Current as at 1 July 2014 Adviser use only. Technical guide: Challenger Lifetime and Term Annuities

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1 Current as at 1 July 2014 Adviser use only Technical guide: Challenger Lifetime and Term Annuities

2 Table of contents Introduction 1 Challenger Lifetime Annuities 2 Product features 3 Centrelink treatment 4 How lifetime annuities are counted toward the Age Pension 4 Treatment of lump sum withdrawals 5 Benefit reduction option 5 Adviser fees 5 Taxation treatment 6 Taxation upon investment 6 Taxation of regular payments 6 Taxation upon withdrawal (death) 7 Taxation upon withdrawal (voluntary) 8 Calculating the reduced purchase price 8 Challenger Term Annuities 9 Product features 10 Centrelink treatment 11 How term annuities are counted toward the Age Pension 11 Treatment of lump sum withdrawals 12 Splitting income 12 Reversionary beneficiaries and joint policies 12 Adviser fees 12 Taxation treatment 13 Taxation upon investment 13 Taxation of regular payments 13 Taxation upon withdrawal (death) 14 Taxation upon withdrawal (voluntary) 14 Calculating the reduced purchase price 15 Case study 16 Useful Centrelink figures 20

3 Introduction With the first wave of baby boomers now hitting retirement age, it s likely you ll have more and more clients coming to you for retirement advice. A person retiring at age 65 today can expect to live 30 years or more, so your retired clients will probably need your help to make their money last the distance. With the full Age Pension currently at $21, per annum for singles and $33, per annum for couples, many of your clients will have to find an additional source of income. This could come from an account-based pension. An annuity is another source of income, one which is secure and dependable, and which can complement both the Age Pension and an account-based pension. Annuities also have technical benefits that can improve your client s financial position. They can help you manage your client s taxation, maintain access to capital and improve their Age Pension entitlements. Term annuities and lifetime annuities are treated differently for Centrelink and taxation. In this guide, we explore the technical aspects of each, including how they are assessed for Centrelink under the Income and Assets tests, how their income is taxed and how they re taxed on withdrawal. Challenger Tech Specialists in retirement and aged care The Challenger Tech team provides specialist technical advice, support and training to financial advisers on retirement and aged care. Have you got a question? Phone challengertech@challenger.com.au The team is ready to answer your question. Challenger Annuities technical guide 1

4 Challenger Lifetime Annuities Product name: Challenger Guaranteed Annuity (Liquid Lifetime) A Challenger Lifetime Annuity (Lifetime Annuity) creates a regular cash flow for life, regardless of how long your client lives or how investment markets perform. It can give them peace of mind during retirement, with the choice to withdraw within the first 15 years. 2 Challenger Annuities technical guide

5 Challenger Lifetime Annuities Product features Figure 1: Challenger Guaranteed Annuity (Liquid Lifetime) at a glance Investment term Investor s lifetime or the lifetime of investor and another person Minimum investment $10,000 Payment indexation Payment frequency Nominating a reversionary The withdrawal period The withdrawal guarantee Voluntary withdrawals On death Benefit reduction option Choice of regular payments adjusted fully in line with changes in the Consumer Price Index (CPI), partially in line with changes in the CPI or not at all. Monthly, quarterly, half-yearly or yearly. The investor can choose for their regular payments to be made for the life of a second person after they die. That person is called the reversionary. If the investor buys their Lifetime Annuity with money rolled over within the superannuation system, the reversionary must be their spouse (as defined by law). The Lifetime Annuity has a withdrawal period of 15 years, so within this period the Lifetime Annuity has a withdrawal value. This means that at any time within 15 years of the start of the Lifetime Annuity, Challenger guarantees that: the investor can end their Lifetime Annuity and take its withdrawal value as a lump sum, and on death of the last annuitant, the withdrawal value of the Lifetime Annuity is paid as a lump sum. If the investor withdraws their Lifetime Annuity at the end of the withdrawal period, the withdrawal value will be a guaranteed percentage of their initial capital investment. If the investor is aged less than 71 when they buy the Lifetime Annuity, this guarantee is 100%. For joint investors, investors with a reversionary, or older investors, the withdrawal guarantee may be less than this and will be determined at the time the Lifetime Annuity is purchased. After the end of the 15-year withdrawal period the investor s Lifetime Annuity will cease to have a withdrawal value and no lump sum will be payable on their death or voluntary withdrawal. The investor can withdraw fully from the Lifetime Annuity within the first 15 years (the withdrawal period); however they cannot make a partial withdrawal. The investor can choose not to have a right to voluntarily withdraw in return for higher regular payments. In this case a withdrawal payment will only be made due to the investor s (or if applicable their reversionary s or joint owner s) death during the withdrawal period. If the investor dies within 15 years of the start of their Lifetime Annuity (during the withdrawal period) and they do not have a reversionary or joint owner, we will make a lump sum payment to their estate. If the investor dies during the withdrawal period and the reversionary or surviving joint owner then also dies during the withdrawal period, we will make a lump sum payment to the reversionary s or joint owner s estate. If the investor dies after the withdrawal period, no lump sum or further regular payment is payable unless they have a surviving reversionary or joint owner, in which case their regular payments will continue to be made to them for the rest of their life. The benefit reduction option is only available if the investor has elected a reversionary or if they are a joint owner. With this option, when the investor buys the Lifetime Annuity they can choose that any payments due after their death (or the earliest death of a joint owner) are paid at a reduced level. They can choose to have those payments reduced by 25% or 50%. If they make this choice, the regular payments will reduce by the chosen percentage, and the withdrawal guarantee also reduces by that percentage. Please refer to the product disclosure statement for full product details. Challenger Annuities technical guide 3

