Means test treatment of lifetime annuities from 1 July 2019

From 1 July 2019 changes to the means test treatment of lifetime annuities for the purposes of determining Age Pension entitlements will come into force. These changes were announced in the 2018 Budget and followed a review by the Department of Social Security (DSS). The changes will be grandfathered so that the new means test rules will only apply to lifetime annuities bought from 1 July.

That means anyone thinking of purchasing a lifetime annuity needs to work out fairly quickly whether they would be better off under the new or existing means test. It’s a complex calculation so you may need independent financial advice. The tables at the end of this article may help guide your decision.

Note: Annuities are a retirement income product that provide regular payments for the rest of your life (lifetime annuities) or a fixed term of your choice. Annuities are generally designed to complement other sources of retirement income such as an account-based pension and the Age Pension because, unlike account-based pensions, annuities provide guaranteed income regardless of how financial markets perform. The price of this certainty is lower returns.

Prior to 1 July 2019, all lifetime annuities were treated the same under the means tests, regardless of differences in the way that they allowed access to capital for voluntary withdrawals by investors or the capital that was returned to investors upon death.

This had led to the promotion and increased sales of lifetime annuities which were designed to allow investors to maintain their capital for lengthy periods at the expense of reduced income, which was viewed as contrary to the purpose of superannuation. The purpose of super is to fund income in retirement rather than to allow people to maintain assets in a tax advantaged environment during retirement.

The new rules will have a greater impact on lifetime annuities which provide access to capital above a prescribed limit. These limits are detailed in a capital access schedule contained in changes to the superannuation regulations that took effect from 1 July 2017.

How lifetime annuities work

Let’s have a brief look at how lifetime annuities work before we look at the means test changes.

When you invest as an individual you are exposed to two main risks in retirement. The risk of adverse market movements means you can’t know how long your money will last. You also have no way of knowing know how long you will live, making it difficult to plan the level of retirement savings you will need to provide an income for life.

When you invest in a lifetime annuity your money is pooled with other investors to deal with these risks. It is essentially a form of insurance where these risks are spread across a large group so that the average return from investing is used to pay an income for the average time that the people in the group live for.

Ideally, in order to maximise the income that can be paid to people in the group, lifetime annuities provided no access to capital after people invested in them and they began to pay income. But this traditional approach resulted in few people investing in annuities because people did not like the fact that nothing would be returned if they died earlier than the average.

This led to the development of lifetime annuities that provide for a return of capital upon death up until the average lifespan. Some also allowed people to voluntarily withdraw capital before the average time which people lived for. The trade-off is a lower level of income than those which allow no repayments or withdrawals.

Despite paying lower income, lifetime annuities that provide access to capital have generally been more popular than those that do not.

Current assets test

The current assets test used for lifetime annuities that applies up until 1 July 2019 reflected the access to capital that these more popular standard lifetime annuities provided by assuming that assets were drawn down evenly over the average life expectancy.

The main reason for treating all lifetime annuities as providing access to capital under the assets test was to reflect the fact that people had invested assets and obtained a benefit. The other reason was to stop people avoiding the assets test by investing in lifetime annuities that provided no access to capital.

If you look at an annuity that pays an income that keeps up with inflation for a fixed period of 20 years where the earning rate is 2% plus inflation, 82.5% of the payments will be made up of the amount that was invested and only 17.5% will be made up of earnings on that amount.

Now if you look at the assets test treatment of allocated pensions (also known as account-based pensions), which are the most common form of retirement income product for superannuation investors, the treatment applied to lifetime annuities is more favourable.

This is because an allocated pension is assessed based on the actual value of the investments held by the person.  If positive earnings are generated, the assessed value will be higher at any point of time than the assessed value of a lifetime annuity, which is assessed as if the investments evenly decline in value over life expectancy.

Essentially, the assets test treatment differed because allocated pensions are assessed inclusive of any earnings generated by the investments whereas the assessment of lifetime annuities ignored earnings.

Current income test

The current income test used for lifetime annuities that applies up until 1 July 2019 was designed only to count earnings, rather than the capital that is returned. Lifetime annuities were presumed to return the amount of capital that was invested over the period for which a person would on average live for.

For lifetime annuities, the amount of capital invested is divided by the average period over which the income is expected to be paid (ie. life expectancy) and this amount is deducted from the income payments to reflect the return of the capital invested. Only the remainder of the payments after deducting this amount is counted for the purposes of the income test.

For many lifetime annuities, this meant that they are counted as effectively having no income because the amount invested divided by life expectancy gave an amount greater than the actual income payments they provided in most cases.

If you look at the income test treatment of allocated pensions, which are subject to the deeming rules (which assume an income is earned based the amount held in the account multiple by a “deemed” level of earnings), the treatment applied to lifetime annuities is much more favourable.

The problem with the old approach

As mentioned, a standardised assets test was applied to all lifetime annuities, regardless of the actual amount of capital investors could access. This led to some non-standard lifetime annuities being developed to take advantage of the standardised assets test treatment.

