disadvantages
As these income streams may vary in length of term, the advantages and disadvantages to individual investors may also vary as they can be used for different reasons. For example, they may be used as a short term parking investment where income payments are derived and capital is returned at the end of the term. Alternatively, they could be used for a very long term (eg. 35 years) and provide no capital value at the end of the term.
The major advantages and disadvantages that apply to all investors in these income streams are:
Comparison of different types of income stream products
Account based Income streams
Account Based Market Linked income streams1
Non Account based Lifetime income streams2
Non Account based Fixed Term income streams3
|Insurance company based||No||No||Yes||Yes|
|Annual income payments are guaranteed||No||No||Yes||Yes|
|Access to capital||Yes||Â||No||No|
|Recipient can vary annual income received||Yes||Yes||No||No|
|Residual capital value allowed||N/A||No||No||No|
|Death benefit payable||Yes||Yes||Possible4||Yes|
|Asset test concession (if purchased)5: * pre-20 Sept 2004||N/A||N/A||100%||100%|
|* post- 20 Sept 2004||N/A||50%||50%||50%|
Investing in Income Streams to suit your needs
Trying to match the investment in income streams to your income needs can require some extra thought. In the 'In Real Life' cases used we assume that investment returns will be consistent over the life of the income stream, whereas in practice they generally vary each year. Also, the cases assume that where income is to increase each year, it does so in a consistent fashion. In practice, our retirement income needs will vary throughout retirement years.
Working out income needs throughout retirement is a very personal thing and it is quite difficult to generalise about income needs.
Some people take the view that they should have higher income in the earlier years of retirement when they are healthy and active. Hence, with greater activities, including travel, expenses may be higher.
Others take the view that they should try to limit living expenses in earlier years to build up capital for later in retirement and also to provide for contingencies such as health costs.
There is no right or wrong answer to this. There may be phases of retirement where your income needs will vary. What you do is to try to design your income stream investments so that the right amount of income is produced at the right times.
When we look at the different income streams from an income flexibility viewpoint we can see how the features are different.
|Type of Income Stream||
|Account Based (Allocated)||Good flexibility with minimum income catering for a wide range of income levels. Capital will be used up more quickly if higher levels of income are taken and preserved for longer if minimum taken.|
|Account Based (Market Linked)||Limited income flexibility (+ 10% or - 10%) but you know that income will be payable for the term selected.|
|Non Account Based (Lifetime)||Very little flexibility apart from the % level of indexation of payments each year but you know that payments are payable for life.|
|Non Account Based (Fixed Term)||Very little income flexibility but again you know that income will be payable for the term selected. However the term selected could be shorter thereby creating higher payments for living expenses.|
So if you wanted to produce a higher income in the earlier years and have a more stable but longer income in later years, you could perhaps invest in an account based allocated pension initially and switch to an account based market linked income stream later.
Alternatively, you could invest in an account based income stream now and draw income at a level closer to the minimum and use a smaller part of your money to invest in a short term fixed term income stream to provide additional funds for living expenses in the shorter term.
1. Income stream must meet requirements in s.9BA of Social Security Act 1991.
2. Income stream must meet requirements in s.9A of Social Security Act 1991.
3. Income stream must meet requirements in s.9B of Social Security Act 1991.
4. Death benefits are payable only where a guarantee period exists and all beneficiaries die within the guarantee period.
5. From 20 September 2007, all new income streams will generally be 100% assets tested
What are the Tax Rules?
The tax rules for your retirement income stream will depend on your age and the type of fund that is paying you the income stream.
Usually Tax Free
From 1 July 2007, if you are over age 60, the income payments you receive will be tax free if they are paid from a taxed super source or fund. Most retirement income streams are payable from taxed super funds - this means funds that are subject to tax on their income along the way. All account based income streams and most publicly available non account based income streams are payable from a taxed source (or fund).
The tax free status of your income stream applies regardless of how much income you derive. So theoretically, if you invested in an account based product you draw the whole amount out and not pay any tax on the amount. Also, because the amount is tax free you don't even have to include it in your tax return.
Payments under Age 60
From 1 July 2007, the taxable income from a superannuation income stream under age 60 will be determined by applying a 'proportioning rule'.
|Source of Income Stream Income||Assessable Component of Income|
|Proportion representing the Tax Free Component in the benefit||Nil - (effectively tax free income)|
|Proportion representing the Taxable Component in the benefit||Fully assessable - (subject to tax at the recipient's marginal tax rates although a 15% tax-offset may apply over age 55)|
- Note income streams from an untaxed source do not receive any tax offset under age 60.
