TRANSITION TO RETIREMENT STRATEGY IN A WIDER CONTEXT

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1 TRANSITION TO RETIREMENT STRATEGY IN A WIDER CONTEXT The use of a transition to retirement pension after preservation age, whilst still working, has gained wide acceptance as a core superannuation strategy. It can be used to supplement income for people scaling back their work hours or for its inherent tax efficiency. However, there is a trend emerging that the strategy needs to be considered in the context of wider retirement plans. The level of aggregate contributions allowed before excess contribution tax is paid is modest. Consequently in many cases it may be necessary to trade off some tax efficiency if extra contributions need to be made close to retirement to achieve a targeted level of superannuation assets. THE WIDER CONTEXT The desired level of retirement income will usually be sourced from private superannuation assets, associated post retirement earnings, and the Age Pension. The objective is often to provide a retirement income for a couple, not just an individual. Consequently, the calculation model for the assets available at retirement should allow for a number of years of Age Pension at the couple rate (while both are anticipated to be alive), and a further period at the single rate (during which only one is alive). There are also decisions needed for the level of reversion on the death of the first retiree and the planned level of indexation before the needed level of private superannuation assets can be calculated. How the various post retirement risk factors are managed also influences the calculations. There is an emerging realisation that longevity risk can be managed with a process rather than by buffers or annuities. A modified approach is to build the TTR strategy into the overall retirement objective. In other words, the TTR strategy is conditional upon the achievement of a broader objective. Currently, TTR calculations tend not to be as highly integrated as this. Most current calculators focus on how long the money will last. This is easier to program than the question that really needs an answer. What level of accumulation of assets is needed? In this newsletter we will first cover regulatory and other requirements of the TTR strategy before turning to how it could be modified to be incorporated into a wider context plan. REGULATORY REQUIREMENTS Transition to retirement rules allow for a member to start receiving a pension (not a lump sum) even though they are still working, once preservation age is reached i.e. Date of Birth Preservation Age Before 01/07/1960 Age 55 01/07/1960 to 30/06/1961 Age 56 01/07/1961 to 30/06/1962 Age 57 01/07/1962 to 30/06/1963 Age 58 01/07/1963 to 30/06/1964 Age 59 After 01/07/1964 Age 60 The income stream must be a non-commutable pension or annuity. The concessional contribution cap for people 50 years of age and over in 2010/11 and 2011/12 is $50,000. This cap is not indexed. There is a proposal to extend this $50,000 cap for individuals who have total super assets of below $500,000. These proposals are not yet law. The non-concessional cap is $150,000 p.a. and will be indexed in $5,000 steps. There is a two year bring forward option.

2 Between preservation age and 60, the taxable part of the income stream is taxed at marginal tax rate with a 15% tax offset. The non-taxable component is tax free. Once age 60 is reached the whole superannuation income stream becomes tax free. The drawdown limit is normally between 4% and 10%. In 2010/11 the minimum has been halved. The 4% minimum becomes 5% once age 65 is reached, and continues to increase at older ages. HOW DOES IT WORK? The first advantage of the transition to retirement strategy is that the ordinary assessable income from the assets backing the pension becomes tax free not taxed at the 15% rate relevant to the accumulation accounts. The second advantage is that income from the super fund is partially tax free before age 60 and totally tax free after age 60. The substitution of replacing super assets with salary sacrifice contributions incurs only a 15% contribution impost rather than top marginal personal tax rate if received as an earned salary. The most efficient tax outcome may not be the minimum or maximum drawdown rate. There are too many factors to take into account to make a simple guess. The diligent approach is to test each of the levels to ascertain which is most efficient. I suggest that two calculations are carried out. The first is a projection of many years and shows the overall broad plan. The second is for a single tax year where the optimal outcome is polished to a high precision. Diagrammatically the before and after strategy looks like this: BEFORE STRATEGY RESOURCE CASHFLOWS EMPLOYMENT ACCUMULATION A/C IN SMSF 85% Package Less Concessional Contributions Equals Taxable Income Less Tax Equals After Tax Income Less Non Concessional Contributions Equals Take Home Income