Because they were treated the same under the assets test as other lifetime annuities with lower capital access, and most lifetime annuities were assessed as having no income under the income test, these lifetime annuities with much higher capital access, like other lifetime annuities, were treated more favourably than allocated pensions. In many cases this led to them providing a higher Age Pension entitlement which would offset, at least in part, the lower income from the lifetime annuity itself.

At the extreme, these non-standard lifetime annuities allowed people to retain access to 100% of the capital invested for up to 15 years after retirement. Standard lifetime annuities and allocated pensions (which require people to withdraw at least a minimum amount each year) did not allow capital to be retained in this way as they only allowed access to a declining amount of capital.

It could be argued that these non-standard lifetime annuities, which provided much higher levels of capital access, allowed people to “have their cake and eat it too” by allowing them to maintain high levels of capital deep into retirement and in doing so to unfairly access higher Age Pension entitlements to offset the lower income that these products provided.

It appears that DSS agreed with this view.

Changes to means tests

Rather than propose that lifetime annuities be treated according to the actual capital that they allowed access to for the purposes of the assets test, DSS proposed that the assets test be changed by reference to a capital access schedule.

This schedule allows for 100% of capital to be returned upon the death of an investor for up to half of the investor’s life expectancy, after which the maximum drops down to the amount given by an even decline in capital over the investor’s life expectancy.

For voluntary withdrawals,  If the capital access provided by the lifetime annuity is equal to or below the amount in the schedule, the amount assessed for the purposes of the assets test will be 60% of the capital originally invested in the lifetime annuity for the period up until life expectancy and 30% of the capital originally invested thereafter.

If the capital access provided by the lifetime annuity is above the amount in the schedule, the amount assessed will be that higher value.

For the income test, 60% of the actual income provided by the lifetime annuity will be assessed.

As the new assets test still does not take account of the actual capital that an investor can access,  people who choose a lifetime annuity with no capital access in order to enjoy a higher level of income will still not gain any benefits in terms of their Age Pension treatment compared to investor in lifetime annuities with capital access.

Summary of new tests versus old tests

The new assets test which assesses only 60% of the capital invested will provide a more favourable assets test treatment than the old assets test for a little over 6 years from the time the lifetime annuity commences. Thereafter it will provide a less favourable assets test treatment than the old assets test.

The new income test will in almost all cases provide a less favourable treatment than the old income test.

Results of new tests versus old tests

The tables below show my calculations of the results of the new tests versus the old tests in terms of the average percentage of the full Age Pension received by superannuation investors up until age 90 compared to investing entirely in an allocated pension on the basis that they invest in either:

• Various types of lifetime annuities on a stand-alone basis; or
• A combination of 70% into an allocated pension and 30% into the lifetime annuities.

It is assumed that investors have no assessable assets or income other than their super and various other standard assumptions are made about earning rates and income payments and other factors. The results are shown for various super balances between $300,000 and $800,000.

Single Homeowner

Stand Alone – Average % of Age Pension received to Age 90

	Pre-change difference to AP				Post-change difference to AP
	$300k	$400k	$600k	$800k	$300k	$400k	$600k	$800k
Lifetime annuity – No capital access	2%	6%	14%	18%	-5%	-1%	14%	12%
Lifetime annuity – Declining capital access	2%	6%	16%	21%	-3%	1%	16%	13%
Lifetime annuity – 100% capital access for 15 years	2%	6%	17%	22%	-3%	-4%	-6%	-8%

Combined – Average % of Age Pension received to Age 90

	Pre-change difference to AP				Post-change difference to AP
	$300k	$400k	$600k	$800k	$300k	$400k	$600k	$800k
Lifetime annuity – No capital access	2%	3%	6%	7%	0%	3%	5%	1%
Lifetime annuity – Declining capital access	2%	3%	6%	7%	0%	3%	6%	1%
Lifetime annuity – 100% capital access for 15 years	2%	3%	6%	7%	0%	0%	-1%	-2%

As you can see, single homeowners do well under the current means test rules in terms of the amount of Age Pension they receive if they partly or entirely invest in lifetime annuities compared to investing in an allocated pension. They will generally still do well (with some exceptions for lower superannuation balances) if they invest in more conventional lifetime annuities from 1 July 2019, though not quite as well as before. If they invest in less conventional lifetime annuities which provide high levels of capital access from 1 July 2019, they may lose some of the Age Pension they will get if they invest in an allocated pension alone.

