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Although building your super account balance to ensure you have a healthy nest egg at retirement is a smart idea, there may be times when saving a bit extra may not be your best course of action.
In fact, research shows the current Age Pension rules and super system can interact to create a zone where you are better off overall with less money saved in your super account when you finally hit retirement.
Many experts call this unfortunate situation a ‘retirement trap’, so it’s worth learning how it works and checking whether you’re at risk of falling into it.
What is the retirement trap?
The so-called retirement savings trap is a black hole in the retirement system where, for some retirees, saving and investing more means they actually end up with a lower level of income during their retirement.
Common sense would say accumulating more savings during your working life should result in a higher income during retirement. For some people, however, accumulating more means the reverse happens. In fact, they are actually penalised for saving more.
This strange quirk in the retirement system is due to the current rules governing the taper rate – or how much your Age Pension entitlement reduces as your retirement assets and income increase – as shown in the graph below produced by National Seniors Australia.
From 1 July 2017, the taper rate for the Age Pension increased from $1.50 to $3.00 and has remained unchanged since then. Services Australia applies the taper rate to your assessable assets when calculating your Age Pension payments. For every $1,000 of assessable assets you hold over the assets test limits for the Age Pension, your fortnightly pension payment is reduced by $3.00 (see Explainer section later in the article).
Retirement trap in action
Source: National Seniors Australia, Fact Sheet: Age Pension asset test taper rate
How will the retirement trap affect your income when you finish work?
For most Aussies, their income in retirement comes from a mix of superannuation, Age Pension payments and income from any investment assets.
Retirees affected by the retirement trap rely on a combination of Age Pension payments and income from their super savings.
According to 2020 research by ETF-provider BetaShares, retirees caught in the retirement trap have an income range between $174 and $2,026 per fortnight. For every additional dollar they earn in income, their Age Pension entitlement reduces by 50 cents.
This effectively halves the value of your additional earnings if you fall into this income range.
If you are an individual homeowner with assessable assets above $270,500 (March to June 2022), your Age Pension entitlement is reduced by $3 a fortnight or $78 per year for every additional $1,000 you have in assets. For a homeowning couple, the taper rate starts having an impact when your combined assets are over $405,000 (March to June 2022).
“For a retiree caught in the retirement trap, additional assets are better off spent, or, if they are invested, must generate returns that are well in excess of 7.8% per year to exceed the pension entitlements that are lost. Unfortunately, such investments generally entail taking risk above levels that are commonly recommended for retirees,” explained Dr Roger Cohen, a senior advisor with BetaShares who co-authored the study.
“The system implicitly encourages these retirees to spend additional savings or redirect them towards exempt assets like their homes, instead of choosing to invest them to generate income.”
Higher investment returns are no solution
Once you fall into the retirement trap, most retirees are unable to invest their way out of a lower level of retirement income.
The BetaShares study found retirees whose super balance falls into this zone must generate an unacceptably high rate of investment returns to compensate for the pension entitlements they lose under the government’s current taper rate.
To offset the reduction in their Age Pension entitlement, retirees must generate an annual return above 7.8% for each $1,000 they have invested, which may be a big call in the next few years.
When releasing the study, Cohen said the retirees most affected by this anomaly in the retirement system are those with a super balance of around $350,000 to $600,000.
His analysis measured retirement incomes using a ‘pension multiplier’ (a number greater than or equal to one), representing the current or future income stream a retiree can expect relative to the Age Pension. For example, a pension multiple of 1.5 means retirees can expect an income one and a half times greater than if they only lived on the Age Pension.
The study also compared the impact of using different investment strategies. It found even if retirees put in place a highly aggressive investment strategy with a high allocation to growth assets, it doesn’t help them escape the retirement trap.
BetaShares modelling using different investment strategies and the retirement trap (light yellow region)
The analysis tested five different investment strategies ranging from 30% to 100% allocation to growth assets.
Source: Cohen, Chen and Zhu, The Retirement Trap, November 2019
Measuring the retirement trap: Danger zone expands
If worrying about the risk of falling into the retirement trap isn’t bad enough, some super experts believe the size of the problem is even larger than previously thought.
A similar analysis of the issue by Industry Super Australia (ISA) in 2020 found that for retiree couples with a 5% drawdown, their disposable income in 2019–20 went backwards if they held between $405,000 to $877,500 in assets.
ISA modelling at the time showed the reduction in disposable income was from $55,854 to $43,875 over this range. So, a couple who saved more than $875,000 for retirement had $12,000 a year less to spend than if they retired with $400,000.
According to the ISA research, more than a million Aussies would be caught in this ‘unfair retiree tax’ over the next decade, leaving them with less spending money after saving more.
“The perverse pension means test really means that those who saved more have less to spend. It provides a disincentive to save, it flies in the face of reason and is just plain unfair,” chief executive Bernie Dean argued when releasing the ISA research.