FNCE20003 Introductory Personal Finance Lecture 8 PDF

FNCE20003 Introductory Personal Finance Lecture 8 – part 2 Funding retirement II Lecturer – Tony Cusack September 2024  Lecture 8 topics Types and regulation of superannuation funds Accessing accumulated superannuation Superannuation pensions and annuities – prici...

FNCE20003 Introductory Personal Finance Lecture 8 – part 2 Funding retirement II Lecturer – Tony Cusack September 2024  Lecture 8 topics Types and regulation of superannuation funds Accessing accumulated superannuation Superannuation pensions and annuities – pricing of pensions and annuities September 2024 FNCE20003 Lecture 8 2  Choosing the appropriate RIS near retirees are therefore faced with some decisions as to how best to maximise their RIS most are reluctant to take equities (or property) market risk with their accumulation, so will typically not take it as a lump sum and invest as we have noted, if the lump sum accumulation is low, the Age Pension might be available to supplement the RIS from that lump sum next, we will go through the pricing of purchased annuities – will focus on term certain annuities, not life annuities (more expensive) – the same pricing formula could be applied to determine the amount to draw down under an account-based pension September 2024 FNCE20003 Lecture 8 3  Pricing of annuities (and pensions) note that these are priced as an ordinary annuity, which is characterised by the following features: i. the periodic payments occur at the end of regular intervals (e.g. at the end of each month or year) ii. the effective rate of interest, i, per payment interval remains fixed for the term of the annuity (thus the adjustment term in the formula) iii. the term is a fixed number, n, of regular intervals recall pricing of an ordinary annuity, e.g. An = R[1- (1+r)-n]/r in these circumstances, the unknown variable is R, which can be determined via the known variables September 2024 FNCE20003 Lecture 8 4  Annuity example a retiree looking to spend $300,000 on a 15-year annuity available at a yield of 5.5% p.a. would be required to pay (PV of $1 p.a.): a15,0.055 = (1-1.055-15)/0.055 = 10.0375809 interpretation: the purchaser must pay $10.0375809 for each annual dollar of this annuity (this would change if period changed) so, $300,000 would provide an annual amount of $29,887.68 paid at the end of each year, i.e. 300,000 / 10.0375809 = $29,887.68 annual annuities are not common in practice September 2024 FNCE20003 Lecture 8 5  Term certain annuities and pensions more practical than an annual payment is an annuity payable at regular intervals, i.e. p times a year – predicated on a fixed rate of interest – payable for a fixed term – can be indexed in various ways – there are restrictions on this if they are ‘complying’ annuities (this is only relevant to certain pre-2007 annuities – we will ignore these, as no new complying annuities can be bought) can have a residual capital value (RCV) at the end of term – this would have the effect of reducing the amount of annuity stream purchased September 2024 FNCE20003 Lecture 8 6  Cost of term certain annuities example: a 20-year annuity payable monthly (p = 12) calculated at a yield of 6.19% and costing $100,000, as both (i) unindexed, or (ii) indexed at 3.0% p.a. in the first year, $A(1/12) is payable at the end of each month (i) for 20 years or (ii) for the first year – for (ii), in the first month of the 2nd year, this amount is indexed to $A(1.03/12), which is then payable at the end of each month throughout the 2nd year, etc. for each annual dollar of unindexed annuity over 20 years, the up-front cost is $11.61206 and the indexed annuity costs $14.70708 (see next slide) these figures derive from the formulae explained on the next few slides – e.g. the formula underlying calculation (ii) is a growth annuity formula September 2024 FNCE20003 Lecture 8 7  Unindexed term certain annuity unindexed, given i = 0.0619, n = 20 and p = 12: an:i(p) = where i(p) = p[(1+i)1/p-1] (to preserve annual i, given monthly payments) i(p) = 12{(1.0619)1/12-1} = 0.0602103, so i/i(p) = 1.028 and a(p)n:i = 11.61206 accordingly, total unindexed income amount p.a. = (100,000 / 11.61206) = $8,612 and monthly unindexed income stream = $8,612 / 12 = $717.67 September 2024 FNCE20003 Lecture 8 8  Indexed term certain annuity indexed (rate of indexation g% at the start of each year after the first): an:i:g(p) = again: i(p) = 0.0602103 and i/i(p) = 1.028, so a(p)n:i:g = 14.71708 accordingly, monthly indexed income stream in first year = (100,000 / 14.71708) = $6,794.83 / 12 = $566.24 monthly amount in the 2nd year = $566.24 x (1.03) = $583.22 … and monthly amount in the 20th year = $566.24 x (1.0319) = $992.89 September 2024 FNCE20003 Lecture 8 9  Term certain annuities assume a 65 year-old decides that she requires a 25-year annuity and a RIS of $2,000 per month (p.m.), indexed at 3% the unit cost due to extra 5 years rises from a(12)20:0.0619:0.03 = $14.71708 to a(12)25:0.0619:0.03 = $17.19387 for each dollar of annuity in the 1st year for a RIS of $2,000 p.m., she would need to pay ~$413,000 (17.19 x 24,000) – if she had access to a higher interest rate, e.g. 8% p.a., this annuity would be less expensive – she would