4 Pillars of Retiree Pension Provisions PDF

4 pillars of retiree pension provisions - Individual savings - Social security - State sponsored complementary private schemes - Continued earnings in retirement Problem arising is that providing adequate social security benefits is increasingly becomi...

4 pillars of retiree pension provisions - Individual savings - Social security - State sponsored complementary private schemes - Continued earnings in retirement Problem arising is that providing adequate social security benefits is increasingly becoming beyond the resources of governments The pension problem - Was main reason why the state sponsored complementary private pension scheme (Superannuation Guarantee Scheme ‘SGS’) -> meets 2 major economic objectives: demographic and economic - Previously, governments had the option of levying tax at a relatively constant rate to provide a pension on which retirees could live - Existing system no longer worked because the proportion of working age people and people over working age is no longer that stationary (the proportion of persons over working age is increasing due to increased life expectancy) The proportion of the population in age range 20-65 years, which provides tax support for the pension expectations of the over 65s os the smallest it has ever been and will probably keep reducing (the problem is more acute in other more rapidly ageing countries) Currently there are 5 people of working age for every person over 65 (historical low) By 2031, it is forecast to be less than 3 The odds of longevity are improving as the force of mortality is declining - Governments no longer have the tax option -> would lead to ‘intergenerational’ inequity -> Workers in successive generations having to pay more and more tax to support growing proportion of retirees (every-increasing tax burden on each generation of workers) - Now, more common for working populations to pay for their own retirement by contributing to government regulated funds (pension funds or superannuation funds) -> seen as a method to avoid intergenerational inequity - National savings had traditionally been insufficient to fund desired investment/spending programs -> additional pool of compulsory savings that super provides (currently around 3.85 trillion), there is more source of investment funds available to augment other national savings - Extra cash plays major part in financing growth in the economy -> cash is invested in equities (on ASX including new issues of shares), bond issues of companies and government (=debt capital), property investment and development, infrastructure projects - Provides significant liquidity to the ASX, bonds markets etc - The SGS has significantly raised national savings since its introduction For retirees, there are 2 main risks  1. Longevity risk: you outlive your retirement lump sum by surviving into old age 2. Inflation risk: inflation will rise significantly over a lifespan, eroding the purchasing power of your income stream RIS systems - tiers Tier 1: social security/ age pension - Basic pension Tier 2: complementary nationally coordinated or state sponsored private pension scheme/superannuation system - Workers contribute to these pension schemes over their working lives to top up or replace Age pension entitlement - Superannuation Guarantee Scheme: fixed proportion of every employee’s salary (11.5%) should be compulsorily contributed to the investment account to provide for retirement income The contributions are deposited into an approved Complying SuperAnnuation Fund (CSF) account in the employee’s name Employees have a choice to the type of investment fund into which money is directed (otherwise default is MySuper account) the proceeds of investment could not be accessed until retirement (limited exception) Complying superannuation fund (CSFs) It needs to be - A resident fund (resident and controlled in Australia) - A regulated fund achieved by 1) having given an irrevocable undertaking to obey the Superannuation Industry Supervision Act 1993 and 2) having had its regulated status confirmed (the application for regulation must be in writing upon 1st - In compliance with the SISA It is good to be a CSF as they are eligible for concessional (favourable) tax treatment on: - Contributions into the fund - 15% tax instead of marginal tax rate - Earnings, dividends and realised capital gains within the fund - taxed at 15% on earnings and dividends (reduced by franking credits) and 10% max on capital gains - Lump sums and pensions taken from the fund: 0% tax if the amount withdrawn arose from a taxed source Non-complying super funds are taxed at 45% regardless of the reason why it is non-complying (non-resident funds, regulated funds contravening SISA and not ‘pardoned’ by APRA/ATO, super funds that do not elect to become regulated) In some cases, funds can escape non-compliance status notwithstanding a breach of SISA Even if there is a pardon, there will be penalties applied for contravening SISA Superannuation Benefits  - Defined benefit plan (mostly phased out): depends on how long you have been in the scheme and the proportion of salary you contributed -> usually designated as a multiple of Final Average salary -> not directly related to superannuation contribution - Accumulation schemes/Defined Contribution plan (more important and more used -> means it is not certain to receive retirement lump sum (RIS)): provides an accumulated amount at the end of your working life -> must participate to provide yourself with an amount to fund your RIS (directly related to the contributions you make) Statement-sponsored complementary private schemes have not been in place long, social security and private pension schemes must work in tandems. For example, recent retirees have not participated in a scheme long enough to generate a lump sum that fully funds an adequate RIS How does the SGS work in practice 1. Employers deduct 11.5% contribution directly from employee’s gross salary and deposit it into an approved (CSF) account that is set up in the employee’s name 2. Employers are required to provide a minimum number of investment option for members, but employees are not obliged to make a selection (your account is portable) Contributions to super 1. A contribution is new money paid into the fund -> can be made by an employer from the salary, personally (using after tax money), on behalf of a spouse, under certain limited employment awards or agreements 2. A rollover is the transfer of a benefit into another fund rather than taking it as a lump sum withdrawal Allowable contributions to super 1. Concessional contributions Mandated employer contributions (11.5% from gross salary) / max is 30k additional (voluntary) contributions from remuneration - Salary sacrifice contributions are pre-tax to the employee and are therefore subject to the 15% contributions tax Other rules relating to contribution (ie for those over 65 years old or spouses)  Can be split with spouse if also a member of the fund -> useful if there is a big difference in income (her balance can be boosted by contributions from the husband) Super co-contribution: you earn less than 45k, you earn 500 2. Non-concessional contributions/Undeducted contributions (UDC) After-tax contributions or undeducted contributions, sourced from after-tax income or personal sources (therefore they don’t attract tax) This is because the contributor hasn’t claimed a tax deduction or received any other type of tax concession on the money contributed Eg. savings, gifts, inheritances, lottery or gambling winnings Any earnings that are already in the fund from non-concessional contributions are usually taxed at 15% Limit of 120k, moving with indexation * exceptions are proceeds from disposal from an eligible small business, downsizer contributions from selling your home (go from big home to a small home), contributions made from a settlement resulting from permanent injury/disablement, transfer of an overseas superannuation balance Currently, people under 75 can bring forward 2 years of UDC in any one year (someone can now contribute 360k (120 X 3) in a current year) -> if one does this, they will not be able to make further UDC in the following 2 years and their balance must be less than 1.66 million dollars (indexed) Cannot be split with a spouse Limitations on concessional contributions - Max of 30k applies to all - Any contributions above cap will attract punitive tax treatment (the excess is taxed at individual MRT and not the 15% concessional CSF rate) - Special rules apply to employees aged over 65 and to individuals whose income is over 260870 (as 11.5% of this is 30k) however carry-forward provisions (for bonuses/promotions for financial years etc) apply from 1 July 2018 Super benefit accumulation - Objective is to maximise the amount of lump sum benefit - Total amount depends on contribution level, asset allocation long-term yields, income level and growth, taxation of contributions and fund earnings, time in the SGS scheme Expected Accumulation Value (EAV)  - Determines the FV of an accumulation over n years based on all relevant variables - - r(p)Need to bring down compounded interest rate to nominal interest rate - CR = 11.5% - Tc = 15% - r = net annual compound earning rate - To increase accumulation: higher earning rate r, higher rate of salary growth g, staying in the scheme longer n, higher employer contribution rate CR, reduced taxes on contributions/fund earnings Tc + making after-tax undeducted contributions + use of salary sacrifice - To reduce accumulation: diminution in r, g, CR, n + increase in taxes, periods of non-contribution (unemployment, family-raising), poor choice of long-term investment portfolio and/or investment manager, unexpected changes to the SGS (legislative risk), divorce (splitting of assets) Current worth of the accumulation - If the RBA meets its 3% per annum inflation target, then purchasing power would be deflated by 1.03^-35, to a factor of 0.2554 Tut Recap Concessional contributions: taxed at 15% + cap (30K p.a.) and can carry on from previous years - Mandated - additional/voluntary - Other rules (for those aged over 65 or spouses) Non-concessional contributions: caped at 120k p.a and can carry on from previous years - After-tax contributions (after-tax income or personal sources) Superannuation benefit accumulation depends on contribution level, asset allocation and long-term yield, income level and growth, tax of contribution and fund earnings, time in the SGS scheme 1. Why must the SGS work in tandem with Social Security and the Age pension SGS hasn’t been implemented for long enough (32 years), it isn’t enough time to fund an adequate income stream for retirees currently It originally only had a 3% p.a. Compulsory contribution rate Only 43% of recent retirees are self funded and only half of these are fully self-funded 2. Explain the demographic and economic imperatives in the context of the SGS Demographic: Populations have been ageing in the recent decades, the proportions of persons over working age is increasing. Provisions of social security for retirees world become more difficult -> Governments no longer have the option of providing provisions via taxation as ever-increasing tax on the working population would lead to ‘inter-generational inequity’ Economic: In many countries, national savings had traditionally been insufficient to fund desired investment and social expenditure. Generating larger funds for the government (SGS results in a pool of compulsory savings) that can be used to invest and augment other national savings and fund expenditures. 