6 Centrelink treatment How Lifetime Annuities are counted toward the Age Pension Centrelink uses two means tests to determine eligibility for the Age Pension: the Income Test and the Assets Test. The test that produces the lowest result is the one that is used to determine entitlements. Lifetime annuities such as a Challenger s Guaranteed Annuity Liquid Lifetime (Lifetime Annuity) receive favourable Centrelink treatment in the form of a deduction amount. This amount was formerly referred to as the deductible amount. The deduction amount generally represents the return of capital over the lifetime of the investor. It is not counted towards either the Income or Assets test. Calculating the deduction amount To calculate the deduction amount for the Lifetime Annuity, divide the purchase price of the annuity by the investor s life expectancy at the start of the annuity (using Australian Government Actuary, Australian Life Tables see page 22). Deduction amount = Purchase price divided by life expectancy at start of annuity For example, Joe, a 65-year-old male has a life expectancy of years. If he invests $58,820 in a Lifetime Annuity, he will have an annual deduction amount of: Once you have worked out the deduction amount, you can then work out the Annuity s assessable income (for the Income Test) and the asset value (for the Assets Test). The following sections summarise how the Lifetime Annuity is assessed under the Income and Assets Tests. It applies to Lifetime Annuities bought with either superannuation or non-superannuation money. Income Test: How to calculate the assessable income Assessable income = Annual payment less annual deduction amount The application of the deduction amount generally means the Lifetime Annuity receives favourable treatment when compared to deemed financial assets, such as term deposits. Assets Test: How to calculate the asset value Asset value = Purchase price less deduction amount The deduction amount will reduce the Lifetime Annuity s asset value counted toward the Centrelink Assets Test every six months, or every 12 months where yearly payments are made. Using the same example as above, Joe and Tina s Lifetime Annuity (with a deduction amount of $2, which pays $2, in the first year) will have the following Centrelink asset value profile. $58,820/18.54 = $3, per annum Where a Lifetime Annuity is established with a reversionary beneficiary or a joint owner (non-superannuation money only), the deduction amount is worked out using the longer of the two life expectancies. For example, if Joe s Lifetime Annuity had Tina (Joe s spouse who is also age 65) as the reversionary, his Annuity s deduction amount will be worked out as follows: Joe s life expectancy = (65 year old male) Tina s life expectancy = (65 year old female) The deduction amount will use Tina s life expectancy: $58,820/21.62 = $2, per annum 1 Based on a Challenger Liquid Lifetime quote as at 1/07/2014 with Joe as the primary owner and Tina as a reversionary owner. There are nil adviser fees and income is paid monthly with no reduction in income upon reversion. 4 Challenger Annuities technical guide