- The Tax Free component of your superannuation benefit will generally comprise personal after-tax or undeducted contributions. In some case, certain other amounts are also included in the Tax Free component of a benefit.
For superannuation income streams that commence on or after 1 July 2007, this new proportioning rule involves a two-step process:
- Step 1 - Determine the proportion of the total superannuation benefit that is the Tax Free Component at the commencement date; then
- Step 2 - Apply this calculated proportion to all future income (and capital) payments that are made from the superannuation income stream.
Sally, aged 57, purchases a superannuation income stream on 1 July 2007 with her total superannuation benefit of $500,000. Her income stream will pay her $2,000 per month. This superannuation benefit consists of the following tax components:
- Tax Free Component = $200,000; and
- Taxable Component = $300,000.
Using the proportioning rule, we can determine that the amount of income she will be able to receive on a tax free basis is:
Step 1 The proportion of Sally's superannuation benefit that is the Tax Free Component
= $200,000/$500,000 = 40%
Step 2 The amount of income able to be received on a tax free basis
= 40% x $2,000 = $800 per month
Therefore the Taxable Component of Sally's $2,000 monthly income payment is $1,200.
Will I get a tax offset?
A tax offset of 15% is available to recipients who are aged less than 60 (but over preservation age) for income streams paid from taxed super funds.
The offset is 15% of the gross pension or annuity payment less the tax free portion where one exists. The following example explains the calculations:
|Gross Pension or Annuity||20,000|
|Less Tax free amount||(4,000)|
|Assessable pension or Annuity||16,000|
|Tax on Assessable pension or Annuity (excluding Medicare levy)||1,500|
|Less Pension Offset @ 15% of $16,000||2,400|
*Note that the tax assessed in the above example has been simplified and there may be other taxation rebates applicable in many cases. Further, Medicare levy may be payable.
In this example, no tax would be payable on this part of the person's assessable income for the year and there would be an excess offset to use against any other tax payable.
Note. If we return to the previous example of Sally, she would be entitled to receive a tax offset of 15% x $1,200 = $180 per month since she is over age 55. From age 60, all of her income payments would be tax-free.
Excess Offset Usage
An excess offset arises where the pension or annuity offset nullifies any tax that would otherwise be payable on pension or annuity payments and the offset is greater than the total tax payable.
It is possible in these situations to offset the excess amount against tax on any other income that the person has in that year. The excess offset cannot be carried forward to the next tax year if it is not used this year.
Working out tax (untaxed funds)
Income streams payable from untaxed funds (e.g. Commonwealth Superannuation Scheme) are generally known as 'defined benefit' super pensions. These types of pensions are usually similar to other lifetime income streams in that payments are generally made for your lifetime and in some cases, also the lifetime of your spouse.
With defined benefit super pensions, some part of your income stream payments may be considered to be tax free. The balance of any income payment will be considered assessable and hence taxable income.
The calculation of the 'tax free' amount depends upon a range of factors, including whether or not the income stream started before 1 July 2007 and whether or not you are age 60 or more. Generally, the tax free component will represent the total amount of any undeducted contributions that were made to your fund. These are contributions made to a fund where no tax deduction has been provided for the contributions. They are also referred to as contributions you make from after-tax dollars.
If you are aged 60 or over, generally you will be eligible to obtain a 10% tax offset on the amount of any taxable income payments you receive from a defined benefit pension.
Mary is a 65 year old public servant who decides to retire in July 2007. Mary will receive an annual superannuation pension of $35,000 p.a. from her public sector super scheme.
Mary also found out that $5,000 of her pension income is considered to come from her personal after-tax contributions that she made prior to retirement (using the proportional method illustrated previously).
Since $5,000 of Mary's $35,000 pension is deemed to come from her after-tax income, she would only have taxable pension income of $30,000. The amount of $5,000 would be paid to Mary tax free.
Mary would also receive a tax offset of 10 per cent of $30,000 (or $3,000). This can be used to offset the amount of tax payable by Mary (depending on her circumstances).
Working out tax (non-super funds)
The tax treatment of income stream payments payable from annuities purchased with non super money is slightly different.
There are a few steps involved in working this out, and a few technical terms you need to know some more about.
Step 1 is to work out your Undeducted Purchase Price (UPP).
Where you have purchased your income stream with other private savings (not 'superannuation money') the UPP will be equal to the purchase price of your investment.