3 WITH TRANSITION TO RETIREMENT STRATEGY RESOURCE CASHFLOWS EMPLOYMENT Package Plus Assessable Pension Income Less Concessional Contributions PENSION A/C IN SMSF Equals Taxable Income Less Tax p.a. ACCUMULATION A/C IN SMSF 85% Plus Rebate Equals After Tax Income Plus Exempt Pension Income Less Non Concessional Contributions Equals Take Home Income The line between the accumulation account and the pension account denotes the annual sweep and reboot strategy. WORKED EXAMPLE Bruce Smith has a Date of Birth of 9/10/1954 and a salary package (inclusive of the 9% SG Contributions) of $130,000. He started a TTR pension at 1/7/2010 with his full account balance of $400,000. The Tax Free percentage is 23%. Testing all drawdown percentages in 0.05% steps shows the smallest tax impost occurs at a 7.35% drawdown level. The first table shows that the take home income is the same before and after the strategy. ITEM WITHOUT TTR STRATEGY WITH TTR STRATEGY Drawdown Percentage 0.0% 7.35% Package $130,000 $130,000 Plus Assessable Pension Income $0 $22,638 Less Concessional Contributions $10,734 $49,888 EQUALS TAXABLE INCOME $119,266 $102,750 Less Tax and Medicare $33,867 $27,509 Plus Rebate $0 $3,396 EQUALS AFTER TAX INCOME $85,399 $78,637 Plus Exempt Pension Income $0 $6,762 Less Non Concessional Contributions $0 $0 EQUALS TAKE HOME INCOME $85,399 $85,399 The second table show the level of asset gain by having a lower tax impost.

4 ITEM WITHOUT TTR STRATEGY WITH TTR STRATEGY Drawdown Percentage 0.00% 7.35% Pension Start Balance $0 $400,000 Less Pension Payments $0 $29,400 Plus Interest $0 $26,988 EQUALS PENSION END BALANCE $0 $397,588 Accumulation Start Balance $400,000 $0 Plus 85% of Concessional Conts $9,124 $42,405 Plus Non Concessional Conts $0 $0 Plus Interest $24,317 $1,475 EQUALS ACCUM END BALANCE $433,441 $43,880 FUND ASSETS END BALANCE $433,441 $441,468 For Mr Smith this produces a healthy increase in the Fund value of $8,027 in a single year at no cost to his take home income of $85,399. After age 60 the difference between the effective rate of tax on the pension income (ie 0%) and the earned income will be even larger. WIDER CONTEXT CALCULATIONS The above is the typical calculation handled by most TTR calculators. It considers how much tax can be saved by an efficient tax strategy. However, especially in the post global financial crisis era, people contemplating their retirement are likely to be asking themselves whether they have sufficient resource to retire, not just whether their current level of savings is organised in a tax efficient manner. This involves a whole series of additional calculations. The first question to be answered is what level of assets will be required at retirement. That in turn depends on: The desired level of retirement income, the level of reversion in the case of a couple and the level of inflation allowed for to cover inflationary expectations; Whether the longevity risk is going to be managed by an annuity, by a buffer approach or a dynamic rebalancing process; The anticipated rate of post retirement earnings expected; How the Age Pension is allowed for. Unless a couple allows for some years at the couple rate and some at the single rate, then this resource will be overstated. The next question to be addressed is whether Mr Smith needs to make more provision than simply the assets building (albeit tax efficiently) utilising the TTR Strategy. The very practical question of ability to afford extra contributions and avoid the excess contribution cap needs to be considered. In the case of Mr Smith, already the concessional contribution under the TTR substitution approach has reached $49,888. This level leaves virtually no concessional contributions before the cap is reached. The situation may be even worse after the 2011/12 year because Mr Smith may only have a $25,000 limit if his account balance is about $500,000. This assumes the Government announced changes are put into law. Consequently the extra resource will be coming from non concessional contributions that are less tax efficient. Even if there was no gain from the pension / income replacement, the strategy would still be worthwhile for reducing the fund earning tax to zero. The above will have many solutions with regard to timing of the additional contributions. There will be extra measures that can be taken to assist tax efficiency. Contributions can not be made directly to a pension account; they need to go to an accumulation account. The maximum tax efficiency is obtained

5 by periodically starting a new pension with these monies or by rolling back, adding the monies and restarting the existing pensions. This approach is necessary as the tax free component may be changed by the new monies. We are in the process of building a new calculator to assist with Transitions to Retirement strategies in the context of an overall retirement plan. In the meantime if you would be a report prepared manually, please do not hesitate to contact us. * * * * * * * * * * * * * *