3. Define ‘Complying Superannuation Fund’ (CSF). What are the advantages of being a CSF? Outline the tax consequences of a complying fund You must be a resident, regulated (by APRA) and not in breach of SIS or not failing the culpability test Key advantages are tax savings on contributions, earnings and withdrawals (after access to the lump sum) If a fund becomes non-complying it loses those tax benefits and it subject to punitive tax, Specifically, tax is levied at 47% on the total fund assets minus undeducted contributions, In additionals, there may be penalties levied for a compliance breach 4. Identify and discuss the different types of contributions that can be made to a superannuation fund Concessional Capped at 30k no other restrictions apply to these contributions for employees up to age 67 - Mandatory contribution from salary (employer contributions) -> 11.5% - Salary sacrifice - Others but are less frequent relating to those over 65 and spouses - Spouse super ‘contribution splitting’ allows the transfer of a portion of allowable concessional contributions to a spouse’s super account. This is permitted within the spouse-spitting contribution rules - For those no longer in full time employment (67-74) they are required to meet a Work test or be eligible for the Work test exemption in order to make voluntary concessional contributions  - Up to 500 if you are a low-middle income earner. The government will contribute 50c for every $1 - GO BACK TO THIS Non-concessional - after-tax contribution or undeducted contributions No tax being deducted from contribution as the contributor hasn;t claimed a tax deduction Any earnings that a super fund derives from non-concessional contributions are taxed at the usual super fund rate of 15% Main types of SuperAnnuation funds - Corporate funds: run by companies for their employees - Industry superfunds: large funds catering for entire industries -> they don’t seek to make benefits rather to provide efficient return to the members - Public Sector Funds -> for government employees (shrinking proportion of superannuation funds but may still have defined benefit scheme based on contributions and years in/guaranteed lump sum) - Public Offer or retail funds -> retail funds charge management fees and don’t necessarily outperform industry funds - Small funds (largest sector in the industry) - Master funds or trusts -> comprising holdings in groups of funds (corporate funds, industry super funds and public offer or retail funds) The statute applicable to super funds is The Superannuation Industry Supervisory Act 1993 (SIS Act) and with only one exception being SMSF, all super funds are subject to regulation by APRA APRA also oversees banks, credit unions, building societies, life insurance, general insurance and reinsurance companies, friendly societies as well as most members of the superannuation industry. Mainly for administrative reasons, SMSFs are subject to regulation by the ATO. ATO sees itself as “protecting the integrity of the system” ATO deals with millions of customers, mainly individuals whilst APRA deals with hundreds of medium to large entities Super funds are set up as a trust A trustee has legal ownership of the assets but not the legal right to use the assets for themselves/ the person who holds the legal title to the property or rights under the trust is the trustee A person whose benefit they are held is called the beneficiary - A cornerstone of the SIS Act is that a Super fund must be set up as a trust. So, in addition to being regulated under SIS Act, as a trust, super funds will also be subject to Commonwealth and State Laws relating to trusts. There is also common law that relates to trusts - Each super fund must have a trustee appointed - Trustees have a fiduciary duty to the fund members - The super fund Trust Deed governs internal rules and rules for external dealings with - it is the fund’s ‘constitution’ document, and will contain certain things as required by the SIS act -> a trust deed is dealt in the ATO - Trustee duties are 1. Act impartially 2. Exercise discretions properly 3. Obey terms of trust deed 4. Not act under direction 5. Act in the best interest of beneficiaries 6. Avoid conflicts of interest 7. Act personally -> you can’t delegate (once the investment decision is made, you have to do it) 8. Act unanimously (or if in the trust deed, majority) 9. Invest promptly and prudently 10. Seek advice -> need to seek advice in relation to investments you are not fully equipped to understand 11. Protect assets 12. Keep proper accounts 13. Act with reasonable skill and diligence 14. Sign an undertaking that they have read and understand the trust deed 15. Avoid compliance errors - Super Fund Trust Deeds must contain provisions that are in compliance with the SIS Act including: 1. Precise definition of benefit types and payment procedures  2. A written investment strategy describing the sorts of investments that the fund is allowed to undertake 3. Process for admission and removal of members 4. Procedures for amending the trust deed 5. Procedures for winding up of the fund - Each Trust Deed must also explicitly state that the fund’s sole purpose is providing retirement benefits Sole Purpose test -> funds are required to meet the Sole Purpose Test - A regulated fund must be maintained solely for provision of retirement benefits to members - This rule means that funds must operate to provide 1. Retirement benefits accumulating prior to retirement or meeting other conditions of release 2. Benefits on meeting a condition of release 3. Benefits to LPR (legal personal representative) on death of a member - For the larger super funds (industry and retail) this rule is very unlikely to be breached because the trustees, investment managers and directors are all sitting independently of hundreds or thousands of members. There is no one trustee that is going to breach the sole purpose test because they cannot act alone as they act on behalf of a large number of members. - For small funds the risk of breach increases - Regulators treat the sole purpose test as a very strong test and deem it breached if current member benefits are provided - The consequences of a breach can be significant (non-complying status which means the value of the assets are subject to tax at 45% and therefore you lose nearly half the value of assets to tax plus the penalty, which is often 90% of the fund value) - In practice, it has been established that related benefits may be provided as long as the core benefits above are provided. For example 1. Provision of life insurance -> passive life insurance strategy 2. Provision of benefits to a contributor to the fund on termination of employment 3. Provision of benefits in the case of ill-health 2 types of small funds (less than or equal 6 ->used to be max 4 but now it caters for families with more than 2 children ) -> represent around 99.99% of funds but only has around 5% of accounts 1. SMSF - Maximum of 6 members - Usually each member is a trustee (or director of the corporate trustee), who cannot be remunerated - “All members are trustees, all trustees are members” = when you are a member of a SMSF you must also be a trustee (this requirement can be met if a corporate trustee is used). However, you are also a beneficiary  In the case of a corporate trustee, all fund members must be directors of the trustee company A corporate trustee is recommended as SMSF trustees have legal exposure The companies eligible to be SMSF corporate trustees have: 1. Not been deregistered by ASIC 2. Do not have any directors or other responsible officers who are disqualified individuals 3. Have not had a receiver or provisional administer appointed to manage their operations - Eligibility criteria Over the age of 18 (or if they are in full time employment) Does not have a mental disability Not an undischarged bankrupt (or are not insolvent and under administration) Not been convicted of an offence involving dishonesty Not previously received a civil penalty under superannuation legislation Not been disqualified by a superannuation regulatory body (ATO or APRA) - Regulated by the ATO - Like all super funds, SMSFs are designed to provide tax-efficient retirement benefits to members of the fund (“sole purpose”) - Can be established from an accumulated balance rolled over from an existing super fund (eg a lump sum from an industry fun, the member’s accumulated balance) -> it is not ‘released’ so no tax will be payable on the lump sum at that time - It can be established by cash and/or asset contribution - The trustee has wide discretion in selection of investments for the fund -> THERE MUST BE AN INVESTMENT STRATEGY -> these investments enjoy tax advantages if the fund is established as a CSF under existing SIS legislation 2. Small Australian Prudential Regulation Authority Fund (SAF) - Maximum of 6 members - Has only a corporate trustee - Regulated by APRA SAF must have an ‘approved’ trustee, a third party which needs to be a licenced professional trustee company, who is remunerated SMSF trustees must be fund members (either directly or indirectly) SAF can include as a member an arm’s length person, such as an employee but a SMSF can only have family members SMSF are also differentiated on the basis that the members must actively participate in management (S.17A of the SIS Act) ->in SAF management is done by approved trustee Accessing accumulated superannuation To assess an accumulated superannuation balance, a condition of release must be met. For example: - Retirement on attaining preservation age (which is 60 for all born after 1 July 1964) - Genuine termination of employment on or after age 60, irrespective of future employment intentions -> acknowledgement that getting back into the workforce at an age older than 60 is very difficult - Reaching age 65 - Death - Permanent incapacitation - Demonstrate severe hardship -> give centrelink number and history and make declaration you cannot make living expenses (look at rules) - Compassionate grounds -> usually relates to terminal illness -> often need to provide a doctor’s certificate that as an estimate on remaining life -> administered by the ATO (eg. medical treatment) The rules also allow for the payment of a ‘non-commutable’ income stream during a period of temporary incapacity Also there are Transition to retirement (TTR or TRIPs) arrangements When a condition of release is met, the accumulated balance can be withdrawn free of tax in full, or in part, for any purpose (eg, to pay off a mortgage, go on a holiday, give money to childre, etc) However, since