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- Federal government’s financial model is unclear
- Susan loses 30% of her income in first year of changes
- Low taper rate scenario (old Age Pension rules)
- High taper rate scenario (current Age Pension rules)
- What happens to the value of Susan’s assets?
- Financial resilience and the degradation of real capital in retirement
- Front loading: Taking from the next generation
- Stolen inheritances to become the norm
- Is Susan’s case unique?
- Susan fights back and spends her savings
- Grab for cash costs more for future governments and weakens trust
- Assumptions used in this article
Introducing our guest contributor, Jim Bonham: Dr Jim Bonham is a retired scientist and manager. Although he is unaffected by the recent changes to the superannuation and Age Pension rules, as an SMSF trustee, he is deeply concerned about the ongoing instability for retirees and future retirees. In the article below, Jim explores the long-term impact of the January 2017 Age Pension changes, for both retirees and for future federal government budgets.
At the beginning of 2017, we finally saw the implementation of a budget measure announced in 2015: the doubling of the Age Pension assets test taper rate (the rate at which a part Age Pension decreases as the value of assets increase). The taper rate results in a loss of Age Pension of $3 a fortnight per $1,000 in assets (roughly $7,800 a year per $100,000 of assets) above a specified assets threshold. Before January 2017, the taper rate was $1.50 a fortnight per $1,000 in assets (or roughly $3,900 a year per $100,000 of assets) above a specified assets threshold.
This change to the Age Pension assets test has forced many Australian retirees to choose between accepting a lower income, or drawing down their savings more rapidly than they originally intended. As a result, the change to the Age Pension assets test has provided a strong incentive for Australians to spend savings, rather than preserve savings in retirement.
Part of the federal government’s story when introducing these changes was that the impact on Age Pensioners would be trivial. For example, when the changes were first announced by then Treasurer Joe Hockey in the 2015 Federal Budget, the following appeared in the Budget Overview:
The changes in the Budget require those pensioners with substantial means to draw on slightly more of their assets to maintain their current income levels in retirement, while the Government continues to support those who need it most. In a worst case scenario, this would mean a 1.8 per cent annual drawdown on their assets…
This trivialisation by the federal government is misleading and self-serving (self-deluding too, as we shall see) and that is what has motivated me to write this essay. For example, the model used by the federal government to justify the changes, results in the Age Pensioner losing 30% of her income in the first year, forcing her to dip into her assets, or to reduce her lifestyle.
Although revenue raising (or, more precisely, expenditure reduction) was the federal government’s motivation in increasing the taper rate, and they have made no secret about that, nevertheless they have been doing their best to muddy the waters.
The federal government increased the lower Age Pension assets test threshold, in order to give some Age Pensioners an expanded benefit. While talking up that benefit, they also portrayed those who suffered a cut in Age Pension benefits as being wealthy and not needing Age Pension support, positioning the federal government as a sort of latter-day Robin Hood.
The federal government may have reduced expenditure in the short term, but the January 2017 changes to the Age Pension assets test will increase government expenditure over the longer term, imposing a greater cost on the next generation of Australians, long after this current government has moved on.
Note: Jack Hammond QC and Terrence O’Brien, supported by technical work by Sean Corbett, have also demonstrated serious flaws with the January 2017 Age Pension changes – the higher taper rate creates a “savings trap”, whereby substantial increases in lifetime savings lead to virtually no increase in retirement income, or even a drop, in retirement income.
Before we look at the calculations, a word of warning: this essay is a commentary on government Age Pension policy. The essay does not constitute financial advice or endorsement of any particular financial strategy.
This essay explores the following issues:
- Financial modelling used by the federal government to defend the Age Pension changes
- Comparison of the old and new Age Pension rules
- Impact of Age Pension changes on real (after inflation) and nominal (before inflation) asset values, and income
- Importance of resilience of capital, and financial resilience in retirement
- Savings for federal government are front-loaded, which means future governments are hit with higher costs
- Cash windfalls to federal government from family inheritances
Federal government’s financial model is unclear
Assistant Minister to the Treasurer, Michael Sukkar, in his correspondence with Jack Hammond, mentioned a couple of model case studies. Mr Sukkar seemed only interested in whether the new taper rate led to decreased government expenditure. He claimed the Age Pension changes reduced government expenditure for the first 37 years of a person’s retirement, commencing from first receipt of the Age Pension. The federal government’s claim seems to be saying that the policy works fine (as a revenue raiser) because the pensioner will die before it blows up and starts costing the government money. Not a reassuring way of putting things, but let’s see what happens when we analyse this claim properly.