Step 2 To determine the tax free amount (its technical name is deductible amount), the undeducted purchase price is divided by the relevant number.
For income streams which are payable for a life the relevant number will be the life expectancy of the recipient. For income streams payable for a fixed term, the number of years it is payable for will be the relevant number.
For a single person, her or his life expectancy factor will be used. For couples, the longest life expectancy of the couple will be used where the income stream has been set up to continue to a spouse in the event of the death of the purchaser.
Step 3 Is there a residual capital value? If the income stream you invest in will pay you back part of your capital at the end of the term, then this must be taken into account in the calculation of the tax free part of your income stream. This does not usually apply for income streams payable from untaxed funds.
Step 4 Do the following calculation:
Tax free amount = UPP less residual capital value Ã· Relevant number
Now that we have looked at the theory, let's look at some real life examples.
Where the undeducted purchase price (UPP) component is say, $100,000, and a single life pension or annuity is purchased by a 65 year old male, the calculation is as follows:
$100,000 Ã· 17.7 = $5,650
This assumes there is no residual capital value involved.
In this case, $5,650 of the annual income payment will be tax free. Normal marginal tax rates will be applied to any income payment in excess of the annual deductible amount. There is no specific tax offset that applies for non-superannuation income streams.
Social Security Rules
Most investments are subject to means testing arrangements for social security pensions and allowances and Veterans' Affairs pensions.
Retirement income streams are no different and they are subject to means testing. However, they have their own specific rules for both the income and assets tests.
For the income test, special rules are applied to most income streams because the income stream payments you receive will generally include a return of part of your capital. So there needs to be a way of working out which bit is income and which is your capital. Generally, for the income test, it is only the income part which is counted under the income test.
For the assets test, all income streams are counted in some way except one category which receives a partial assets test exemption. As a general rule, only those income streams where your capital cannot be accessed receive a part exemption from the assets test.
Categories of Income Streams
The treatment of your income streams under the income and assets tests will differ depending upon:
- the characteristics of the income stream; and
- the duration over which income (and capital) is designed to be paid; and
- your age at the time of commencing the income stream.
What this means in practice is that income streams will be treated according to their features under social security rules. Income streams are classified into three separate categories for social security purposes as shown in the following table.
|Short Term Assets Tested||Characteristics:
All income streams which are not Category 2 or 3 income streams (generally income streams of a fixed term of 5 years or less).
|Income stream types included in this category
|Long Term Assets Tested||Characteristics:
Income streams that are payable for a fixed term in excess of 5 years, and all other income streams that do not meet the specific requirements of Category 3.
|Income streams included in this category :
|Long Term Partially Assets Test Exempt||Characteristics:
All non account based lifetime income streams that meet the general conditions below.
Certain fixed term income streams that meet the following conditions as well as the general conditions below:
For market linked income streams, the income payments must be at least the annually determined minimum level.
General conditions All Category 3 income streams must meet a number of conditions. The main ones are listed here. The income stream must:
There are other characteristics that must be met (particularly if your income stream can be paid to another person on your death) and you should seek further information about this.
Income stream types included in this category
The partially assets test exempt category of income streams will cease from 20 September 2007, meaning that there will not be any income streams purchased after that date that will benefits from a full or partial assets test exemption.
For certain income streams purchased prior to 20 September 2004, different rules applied and complying income streams received more generous assets test treatment than is currently the case.
How do the 'life expectancy' rules work in practice for income streams purchased before 20 September 2007?
To qualify as a complying income stream and hence receive more favourable assets test treatment, certain fixed term and market linked income streams must at least be payable for a term which is broadly equal to the life expectancy of the purchaser (rounded up to the nearest whole year). As we have seen there are other circumstances where the term can be up to the number of years to age 100. To illustrate this let's have a look at a couple of cases.
|Joe is age 72 and has an average life expectancy of 12.75. If he purchased a life expectancy income stream with no residual value that met the other conditions for a complying income stream, 50% of Joe's income stream value would be exempt from the assets test.|
|Elizabeth is aged 63 and has an average life expectancy of 22.85 years. If she purchased a market linked income stream with a term of at least 23 years and it met the other conditions for a complying income stream, 50% of Elizabeth's income stream value would be exempt from the assets test.|
|Bill is aged 66 and his spouse Julia is age 64. His life expectancy is 16.95 years and hers is 22 years. If they purchased a market linked income stream that:
What are the means testing rules?