the key objective of the accumulation is to satisfy the need to provide a pension or RIS, retirees need to be mindful how they spend accessed super money Superfund Pensions and annuities are probably the most effective ways to provide a RIS - Pensions are provided from a super fund, by drawing directly on the fund Superannuation pensions are known as account based RIS (funded by drawing regularly on the accumulated lump sum) In the majority of cases, a condition of release has been met and it will be tax-free Individuals are free to choose the amount they take in the form of a pension each year The specific basis for payment is defined in a trust deed and depends on the member’s eligibility  A minimum drawdown amount will be required to ensure that the capital is generally drawn down over time, no maximum will apply (with the exception of pensions commenced under Transition-To-Retirement arrangements) The minimum pension payments are set out as a percentage of the Pension account balance, based on age of the pensioner It scales up as the system is set up as a tax advantage for the members of the super fund. As a member, you are the one getting the tax advantage and the government doesn't want you to retain the tax advantage that will be passed onto your family. - You must take out this minimum, otherwise the smaller amount you have withdrawn will be fully taxable. If you take out the minimum, it is not taxed For account-based pension standards, the minimum standards require 1. Payments of the minimum amount to be made at least annually, allowing pensioners to take out as much as they wish above the minimum (including cashing out the whole amount) 2. An amount or percentage of the pension cannot be prescribed as being left-over when the pension creases 3. The pension can be transferred only on the death of the pensioner to one of their dependents or cashed as a lump sum to the pensioner’s estate Account-based payment standards - In the first year, the minimum required payment is pro-rata based on the number of days remaining: thereafter, it is the percentage of the super account balance as at 1 July each year. A minimum income payment must be made, at least one per year (calculated to nearest $10) and typically there is no maximum payment specified, unless there is TTR involved (then 10% maximum) or Fund Deed imposes a maximum (rare) - Computations are allowed at anytime - This may be reverted on the death of recipient, but only to a dependent The main issue with account-based pensions is that they can be drawn down to 0 quite quickly, However, the tradeoff to this risk is their potential for better capital  growth and returns. They also offer greatest flexibility to protect against longevity risk as the owner can decide when and how much is drawn, which will also determine how much remains invested as a lump sum. They can be used to deliver both basic and discretionary income (discretionary being extra drawings if required for example emergencies) and this is typically not an option with non-account based RIS - Annuities are purchased from an annuity provider, such as a Life (insurance) Office, bank or commercial provider (Challenger Financial Services is Australia’s biggest provider of annuities). The interest rate they’ll offer you in your annuity will be lower than the interest rate that they would charge if it was the other way around, if you were borrowing from them. Effectively, an annuity purchase is lending to the provider and they’re paying you interest, which is the implicit rate within. PV is the amount invested Annuities are known as non-account based RIS -> purchased from an annuity provider by a lump sum of the member The annuity provider does not maintain an account balance specifically attributable to the member, but pays from funds that are pooled They provide an income stream that is payable for the life of the member or reversionary beneficiary or a specified term] These payments must still meet the ‘minimum’ standards as essentially the lump sum purchase price is converted to annuity payments A Residual Capital Value (RCV) may be available to the estate but this is uncommon The RIS payments arise from a personalise contract (policy) between the seller (eg a life company) and the purchaser, who becomes the policy owner In essence, the retiree has purchased an income stream by exchanging part or all of the lump sum accumulation (note: it’s the opposite of a home mortgage loan) Annuities can be purchased by anyone at any age to provide an income stream. Therefore, an annuity can be purchased as a RIS using funds from the ‘released’ super accumulation (a condition of release must have been met) Types of non-account based RIS include: 1. Fixed term/term certain annuities: commutable income stream payable for a fixed term and price based on the recipient’s age at commencement and also the implicit interest rate within 2. Life/lifetime annuities: paid for as long as the purchaser/annuitant is alive and stops as soon as the annuitant dies. However, they are relatively expensive and their pricing is based on actuarially determined life expectancies (the Australian Government Actuary’s mortality table). Risk that you take on with lifetime annuity is that you may live shorter than expected and the risk that the provider takes on is that you may live longer than expected.  The issues with non-account based RIS are 1. Purchase price -> the more you pay, the higher the income stream 2. Term of the annuity 3. Implicit market Interest Rate -> the earning rate/yield (return) of the lump sum and it is fixed for the life of the annuity. The interest rate level has a significant impact on the amount of RIS received. Tutorial 8 Questions 1. Trust deeds must contain 1. Appointment and removal of trustees 2. Decision making powers of trustees 3. The fund’s investments strategy 4. Who can be members 5. Who can contribute to the fund 6. The nature of benefits, when and how it is calculated 7. Procedures for changing trust deeds 8. Procedure for winding up fund A statement that the fund exists to fulfil one of the core purposes 2. Fiduciary duty = best interest duty In the case of superannuation fund trustees, the duty means that they are required to act in the fund members’ best interests, specifically in relation to the provision of retirement benefits (meeting the Sole purpose test) 3. Basic requirements to qualify as a SMSF are - max members is 6 - all members are trustees and all trustees are members (it is possible to have a corporate trustee) - regulated by the ATO - all fund members are related Crucial requirements are - It must comply with Sole Purpose test -> its prime purpose is provision of retirement benefits - It has a written investment strategy - that takes into account the needs of its members SMSF is regulated by ATO and SAF is regulated by Apra Advantages of SAF: 1. access to the Superannuation complaints tribunal 2. more flexible membership is possible with fewer restrictions on relationships between members 3. For SAFs some financial redress is possible if trustee or administrators prove fraudulent Disadvantage of SAF: 1. Approved trustees may be costly 2. Trustees still need to manage investments 4. Why might an SMSF choose to have a corporate trustee rather than having all fund members as individual trustees? Trust duties are onerous and penalties apply to breach of duties. Issues: - A corporate trustee has limited liability as opposed to individual trustees who carry person liability for breaches (and would each pay individual fines)  - Change of membership is easier with a corporate trustee - Change of title to fund assets is easier with a corporate trustee - Corporate trustees can automatically pay lump sums, avoiding additional attention to more rigorous compliance obligations under the sole purpose test - Litigation under against the trustee will not usually involve fund members 5. Conditions of release Common ones - Reach age 65 - Death - Retirement on attainment of preservation age - Genuine termination of employment on or after age 60, irrespective of future employment intentions Most difficult - Compassionate grounds - Demonstrate severe hardship - Permanent incapacitated 6. Government set a minimum drawdown amount so that retirees cannot try to retain/build up the balance of their pension accounts by taking minimal pensions of all of their residual lies and taking advantage of the concessional tax (no tax) on investment earnings and capital gains of SGS. Since the underlying principle of the SGS is that RIS funding is to be encouraged by the provision of tax benefits, the government is not willing to extend these tax benefits outside the system (eg for bequest motives) In 2020-2022, because of covid, there was a sharp drop in equities and other asset markets, the average value of super accumulations was reduced and the government has sought to allow people at or near retirement to preserve as much of the capital assets as possible (by not being forced to sell shares at a loss to fund pension payments above a level than would be required). 8. Account-based RIS payments are drawn directly from Superannuation fund account and the specific basis for payment is defined in a trust deed and depends on the member’s eligibility - Benefit is better capital growth and returns and they offer greatest flexibility to protect against longevity risk. This is because the owner can determine when and how much is drawn, which will also determine how much remains invested as a lump sum - Risk is market risk and risk - Account-based RIS carry more risk that fixed term and lifetime RIS as the balance can be drawn down to zero quite quickly Non account based RIS are made by providers (such as life insurance companies_ on the basis of a personalised contract between a life company and the policy owner  - Provides a fixed entitlement to an income stream, which provides peace of mind for many retirees - On average will provide a lower RIS over the long-term. This can be exacerbated in low interest periods (such as the present) since the amount of purchased RIS is a function of the interest rate of return 9. a) She has reached age of preservation (65) and retirement from the workforce b) 5%, therefore 26k c) Fortnightly pension is 1000 and in the 20th year it is 1000 X indexation^n which is 1753.51 per fortnight, with the assumption that there will be sufficient balance remaining in the later years to fund these pensions. It also assumes that the balance does not go above 520 k in early years (due to earnings exceeding pension drawn). If this were to occur, the minimum pension to draw would need to be increased. d) No tax paid, she has met minimum drawdown and thus is tax free, if she was to draw any less, the full amount would be accessible to income tax at her MTR. In addition, if she was to qualify for the Age Pension, the ATO is assessable to income tax but will typically not attract tax due to its low level e) Pros: security Cons: longevity risk as an annuity would stop after 20 years (alternative: life annuity would be more expensive) Estate Planning -> more