7 Figure 2: The asset value of a Lifetime Annuity reduces over time Start of year 1 $58, $56, $53, $50, $47, $45, $42, $39, $37, $34, $31, $28, $26, $23, $20, $18, $15, $12, $9, $7, $4, $1, $0.00 Asset value for social security purposes Benefit reduction option If the benefit reduction option has been selected for the Lifetime Annuity, the regular income payments (and the withdrawal guarantee) of the Annuity is reduced by the reduction percentage on death of the primary owner (or the earliest death of a joint owner). The benefit reduction option does not change the Centrelink deduction amount. The asset value profile of the Lifetime Annuity will continue to reduce over time as detailed in Figure 2. However, as the amount of regular income payments are reduced (and the deduction amount remains unchanged), the amount assessed under the Income Test is also generally reduced. Adviser fees Upfront adviser service fee Where an upfront adviser service fee has been negotiated, the Lifetime Annuity s regular income payments are reduced to reflect the amount of the fee. However, this fee does not reduce the purchase price. Ongoing adviser service fee With the Lifetime Annuity, your client can agree to the payment of an ongoing adviser service fee, which can be deducted from their regular payments. Annuities that pay an ongoing adviser service fee have their regular income payments reduced by the amount of the fee and the net amount credited to the client s nominated account. Centrelink does not reduce the assessable income of the Lifetime Annuity by the amount of this fee. Treatment of lump sum withdrawals Centrelink will treat the full withdrawal of the Lifetime Annuity as the return of capital, which means that even in situations where the withdrawal amount is greater than the Centrelink asset value, the withdrawal amount will not be assessed as income under the Income Test. The manner in which the funds are subsequently invested will determine how it will be assessed under the Assets and Income Tests. For example, if the withdrawn funds are invested in a term deposit, Centrelink will assess the value of the term deposit as a financial asset and deem it under the Income Test. Challenger Annuities technical guide 5

8 Taxation treatment This information applies to individual Australian tax residents only and is based on our understanding of current taxation legislation as at the date of this document. Taxation upon investment No tax is deducted from the initial amount invested in a Lifetime Annuity bought with non-superannuation money. Lifetime Annuities bought using rolled over superannuation funds with an untaxed element will have the applicable tax deducted from the untaxed component prior to commencement. Note: The Lifetime Annuity can only be purchased with superannuation funds that are classified as unrestricted non-preserved. Taxation of regular payments Non-superannuation money The regular payments are split into two components: Deductible amount The deductible amount is the amount of each annuity payment that is deemed to represent the return of part of the original investment. This amount is tax free. The deductible amount is calculated based on the gender and age of the investor at the time of investment. It is fixed for the term of the Lifetime Annuity. To calculate the deductible amount, divide the purchase price by the investors life expectancy at commencement. For joint policies or policies with a reversionary beneficiary, the longest life expectancy of the two is used to calculate the deductible amount. For example, Joe and Tina s Lifetime Annuity (with Tina as a reversionary) will have an annual deductible amount of: $58,820/21.62 = $2, per annum Assessable amount If annuity payments in the financial year are greater than the deductible amount, then the excess amount is called the assessable amount and is assessable as income. The assessable amount is the amount (if any) of each annuity payment that is deemed to represent earnings. Depending on the investor s personal circumstances, this amount may be subject to Pay As You Go (PAYG) withholding tax. Where income paid from a Lifetime Annuity is less than the deductible amount, no income is counted for taxation purposes. The excess deductible amount does not reduce other taxable income of the individual. The excess deductible amount is carried forward and may be used to offset assessable income from the Lifetime Annuity in future years (if any). Joint policies Challenger allows investors to select the income payment amount to be paid to each owner. For example, one owner can be allocated 30% of the income payments and the second owner the remaining 70%. In these cases, the deductible and assessable amounts for tax purposes will also be split in these portions. On death of one of the owners, the full income payment (subject to any reduction selected) will be paid to the surviving owner. The deductible amount remains unchanged while the assessable amount will be worked out based on the income payment at the time. Where a benefit reduction was selected, the assessable amount may also reduce. Reversionary Where a reversionary is nominated, income payments will continue to be paid to the reversionary and taxed in their name. Note that the deductible amount does not get recalculated and the assessable amount (if any) will be the portion of the income payment in excess of the deductible amount. Superannuation money Superannuation income streams such as superannuation annuities that meet specific SIS standards receive favourable tax treatment. One of the SIS standards require that payments received in the first year must meet the Government s minimum payment standard. Generally, this means tax-free income from the income stream for those aged 60 and above. For those younger than 60, and at least preservation age, only the taxable component of the income payment is taxable (with tax reduced by a 15% tax offset). On death of the original owner, the income paid to the reversionary (if applicable) will also be tax free if the original owner or the reversionary was aged 60 or over at the time of death. 6 Challenger Annuities technical guide

