AFC3440 TUTORIAL 4, ANSWERS 2008

Topic Four: Social Security, Age Pension and Super

Question 1 (i) What is the principal objective of most Australian retirees?

(ii) List some other likely objectives (not necessarily all financial).

Answer:

(i) Most lump sum retirees will need to convert their lump sum (or part of it) into a
reliable income stream to last the remainder of their lives.

(ii) Some other likely objectives:

• pay off any remaining mortgage
• have something left over by way of bequests to kinsfolk
• relocate to enjoy a quiter lifestyle
• write a book, paint, play more golf, travel, spend more time with siblings, children,
grandchildren etc.

Q.2 Explain why the Superannuation Guarantee Scheme must work in tandem with
Social Security and the Age Pension.

Answer:

The SGS has only been in operation since 1992. Then it started off with a compulsory
contribution rate of only 3% p.a. which has gradually been increased to the current
9% p.a. In addition tax at 15% is levied on contributions. Consequently only a small
proportion of current retirees will have accumulated enough to be entirely self-
funding from super. Those who are are generally recipients of defined benefit
pensions (teachers, nurses, public servants, academics, some ex-company employees).
Only about 11% of retirees are self-funding. For 67% of current retirees over age 45,
the Age Pension is the main source of retirement income.

Q.3 (i) The minimum proportion of Table 1 ‘New Pensions’ mean that retirees must
take increasing proportions of their account balance as they get older. Why does the
government insist on this?
(ii) How in general terms do the new provisions compare with the amounts taken
under the old ‘Pension Valuation Factors’ which formerly applied to allocated
pensions?

Answer:

(i) The government is concerned that retirees may try to build up account balances in
their new pension investment accounts by taking minimum pensions all their residual
lives, and using the concessional tax (i.e. no tax) on investment earnings and capital
gains in this phase of SGS. Persons with bequest motives may do this. The new
pension minimum proportions oblige retirees who want tax-free income to take an

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increasing proportion of their account balance (10% over age 85 and 14% over age
95)
(ii) The Pension Valuation Factor which determined the minimum amount of
allocated pension to be drawn down had a similar effect. It implied a fairly robust
annual compound rate of indexation on a starting pension. That is the proportion of
account balance which had to be taken using an allocated pension and PVFs also
increased with increasing age.

Q.4 (i) What is Centrelink?

(ii) List some welfare benefits administered by Centrelink.

Answer:

(i) Centrelink is the one-stop shop which administers Australia’s Social Security
welfare system.

(ii) Some important payments administered by Centrelink include:

Newstart, Austudy, Youth Allowance, Age Pension, Carer payment, Carer allowance,
Rent assistance, Family assistance. Check www.centrelink.com.au

Q.5 In general terms, how are Age Pension entitlements determined?

Answer:

Persons apply for the Age Pension. Provided certain residential requirements are
fulfilled, and the person is over Age Pension age (usually 65) means tests are applied.
There is an assets test and an income test, both of which are used to determine
entitlement. The test which results in the lower Age Pension entitlement prevails.
If persons have too many qualifying assets, the maximum allowable pension amount
(currently $543.50 for single retirees and $452.00 each for a retiree couple) is reduced
in proportion to the excess, or entirely wiped out.
Similarly if persons have too much qualifying income, this will reduce or wipe out the
Age Pension entitlement.
In respect of the income test, for persons who purchase an income stream there is a
‘return of capital’ component reflecting the fact that part of the pension taken usually
consists of return of part of the purchase price capital. This usually makes the income
test less stringent than the assets test.
On the other hand, for persons with financial assets outside the super system, those
assets are deemed to earn income at certain fixed rates (‘deeming rates’), regardless of
the actual earnings they produce. This ‘deemed income’ is added to other income for
income test purposes.

Q.6 (i) What are the current deeming rates?

(ii) List some financial assets subject to deeming provisions.

Answer:

(i) The rates currently (since March 2007) are:

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3.5% for first $39,400 of financial assets ($65,400 couples)

5.5% for financial assets exceeding these figures

(ii) Financial assets such as shares, bonds, cash-at-bank, and annuities of term less
than 5 years are subject to the deeming provisions.

Q.7 An investor owns:

(i) $100,000 of NAB shares
(ii) a five year indexed annuity paying $15,000 p.a. indexed at 3% p.a.payable
monthly purchased for $50,000.
Discuss the way that deeming applies to these assets.

Answer:

(i) Regardless of NAB’s dividend payments, the shares are deemed to have returned;

0.035×$39,400 +0.055×$60,600 = $4,712

(ii) Regardless of the annuity payments, the $50,000 investment is deemed to have
yielded 0.035×$39,400 +0.055×$10,600 = $1,962

Q.8 When applying Centrelink’s income test, annual income is reduced by a ‘return
of capital’ component. Calculate the annual return of capital component if $500,000
was used to purchase:

(i) a term certain annuity of 25 years

(ii) a life annuity by a single female retiree aged 65
(iii) a life annuity reversionary to a spouse by a couple both aged 65

Answer:

(i) the ROC is $500,000/25 or $20,000 p.a.

(ii) ROC is $500,000÷(life expectancy) = $500,000/21.15 = $23,6401

(iii) ROC is $500,000÷(longer of two life expectancies) = $500,000/21.15 = $23,6401

Q.9 Belinda has $580,000 in super, a remaining mortgage of $60,000 on her home,
and lifestyle assets of $75,000. Belinda is aged 64 and retired.
She intends to pay out her mortgage and use a new pension, taking $1,000 per
fortnight. She will index this amount at 3% p.a. each new year.
(i) How much is the annual ROC component of Belinda’s indexed pension?
(ii) How much age pension (maximum $543.50 p.f.) can Belinda expect under the
assets test?
(iii) How much under the income test?
(iv) What is Belinda’s total annual pension?
(v) How much tax does she pay?