important now since population is ageing - Defined as the planning and documentation of the wishes of a person for the distribution of all assets under their control, following their death - Effective estate planning seeks to ensure that assets go to the right beneficiary, at the most appropriate time, in the most tax-effective manner Aims to provide a straightforward transition to the client’s beneficiaries on death, taking into account the circumstances of the beneficiaries - Desirable features of an estate plan: 1. Administratively simple 2. Inexpensive to maintain 3. A balance of life-time enjoyment and preserving wealth for family members 4. Reviewed regularly Estate planning Estate = living or dead person’s net worth Key elements: Will, appointment of executor, establishment of a trust (not applicable to everyone), Power of Attorney (PoA) Since Financial Planners are generalists, they can prepare the estate planning ‘road map’, but will not generally be directly involved in the preparation or execution of legal documents (wills)  - The FP can provide related financial planning advice, but should recommend that the client seek further specialist estate planning advice Testator/Testatrix (if female) = the person making a will Beneficiaries = persons who collectively are entitled to receive all or part of the estate of a deceased person, in accordance with the terms of a will or the laws of intestacy Bequest = a gift of property, etc Devise: a gift of land in a will to a nominated beneficiary Legacy = A gift of personal property, etc Executor/Executrix = the person named in a will and appointed to look after the estate of a deceased person, including winding it up (also known as the Legal Personal Representative (LPR)) Trustee = holds property in trust for another Corporate Trustee = a trustee set up as a company (typically for limited liability reasons) Guardian = a person appointed in a will or court order to care for and manage the affairs of a beneficiary such as a minor Ademption = complete or partial extinction of a legacy by an act of the testator(other than revocation) during his/her lifetime -> eg a prior to death sale of a will asset Estate Assets - Assets that are owned in the personal name of the individual will be included in their estate - Accordingly, all real property, financial assets (cash, shares, loans, etc), personal and household items, cars, collectibles, etc - Must be dealt with by wills - Capable of being disposed of by a will - An issue that arises is that asset distributions under a will are vulnerable to challenges by an unhappy family members or other claimants (any claimants would need to meet specific criteria to challenge a will) - Wills are also vulnerable to access by a client’s financial creditors if s/he dies an undischarged bankrupt (unless protected by legislation) Non-Estate assets - Assets that are controlled but not owned by the individual - These include jointly-owned assets (home)-> the survivor is generally entitled to sole ownership, unreleased superannuation benefits, assets held in trust -> superannuation entitlements (the fund Trust Deed typically distributes to the most appropriate person(s) eg spouse), life insurance proceeds (depends on who owns the life policy; if the person who took out the policy dies, then the amount of the claim is an asset of the estate, assets dealt with by Binding Financial agreements But not assets held as ‘tenants in common’ (ownership shares are separate and are included in deceased estates ie they are estate assets) - Binding Financial Agreements (BFAs) can be used to regulate financial and other arrangements typically related to marriage -> commonly related to as prenuptial  agreements, they detail agreed outcomes relating to separation, divorce and even on death Essentially deadlock-breaking devices, parties should give consideration to BFAs at the time when they are most amenable to considering them (ie in advance of when they might be needed) If a BFA is properly drawn up, they are enforceable and the agreed provisions can be put into effect (they override Family Court’s jurisdiction) but sometimes they do not address changing circumstances well enough Such certainty of outcome may be necessary because of the significant wealth that one partner has compared with that of the spouse or because the client is in business with third parties - A BFA could provide certainty that the business would not have to be sold as a result of a claim by a spouse in the future (this is prudent for the running of some businesses). A BFA can give protection not only to families, but also to business partners. - Additional planning is often required in relation to the distribution of non-estate assets - Not distributed by a will Wills = a legal document that disposes of a deceased estate’s assets to the people intended It specifies how property is to be dealt with after the death of the testator and it provides 1. Directions as to who are the beneficiaries to the assets and income of the estate 2. Directions in the event that a beneficiary should die before the testator 3. Nomination of executor(s) to manage the deceased estate 4. Nomination of guardians for minors 5. Any other specific directions by the deceased The applicable laws for wills include 1. Wills Act 1997 (commenced 20/7/98) 2. Wills Act 158 (applies to wills made before 20/7.98) 3. Administration and Probate Act 1958 (contains the formula for distributing assets when there is no will and contains the provisions about contains the provisions about challenging a will) Who can make a will 1. Anyone over the age of 18 who has testamentary capacity (is of sound mind) - Exceptions to the age 18 rule are married minors, court authorised 2. Sound mind means having sufficient capacity to understand the nature of - The act of making a will and its effects - What they are doing by signing the will - The property to be willed to the beneficiaries 3. Must not be made under duress or coercion To be valid, all willing must be in writing (do not have to follow a set format but it is recommended). The testator(rix) must sign the will him/herself, or it must be signed by someone else in his/her presence and in his/her direction. A will must be executed in the presence of 2 independent witnesses (in presence of each other). A will does not necessarily have to be prepared by a solicitor (but it is advisable, especially if financial arrangements are complicated) Form of a will The recognised order 1. Name, address and occupation of the testator 2. Revocation of former wills 3. Appointment of executor and trustee 4. Specific gifts of personal estate 5. Specific gifts of real estate 6. Life interests 7. Residual interests 8. Maintenance and provision for infants 9. Declarations of intentions and appointment of guardians 10. Disposal of body and funeral arrangements Key factors to consider in preparing a will 1. WHat assets do I have now, and may I have in the future, to give away? 2. To whom do I wish to leave them? 3. Who is going to have the task of handing over the assets and look after my estate (who will be my executor) 4. What powers does my executor need? For incomplete wills, the Wills Act 1997 allows the Supreme court to verify a will, even if some of the formalities are wrong Life/duration of a will - Once a will is valid and signed, it remains valid until it is revoked - Voluntary revocation = if a will is redrafted or a new will is made - Involuntary revocation -> marriage automatically revokes a will. However, divorce and separation do not revoke a will (with some minor exceptions depending on when the will was made) Changing a will - A will can be changed by preparing a codicil (an additional will but it will usually only relate to a specific aspect of the will eg. adding a grandchild to the will) -> it is the most effective way of amending an existing will but it is recommended for simply amendments only and executed as a separate document - Alternatively, preparing a new will automatically revokes an older will Beneficiaries - Can be family members, friends, charities, creditors and other entities (in theory, there is no restriction on who a testator chooses as a beneficiary)  - Issues to be considered for distributions to beneficiaries include: eligibility to age pension, exposure to risk (bankruptcy), taxation status, ability to manage finances, potential family law problems) Choosing an executor/LPR - The executor/LPR ensures that a testator’s instructions are carried out and associated duties and completed - No special qualifications are needed but must consider if they are up to the task - It can be a natural person (principal beneficiary, relative), Public Trustee, trustee company or professional adviser - Generally, the executor’s role is voluntary and not paid unless expressly provided - Should also consider appointing a substitute executor (sometimes people die at the same time etc) - Being an executor is demanding and time consuming and requires one to have good business and organisational skills (do need to understand the assets) - Their rules include 1. Take control of body, locate the will, arrange (and pay for) the funeral 2. Identify, collect, control and protect the assets 3. Identify and pay all liabilities 4. Obtain a ‘grant of probate’ of the will 5. Pay the costs of administering the estate 6. Distribute the assets 7. Lodge tax returns and pay taxes (usually requires 2 ITRs (tax returns) in the year of the death) 8. Defend the will if there are any challenges Deceased Estates = the net worth of a person when they are dead - Cannot be dealt with until a grant of representation is obtained (either by probate or by Letters of Administration) - The process commences with the placing by the executor of appropriate newspaper advertisements notifying of an intention to deal with assets - Following the lapse of a statutory time period, an application may be made to the Registrar of Probates (of the Supreme Court) Probate - In most cases, an executor will be quired to obtain a grant of probate to take possession of the estate assets (as testator’s legal representative) - This is the formal process by which a will is proved as ‘last will and testament’ to confirm executor, and to be registered with the court - It evidences that proper administration of the estate has been completed - A probate parchment (formal document that needs to be showed to parties eg banks that hold assets) is the issued, with the will attached  - Institutions or organisations holding assets of deceased will typically request a sighting of the Probate before releasing the assets to the executor (bank balances, listed share investments, etc) - In cases where probate cannot be obtained (no valid will or no executor), the court’s approval for someone to administer the estate of a person is provided by Letters of Administration - The reason for considering the appointment of a substitute executor is that there will be a problem administering a deceased estate if the nominated executor is unable to act as probate cannot be obtained (eg. one appointed their spouse as executor of their estate but they were both killed in a car accident) - Typically, the principal beneficiary or nearest next of kin (prioritises the spouse) applies to become estate administrator by obtaining a grant of ‘Letters of Administration’ Intestacy - Full intestacy occurs when a will is not made or when a will is made but cannot be admitted to probate as its execution was obtained under duress or the deceased lacked testamentary capacity - Partial intestacy occurs when the will does not dispose of all the estate assets, a particular bequest is invalid, a beneficiary predeceases the testator or by operation of the “doctrine of forfeiture” (where a person entitled to an interest is criminally responsible for the death of the testator) - An administrator will need to be appointed (usually next of kin) by way of Letters of Administration and is required to follow the statutory rules of intestacy, which prescribe precise rules relating to distributing estate assets - The fundamental principle of distribution under these rules is that they are governed by marital and blood relationships - What happens if a person dies without a will and without dependents? 