9 Challenger s quote facility equote, available on our AdviserOnline site provides quotes that meet the SIS payment standards to ensure payments made to those 60 and above are tax free. Note: Challenger currently only offers superannuation annuities to people aged 60 and over with unrestricted non-preserved benefits. Taxation upon withdrawal (death) Non-superannuation money Upon death, any amount payable to the investor s estate will comprise an amount that represents a return of remaining capital (called the reduced purchase price) and income. The reduced purchase price is worked out by reducing the purchase price by the deductible amount each year. If the income payments were less than the deductible amount, then the purchase price is reduced by the income paid. The taxation of death benefits generally depends on the tax circumstances of the estate. For the period from death to 30 June, and the following two income years, under current rules, the estate will be taxed on the income component at the same marginal tax rates as an individual (including being eligible for the tax-free threshold, but excluding Medicare Levy). If administration of the estate is not finalised within that period, the estate will continue to be taxed at broadly the same marginal tax rates as an individual (excluding Medicare Levy), however it will no longer be entitled to a tax-free threshold. In Joe and Tina s case, if their Lifetime Annuity (of $58,820) was purchased using non-superannuation money and in the event that both died within the guaranteed period, the estate of the last surviving partner will have the following assessable income upon receiving the withdrawal payment. Figure 3: The estate s assessable income upon receiving the withdrawal payment End of year Withdrawal value 2 Reduced purchase price Income component (assessable) 1 $58, $56, $2, $57, $53, $4, $56, $50, $6, $56, $47, $8, $55, $45, $10, $55, $42, $12, $54, $39, $15, $54, $37, $17, $54, $34, $20, $55, $31, $23, $55, $28, $27, $56, $26, $30, $57, $23, $34, $58, $20, $37, $58, $18, $40, Superannuation money Lifetime Annuities bought with superannuation money are generally made up of a taxable and a tax-free component. The portion of these components is set at the start of the Lifetime Annuity and remains fixed for the life of the Annuity. On death, the amount paid to tax dependants is tax free regardless of the components. However, if the estate pays the benefits to a non-tax dependant, the taxable component is subject to tax at a maximum rate of 15%. In summary, tax dependants are: your spouse or ex-spouse a child under the age of 18 (or otherwise financially dependent on you) someone who is financially dependent on you someone in an interdependency relationship with you. 2 Based on Challenger Guaranteed Annuity (Liquid Lifetime) and bank bill swap rates effective 1/07/2014. Challenger Annuities technical guide 7

10 Taxation upon withdrawal (voluntary) Non-superannuation money If a Lifetime Annuity is withdrawn before or at the end of the withdrawal benefit period, the withdrawal value will comprise an amount that represents a return of remaining capital (called the reduced purchase price see following section) and income. The income component of the withdrawal will be assessable to the investor and, depending on personal tax circumstances, subject to tax. Using the same example above, if Joe and Tina decided to withdraw their Lifetime Annuity in full, their Annuity will have the following income component: Figure 4: Joe and Tina s income component on withdrawal End of year Withdrawal value 3 Reduced purchase price Income component (assessable) 1 $58, $56, $2, $57, $53, $4, $56, $50, $6, $56, $47, $8, $55, $45, $10, $55, $42, $12, $54, $39, $15, $54, $37, $17, $54, $34, $20, $55, $31, $23, $55, $28, $27, $56, $26, $30, $57, $23, $34, $58, $20, $37, $58, $18, $40, Calculating the reduced purchase price The reduced purchase price of an annuity for taxation purposes is calculated by deducting the total of the deductible amounts applied against the annuity from the amount invested. For example, Joe and Tina, who invest $58,820 in a Lifetime Annuity, will have the following reduced purchase price at the end of the first year: Deductible amount: $2, (see page 6 for calculation) Annuity payment received: $2, Deductible amount applied to Annuity: $2, End of year one reduced purchase price = $56, ($58,820 $2,720.63) This is the methodology used when calculating the reduced purchase prices shown within the tables on this page. If Joe and Tina selected a benefit reduction of 50%, the income payments would reduce to $1, per annum. As this is less than the deductible amount, the reduced purchased price would be reduced by these income payments going forward. Superannuation money Where a Lifetime Annuity purchased with superannuation money is withdrawn within the withdrawal period, the amount withdrawn can be paid as a lump sum or rolled over to another superannuation fund. Amounts taken as a lump sum are generally tax free for people age 60 and over. 3 Based on Challenger Guaranteed Annuity (Liquid Lifetime) and bank bill swap rates effective 1/07/ Challenger Annuities technical guide

11 Challenger Term Annuities Product name: Challenger Guaranteed Annuity A Challenger Term Annuity (Term Annuity) creates a regular, guaranteed cash flow for your client s desired term, regardless of how investment markets perform. It can give your client peace of mind during their retirement with the flexibility to withdraw at any time. Challenger Annuities technical guide 9