The following table shows how each of the 3 categories of income streams are generally assessed for determining the income for the income test, and the asset value for the assets test.
|Category||Income Test Rules||Assets Test Rules|
|Short Term Assets Tested||Subject to 'Deeming' and the deemed income is based on the assets test value (see below for 'deeming' rules).||Assets tested and there is a formula for working out the asset value (see below for details).|
|Long Term Assets Tested||The income stream payment is assessed but it is reduced by an amount of 'exempt income' (see below for details).||This category is assets tested.
Where the income stream is account based it is the investment account balance which is counted.
In any other case there is a formula for working out the asset value (see below for details).
|Long Term Partially Assets Test Exempt||The income stream payment is assessed but it is reduced by an amount of 'exempt income' (see below for details).||This category receives a 50% assets test exemption provided it is purchased prior to 20 September 2007.
In some cases, a 100% assets test exemption applies for complying income streams purchased prior to 20 September 2004.
How to work out the income and assets test values
Working out values for the income test
For category 2 and 3 income streams, the income stream payments will be treated as income. However part of that income will be exempt from the income test. To work out how much of the annual payment from the income stream will be assessed for social security purposes, use the following formula:
For category 2 income streams:
Annual Payment less [(Purchase Price - RCV) Ã· Relevant Number]
For category 3 income streams:
Annual Payment less [Purchase Price Ã· Relevant Number]
The relevant number is:
- For an income stream payable for a fixed number of years, that number of years.
- In all other cases the longest life expectancy of either the investor and/or the reversionary beneficiary (where specifically nominated).
Where an income stream is purchased on the basis that the income may be payable to a spouse or other person, or the investment is made jointly, the longest life expectancy (per the tables referred to earlier) of the couple is used in this calculation.
Note that the Purchase Price will be reduced by the total amount of any lump sum commutations made at any stage after commencement.
Defined Benefit Pensions
Defined benefit pensions have their own special income test calculations. The assessable income amount is calculated as:
Annual Payment less Deductible Amount (which is defined as per relevant tax calculations)
From 1 July 2007, the formula used to calculate deductible amount will change for new income streams and also for existing income streams when the recipient turns age 60. However, this method will still be used to assess the amount of income on an ongoing basis at any age.
|Category 2 Income Stream
Alfonso is 66 years of age. He is single and has an average life expectancy of 16.9years. He invests $100,000 in an allocated income stream and he receives an incomeof $8,000 in the first year. When he works out his income for the income test he dothe following calculation:
$8,000 - $100,000 Ã·16.95 = $2,101 16.95
This means that of his $8,000 income payment, $2,101 is counted as income under the income test.
If Alfonso invested in a 10 year fixed term income stream, which had no cash back at the end of the term (ie no residual value) and income payments of $13,500, he would work out his income as follows:
$13,500 - $100,000 Ã·10.00 = $3,500 10.00
This means that of his $13,500 income payment, $3,500 is counted as income under the income test.
Working out values for the assets test
For those non account based income streams which are subject to the assets test, there is a formula for working out an asset value. The reason there is a formula is because there is no clearly identifiable asset value once the income stream has been purchased and hence one needs to be calculated.
For account based income streams there is no need to work the asset value as this value will be the investment account balance.
To work out the asset value during the period of the income stream the following formula applies.
Purchase Price - [ [ (Purchase Price - RCV) Ã· Relevant Number] x Term Elapsed ]
The term elapsed is the number of years that have elapsed since the income stream commenced. In most cases the asset value is reduced six monthly in arrears (which means that the asset value equals the purchase price for the first 6 months). However, where the income payments are annual, the asset value decreases annually in arrears.
For lifetime income streams, this formula means that there will be no assessable asset value once the income has been paid for a term at least equal to the appropriate life expectancy of the person (or couple).
Defined Benefit Pensions
Defined benefit pensions have their own formula to calculate the amount of assessable asset values each year. In some cases, some of all of the asset value may be exempt where the defined benefit pension meets all of the required criteria to be a 'complying' pension for social security purposes.
|Category 2 Income Stream
Take Alfonso from the previous example. He invested $100,000 in a 10 year fixed term income stream. We'll assume he receives his income payments monthly. After 6 months has passed Alfonso has his income stream assessed under the assets test. At that time the calculation of the asset value will be:
So for the second six months his asset value for the assets test will be $95,000. This figure will reduce every 6 months thereafter for the 10 year period.
Impact of 'deeming' for short term income streams
Under the income test, those income streams which are classified as short term (ie. 'category 1' income streams) will have their asset value (as calculated above) subject to the deeming rules. This means that 'deemed' income is assessed for the income stream. The actual income is not counted.