1. Distribution is based on next of kind, if any 2. In Australia, specific rules depend on the state of residence - In Victoria, the administrator first needs to establish a current family tree and distribute as follows 1. To the surviving spouse/partner (first $100,000 plus ⅓ of balance of estate ; the remainder is split equally between children ; if no children, the spouse gets everything) 2. If no surviving spouse, to the children - equally 3. If no surviving spouse or children, to any living next of kin (first parents, if none surviving, siblings ; if none surviving, others such as grandparents, uncles and aunts, cousins) 4. If none of the above, to the Crown (the government) Contesting a will - General rule is that a person can leave assets to whomever they wish (there is no obligation on anyone to allocate equally or fairly) - Under common law, wills can be challenged on grounds of:  Lack of testamentary capacity Undue Duress Incorrect execution - Persons can have the legal costs of contesting a will paid out of the estate (such claim must be made within 6 months from probate), but not if the challenge is deemed to have no appropriate basis - The general principle of ‘no restriction on beneficiary choices’ is modified by Family Law, which imposes a responsibility to make a provision for family/others - If inadequate provision is made, a person can make an application to contest under the Testator’s Family Maintenance Act 1912 (TFM claim) - TFM claims are limited to the following people: Surviving spouse or de facto Children (including ex-nuptial, adopted and stepchildren) Parents (if you die without a spouse or children) A divorced spouse who is receiving or entitled to receive maintenance from you at the date of your death Estate challenges - Each state has a legislation granting the right to challenge a person’s estate (not specifically distributions by the will) to persons who can establish a right to maintenance by that person - Potential claimants include estranged children whom the testator might want to disinherit, ‘unknown’ children who might claim paternity of a deceased testator or long-term carers of a testator - One key general rule is that only a person’s estate assets are vulnerable to an estate challenge 3-year rule for Tax - Australian tax law allows executors up to 3 years to finalise an estate - During this time, the deceased estate is taxed as if an individual -> standard personal income tax rates apply to the income (interest, rent, dividends, etc.) earned by the estate assets > it is favourable - This rule is essentially a concession granted by the ATO that may provide some tax savings benefits to beneficiaries (where beneficiaries are in full employment and currently in top MTR, lower tax will apple to distributions delayed by the executor) - Acknowledgement of the legal process to for example get a proate Power of Attorney - A legal document under which a person (the donor) appoints another person (the attorney) to act as his/her agent -> sign contracts, manage affairs, medical decisions - Operates only during the lifetime of the donor - Can be general (non-enduring) PoA, enduring (financial or medical) or power of guardianship - A general PoA ceases to operate if the donor loses mental capacity to act  - An enduring PoA will remain valid and applicable even if the donor loses their mental capacity to act - Authorises the attorney to undertake any specified legal, administrative or financial matter that the donor can undertake in his/her own right -> but they can endure past loss of testamentary capacity - The donor must have capacity to execute a PoA for it to be valid (the concept of ‘sound mind’ once again applies) - A donor may execute more than one poA and similarly can revoke one or all PoA - Operates under state law and some jurisdictions require a PoA to be registered as effective - A PoA cannot make a will for the donor, undertake illegal acts, delegate power to another (unless expressly specified by the PoA), exercise the donor’s power as trustee, make decisions about the donor’s ‘lifestyle’ (for instance in the matter of medical treatment unless there is an express provision in the PoA as exists to a limited extent in Victoria or ACT) Trusts -> arrangement but is not a legal entity - a fixed trust/unit trust gives beneficiaries a fixed entitlement to distributions and capital in proportion to the number of units held (similar to shares in a company, units are in the arrangement) - A discretionary trust gives beneficiaries an entitlement to be considered for distributions from the trust but not the right to receive distributions - 2 main types of trusts 1. A living/inter vivos trust (established during a person’s lifetime and deals with arrangements during the lifetime), of which family trusts are a common example 2. A testamentary trust (established after the death of the testator, by the will), which only comes into effect upon the testator’s death Family Trust Structure - A (discretionary) family trust (FT) can be effective for tax and estate planning as it enables family assets and income to be shared amongst beneficiaries - If the parents own substantial income earning assets, perhaps including an operating businesses or investment properties, these assets can be contributed to a FT and the income from the assets is earned in the name of the FT The trustee holds the assets on behalf of the beneficiaries Income is distributed to the beneficiaries at the discretion of the trustee, which can result in tax savings (or even assist in meeting expenses) Eg. income distributed to a non-working spouse or children over 18 will be taxed at their marginal rates, with full tax-free threshold (but not to minors) Testamentary Trusts (TT) can be used to provide: - For minors and/or family members with disabilities - Asset protection for intended beneficiaries -> trust can hold asset for a minor and administer that asset  - Maintenance of social security benefits -> avoids destroying the ability to receive aged pension or any social security benefit as the beneficiary does not own it (the trustee owns it and maintains it on behalf of the beneficiary taxation benefits) - Taxation benefits, particularly generation of ‘expected income’ (minor beneficiaries) These beneficiaries pay tax on income received from a trust at adult MTRs Income splitting between the surviving spouse and children is possible * TTs can be set up as beneficiary trusts, superannuation proceeds trusts, restricted trusts and discretionary life interests - TTs are not always the best solution for every client The manner in which they are drafted can significantly impact upon how they operate, as they need to be able to deal with future events Poorly drafted trusts in inappropriate circumstances can at best be a nuisance and at worst can lead to outcomes that greatly devalue an inheritance - A discretionary trust can long outlive the client (max lifespan being 80 years) - Control of the trust and its assets must therefore be carefully considered when drawing it up SMSF and estate planning - SMSF trust deeds typically allow members to transfer accumulated benefits on death, thus bypassing probate, etc on such benefits - Transfer of benefits can be accomplished by trustee directive (eg Binding Death Nominations, BDN) or forfeiture into the fund’s reserves - We have seen that bequests made to dependents via wills can be challenged on the basis of ‘not making adequate provision’; however SMSF trustee directives with current BDN’s are very strong and not usually overruled It is a way of protecting against a will or estate challenge - Provisions of the SMSF trust deed will take precedence over any instructions given in a will -> creating a will and automatically expecting it to be a binding authorisation of where super benefits are paid may might not work - Since super benefits are non-estate assets, they are protected from estate and will challenges - To take advantage of this, the SMSF trust deed should always reflect what you want to achieve (do you want to pay a lump sum of assets, or provide for an income stream?) Financial planning It is of clear importance that financial planners are aware of the nature and applicability of each of these items, as part of KYP rule For example, financial planners must be aware that wills can be challenged, but disposals of superannuation assets cannot be challenged, so are highly flexible and tax-effective, especially when dependents are involved. This can therefore have an impact on the nature of financial advice provided For effective estate planning, use the following checklist 1. Check trust deeds and have them updated when you circumstances or those of family members begin to change 2. Have a current will and adjust, if necessary, for changing family or other situations so that it properly reflects your wishes 3. Select Trustees/PoA carefully 4. Recognise the time and costs involved in various structures 5. Be clear on your wealth generation objectives for after your death -> determine what type of income streams, under what asset structures, you want for living beneficiaries 6. Have a clear strategy for super and non-super assets 7. Ensure any death benefit nominations are properly structures and documented, taking tax and legal issues into account 8. Consider complementary vehicles alongside SMSFs that may help with estate planning, such as trusts or other specialist retirement products/advice 9. Ensure your lawyer, accountant and other SMSF advisers prepare and hold completed and signed documentation Lecture summary Estate planning is the preparation of the wishes of a person for the distribution of all assets under their control after death -> tax law allows executors 3 years to finalise an estate Desirable features include simplicity, inexpensive, balanced and reviewed regularly. Key elements include a will, an executor a trust and a Power of Attorney Non-estate assets