Australian Government, The Treasury -

Review of Pensions in Small Superannuation Funds

5 Strategies for addressing issues

5.1 Introduction

The initial round of submissions suggested a number of proposals to overcome issues with small funds providing defined benefit pensions. To facilitate further comments, the discussion paper presents three possible strategies that could provide greater retirement income choice for members of small funds. To varying degrees each strategy could allow small funds to provide a broader range of pensions to their members, and could address, either directly or indirectly, the taxation, social security, risk and complexity issues raised.

The strategies canvassed are to:

The strategies encompass and build on many of the suggestions contained in initial submissions to the review. These submissions are posted on the review’s website.

The following income stream characteristics would maximise public compliance and minimise compliance and administration costs for individuals, industry and government:

Moreover, any incentives or disincentives should be deliberately designed, be clearly identifiable and operate consistently across products. This avoids opportunities for abuse, consistent with the overall objectives of the retirement income system.

As far as possible these characteristics form the basis for developing the strategies.

The budgetary cost of each option is still to be estimated. A possible outcome from the review could be that the restrictions on small funds providing defined benefit pensions would remain in place. Whether or not new products or product modifications or new rules for defined benefit pensions were introduced would be a matter for Government.

5.2 Develop new rules for the provision of defined benefit pensions

Under this strategy, new pension standards and taxation rules would address the Reasonable Benefit Limit (RBL) compression, estate planning and risk management issues associated with funds providing defined benefit pensions. To ensure equity and competitive neutrality these new rules may apply to all pension and annuity products. If the Government fully implements this strategy small funds may be able to provide defined benefit pensions. However, the new rules would need to be simple and transparent and operate in a manner that minimises compliance costs.

5.2.1 Options to address RBL compression

Initial submissions have put forward two main approaches to address RBL compression.

The first approach is that a pension entitlement based on a given account balance or asset value (net of undeducted contributions) be taken as the purchase price of the pension. This would apply regardless of whether the pension was purchased from a third party or by book entry within a small fund. The valuation method could be administered under Section 140ZO of the Income Tax Assessment Act 1936 (ITAA 1936), with the pension valuation factors remaining as default factors for funds not covered by these arrangements. This approach would involve amendment to Section 140ZO of the ITAA 1936.

The second approach is updating the pension valuation factor tables in Schedule1B of the Superannuation Industry (Supervision) Regulations 1994 (SISR) using current economic and mortality data. This approach could involve developing more detailed tables, possibly modelled on those used in Schedule 4 of the Family Law (Superannuation) Regulations 2001 that better reflect individual pension characteristics. These factors could be updated regularly. For example, they could be updated to coincide with the five-yearly release of the Australian Life Tables.

This latter approach would value all lifetime pensions on a more accurate and consistent basis, including pensions paid by public sector and corporate funds, for reasonable benefit limit purposes. However, it would still provide scope for some RBL compression in small funds through adjustment of the pension’s annual value and undeducted purchase price.

The above two approaches could also be implemented together; that is, using a purchase price approach where there is a clear purchase price and updating the pension valuation factors for public sector and corporate defined benefit funds where there is no identifiable purchase price.

The formula in section 140ZO of the ITAA could be amended to prevent valuations being manipulated through the use of large undeducted contributions. The Institute of Actuaries of Australia’s submission proposes a formula whereby the addition of undeducted contributions has no effect on the RBL value of the pension. This formula values the pension by multiplying the annual pension by the pension valuation factor and adding the residual capital value, and then reducing this amount proportionately corresponding to the share of the undeducted contributions in the purchase price (or by the absolute value of the undeducted contributions if that will give a higher resultant capital value).

5.2.2 Options to address estate planning

Pension design standards and additional taxes to recover excessive benefits could address estate planning.

Pension design standards could:

Specific taxation measures also could address estate planning involving defined benefit pensions in small funds. For example, residual capital remaining in a small superannuation fund after the death of a pensioner or reversionary pensioner (outside the pension guarantee period) could be taxed as special income of the fund under section 273 of the Income Tax Assessment Act 1936.

Alternatively, income from pension reserves that do not qualify for a taxation exemption (the excess above the actuary’s ‘best estimate’ value) could be taxed as special income. Otherwise reserves could be taxed as they emerge in the way life office profits are taxed.

However, such options would add more complexity. These measures would need careful drafting so they do not have unintended consequences and are not easily circumvented through restructuring pension arrangements.

5.2.3 Managing risk

Initial submissions highlight that members in small funds ultimately bear the risk of a defined benefit pension. An alternative would be to formally transfer this risk from the superannuation fund to the pension recipient. If this occurred, defined benefit pensions provided by small funds could be renamed to distinguish them from guaranteed income stream products.

However, if these pensions were to continue to receive complying status for tax and social security purposes, the taxpayer would require certainty that these pensions would remain payable for the recipient’s life expectancy or lifetime.