only need ~$345,000 to provide $2,000 p.m. – if the interest rate was only 3.75%, the cost would be ~$540,000 these examples highlight the importance of market interest rates in determining the amount of RIS by annuity September 2024 FNCE20003 Lecture 8 10  Retirement phase arrangements recall that when a condition of release is met, the member can access the accumulated lump sum and has choices in how to deal with it at the point in time when the member decides to withdraw from the lump sum, the member account is in ‘retirement phase’ the assets comprising the member’s account balance (to fund the pension) are held in an account in the fund designated ‘pension account’ (note: cap) key point: earnings on this account are tax exempt, as are the pension payments if the minimum pension is drawn note also that it is still possible to keep contributing to super in retirement phase, even if a pension is being drawn from the released benefits September 2024 FNCE20003 Lecture 8 11  Retirement phase arrangements that is, if the member is still working at least part time but has also met a condition of release (e.g. is aged over 65), then s/he can still contribute to an accumulation account in the fund in these circumstances, the member will have two accounts in the super fund: a pension account and an accumulation account this is not possible in accumulation phase, only in retirement phase – i.e. when a pension is taken after meeting a condition of release earnings on the pension account assets remain tax free, but earnings on the accumulation account are taxed at 15% (as are the contributions) the fund trustee must be careful in maintaining the different accounts September 2024 FNCE20003 Lecture 8 12  Superannuation and the Age Pension as previously noted, the Age Pension operates as a ‘safety net’ for retirees who provide for their own pension from a lump sum – it is the same in many overseas systems current data shows that many Australian retirees are still reliant on the Age Pension for at least some of their RIS accordingly, the interaction between the Age Pension and superannuation remains important this means that FPs should maintain a detailed knowledge of precisely how the Assets Test and Income Test apply to determination of Age Pension entitlements in different circumstances September 2024 FNCE20003 Lecture 8 13  Lecture 8 topics Superannuation pensions and annuities – pricing of pensions and annuities Taxation of superannuation benefits September 2024 FNCE20003 Lecture 8 14  Superannuation taxation recall that tax incentives on superannuation relate to four different stages: 1. Concessional contributions: when you, or your employer, makes concessional (before-tax) contributions, they are taxed at the concessional rate 2. Non-concessional (after-tax) contributions and co-contribution: indirectly, when you make a non-concessional (after-tax) contribution – although this type of contribution does not directly receive any tax incentives, the investment earnings on these contributions are concessionally taxed (see next) 3. Investment income on super fund investments: when your super fund earns income on fund investments 4. Superannuation benefit payments: when your super benefit is released September 2024 FNCE20003 Lecture 8 15  Taxation of released super fund benefits it follows that the income tax system applicable to individuals is not directly applicable to super fund benefits that are accessed the circumstances, nature and timing of access to super fund benefits will drive the taxation consequences as noted earlier, in most cases, no tax will apply to super benefits that are accessed – via lump sum or pension – after a condition of release has been met however, there may be a tax liability on one or more components of an accessed benefit, depending on specific circumstances – under the rules, a distinction is made between “taxable component” and “tax-free component” of accumulated super benefits (too much detail for this course) September 2024 FNCE20003 Lecture 8 16  Taxation of death benefits technically, lump sum death benefit payments will be tax free if paid to a death benefits dependant (dealt with Division 302 of the ITAA) – this covers spouse, children under 18 at time of death, and other persons who are financially dependent on the deceased any “taxable component” of a lump sum (uncommon) that is paid to a non- dependant will be taxed at 15% the taxation of a death benefit that is paid as a ‘reversionary pension’ will depend on the age of the reversionary beneficiary – reversionary: reverts to a nominated beneficiary see also Superannuation death benefits | ATO September 2024 FNCE20003 Lecture 8 17  How tax applies to your super in summary, to work out how your super withdrawal will be taxed (if at all), you need to know: – your age when you access the accumulation – whether any of the money in your account is taxable (uncommon) – whether you will get the payment as an income stream or lump sum these factors determine whether you: – pay any tax on the withdrawal (for example, whether it is taxable income due to the existence of a taxable component in the lump sum) – get tax offsets that reduce the amount of tax you pay September 2024 FNCE20003 Lecture 8 18