Unfortunately, Mr Sukkar’s claim was surrounded by a vacuum of detail. We are told the Age Pensioner is single, she owns her home and her initial capital is $550,000 but that’s all. Does she have any non-financial assets, or other income? How is her money invested – in or out of super? What is her return after fees? What would her withdrawal strategy have been under a low taper rate scenario (before January 2017 changes were introduced)? What assumptions are made about inflation and the indexation of pension parameters?
All of these parameters need to be specified to model the long-term effects of the Age Pension rules, and we are left wondering why none of this information was provided. Perhaps the 37-year figure only applies for a carefully chosen set of parameters? And, OK, it’s nice for the government that they have saved some money, but what are the effects on the Age Pensioner and why didn’t Mr Sukkar see fit to mention them? How might the Age Pensioner used in the government’s example really react? Will she just be content to top up her income from her savings?
In the analysis below I’ll take quite a different tack from the federal government’s basic model. I’ll choose inputs which are reasonable, and state them, and then explore the consequences.
Susan loses 30% of her income in first year of changes
In common with Mr Sukkar, I’ll assume that the pensioner – let’s call her Susan – is a single home-owner who begins retirement with $550,000 invested. This was the upper Age Pension assets test threshold for a single homeowner at 1 July 2017, and it represents the asset value which causes the greatest loss of pension in the first year. Using this example does not mean it is the case most affected over a longer time-span.
For simplicity, I’ll assume Susan owns her home but her other assets are negligible. And I’ll also assume she has no income other than her investment earnings and part Age Pension (if any). In our model, Susan will live to 95, which puts her in the longest-living 20% of women, but giving her a long life allows us to follow her finances for a long time. Using a longer timeframe helps make things clearer, but the consequences of the taper rate change actually unfold long before Susan reaches 95.
Susan was just over 65½ when she began a part Age Pension on 1 July 2017. Clearly, retiring with $550,000 in savings in anticipation of funding a 30-year retirement cannot be considered wealthy.
Mr Sukkar did not say how Susan invested her money, but we’ll assume she put it in a fund returning 4.5% after fees – a middle of the road investment, typical of a more conservatively invested “balanced” fund.
Susan’s investment will earn her $24,750 per year, which is not enough to attract income tax (assuming she qualifies for the Seniors and Pensioners Tax Offset – see SuperGuide article How does SAPTO work? (Senior Australians and Pensioners Tax Offset)), so we’ll assume she keeps it outside the superannuation system. Keeping her savings outside the super system gives Susan the freedom to withdraw as much or as little as she likes.
Inflation is assumed to continue at 2% per year, and wages growth increases at 3% per year. Maybe inflation won’t stay as low as it is now, but using a higher value affects only the detail and not the general conclusions of this study. Note also that the average inflation rate over the last 30 years is only slightly higher at about 3%.
A full list of parameters, and their assumed indexation, is given at the end of this article.
The amount of Susan’s Age Pension each year is calculated by applying the Age Pension income test to her deemed investment income, and the Age Pension assets test to the value of the investments – and selecting whichever gives the lower result. There is a lot of information about this calculation on the Centrelink and SuperGuide websites (see SuperGuide article Am I eligible for the Age Pension?).
Now we are in a position to compare two scenarios for Susan: one in which the Age Pension rules are assumed to remain the same as they were in 2016 (old Age Pension rules), apart from routine indexation, and the other scenario in which the current rules (introduced in January 2017) are applied.
Low taper rate scenario (old Age Pension rules)
In the first case, I’ll call it the low taper rate scenario (hypothetically assuming the previous taper rate continues to apply, that is a loss of $1.50 of Age Pension per fortnight for every $1,000 above the FULL Age Pension threshold, rather than $3.00 a fortnight), Susan simply draws the income from her investment and adds that to a part Age Pension. In the first year she receives $24,750 from her investment and $9,919 from a part Age Pension making her total income $34,619. This strategy ensures that the nominal value of her investment remains at $550,000 although over time inflation substantially reduces the real value (i.e. the purchasing power) of that investment.
High taper rate scenario (current Age Pension rules)
In the second, case (based on the current post-January 2017 rules) I’ll assume that Susan withdraws some of her capital each year so that her total income matches what she would have received in the low taper rate scenario. Susan tapping into her savings to replace lost Age Pension income is what the government expects retirees will do, and is effectively their recommendation, as per the 2015 Budget Commentary.
Actually, the federal government’s expectation that retirees will simply dip into their savings each year is a rather theoretical strategy, because in practice Susan is unlikely to be able to work out what her income under the old taper rate would have been – especially after a few years. Even so, it’s very useful for us to assume that Susan can work out the difference in order that we can understand the consequences of the taper rate change.