Under deeming, the values of all of your 'financial investments' are added together. Income on the total value is assessed at the rates in the table below. The actual income from these investments is not assessed. Financial investments include bank, building society and credit union deposits, cash, shares, fixed interest investments, managed investments and category 1 income streams.
Deeming rates are adjusted from time to time. The rates which apply at 1 July 2007 to financial investments, including short term category 1 income streams are:
|Deeming Rate||Deeming Rate Threshold|
|3.5%||Up to $39,400|
|5.5%||Excess over $39,400|
|Deeming Rate||Deeming Rate Threshold|
|3.5%||Up to $65,400|
|5.5%||Excess over $65,400|
*These rates are subject to review by the Minister for Families, Community Services and Indigenous Affairs and may be varied from time to time.
Need more information about social security?
While this information contains a general outline of the social security rules, it does not include all of their details. If you need more information about social security rules, you could seek further information from a Centrelink Financial Information Service Officer.
Retirement Income Stream Estate Planning Issues
What issues are relevant for estate planning?
Inevitably, as we approach retirement or are already in retirement, we start to think more about family issues. Estate planning is the term that is generally given to planning your family affairs so that in the event of your death, your wishes are both clearly outlined and administered the way you intended them to be.
This includes considering issues such as:
- Do you wish to leave money to your estate, remembering your current needs?
- If you wish to leave money to others, how much is appropriate, given your level of assets and current needs?
- If you wish to leave money to others, how do you best direct money to them?
These are common questions and your requirements in these areas will no doubt vary over time.
One of the key parts of estate planning is your Will. This is the document that sets out who you want your money to go to. Many people do not have a Will. If you die without a Will, State laws determine who gets the proceeds of your estate. For example, if you are married without children, your assets will pass automatically to your spouse. This may or may not agree with your wishes.
Anyone with experience in dealing with estates would strongly recommend that you have a current Will, as its existence will certainly assist any family members that you pre-decease. If you are part of an 'extended' family it is vital that you have a Will.
When you establish a Will you will also set out who is to be appointed as your executor or executors. This is the person or persons that you are entrusting with the job of looking after your affairs until your estate is distributed to your nominated beneficiaries. The selection of this person is an important decision. The person can be a member of your family, a friend - or for example, your solicitor or accountant.
Income streams and your estate
- As your retirement income stream entitlements are part of your assets at the time of your death, it is important to consider these benefits as part of your estate planning.
- If you have a partner, usually the first issue to consider with income streams is whether you wish to have the income stream continue directly to them on your death. We have mentioned that it is possible to ensure that an income stream (usually referred to as a reversionary income) is payable to your partner in the event of your death. This is one of the important choices that you have to make when investing in, or commencing to receive, an income stream.
On the other hand, if you are single or you simply do not wish to set up a reversionary income stream, then you can consider nominating a dependant to receive any lump sum benefits payable on death.
There are different estate planning issues to consider, depending on the income stream selected and whether or not it is purchased with 'superannuation money' or other savings. This is one area where a financial planner can be of great assistance.
For example, where the trustee of the superannuation fund from which your pension was being paid decides to pay any death benefit to your nominated dependant(s), then this amount will not form part of your estate. The benefit will simply be paid from the superannuation fund directly to your nominated dependant(s).
In many cases, this would achieve the same result as not making a nomination and having the benefits become part of your estate. This is the case where your spouse is the recipient of any death benefits - either way you arrange it you will achieve the same result.
One advantage of making an appropriate nomination with your superannuation fund is that the trustee can elect to pay any benefits directly to your spouse rather than through your estate. This can avoid delays that can arise with the winding up of your estate or dying without a Will.
While the trustee of your superannuation fund is not bound to follow any specific nominations upon your death (unless you have lodged a binding nomination with the trustee), they will have regard to them when deciding to whom benefits are to be paid.
The following table summarises the options for nominating how your incomes stream benefits can be handled upon death:
|Income Stream Type||Estate Planning Options||Is Death Benefit part of the Estate? (Yes/No)|
Yes or No (depends if nominations exist)
||Yes or No (depends)
*The above table assumes that a beneficiary exists at the time of death where a nomination is made, otherwise any benefits will be paid to your estate.
Reversionary income streams can only be payable to a spouse or a child. The child must be either under 18 or under 25 and in full time studies. Where income stream payments are made to a child they must cease by age 18 if not in full time study, or by age 25 for a child in full time study.