are ones controlled but not owned by an individual, including jointly-owned assets, unreleased super, trust assets and life insurance proceeds Deceased Estates cannot be dealt with under with under a grant of representation is obtained Probate -> will proves as ‘last will and testament’ and registered with the court Letter of administration -> court approval where no probate can be obtained A will is a legal document that specifies how the property of a deceased estate is to be dealth with 1. To make a will, one must be over 18 with testamentary capacity 2. Must be in writing and signed in front of 2 independent witnesses, there is no set form in theory 3. Valid until revoked (voluntary or involuntary) 4. Can be changed via a codicil (additional will) 5. No restrictions on beneficiaries 6. Executor can be a person, public trustee or company - ensures that the instructions are carried out Full intestacy = where a will is not made, or cannot be admitted Partial intestacy = where a will does not dispose of all assets, a particular bequest is invalid, a beneficiary predeceases the testator or doctrine of forfeiture -> statutory rules need to be followed Contesting a will - NB. No obligation to distributed fairly or to any particular person under a will - Common law challenge grounds of 1, lack of testamentary capacity 2, undue duress or 3. Incorrect execution - Family law imposes a responsibility to make a provision for others -> Testamentary Family Maintenance Act 1912 (TFM) claims can be brought if inadequate provision is made Challenging an estate - Each state has legislation granting the right to challenge a person’s estate (not specifically distributions by the will) to persons who can establish a right to maintenance by that person  - NB, only estate assets are vulnerable to an estate challenge Binding Financial agreements (prenuptial agreements) - Detail agreed outcomes relating to separation, divorces and death - Enforceable if properly drawn up - Can be used to provide assurance to third parties involved with either party Powers of Attorney (PoA) - Donor appoints attorney to act as their agent - Can be enduring (remains valid even if donor loses capacity) or general - Cannot make a will, delegate, act as trustee, make lifestyle decisions Trusts - Can be fixed (unit) trusts, giving beneficiaries a fixed entitlement to distributions, or discretionary trusts, giving beneficiaries an entitlement to be considered for distributions, but no guarantee Family Trusts - Asses can be held in trust - Income is distributed to beneficiaries at discretion of the trustee - income is then taxed at MTR for beneficiaries Testamentary Trusts - Created under a will and is essentially a family trust - Children pay tax at adult MTR (beneficial) - Drafting is important and lifespan of 80 years SMSFs - SMSF trust deeds typically allow members to transfer accumulated benefits on death, thus bypassing probate etc on such benefits (can be viewed BDN or reserves - Provides protection from will or estate challenges -> SMSF trustee directives with current BDNs are very strong and not usually overruled - SMSF trust deed is stronger than will as super assets are non-estate assets Tutorial 9 1. Who can make a will? 1. Any person over 18 yrs old (or under 18 but married) who has testamentary capacity What are the main requirements for a valid will? 1. Will must be in writing 2. Signature of testator must be attested by 2 independent witnesses present when the will is signed 3. The testator must have testamentary capacity 4. The testator must have the intention of making a will 5. The testator must be of legal age (18 years old or under if married) What class of assets are disposed of by wills Only assets that are the personal estate of the testator may be disposed of b y will (non-estate assets are dealt with outside of the will) 2. What does testamentary capacity mean? What are the tests? They are of sound mind and the tests for testamentary capacity are: does the testator know the extent of the property? Does the testator understand that he/she is making a will? Does the testator know the claims of persons excluded from the will? 3. Principal duties of a testaor’s executor 1. Locate and prove the will 2. Administer the estate personally 3. Collect and protect estate assets 4. Ascertain and pay debts especially tax 5. Apportion liabilities among beneficiaries 6. Keep Accounts and records of all dealings with estate assets and liabilities 7. Distribute the estate’s net assets to those entitled to receive them 4. Non-estate assets = assets that are not ‘your own’ and are not disposed of in wills Examples 1. Joint Owned Assets: Assets held in joint tenancy such as a house, bank accounts will automatically pass to the surviving joint owner(s) on the death of one owner by right of survivorship. They do not form part of the deceased’s estate and are not subject to the will 2. Superannuation: Superannuation benefits are distributed according to the rules of the superannuation fund and the instructions provided by the deceased via a domination. A binding death nomination can direct the superannuation trustee to pay the death benefit to a specific beneficiary or to the estate to be dealt with under the terms of the will. A non-binding death nomination is a preference but not legally binding. Lapsing = every 3 years the death nomination must be renewed but non-lapsing is valid infinitely) 3. Life insurance policies: are typically paid directly to the nominated beneficiary or beneficiaries and do not pass through the will, unless the estate is nominated as the beneficiary 4. Trust assets. Assets held in a discretionary trust, or family are controlled by the trustee and are not owned by the individual personally. Therefore, they do not form part of the deceased’s personal estate and are not dictated by the will What estate planning techniques may apply in relation to non-estate assets? 1. Joint ownership considerations: Changing from joint tenancy to tenancy in common can allow an individual’s share of the asset to be dealt with under their will 2. Trust deeds: An estate plan should consider the control mechanisms. Control of a trust may be passed on through the trust deed or via the will, depending on the structure and terms of trust  3. Superannuation Nominations: Ensuring that a valid binding death benefit nomination is in place ensures that superannuation benefits are distributed according to the individual’s wishes 4. Life Insurance Nominations: Reviewing and updating the beneficiary nominations for life insurance policies to ensure they align with current wishes and life circumstances 5. Power of Attorney/Guardianship: Establishing powers of attorney and guardianship arrangements can ensure that an individual’s affairs, including non-estate assets are managed according to their wishes if they become incapacitated. 5. What are the arrangements relating to the meeting of income tax obligations of a deceased individual 2 tax returns need to be prepared in the financial year of death (one individually and one is a Trust income tax return(from date of death until the following 30th June) & medicare levy and medicare surcharge may also be payable for the individual one but none on the rest tax return) 1. The first tax-return is prepared in relation to the period that the deceased was alive, All income derived and expenses incurred in that period are to be included and individual tax rates with the full tax-free threshold apply. Medicare levy and Medicare levy surcharge may also be payable 2. The second return is a Trust income tax return, relating to the income and expenses of the deceased estate from the date of death until the following 30 June. The taxable income in this return is subject to MTRs but there is no Medicare Levy or credits - the Trust is treated as a new taxpayer so in this full tax yearn effectively 2 tax-free thresholds apply Until the deceased estate has been administered, a trust tax return will be required. In the following 2 tax years, the same rules will apply (the taxable income is subject to individual tax rates with the full tax-free threshold). If the estate persists past the 3rd tax year, the taxable income is subject to special/increased rates.. Trust tax return will not be required where administration of the deceased estate has been finalised prior to 20th June. Trust created for a deceased estate is different from any testamentary trust that is created by a will 6. What are the principal grounds on which wills may be challenged 1. The will is invalid (not properly executed, revoked by a later will, testator did not have testamentary capacity, there was undue duress applied etc) 2. The will is valid but it failed to make provision for one or more beneficiaries (family provision legislation) -> TFM claims If inadequate provision is made, a person can make an application to contest under the Testator’s Family Maintenance Act 1912 (TFM claim) TFM claims are limited to the following people: surviving spouse or de facto; children (including ex-nuptial, adopted and step children); parents (if you die without a spouse or  children); and a divorced spouse who is receiving or entitled to receive maintenance from the testator at the date of your death 7. Probate = recognition/verification by the court of a properly executed will. In most cases, an executor (testator’s LPR) will be required to obtain a grant of probate to take possession of the estate assets) Process of obtaining probate 1. The will is proved as last will and testament 2. The executor is confirmed and registered with the Court 3. Verifies proper administration of the estate has been completed After these steps, a probate parchment is issued by the court, with will being attached. Note that financial institutions or organisations holding assets of the deceased can insist on sighting this Probate parchment before releasing the assets to the executor 8. Intestacy is when a testator dies without disposing of the whole of his/her property by will (can be total or partial). Consequences include: estate is distributed other than in intended ways, failure to provide for the particular needs of the deceased’s family, additional expense and diminution of value of the estate, delay in the administration of the estate, no provision being made for deceased’s de facto or stepchildren 9. A general power of attorney is non-enduring (ceases to operate if the donor loses mental capacity) Enduring power of attorney is an appointment of a legal personal representative to manage one’s financial affairs in absentia under defined circumstances but also in the event the principal becomes legally incapable of doing so (insane, comatose etc) The objective in appointing an enduring power of attorney is particularly to ensure that in the case of becoming legally incompetent a trusted representative will try to implement his/her principal’s intentions. They cannot write a binding death nomination! 