In the first year since the January 2017 changes were introduced (high taper rate scenario), it means Susan needs to withdraw an extra $9,919 to receive the same annual income as before the January 2017 Age Pension changes. The $9,919 may indeed be just 1.8% of Susan’s assets, but that is also 30% of her income, which is quite a shock.
Losing 30% of her income was not what Susan was expecting when she started seriously to build up her savings for retirement more than a decade ago, and her savings strategy would have been quite different if she had known what was coming. In the words of Treasurer Scott Morrison, she is acutely conscious of the “effective retrospectivity” of this change. (Ironically, Morrison was actually commenting on the Australian Labor Party’s approach to a superannuation issue, see Address to the SMSF 2016 National Conference, Adelaide).
In the first year of the new taper rate, Susan’s loss is the federal government’s gain but by the time she is 95, she has lost , in real terms, $3 of assets for every $1 of pension the federal government saves, which is incredibly inefficient. What on earth is going on?
Based on my analysis, up until Susan turns 77, the government pays her less Age Pension under the high taper rate scenario, saving $56,962 (in 2017 dollars) during this period. But from age 77 onwards, her assets have decreased so much as a result of topping up her income that the federal government ends up paying her more Age Pension than they would have if the Age Pension assets test taper rate had remained low (pre-January 2017 rules). By the time Susan is 95, the federal government’s real savings have dropped to just $18,770, but Susan’s total real asset loss is $59,843 – three times as much.
Figure 1 below helps explain this outcome.
This situation arises because the high taper rate curve in Figure 1 is steeper than the low taper rate curve, and that is because:
- More rapid drawdown of assets in the high taper rate scenario pushes Susan’s Age Pension higher
- The higher asset taper rate further increases the rate at which this happens
This double whammy is an essential consequence of the federal government trying to raise revenue by changing the taper rate; it is not a consequence of the particular strategies I have assumed for Susan. Any strategy in which the real (after inflation) value of assets declines significantly through retirement will give essentially the same result (the numbers will be different, but the same effect will occur).
What happens to the value of Susan’s assets?
What happens to Susan’s finances in nominal dollar terms (i.e. in the dollars of the day) and also in real terms (adjusted for inflation so they are given in 2017 dollars)? Nominal dollars make some aspects of Susan’s finances easy to understand, but the real (2017) values show what happens to the buying power of her money: we all know that a dollar today won’t buy anything like what it would buy ten years ago – and we’re going to look up to 30 years into Susan’s future, so inflation matters.
Susan’s income and low taper rate scenario: Under the pre-January 2017 rules, Susan’s real income (in 2017 dollars) rises steadily but slowly over the 30 years of her retirement, from $34,669 to $40,790.
Susan’s income and high taper rate scenario: Under the current Age Pension rules (from January 2017 onwards), exactly the same happens, because matching income is the whole point of her high taper rate strategy.
The story is very different for Susan’s assets: In nominal terms, although the initial high taper rate hit on Susan’s assets is small (1.8%) as mentioned earlier, after 16 years Susan only has about $450,000 left. A few years later this has settled down to about $442,000 where it remains – a drop of about 20% compared to the low taper rate scenario, in which her nominal capital was preserved.
The real (after inflation) value of Susan’s assets declines steadily regardless of the taper rate: during the last 15 years, the real asset value is about 20% lower in the high taper rate scenario, like the nominal asset value. This equates to a loss (in 2017 dollars) of about 11% of her initial capital, but that comes on top of a loss of 45% in real asset value simply as a result of inflation so it’s a pretty severe hit.
Susan loses $59,843 in real asset value after 30 years, while the federal government saves $56,962 (in 2017 dollars) but gives back $38,192, which means the federal government has only saved $18,770 (in 2017 dollars). All this does from Susan’s point of view is stem some further erosion of capital: she will never recover the capital she lost in the early part of her retirement.
For more detailed analysis of this comparison, including charts, click on this pdf.
Financial resilience and the degradation of real capital in retirement
The inexorable degradation of real (after inflation) capital (assets) in retirement is something our politicians don’t talk about much when they talk about retirees amassing or preserving wealth in retirement. Politicians referring to retirement wealth are usually referring to nominal wealth. Misleading? Indeed. Listen carefully.
The federal government would argue that it is appropriate that Susan has used some of her assets to help fund her retirement, rather than just pass those assets on to her beneficiaries. What the federal government fails to say however, is that the loss of assets does not just affect her estate: it is money that would have provided some resilience against emergencies, or to help with care later in life.