Portfolio rules for small funds paying defined pensions would provide greater certainty. Current actuarial certification requirements could be enhanced or the investment rules in the Superannuation Industry (Supervision) Act 1993 (SISA) and SISR could be tightened. The latter approach would allow these rules to be applied to all small funds that paid income streams.

Longevity insurance (in the form of a deferred annuity) could also be attached to a pension to help manage the mortality risk. The cashing rules and pension standards in the SISR would need to be amended so people could access the insurance through pension products or from rollover amounts on, or after, age 65.

Key questions on the strategy to develop new rules for defined benefit pensions

  • Defined benefit pensions in non-arm’s length funds can be structured to provide a residual capital value. What role do residual capital pensions and annuities have in providing retirement income?
  • What would be the likely demand for defined benefit pensions in small funds if the above measures to develop new rules were implemented?

5.3 Modify existing pension products

Four modified product options are presented. The first two options involve managing the longevity risks of the market linked pension by extending the term and attaching longevity insurance respectively. The third involves smoothing payments of the market linked pension to provide more predictability within the context of the existing term options. The fourth option involves managing the longevity risks of the allocated pension through updating the minimum payment factors.

5.3.1 Extending the maximum term of the market linked pension

Presently, market linked pension terms range from the life expectancy of the retiree to their life expectancy calculated as if they were five years younger. Alternatively, where the pension reverts to a spouse, the pension can be based on the longest life expectancy of both spouses (or life expectancy if the spouses were five years younger). Market linked pensions can be commuted and recommenced to take advantage of increased life expectancy on reaching a given birthday, thereby increasing the effective term of the pension.

The maximum pension term could be extended to cater for retirees seeking an income stream well beyond their life expectancy. This would provide retirees with a greater degree of certainty that they will not outlive the pension. The average pension income would be lower to allow for the longer term.

5.3.2 Attaching longevity insurance to a market linked pension

A deferred lifetime annuity could be attached to a market linked pension to insure against the possibility of a retiree living beyond the pension term. The deferred annuity would commence following the final pension payment. Annuity premiums could be paid annually from the pension account balance or through a one-off payment from the account balance at the commencement of the pension.

The design features of the deferred annuity would be based on the standards in sub regulation 1.05(2) of the SISR. Therefore the annuity could not be commuted to a lump sum or have a residual capital value. However, annuity payments would be deferred and could be reduced, or cancelled, if premiums had not been paid for the full term of the pension.

5.3.3 A mechanism to allow the smoothing of pension payments

As a market linked pension is an account based pension, retirees can tailor their investment portfolio to meet their retirement income needs. Retirees wanting a stable income stream, for their life expectancy, could opt for a market linked pension that invested in fixed interest securities. A more diversified portfolio may deliver a higher retirement income but greater income variation over time.

The payment formula for a market linked pension divides the pension account balance on 1 July each year by a fixed drawdown factor. While these factors should increase pension payments in nominal terms over time (subject to investment returns), they do not provide any leeway to vary payments in a given year.

A possible mechanism to smooth income payments could be to allow an annual payment within the range of the payments calculated under the existing payment formula for the current year and the previous year. This would smooth income payments between years without providing significant tax deferral advantages. The capital would be exhausted at the end of the term.

5.3.4 Updating the basis for the allocated pension

An allocated pension provides considerable flexibility in the annual drawdown of retirement income, within the range of the minimum and maximum payment factors. It can also be commuted to a lump sum at any time. The pension is not a complying income stream for tax and social security purposes.

The minimum payment factors for this pension are designed so the pension payment in any one year is similar to that from a reversionary, CPI-linked lifetime pension purchased with the account balance at the start of the year. The maximum pension factors are based on a reasonable income stream being paid to age 80. These factors have not been updated since the product commenced in 1992.

Updating of the minimum payment factors to reflect current economic and mortality assumptions would allow lower annual payments in initial years. This would lead to higher levels of income being paid in later years than at present because of larger account balances in these years.

Key questions on the strategy to modify existing products

  • Would there be a demand for the above modified products?
  • Would the industry be willing to offer such products? For example, is it feasible to develop longevity insurance products that could be provided to small superannuation funds?

5.4 Introduce new pension products

Some initial submissions have proposed new pension designs. The Institute of Actuaries of Australia proposed a lifetime allocated pension and two alternative lifetime pension products. PricewaterhouseCoopers Securities Ltd, Rice Walker Actuaries Pty Ltd and Actuarial Solutions Pty Ltd also proposed new products.

Two new product options are presented in this paper to evoke further discussion. To address tax avoidance and risk management issues, the options canvassed are limited to account based products. Each option aims to provide a CPI-indexed pension until, at least, an advanced age, but with payment adjustments to eliminate the build up of excessive reserves.

The new product options would use pension valuation factors to minimise complexity so fund members can administer them. They would also remove the potential for unintended access to tax concessions that could occur when pension payment and reserve levels are set by a private actuary. The Australian Government Actuary would prepare the pension valuation factors and updates would coincide with the publication of the Australian Life Tables.