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Answer:

(i) Belinda’s life expectancy is 22.00 years. Her ROC is thus $520,000/22 = $23,636
p.a.
(ii) Under the assets test, Belinda’s Age Pension reduction is:

1.50×(520,000+75,000 – 166,750) = $642.38

This wipes out the Age pension entitlement. Belinda will obtain no Age Pension under
the assets test.

(iii) Under the income test, Belinda’s income would be assessed as $26,000 - $23,636
= $2,364 or $90.92 p.f. Since Belinda is allowed $132 under the income test without
penalty, there would be no reduction under this test.

But Belinda cannot obtain any age pension, because she is wiped out under the assets
test. Note that this situation may change as Belinda’s assets are gradually eroded.

(iv) Belinda’s total annual pension is $26,000

(v) Belinda pays no tax. Her $26,000 is 5% of her $520,000 lump sum.

Q.10 A retiree couple Bill and Jenny, own their own home, have $450,000 in super,
$60,000 in lifestyle assets. Bill is (M66) and Jenny is (F64) but both their parents
lived to ripe old ages, so they fear they need to achieve good returns on their super
lump sum to manage inflation and longevity risks. They propose using a the de facto
ORARIS strategy as outlined in the Example of a Financial Plan posted to MUSO.
In the first year they expect to draw down $22,500 income (the minimum allowable
amount to be tax-free.
(i) Find their pension entitlement under the Assets test.
(ii) Find their pension entitlement under the Income test.
(iii) How much tax do Bill and Jenny pay?

Answer:

Note that since these answers were written, the pension rates have changed to $456.80
p.f. for each member of a couple, rather than the $452 p.f. used here

(i) Under the assets test Bill and Jenny’s maximum $452.00 p.f. each will be reduced
by:

$0.75×(510 – 236.5) = $205.13 p.f.

so that under this test their entitlement is $246.87 p.f.

(ii) Under the income test, Bill and Jenny’s ROC is 450,000/22 = $20,455 p.a.
($22,500-$20,455) = $2045 or $78.65 which is under the allowable threshold.

So their overall entitlement is determined by the assets test.

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This is 26×246.87 = $6418.62 p.a. each.

Thus each has a pension of 0.5×$22,500 + $$6418.62= $17,643.62

Bill and Jenny pay no tax on the $22,500 as it represents 5% if their account balance.
Tax is payable at 15% on the $419 by which their Age Pension is above the $6,000
tax-free amount. This is about $63. But since there is a low income rebate of $750
available to taxpayers with incomes below $30,000 they will pay no tax.

Q.11 Marlene aged 61 has been unemployed for ten months. She has $600,000 in
super and has been looking for work. She has decided to purchase a 4-year annuity of
$24,000 payable monthly and indexed at 3% p.a. She can obtain this at a yield of
5.6% from a commercial provider. She is also going to apply for Newstart. Marlene
owns her own home, has lifestyle assets of $75,000 but no significant liquid reserves.

(i) How are Marlene’s superannuation assets treated under Centrelink’s assets test?
(ii) How much does Marlene’s annuity cost to purchase?
(iii) How much newstart (maximum $470.70 p.f.) can Marlene obtain?

Answer:

(i) The super does not count as an asset in Centrelink’s asset test between ages 60 and
65.
(ii) The pension will cost:

24,000×a(12)4:0.056:0.03 = 24,000×$3.743036 = $89,832.87

(iii) There is no reduction to Marlene’s Newstart allowance under the assets test. Her
$75,000 lifestyle assets together with the $89,833 of annuity (now a financial asset
outside the super system) sum to $164,832 and this below the $166,750 threshold.
Since the annuity is of term less than five years its income value is assessed under
deeming provisions. The deemed income is:

0.035×$39,400 +0.055×($89,833-$39,400) = $4,153 or $159.72 p.f.

Since this lies between $62 and $250 it results in a reduction of ($159.72-$62)×0.5 or
$48.86

So Marlene obtains $470.70- $48.86 = $421.84 p.f. ($10,968 p.a.) of Newstart.

Q.12 What is the pension bonus scheme?

The Pension Bonus Scheme (PBS) is a voluntary scheme that rewards people who
defer claiming Age or Service Pension. To benefit you must register as a member then
continue to meet a flexible work test for at least 12 months before claiming the
Pension Bonus. You cannot automatically claim PBS without registering for it.
Payment rates effective from 20 September 2007 are shown below in Table 1. The
bonus is paid as a non-taxable lump sum once you claim and get Age Pension.

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Bonus Years Single Partnered (each)
1 year $1314.10 $1097.60
2 years $5256.60 $4390.40
3 years $11 827.20 $9878.40
4 years $21 026.20 $17 561.60
5 years $32 853.50 $27 440.00
Table 1 PBS entitlement maximum amounts

Answer:

Q.13 Discuss in general terms the combined effects of abolishing ‘complying income
streams’ but reducing the assets test taper

Answer:

The abolition of complying income streams has meant a considerable reduction in the
age pension entitlement of many who would have purchased them. The reduced taper
is poor compensation for the 50% asset reduction such income streams attracted.
But persons already on TAPs for instance will be advantaged, in that they will get
more age pension than before. Not only is the 50% assets test exemption still
available to them, the reduced taper of $1.50 p.f. for each $1,000 of excess assets
now applies instead of the old $3.00 p.f.
However, for persons especially couples on allocated pensions (now ‘new pensions’)
there is now the possibility of some Age Pension entitlement, where in the past they
obtained none. In economic terms it is going to cost the government more for the
latter group than they save with the former; i.e the overall Age Pension payout will
increase because of the amendments.