Australian Government, The Treasury -

Review of Pensions in Small Superannuation Funds

APPENDIX D

Cameo analysis comparing taxation and age pension outcomes from allocated, market linked and lifetime pensions paid from a small superannuation fund

Cameo 1 — $600,000 purchase price

Romeo is planning to retire on 1 July 2005 when he will be aged 65. He is married to Juliet who is five years younger than him. Romeo will have a benefit of $600,000. Table1 illustrates the outcomes that Romeo would receive from the purchase of either an allocated pension, a market linked income stream or a lifetime pension paid from a small superannuation fund. The assumptions used for the illustrations are attached. The allocated pension is paid using the minimum drawdown factors. The market-linked pension is based on the life expectancy of a 55 year old female (five years younger than Juliet), giving a term of 30 years. The lifetime pension is indexed at 3percent per annum and is 100percent reversionary.

Table 1 shows that the income taken from the lifetime pension can be considerably less than the minimum required to be taken under each of the allocated and market linked products. That is, $24,000 in the first year compared with $38,200 and $32,600 for the allocated pension and market linked product respectively. It is not until some 20years later that the payment received from the lifetime pension is close to that required to be paid under the allocated pension. Because of the low pension payment, over time this results in a significant build-up in the fund, such that at age 85 the account balance remaining in the lifetime pension is $803,400 compared to $317,400 and $453,400 for the allocated and market linked products. In other words, the account balance has grown for the lifetime pension in nominal terms, compared with the reduction in the account balance in the other products.

In each case, the balance remaining in the fund at death is generally available for payment to dependants tax free or to the estate (how the estate distributes the death benefits will determine the tax outcomes). Clearly, the larger the amount remaining in the fund at older ages the greater the likelihood that a significant amount will remain on death. If beneficiaries are also members of the fund, there is the possibility that monies will be transferred to their accounts and remain in the accumulation phase attracting concessional tax treatment for a further 30 years or more. This shows the scope available for estate planning that can be obtained from the lifetime pension.

Table 1: Cameo 1 — $600,000 purchase price (view Table 1)

Further, Table 1 shows that Government outlays in relation to the Age Pension are generally higher for the lifetime pension than for the other two products in this period. This is because there is no assets test exemption for the allocated pension while only 50per cent of the assets supporting the other pensions are counted for determining access to the Age Pension. Lower tax payments are also made under the lifetime pension compared with the market linked pension, despite both qualifying for the same treatment for the assets test.

No tax is payable in any of the three cases if the $600,000 purchase price is made up wholly of undeducted contributions.

Cameo 2 — $5,000,000 purchase price

Carlos is planning to retire on 1 July 2005 when he will be aged 65. He is married to Camille who is five years younger than him. Carlos will have a benefit of $5,000,000. Table 2 illustrates the outcomes that Carlos would receive from the purchase of either an allocated pension, a market linked income stream or a lifetime pension paid from a small superannuation fund. The assumptions used for the illustrations are attached. The allocated pension is paid using the minimum drawdown factors. The market-linked pension is based on the life expectancy of a 55 year old female (fiveyears younger than Camille), giving a term of 30 years. The lifetime pension is indexed at 3percent per annum and is 100per cent reversionary.

In assessing the cost of the lifetime pension for RBL purposes, it is assumed that there is no excessive component (that is the benefit has been compressed to below the pension RBL). This is achieved through $2,500,000 of the purchase price arising from undeducted contributions and RBL compression of the remaining component of the purchase price to reduce the amounted counted for RBL purposes to be less than the pension limit of around $1,200,000.

Table 2 shows that the income taken from the lifetime pension can be considerably less than the minimum required to be taken under each of the allocated and market linked product. That is, $200,000 in the first year compared with $318,400 and $271,800 for the allocated pension and market linked product respectively. It is not until some 20years later that the payment received from the lifetime pension is close to that required to be paid under the allocated pension. Because of the low pension payment, over time this results in a significant build-up in the fund, such that at age 85 the account balance remaining in the lifetime pension is $6,695,000 compared to $2,645,000 and $3,778,000 for the allocated and market linked products. In other words, the account balance has grown for the lifetime pension in nominal terms, compared with the reduction in the account balance in the other products.

Table 2: Cameo 2 — $5 million purchase price, including $2.5 million undeducted contributions (view Table 2)

In each case, the balance remaining in the fund at death is available for payment to dependants tax free or to the estate (how the estate distributes the death benefits will determine the tax outcomes). Clearly, the larger the amount remaining in the fund at older ages the greater the likelihood that a significant amount will remain on death. If beneficiaries are also members of the fund, there is the possibility that monies will be transferred to their accounts and remain in the accumulation phase attracting concessional tax treatment for a further 30 years or more. This shows the scope available for estate planning that can be obtained from the lifetime pension.

In this scenario age pension outlays do not arise with any pension product until age92 (allocated pension), and age 95 (market linked pension).

Tax paid under the lifetime pension is only one-third to a half of that payable under a market linked pension, despite both qualifying for the same treatment for the assets test. Tax payments are also considerably less than under an allocated pension until after age 85. Approximately 35per cent more tax would be payable under the lifetime pension if the RBL test were aligned with the test for market linked pensions. However the market linked pension would still deliver about 70per cent more tax than the revamped lifetime pension. (This is because of the requirement to maintain reserves and the more favourable treatment of the undeducted purchase price for the lifetime pension.)

Assumptions

For the purposes of providing illustrations, it is necessary to make assumptions about the future. Given the complexity of some of the issues involved, some simplifying assumptions have been made. Nevertheless, the resulting illustrations are considered, in aggregate, to provide a reasonably realistic exposition of the principles involved. It should, however, be noted that the assumptions used do not necessarily represent the Australian Government Actuary’s (AGA’s) or Treasury’s best estimates of future outcomes on individual matters.

Assumptions set by Treasury
Additional Assumptions set by AGA

 

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Commonwealth of Australia 2005
ISBN 0 642 74275 8