The proposed options are:

Under each option income payments would be reviewed annually and reset if they fell outside an acceptable corridor. The new pensions would be complying income streams for reasonable benefit limit and social security purposes. As such they could only be commuted into other complying income streams and would involve a steady, predictable drawdown of income. Income payments from the pensions would be assessed for taxation and social security purposes on a consistent basis with similar products.

Further details of the options are set out below.

5.4.1 Lifetime annuity approach to determining the initial income — annual rebalancing within a corridor

This option aims to provide a CPI-indexed pension until, at least, an advanced age. The pension would be subject to annual review to assess whether the fund level remained within an acceptable corridor. Income payments could increase or decrease following this review. The corridor would enable the pension to provide a relatively stable income and assist in smoothing out any investment volatility.

Central pension valuation factors would be used to set the initial pension payment and, if required, to rebalance payment levels following a review. Two other sets of pension valuation factors (high and low pension valuation factors) would be used for the annual review to assess whether the fund level was excessive or too low, relative to the pension being paid. The central factors would be based on a lifetime annuity, using a conservative earnings rate and adjusted mortality assumptions to allow for improved mortality and some degree of selection.

The lifetime annuity approach would generally allow a steady income stream to be paid until the youngest beneficiary reached, about, age 85. However, beyond this point income payments would taper off until the pension account was exhausted. This shortcoming could be eliminated through requiring that the pension be commuted to purchase a lifetime annuity at an advanced age, perhaps when the youngest beneficiary was say 85. This would also reduce the potential for significant balances to remain in the pension account following the youngest beneficiary’s death.

Features of the product design

Initial payment setting
Rebalancing method

5.4.2 Annuity certain (term certain) approach to determining the initial income — annual rebalancing within a corridor

This option would aim to provide a CPI-indexed pension until the youngest beneficiary reaches age 95. The pension would operate in a similar manner to the life time annuity approach except that the factors would be based on a term certain annuity, with a moderate earnings rate, to age 95 for the youngest beneficiary.

The pension would have relatively similar initial income payments compared to the lifetime annuity approach and would allow a relatively stable income stream to be continued for the pension’s term. Income payments would, in practice, approximate payments under a market linked income stream with an extended term.

Features of the product design

Initial payment setting
Rebalancing method

The same annual rebalancing method described in 5.4.1 would be used.

5.4.3 Graphical representation of the lifetime and term certain annuity approaches

Chart 1 shows the pension draw downs for the lifetime annuity approach (for a single male) and the annuity term certain approach. Chart 2 shows the closing balances for the two approaches. It should be recognised that these charts give a highly simplified example of the differences in the approaches for a male aged 65 at commencement. For purposes of comparison, the pension draw downs and closing balances for a male under the current market linked income stream have been plotted on Charts 1 and 2 respectively (based on the maximum term of twenty two years).

The charts are based on the following assumptions: purchase price $200,000; age at commencement 65; CPI increase 3 per cent; and investment return 6 per cent.

Chart 1 shows that income levels under both the lifetime annuity and annuity term certain approaches would be broadly similar up to about age85. Under the term certain approach, income levels would continue at roughly the same level in real terms until the end of the term. Under the lifetime annuity approach, income levels start to taper off in real terms and, as a result, income would be paid over a longer period.

Chart 2 shows that the annuity term certain approach has higher balances over most of its term, reflecting slightly lower income draw downs until age 80. However, the account balance runs down quickly from age80 until age95 in order to fund constant real incomes. The balance for the lifetime annuity approach falls at a steadier rate reflecting lower real incomes over a longer term.

These charts clearly show the lower incomes associated with the lifetime annuity approach in later years. They emphasise that the lifetime pension payable from an account balance would not address longevity risk unless it were to be commutated to a purchase a lifetime annuity at some stage, preferably before reaching age 90.

The charts also show the current market linked income stream provides a greater level of income over life expectancy compared to either the lifetime annuity or term certain approaches. However, the market linked income stream by itself would not address the circumstances where an individual lives significantly beyond life expectancy.

Chart 1: Annual pensions drawn from the market linked income stream and possible lifetime annuity and term certain annuity approaches

Chart 1: Annual pensions drawn from the market linked income stream and possible lifetime annuity and term certain annuity approaches

Chart 2: Closing balances from the market linked income stream and possible lifetime annuity and term certain annuity approaches

Chart 2: Closing balances from the market linked income stream and possible lifetime annuity and term certain annuity approaches

Key questions on the strategy to introduce new products

  • Should new products be introduced or should modifications be made to existing account based products?
  • Would the industry be willing to offer such products? For example, would annuity providers be willing to offer lifetime annuities at an advanced age, and if so, from what age?

 

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Commonwealth of Australia 2005
ISBN 0 642 74275 8