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

13 Centrelink treatment How Term Annuities are counted toward the Age Pension Unlike the Lifetime Annuity, the Centrelink assessment of Challenger s Guaranteed Annuity (Term Annuity) will depend on the actual term of the annuity. Terms of five years or less A Term Annuity with a term of five years or less will be classified as a short-term income stream and treated as a financial investment. Centrelink s income and asset assessment of short-term income streams are as follows: Income Test Deemed (refer to the appendix for current rates) Assets Test Asset value = Purchase price less (deduction amount multiplied by term elapsed) Terms greater than five years A Term Annuity with a term of six years or more will be classified as a long-term income stream (unless the term is equal to or greater than the person s life expectancy) and will be assessed under Centrelink s Assets Test and Income Test as follows: Income Test Assessable income = Annual payment less annual deduction amount Assets Test Asset value It is important to note that the above: = Purchase price less (deduction amount multiplied by term elapsed) applies to annuities bought with either superannuation or non-superannuation money, and the purchase price is reduced by any withdrawals. Calculating the deduction amount The deduction amount generally represents the return of capital over the term of the annuity. To calculate the deduction amount for a Term Annuity, divide the purchase price (less withdrawals and residual capital value) by the nominated term at commencement. For example, Joe and Tina also bought a Term Annuity for $45,000 as part of their retirement plan. The Term Annuity has a 10 year term with no residual capital value. Joe and Tina s Term Annuity will have a deduction amount of: $45,000/10 = $4,500 per annum Income Test: How to calculate the assessable income The deduction amount is the portion of each annuity payment that is not counted for Centrelink purposes. This means that where income paid from the annuity exceeds the deduction amount, then only the difference between income paid and the deduction amount is counted for Centrelink purposes. Assets Test: How to calculate the asset value The amount of the purchase price counted as an asset for Centrelink will reduce by the deduction amount over the term of the annuity. Where income payments are paid more frequently than yearly (e.g. monthly) the purchase price will reduce every six months. If income is paid yearly, the purchase price will reduce every 12 months. Assuming Joe and Tina do not make any withdrawals from their Term Annuity, the assessable asset value of their Term Annuity will reduce uniformly as follows: Figure 6: Joe and Tina s reducing assessable asset value Start of year 1 $45,000 2 $40,500 3 $36,000 4 $31,500 5 $27,000 6 $22,500 7 $18,000 8 $13,500 9 $9, $4, $0 Asset value for Centrelink purposes Challenger Annuities technical guide 11

14 Treatment of lump sum withdrawals Centrelink/DVA treats full and partial withdrawals of the Term Annuity as a return of capital, and does not currently assess them under the Centrelink Income Test. This includes situations where the withdrawal amount exceeds the Centrelink asset value. How the funds are subsequently invested will determine how it will be assessed under the Assets and Income Tests. For example, if the withdrawn funds are invested in a term deposit, Centrelink/DVA will assess the value of the term deposit as a financial asset and deem it under the Income Test. Where a partial withdraw is made, Centrelink will recalculate the assessable asset value of the Term Annuity based on a purchase price and deduction amount that reflects the withdrawal. For example, if Joe and Tina withdrew $10,000 from their Term Annuity at the end of the second year the deduction amount going forward will be: = Purchase price (less withdrawals and residual capital value) divided by the nominated term at commencement = ($45,000 $10,000)/10 = $3,500 per annum Their assessable asset value after the withdrawal will be: = Purchase price less (deduction amount multiplied by term elapsed) = ($45,000 $10,000) ($3,500 x 2) = $28,000 Splitting income Where the Term Annuity is owned jointly by two investors (non-superannuation money only) the income payment can be split according to a nominated proportion. This portion will also be used to split the deduction amount and assessable asset value across the two investors for Centrelink purposes. Reversionary beneficiaries and joint policies On death of the primary owner, payments will continue to the reversionary beneficiary or remaining owner (joint policies). For Centrelink purposes, the reversionary beneficiary will inherit the deduction amount and assessable asset value of the primary owner. For joint policies, the full deduction amount and asset value are applied to the surviving owner s Income and Assets Test assessments (that is, the income split portion is no longer applied). Adviser fees Upfront adviser fees Where an upfront adviser service fee has been negotiated, the Term Annuity s regular income payments are reduced to reflect the amount of the fee. However, this fee does not reduce the purchase price used to calculate the deduction amount. Ongoing adviser service fee With the Term Annuity, your client can agree to the payment of an ongoing adviser service fee, which can be deducted from their regular payments. Annuities that pay an ongoing adviser service fee have their regular income payments reduced by the amount of the fee and the net amount credited to the client s nominated account. Centrelink does not reduce the assessable income of the Term Annuity by the amount of this fee. 12 Challenger Annuities technical guide