10. Testamentary trust is a legal arrangement created through a will that becomes effective upon the death of the will-maker (testator). It involves a trustee managing and holding the deceased’s assets for the benefit of the beneficiaries, in accordance with the conditions set out in the will Testamentary trust is established after the death of the testator by the will and only comes into effect upon the testator’s death Main benefit of testamentary trust (relative to a discretionary family trust) are tax advantages Tax advantages for beneficiaries (especially minors) 1. Income derived from testamentary trust can be distributed to minor beneficiaries and be taxed at normal adult marginal tax rates, rather than the penal rates that typically apply to unearned income received by minors from other sources  2. This can result in substantial tax savings if there are minor beneficiaries, as each minor beneficiary is entitled to the tax-free threshold, potentially allowing for a significant amount of income to be distributed tax-efficiently It can provide for minors and/or family members with disabilities, maintenance of social security benefits, taxation benefits, particularly generation of ‘excepted income’ (minor beneficiaries) -> these beneficiaries pay tax on income received from a trust at adult MTRs and income splitting between the surviving spouse and children is possible -> this can result in substantial tax savings if there are minor beneficiaries, as each minor beneficiary is entitled to the tax-free threshold, potentially allowing for a significant amount of income to be distributed tax-effectively Other benefits of a testamentary trust 1. Asset protectionL Since the assets are held within the trust they are generally protected from the personal financial issues of the beneficiaries, such as bankruptcy or marital breakdowns. This means that the assets are less likely to be attacked by creditors or be subject to external claims 2. Estate planning flexibility: Similar to other trusts, testamentary trusts can be structured with specific conditions for asset distribution, This allows the testator to set terms that reflect their wishes for how and when the beneficiaries should receive their inheritance. Testamentary trusts can also help in avoiding challenges to the estate, as they may provide a clearer structure and guidance on the distribution of assets, which can help in deterring family disputes over the will 3. Potential capital gains benefits: Beneficiaries of the testamentary trust may receive a cost base reset for the assets at the time of the testator’s death, potentially reducing capital gains tax liability when the assets are eventually sold Asset protection - The objective of an effective financial plan is to address earning sufficient income to adequately fund living (Consumption) and investment (S) ensuring the latter provides the means for an adequate RIS - Financial plans are prepared assuming a continuing income - Risk of this assumption is that there is insufficient focus on protecting the means of generating savings - Since the most effective way to protect the means of generating savings is via life and other insurance arrangements, our focus will be on the features of these risk management products Ownership of assets -> First step is to affirm ownership or control of assets (ensuring appropriate legal title is held) -> Issues arising here relate to assets purchased in other names (a building held in the business name, investment assets in spouse name etc). This is because legal title gives the owner the right to deal in the assets such as sell them -> good for tax benefits but not good if there are subsequent disputes ->This concept extends to legal ownership of any asset being insured - Other relevant considerations include: i) assets protected by Binding Financial Agreements ii) assets owned as tenants-in-common (vs joint tenants) -> tenants-in-common means that they both both equity stake and joint tenants mean that they own it together iii) superannuation assets subject to Binding Death Nominations - Minor Aspects of asset protection that should not be overlooked are: i) guarantee periods on purchases of assets of services ii) retaining records as to proof and date of purchase iii) guarantee periods on word done by tradespeople iv) estimate of time to failure Joint tenants-> if one of them dies then 100% ownership goes to the other and that stays out of the will If you want to bequeath your 50% to someone else after passing, then you have to structure the ownership as tenants-in-common Risk and Insurance - Normal activities of daily life carry the risk of losses, even potentially large financial losses and thus people are willing to pay a small amount of protection against some risks because that protection provides valuable peace of mind - Insurance -> describes any measure taken for protection against risk “A risk transfer mechanism that ensures full or partial financial compensation for the loss or damage caused by event(s) beyond the control of the insured party” The nature of insurance - Parties that transfer specified risks to the insurer are exchanging a potentially large uncertain loss for a relatively smaller certain payment (the premium) - Insurers are willing to accept transferred risks in circumstances when they are able to pool such risks Risk pooling is the sharing of total losses among a group - Effective risk pooling is accomplished by combining a group of similar ‘objects’ for which the aggregate losses across the group become predictable within narrow limits - Insurers charge client/the insureds based on that expected loss + margin Risk Pooling Economically Feasible Individuals will only take out insurance if: 1. The maximum possible loss must be relatively large 2. The premium is not excessive The potential loss must justify the cost of the premium - Insurers must always charge more for their service than the expected value of a loss (but not too much more) or they would earn no margin - Insureds are willing to pay more to avoid a loss than the true expected value (EV) of that loss Insurance Policies -> Insurance takes the form of a contract that is known as an insurance policy - In Australia, insurance policies are subject to requirements in statutes, administrative agency regulations and court decisions - Under an insurance policy, the insurer indemnifies the insured against a specified amount of loss, occurring from specified eventualities within a specified period - Insurance provides necessary funds to cover financial losses or reinstate lost assets - The losses that are covered by insurance arise as a result of perils, which arise due to hazards/ Insurance covers losses from perils, and understanding hazards helps insurers assess risk and set premiums accordingly. Professional indemnity -> for professionals in case they get sued Indemnity = “security or protection against a loss or other financial burden” - In insurance, the effect of indemnity is that it seeks to restore insureds to their position that existed prior to a loss - This principle ensures that an insured may not collect more than the actual loss in the event of damage caused by an insured peril -> this serves to control moral hazards that might otherwise exist and therefore the likelihood of intentional loss is greatly reduced - It is an important principle in insurance, ensuring that no profit can be made from a loss event Peril = the cause of a loss - If a house burns because of a fire, the peril, or cause of, loss, is the fire - If a car is destroyed in an accident, the accident/collision is the peril as it is the cause of loss - Other common perils that result in losses include fire, cyclone, storm, flood, lightning earthquakes, malicious damage theft and burglary - Only perils can be insured against Hazard = a condition that creates or increases the chance of a loss -> a hazard increases the chance of a peril event - 3 major types of hazards: physical, moral and morale hazard - Physical hazard = a physical condition that increases the chance of loss A business owns an older building that has defective wiring -> this is a physical hazard that increases the chance of a fire (the peril)  Any loss is not directly as a result of the hazard (defective wiring), but as a result of the peril (fire) - Moral Hazard = a situation in which an insured party actively gets involved in a risky event to cause a loss, knowing that it is protected against the risk and the other party will incur the cost ( will occur when the insurance payoff is > insured asset value) Moral hazard involved unethical or immoral behaviour by an insured person seeking to gain at the expense of insurers and other policy owners It arises when both parties have incomplete information about each other, in the sense that insurers aren’t aware of what the insured will do Moral hazard is potentially present in all forms of insurance and it can be difficult to control For example, consider a business that is overstocked with inventories because of a severe business recession and is unable to sell them. If the warehouse and inventory are insured, the owner of the firm may decide to deliberately burn the warehouse to collect money from the insurer. Therefore, the unsold inventory has effectively been sold to the insurer by way of the deliberate loss. In practice, any fires are due to arson, which is a clear example of moral hazard, though not always related to insurance claims. - Morale Hazard = a situation that arises due to carelessness or indifference to a loss because of the existence of insurance The presence of insurance causes an insured to be careless about protecting their property and therefore the chance of loss is increased For example, motorists know their cars are insured and therefore some are not too concerned about the possibility of theft. Their lack of concern will lead them to leave their cars unlocked, so the chance of a loss by theft is thereby increased because of the existence of insurance Moral and morale hazard differ on the basis of the intent of the insured, but can result in the same outcome for the insurer Principle of utmost good faith - “A positive duty to disclose voluntarily accurately and fully, all facts material to the risk being proposed, whether requested or not” - Applicable to all contracts of insurance - The implication of this principle is that a higher standard of honesty is imposed on parties to an insurance agreement than is imposed through ordinary commercial contracts - This casts a different light on the interpretation of insurance agreements relative to general business contracts Types of insurance - Life and health - Property - Public liability - Business interruption - Fire, burglary and theft insurance  - Marine insurance - Motor vehicle insurance - Workers compensation Insurance protection for individuals - Protection against loss of income on death is provided by life insurance (either permanent plan or term life) - Protection against loss of income because of temporary disablement is provided by income protection policies -> often rolled into life-insurance policy anyway - Life and income protection policies may have a trauma insurance ‘add-on’ - Key person insurance can typically be used to