Such resilience is a tremendously important purpose of capital (assets). Although plenty of government support is provided in, for example, health care, you can often do a lot better with some money behind you. Not all treatments are fully covered by Medicare; some are extraordinarily expensive, or lead to long-term living costs; and it may come as a shock that “elective” surgery only means that the condition is not (yet) life-threatening.
Financial resilience is also important in terms of life emergencies: the day (we all have them) when the washing machine self-destructs and the car sputters to a halt on the freeway; or when a close relative or friend needs some serious support.
A significant burden is removed from the federal government’s shoulders if retirees have the financial resilience to cope themselves with many of these financial shocks.
Unfortunately, the federal government seems to pay no heed at all to these important purposes for capital in retirement; they always talk as if the only purpose of holding capital is to generate income for day-to-day living, which is both simplistic and naïve, and in the end is against the federal government’s interest too.
Front loading: Taking from the next generation
The federal government’s Age Pension savings are heavily front-loaded, while they have back-loaded the cost of achieving these savings. The federal government will have to pay Susan a higher Age Pension later in life to compensate for the capital depletion early in her retirement. Susan’s capital losses, on the other hand, are front-loaded and she’ll never get back the $40k she loses in the first five years – or the $20k still to go.
Another way to express the federal government’s current Age Pension policy: not content with taking money from today’s Age Pensioner, the government is effectively also taking it from future governments.
The federal government may not care too much about any of this, as they can always change some rules again later (stand by for yet another round of “escalating Age Pension costs”, “wealthy retirees must contribute more” and so on). Unfortunately, if federal governments are forever playing catch-up like this we’ll never get anywhere.
The government may argue that money in their hands is more valuable to the nation in the long run than money in Susan’s account. In other words they would apply a higher discount rate to their Age Pension savings (and subsequent cost increase) than to Susan’s asset reduction, making the long-term consideration of government costs seem less important and the process over all seem more efficient.
Unfortunately, though, significant headaches are actually not that far in the future and they can’t easily be discounted. The gap at any point in time between the two curves in Figure 1 above represents the Age Pension savings per year, and that halves in just the first 5 years of Susan’s retirement. In Susan’s case (and that of anyone with less than $550,000 of initial assets), the cost savings start to fizzle in year 2. After a few more years any further savings are so small they just vanish into the rounding errors of the annual budget, and beyond that (after Susan turns 77) the federal government loses money compared to the low taper rate scenario.
Stolen inheritances to become the norm
Australians are living longer and it’s not uncommon for retirees to receive some inheritance from their – by now – very elderly relatives. Such payments may or may not be financially significant, but it is always a very emotional thing for all parties.
Susan is no exception, and at age 70 she receives an inheritance of $50,000. Alarmed by now at the rate her capital is shrinking, she decides to add the inheritance to her existing investments, while making no change to her withdrawals strategy.
Unfortunately, this just sets off another round of reduced Age Pension payments and increased withdrawal, so that later in life, all bar $15,000 (in 2017 dollars) of the inheritance has vanished, without her receiving a single benefit from it. The federal government just took it.
Is Susan’s case unique?
Susan’s case is not really unique. Her case is significant for reasons already discussed but if you take a life-long view, as retirees must, Susan’s scenario isn’t even the most affected under the new Age Pension rules.
Take Tom for example: like Susan, a single homeowner starting his pension in 2017 and using the same strategies, but having $750,000 instead of $550,000 in initial assets. Tom’s initial Age Pension loss to be topped up from savings is only $2,119, far less than Susan’s $9,919 (refer earlier).
But Tom’s losses compared to the low taper rate scenario (pre-January 2017 Age Pension rules) grow rapidly. Each year the federal government saves more on Age Pension costs until by the time he is 74, they are saving $9,035 per year (in 2017 dollars). Meanwhile Tom’s real (after inflation) assets have shrunk to $576,986, putting him in almost exactly the same position that Susan was in at the start of her retirement.
From then on, the story unfolds in the same way, as back-loaded costs come home to roost for the federal government (see Figure 2 below). By the time Tom gets to 95 (if he lives that long), the government’s real Age Pension savings will be $62,061, only half of Tom’s real asset loss of $117,045. As in Susan’s case, the process of converting Tom’s assets into government income is extraordinarily inefficient.
Tom’s long term real asset loss is twice Susan’s, so Susan is by no means the most affected by the change in taper rate.
Susan fights back and spends her savings
While I was preparing this manuscript, Susan got a peek at the draft and now she can see exactly what will happen to her finances. She’s ropeable that she has been called on to top up the government’s budget, and in such an inefficient way, while the politicians continue to talk up the prospect of tax cuts for those far wealthier than she.