15 Taxation treatment This information applies to individual Australian tax residents only and is based on our understanding of current taxation legislation as at the date of this document. Taxation upon investment No tax is deducted from the initial amount invested in the Term Annuity using non-superannuation money. Term Annuities purchased using rolled over superannuation funds with an untaxed element will have the applicable tax deducted from the untaxed component prior to commencement. Note: The Term Annuity can only be purchased with superannuation funds that are classified as unrestricted non-preserved. Taxation of regular payments The tax treatment of the Term Annuity s regular income is different for annuities purchased with non-superannuation and superannuation money. Non-superannuation money For Term Annuities purchased with non-superannuation money, the regular payments are split into two components: Deductible amount The deductible amount is the amount of each annuity payment that is deemed to represent the return of part of the original investment. This amount is tax free. The deductible amount is calculated in the same way as the deductible amount used for Centrelink purposes, that is: [Purchase price (less partial withdrawals) less the residual capital value]/term of the annuity Assessable amount If annuity payments in the financial year are greater than the deductible amount then the excess amount is called the assessable amount and it is assessable as income. The assessable amount is the amount of each annuity payment that is deemed to represent earnings. Depending on the investor s personal circumstances, this amount may be subject to Pay As You Go (PAYG) withholding tax. Joint policies Challenger allows policy owners to select the amount to be paid to each owner. For example, one owner can be allocated 30% of the income payments and the second owner the remaining 70%. In these cases, the deductible and assessable amounts for tax purposes will also be split using these portions. On death of one of the owners, the full income payment will be paid, and the full deductible amount will be allocated, to the surviving owner. Reversionary beneficiaries Where a reversionary beneficiary is nominated, income payments will continue to be paid to the reversionary and taxed in their name. Note that the deductible amount does not get recalculated and the assessable amount will be the portion of the income payment in excess of the deductible amount. Superannuation money Superannuation income streams, such as superannuation annuities, that meet specific SIS standards, receive favourable tax treatment. Generally this means tax-free income from the income stream for those aged 60 and above. For those younger than 60 and at least preservation age, only the taxable component of the income payment is taxable (with tax reduced by a 15% tax offset). On death of the original owner, the income paid to the reversionary (if applicable) will also be tax free if the original owner or the reversionary was aged 60 or over at the time of death. One of the SIS standards requires minimum income payments to be paid from the annuity. If the Term Annuity has an RCV (10% to 100%), unlike the Lifetime Annuity, where the minimum income payment is only required to be met in the first year, the Term Annuity s income payments will need to meet minimum standards each year. If the Term Annuity has no RCV, a minimum payment requirement must only be met in the first year. For example, let s assume Joe and Tina s Term Annuity had a 15 year term, had 100% RCV and was purchased using superannuation money rolled over from Joe s accumulation fund. The Term Annuity will need to meet minimum payments of 5% per annum for the first 10 years (when Joe is below 75) and then 6% per annum for remaining five years when Joe is 75 and over. Challenger Annuities technical guide 13

16 Where minimum income payments cannot be met in each year, Challenger s quote software equote will require a reduced residual capital value to be selected so that each year s income payment can be increased by an additional capital return. Note: Challenger currently only offers superannuation annuities for people aged 60 and over with unrestricted non-preserved benefits. On death, if there is a nominated reversionary beneficiary, income payments will continue to be paid to the beneficiary. Taxation upon withdrawal (death) Non-superannuation money Upon death, any amount payable to the annuitant s estate or beneficiaries will comprise an amount that represents a return of remaining capital (called the reduced purchase price) and income. The reduced purchase price is worked out by reducing the purchase price by the deductible amount each year (if the income payments are less than the deductible amount, then the purchase price is reduced by the income paid). The taxation of death benefits is generally dependent on the tax circumstances of the estate and the beneficiary. Payments made to the estate Currently, for the period from death to 30 June and the following two income years, the estate will be taxed on the income component at the same marginal tax rates as an individual (including being eligible for the tax-free threshold, but excluding Medicare Levy). If administration of the estate is not finalised within that period, the estate will continue to be taxed at broadly the same marginal tax rates as an individual (excluding Medicare Levy), however it will no longer be entitled to a tax-free threshold. Payments made to beneficiaries Beneficiaries are taxed on the income component at their marginal tax rate plus the Medicare levy. In Joe and Tina s case, if their Term Annuity of $45,000 was purchased using non-superannuation money and in the event that both died, the estate of the last surviving partner to pass away will have the following assessable income upon receiving the withdrawal payment. The income component is calculated the same way if a beneficiary is to receive the payment, however may be split if there are multiple beneficiaries. Figure 7: Assessable income to Joe and Tina s estate upon their deaths End of year Withdrawal value 4 Reduced purchase price 1 $39, $40, $0.00 Income component (assessable) 2 $36, $36, $ $33, $31, $2, $30, $27, $3, $26, $22, $3, $22, $18, $4, $17, $13, $3, $12, $9, $3, $6, $4, $1, $0.00 $0.00 $0.00 Superannuation money Term Annuities that are commenced using superannuation money are generally made up of a taxable and a tax-free component. The portion of these components is set at the commencement of the Term Annuity and remains fixed for the life of the annuity. On death, the amount paid to tax dependants is tax free regardless of the components. However, if the estate pays the benefits to a non-tax dependant, the taxable component is subject to tax at a maximum rate of 15% (Medicare levy may also apply). In summary, tax dependants are: your spouse or ex-spouse a child under age 18 (or otherwise financially dependent on you) someone who is financially dependent on you someone in an interdependency relationship with you. Taxation upon withdrawal (voluntary) Non-superannuation money If the Term Annuity is withdrawn in full, the withdrawn amount will comprise of a return of remaining capital (called the reduced purchase price) and income. The income component of the withdrawal will be assessable to the investor and, depending on personal tax circumstances, subject to tax. 4 Based on Challenger Guaranteed Annuity and bank bill swap rates effective 1/07/ Challenger Annuities technical guide