Single Non-Homeowner

Stand Alone – Average % of Age Pension received to Age 90

	Pre-change difference to AP				Post-change difference to AP
	$300k	$400k	$600k	$800k	$300k	$400k	$600k	$800k
Lifetime annuity – No capital access	3%	5%	7%	13%	-5%	-7%	10%	-1%
Lifetime annuity – Declining capital access	3%	6%	9%	16%	-3%	-5%	7%	3%
Lifetime annuity – 100% capital access for 15 years	3%	6%	10%	17%	-3%	-4%	-8%	-9%

Combined – Average % of Age Pension received to Age 90

	Pre-change difference to AP				Post-change difference to AP
	$300k	$400k	$600k	$800k	$300k	$400k	$600k	$800k
Lifetime annuity – No capital access	2%	3%	3%	5%	0%	-1%	-1%	4%
Lifetime annuity – Declining capital access	2%	4%	4%	6%	0%	-1%	0%	5%
Lifetime annuity – 100% capital access for 15 years	2%	4%	4%	6%	0%	0%	-2%	-2%

Single non-homeowners will generally qualify for less Age Pension if they invest in lifetime annuities from 1 July 2019 than if they do so now whether they invest in conventional or less conventional lifetime annuities with few exceptions to that outcome.

Couple Homeowner

Stand Alone – Average % of Age Pension received to Age 90

	Pre-change difference to AP				Post-change difference to AP
	$300k	$400k	$600k	$800k	$300k	$400k	$600k	$800k
Lifetime annuity – No capital access	0%	1%	5%	12%	0%	-1%	3%	14%
Lifetime annuity – Declining capital access	0%	1%	5%	12%	0%	-1%	4%	15%
Lifetime annuity – 100% capital access for 15 years	0%	1%	5%	12%	0%	0%	-2%	-4%

Combined – Average % of Age Pension received to Age 90

	Pre-change difference to AP				Post-change difference to AP
	$300k	$400k	$600k	$800k	$300k	$400k	$600k	$800k
Lifetime annuity – No capital access	0%	1%	2%	5%	0%	0%	4%	6%
Lifetime annuity – Declining capital access	0%	1%	2%	5%	0%	0%	4%	6%
Lifetime annuity – 100% capital access for 15 years	0%	1%	2%	5%	0%	0%	0%	0%

Homeowners who are part of a couple do well under the current means test rules in terms of the amount of Age Pension they receive if they partly or entirely invest in lifetime annuities compared to investing in an allocated pension if they have higher superannuation balances. They will generally still do well (with some exceptions for lower superannuation balances) if they invest in more conventional lifetime annuities from 1 July 2019, and in some cases will do better. If they invest in less conventional lifetime annuities which provide high levels of capital access from 1 July 2019, they may lose some of the Age Pension they will get if they invest in an allocated pension alone.

Couple Non-Homeowner

Stand Alone – Average % of Age Pension received to Age 90

	Pre-change difference to AP				Post-change difference to AP
	$300k	$400k	$600k	$800k	$300k	$400k	$600k	$800k
Lifetime annuity – No capital access	0%	1%	5%	7%	0%	-1%	-4%	-3%
Lifetime annuity – Declining capital access	0%	1%	5%	7%	0%	-1%	-3%	-1%
Lifetime annuity – 100% capital access for 15 years	0%	1%	5%	7%	0%	0%	-2%	-5%

Combined – Average % of Age Pension received to Age 90

Non-homeowners who are part of a couple will generally qualify for less Age Pension if they invest in lifetime annuities from 1 July 2019 than if they do so now whether they invest in conventional or less conventional lifetime annuities with few exceptions to that outcome. 

A Sting in the Tail

Put simply, the changes will lead to mixed results depending on the situation of the investor in relation to the Age Pension. However, they will be generally successful in reducing incentives to invest in non-standard lifetime annuities which provide higher levels of capital access.

One thing I would like to point out is that overall results shown above can mask underlying differences in Age Pension entitlements over the course of retirement.

Under the assets test, allocated pensions are assessed on the basis of the actual value of assets held and these can be expected to decline over time. In contrast to this, lifetime annuities will from 1 July 2019 be assessed on a fixed percentage of the original amount invested before and after life expectancy. Eventually the assets test applied to a lifetime annuity will give a lower Age Pension entitlement than the assets test applied to an allocated pension.

Under the income test, allocated pensions are assessed on the deemed earnings of the assets held. Because these assets can be expected to decline over time, the assessed income will also decline over time. In contrast, lifetime annuities will from 1 July 2019 be assessed on the basis of a fixed percentage of the actual income they provide. Given this income will be steady or will increase over time with indexation, the assessed income will either be steady or will rise over time. Eventually the income test applied to a lifetime annuity will give a lower Age Pension entitlement than the income test applied to an allocated pension.

Case study

Take the example of a single homeowner who invests $600,000 in either an allocated pension or a lifetime annuity with no capital access. Investing in a lifetime annuity will give them on average 14% more of the full Age Pension to age 90 than an investment in an allocated pension.

However, this result masks differences in their Age Pension entitlements over time.  Below are the yearly averages for the percentage of the full Age Pension that an investor in the allocated pension or a lifetime annuity with no capital access will receive. As can be seen, the allocated pension will provide entitlement to a lower percentage of the full Age Pension for the first 13 of the 25 years but will provide a higher percentage (shown in red) for the remaining 12 years.

Of course, this result will not be true in all cases but the general trend of the results shows that investors in lifetime annuities with have higher Age Pension entitlements in the earlier years of retirement than in the later years compared to their entitlement if they invest the same amount in an allocated pension.