But Susan is nothing if not resilient and fleet-footed; she reasons, why wait for the government to pinch my money? So she takes out $50,000 from her savings right now during the first full year of her retirement. She won’t waste it. It’s going to maintenance of her house, adding solar cells and preparing it for her later years – wheelchair friendly, grab rails in the bathroom, and so on.
The consequences are interesting, to say the least. The table below sets out the financial outcome from Susan spending $50,000 of her retirement savings. All of the figures in the table are 2017 dollars.
Susan spends $50,000 today, rather than preserving savings
|Scenario||Real assets at age 95||Change||Total lifetime real pension||Change|
|Low taper (pre- January 2017)||$303,639||$0||$559,198||$0|
|High taper (post-January 2017)||$243,796||-$59,843||$540,427||-$18,771|
|High taper with $50k withdrawal||$227,036||-$76,603||$592,468||$32,270|
With Susan taking that $50,000 out of her investments early in retirement, she reduces her final real asset value further, but only by $16,760 (in 2017 dollars), which is not a bad price for freeing up $50k cash in hand, without affecting her income at all (because her high taper rate strategy is designed to match income to the low taper rate scenario).
When Susan spends $50,000 today, the federal government doesn’t do so well, sadly. Instead of saving Age Pension costs over Susan’s lifetime (as they would have, had she sat like a rabbit in the headlights and passively accepted the government’s suggested strategy), the government is now $51,041 (in 2017 dollars) worse off than if she had not made that withdrawal. If Susan lives even longer than 95, the federal government’s losses will increase even further.
Remember Minister Sukkar’s claims (refer earlier in this essay) that the Age Pension changes would reduce government expenditure for the first 37 years of a person’s retirement? In the scenario the government uses to justify this claim, that is Susan’s scenario outlined earlier, Susan’s $50,000 withdrawal has brought forward that break-even point to just 20 years. If Susan withdraws $100,000, it would be 10 years.
Grab for cash costs more for future governments and weakens trust
The Age Pension assets test taper rate change is obviously not trivial, but the problems for the federal government go much deeper than a simple deception.
The system of means tests for the Age Pension is complex. Fiddling with the parameters of this system is fraught with unintended consequences, as we have seen, and is a terrible way to cut government costs – both financially and socially.
The federal government seems to have little appreciation of this, and even less appreciation of the true financial position of people like Susan and Tom, or of the perspective necessary to manage limited finances over a potentially very long retirement.
Susan, with her $550,000 sensibly invested, has so little income she pays no tax, and she doesn’t even reach ASFA’s “comfortable” income level (for what is considered a comfortable retirement, see SuperGuide article How much super do I need to retire?).
You really have to wonder: why target Susan, and others like her, to prop up the federal budget? And with such a self-defeating scheme?
Did the federal government consider any of this? They haven’t said so, but maybe one day Jack Hammond’s repeated requests for their modelling will answer the question.
In making a quick grab for cash they have set future governments up for additional costs, and provided strong incentives for action by current and future Age Pensioners which will subvert even their immediate cost savings.
Worse, the federal government have taken a huge step backwards, by undoing the halving of the asset test taper rate that took place from September 2007 which was done to prevent exactly the sort of problems exposed here.
The Age Pension changes, and the long-term effects of those changes, can only weaken people’s trust in the whole Australian retirement system.
About the author: Dr Jim Bonham is a retired scientist and manager. Although he is unaffected by the recent changes to the superannuation and Age Pension rules, as an SMSF trustee, he is deeply concerned about the ongoing instability for retirees and future retirees.
Assumptions used in this article
The following data were used in this article, and for Age Pension purposes, assumes a single homeowner:
|Lower asset threshold||Low taper: $212,135 (estimated)|
High taper: $253,750
|Asset test taper rate||Low taper: $39 p.a. /$1,000 of assets|
High taper: $78 p.a. /$1,000 of assets
|Lower income test threshold||$4,368 p.a.||CPI|
|Income test taper rate||$0.50 per $1.00 of income||CPI|
|Lower deeming rate||1.75% for income < threshold||N/A|
|Upper deeming rate||3.25% for income > threshold||N/A|
|Deeming threshold||$50,200 p.a.||N/A|
|Full pension||$23,096 p.a.||Wages|
|Inflation (CPI) rate||2% p.a.||N/A|
|Wages growth rate||3% p.a.||N/A|
The high taper rate parameters are as at 1 July 2017, but those for the low taper rate scenario are estimates of what would have been, calculated by assuming that the lower asset threshold increased from its value at 31 December 2016 in the same ratio as the upper threshold increased from 1 Jan 2017 to 1 Jul 2017.
Calculations were performed with an annual time-step, with investment withdrawals made at the end of each year.