17 For example, Joe and Tina s Term Annuity will have the following assessable income component upon a voluntary full withdrawal: Figure 8: Joe and Tina s assessable income upon full withdrawal End of year Withdrawal value 5 Reduced purchase price 1 $35, $40, $ $33, $36, $ $30, $31, $0.00 Income component (assessable) 4 $27, $27, $ $24, $22, $2, $20, $18, $2, $16, $13, $3, $11, $9, $2, $6, $4, $1, $0.00 $0.00 $0.00 Calculating the reduced purchase price The reduced purchase price of a Term Annuity for taxation purposes is calculated by deducting the total of the deductible amounts applied against the annuity from the amount invested. For example, Joe and Tina s 10-year Term Annuity will have the following reduced purchase price at the end of the first year: Deductible amount: $4,500 (see page 11 for formula) Annuity payment received: $5, Deductible amount applied to annuity: $4,500 End of year 1 reduced purchase price = $40,500 ($45,000 $4,500) This is the methodology used when calculating the reduced purchase prices shown within the tables in the previous sections. With a partial withdrawal, the withdrawn amount will generally be classified as return of capital and will not be taxed. The deductible amount applied to future income payments will be recalculated to reflect the partial withdrawal. For example, if Joe and Tina withdrew $10,000 at the end of the second year the deductible amount that would apply going forward would be: [Purchase price (less partial withdraws) less the residual capital value] / term of the annuity = ($45,000 $10,000)/10 = $3,500 per annum Superannuation money Where a Term Annuity purchased with superannuation money is withdrawn, the withdrawn amount can be paid as a lump sum or rolled over to another superannuation fund. The tax-free and taxable components of the withdrawal are in proportion to the amounts locked in at commencement. Amounts taken as a lump sum are generally tax free for people aged 60 and over. 5 Based on Challenger Guaranteed Annuity and bank bill swap rates effective 1/07/2014. Challenger Annuities technical guide 15

18 Case study Joe and Tina Clients Joe and Tina Age 65 and retiring Assets $330,000 superannuation in Joe s name Goals To always have money to pay for basic costs of living, have enough income to live comfortably, make sure their savings last the rest of their lives and protect against share market risk. 16 Challenger Annuities technical guide

19 Case study Case study Joe and Tina Joe and Tina are 65 years old and retiring. Joe is a store manager and Tina is a stay-at-home mum. They have $330,000 in superannuation, all in Joe s name. They own their home and have $20,000 in home contents. They have no other financial assets or debts. Joe and Tina estimate they ll need a minimum income of $33,500 per year to maintain a modest lifestyle in retirement (this is roughly in line with the relevant ASFA Retirement Standard 6 ). However, they would prefer a slightly more comfortable retirement, particularly for the first ten years while they re most active. They think they would need $50,000 per year to achieve that. Joe and Tina will receive some secure income from the Age Pension. Under current rules 7, this is $30,559 in the first year of retirement. They expect their Age Pension will be less than their minimum income requirement, so they would like to find an additional source of secure income to make up the difference of $2,941 and ensure they can pay their bills. Joe and Tina s life expectancies are and years respectively 8. This is an average only they are in good health, so could expect to live well past age 90. Like many Australians, Joe and Tina fear that their savings will not last as long as they will. Joe and Tina are concerned about share market volatility and would like moderate exposure to growth assets (50% in growth assets, 50% in defensive assets). They visit their financial adviser to find a suitable solution. The financial adviser s recommendation Joe and Tina s financial adviser recommends that they convert their superannuation into a combination of income streams. This strategy is designed to give Joe and Tina not only their preferred level of income, but also the flexibility and certainty that they desire. The first income stream is a Challenger Lifetime Annuity. A Challenger Lifetime Annuity is a secure investment that can provide a series of regular payments for the rest of their lives (assuming they don t withdraw during the 15 year withdrawal period). The Challenger Lifetime Annuity they decide to purchase will cost $58,820 and can provide $2,941 9 per year of additional income above the Age Pension 10 for the rest of Joe and Tina s lives. On the death of one spouse, payments will continue for the life of the surviving spouse. The next recommended income stream is a ten year Challenger Term Annuity with no remaining capital at the end of the term. A Challenger Term Annuity can provide regular, known payments for a fixed period of time (assuming they don t withdraw early). This will cost $45,000 and lock in income of $5,012 per year for ten years 9. Their adviser also recommends that they set up an accountbased pension with their remaining superannuation balance of $226,180. With an account-based pension they can choose from a range of investments and select the income they draw, subject to minimum payment requirements. Their adviser recommends that they draw $11,488 from their account-based pension in year one. After talking to their adviser, it is decided that the accountbased pension will be invested in a mix of 73% growth and 27% defensive assets to meet Joe and Tina s preferred overall asset allocation of 50% growth, 50% defensive 11. The account-based pension is designed to provide money to pay for hobbies and other nice to haves until it runs out. 6 The ASFA Retirement Standard benchmarks the annual budget needed by Australians to fund either a comfortable or modest standard of living in the post-work years. Visit resources/retirement-standard for more information. 7 Based on the scenario where Joe converts his entire superannuation into an income stream and drawing the required legislative minimum. 8 Source: Based on Life Expectancy Tables from Australian Government Actuary 9 Based on applicable Challenger annuity rates as at 1 July 2014 with no monthly payments, no adviser fees and assuming Joe and Tina don t withdraw. Challenger annuity rates are subject to change. To help protect the purchasing power of the regular payments they receive from the effects of inflation, Joe and Tina have chosen CPI indexation for the Term Annuity and partial indexation for the Lifetime Annuity. 10 All references to the Age Pension are to the current Age Pension amount at the date of this document that would be received by a couple in the same situation as Joe and Tina. 11 The annuities form part of the defensive portion of the portfolio. Challenger Annuities technical guide 17

20 With this strategy, Joe and Tina are matching income from different sources to different expenses. The secure income from the Age Pension and annuities can pay for their basic costs and planned discretionary expenses, while marketlinked income from the account-based pension affords them a comfortable life (Figure 9). The income streams, when totalled, provide $19,441 income for Joe and Tina in the first year of retirement. With their Age Pension payments of $30,559 on top, Joe and Tina have a total income of $50,000 in that first year (Figure 10). After speaking to their adviser, Joe and Tina s $330,000 superannuation balance is invested so that during the first year of retirement: a $58,820 Challenger Lifetime Annuity gives them $2, a $45, year Challenger Term Annuity gives them $5, a $226,180 account-based pension gives them $11,488 they receive $30,559 from the Age Pension Total income during the first year of their retirement is $50,000. Figure 9: Matching income to help Joe and Tina meet their goals over time Income to pay for desirables Peak spending years Term annuity Account-based pension Figure 10: First year s income from different sources can be matched to different expenses { For things like: holidays Income meals out to pay for entertainment desirables home repairs other unforeseen costs emergencies Income to pay for essentials { Total income of $50,000 For things like: food clothing utilities health expenses This diagram is illustrative only and not to scale. It is not a prediction or guarantee of any particular outcome. Strategy considerations By investing in a combination of a Challenger Lifetime Annuity, Challenger Term Annuity and account-based pension, Joe and Tina have: A safe and dependable income stream from the Challenger Lifetime Annuity that, in addition to their current Age Pension entitlement, can cover basic expenses, last for the rest of their lives (assuming they don t withdraw early) and provide some protection against share market risk. An additional amount of income for ten years from the Challenger Term Annuity (assuming they don t withdraw early). Market-linked income from the account-based pension designed to pay for the nice to haves and maintain some flexibility. Income to pay for essentials Lifetime annuity Age pension Exposure to the share market through the account-based pension. 65 Age This diagram is illustrative only and not to scale. It is not a prediction or guarantee of any particular outcome. 12 Based on applicable Challenger annuity rates as at 1 July 2014, no adviser fees and assuming Joe and Tina don t withdraw. Challenger annuity rates are subject to change. To help protect the purchasing power of the regular payments they receive from the effects of inflation, Joe and Tina have chosen CPI indexation for the Term Annuity and partial indexation for the Lifetime Annuity. 18 Challenger Annuities technical guide