alleviate financial loss to a business arising from premature death or disability of a key employee -> good for small businesses - Is not possible to provide protection against job redundancy (losing your job as it is probably not a peril rather a hazard) by use of an insurance policy Life insurance - Operates to reduce the financial impact of death or other serious contingencies affecting the capacity to provide income to cater for dependents If the family income earner dies or is permanently incapacitated, the financial stability of any dependents can be retained by appropriate life insurance - Evidence points to underinsurance in Australia On average individuals do not carry sufficient insurance to meet financial needs of dependents - The life insurance industry is subject to considerable regulation as follows The Corporations Act The ASIC Act Insurance Contracts Act 1984 Life Insurance Act 1995 Privacy Amendment (Private Sector) Act - A key part of regulation of the industry is that providers of life insurance must hold a proper licence under the Life Insurance Act and currently there are only 24 licensed providers - - The ‘big 4’ banks (ANZ, CBA, NAB and Westpac) also hold licences (but not necessarily in their own name) - The parties to a contract of life insurance 1. The owner of the policy 2. The insured life 3. The beneficiary(ies) 4. The ‘Life Office’ - Life insurance company There is a difference between the policy owner and the insured life, although the owner and the insured can be and is often the same person The person who buys a policy on his own life is both the owner of the policy and the insured life If the wife of that person was the buyer of the policy on his life she is the policy owner and he is the insured life The policy owner pays for the policy and also acts as the guarantor (that premiums will be paid) The beneficiary receives policy proceeds upon the insured person’s death The policy owner designates the beneficiary, but the beneficiary is not a direct party to the policy (the owner can change the beneficiary, unless the policy has an irrevocable beneficiary designation) The life insurance company is the provider of the insurance and charges a premium based on pooling and risk assessment considerations Life Insurance Premiums - Are based on risk pooling accomplished by combining a group of similar objects (lives) for which the aggregate losses across the group are predictable - This prediction is actuarially determined based on 1. Life expectation experience (usually based on a mortality table, with appropriate specific adjustments for individuals) and; 2. A market rate of interest - There are numerous variations of life insurance policies available in the market, depending upon the term, nature and level of cover sought Life Insurance policies -> 2 major categories 1. (Term) protection policies - designed to provide a benefit in the event of specified event typically a lump sum payment The most common form of this policy is term life insurance (TLI) 2. Investment policies - the main objective is to facilitate the growth of capital by regular premiums Usual forms are whole life and endowment policies These policies were traditionally prevalent but in recent years they have been phased out and replaced by term protection products (this is due to the growth of investment alternatives that are more attractive) Term Life Insurance (TLI) - Provides a lump sum payment on death of the insured to the policy owner or nominated beneficiaries - The amount of the lump sum is specified in the policy and drives the premium - In the event of diagnosis of a terminal illness with less than 12 months life expectancy the policy will often allow an advance payment of total sum insured  - The level of cover will be based on considerations including required income stream for dependents, children’s education, mortgage and other debt outstanding etc - TLI is the most common form of life insurance in Australia, since whole life and endowment policies are generally no longer available - Life Insurance in Estate Planning - Life insurance has several uses in estate planning: Key person insurance Buy-sell agreements Provision for self (income maintenance) in case of disability or trauma) Equalising bequests to different beneficiaries - Key person insurance and buy-sell agreements are examples of how life insurance can be used in Business Succession Planning - A key issue is who is the beneficiary of the life insurance policy (testator, spouse, business partner, trust etc) Key person insurance -> typically used to alleviate financial loss to a business arising from premature death, disability or incapacitation of a key employee - Such financial loss might arise due to: immediate loss of expertise potential sales loss, reduced profitability, time and cost of finding a suitable replacement, loss of goodwill/customers - Key person insurance is paid for and owned by the business Buy-Sell Agreement -> a contract usually entered into between business partners, pursuant to which the remaining partners are compelled to buy out the other partner’s interest in the business should a specific event occur - Specific events that may trigger a Buy-Sell agreement include death, divorce, long-term disability, retirement or bankruptcy - Should any of these events occur, the remaining business partners would be disadvantaged because in most cases another party (the beneficiaries) would have an ownership interest in the business - The main risk is that the beneficiaries wish to cash out their interest at market value, but the remaining partners can’t fund such purchase  - It makes sense to have an agreement that facilitates a transfer of the ownership interest to existing owners when a trigger event occurs - The effect of a Buy-Sell agreement is to ensure that, eg. in the case of death, the purchase of the business interest is funded by proceeds of a policy of life insurancem paid to the estate of the deceased owner - These insurance proceeds are not subject to income tax or CGT when paid to the estate or directly to beneficiaries (however a subsequent sale of the equity may give rise to CGT) - Note: there may be a problem with these agreements in SMSFs Accidental death cover - Accidental death is a limited life insurance, designed to cover the insured should they die due to an accident - Accidients include anything from an injury and upwards but do not typically cover deaths resulting from health problems or suicide - Because they only cover accidents, these policies are much less expensive than other life insurance policies - Accidental death insurance is often not paid out as death by accident is relatively uncommon Personal income protection policies -> designed to provide an income stream to the insured should the person become totally or partially disabled and thus unable to earn income - After a waiting period (typically 90 days), benefits are payable for a predetermined period (which could be the whole of life) - Under this insurance up to 75% of the life insured’s earned income may be insured (paid in the same way as a regular salary) - Like any insurance policy there are crucial definitions to determine, such as income and disability - The definition of ‘income’ differs between self-employed and salaried: Self-employed: total income earned in the conduct of business due to the insured’s personal exertion, less their share of business expenses necessarily incurred Salaried (employees): salary, fees, commissions etc which comprise the insured’s total remuneration package - Total disability comprises 3 tiers/types: duties based, income based and hours/time-based - Duties-based is the most common and usually the best as any claim will be linked to your inability to perform income producing duties Total and permanent disablement - Total and permanent disablement (TPD) insurance provides for payment of sum insured if life becomes totally and permanently incapacitated through injury or illness - Such policies will also put a sum on loss of limbs, loss of sights, etc  - There are 3 types of occupation defined for TPD and each requires that the life insured is unable to perform any work for 6 consecutive months. These types are: Standard (or Any), Own and Homemaker Standard/Any - unable to perform duties of any occupation for which he/she is reasonably suited by education, training or experience Own - unable to perform the duties of their own occupation Trauma Insurance - Provides financial cover in the event of a specified medical catastrophe, including the conditions listed earlier (Alzheimer’s, stroke, etc) - Although this list can be long, 92 of all trauma claims arise from heart attack, stroke, cancer and heart surgery - It can be packaged with TPD or as a stand-alone - Note that the inability to work is a prerequisite for TPD insurance claims but here is no such requirement for claims under trauma insurance Other types of insurance taken out by individuals include: - Motor vehicle - Private property, especially real estate - Landlords’ - Recreational/holiday - Professional indemnity - Private/public liability Motor vehicle insurance -> relates to accidental damage to or by a vehicle but there can be insurance against losses arising from other perils, such as fire and thefts - The main types of damages from other perils are 1. CTP: compulsory third party (for third party personal injury) -> this one does not insure against third person property damage 2. TPPD: third party property damage 3. TPPDF&T: third party property damage, fire and theft Note: these are separate policies, requiring payment of separate premiums Issues for financial planners There are good reasons as to why FPs should understand and advise in relation to insurance: - It is part of a complete financial plan - To save clients financial loss - To avoid litigation - To protect the adviser’s client base - To ensure the adviser himself has adequate professional and personal cover It is important that FPs protect themselves by maintaining record (eg. of client-specified exclusions when advice is given and recommendations made) Lecture Summary Ownership of assets: ensuring proper legal title is held, BFAs, Tenants in common vs Joint Tenancy, Binding death nomination Risk and insurance - Insurance is a “risk transfer mechanism that ensures full or partial financial compensation for the loss or damage caused by event(s) beyond the control of the insured party” - Parties that transfer specified risks to the insurer are exchanging a potentially large uncertain loss for a relatively smaller certain payment (premium) Risk Pooling - Insurers are willing to accept transferred risks in circumstances when they are able to pool such risks - Combining a group of similar ‘objects’ for which the aggregate losses across the group become predictable within narrow limits - Insurers charge clients (the insureds) based on that economic loss + margin Economically feasible - Most individuals will only take out insurance if 1. The maximum possible loss is relatively large and 2 the premium is not excessive (potential loss must justify the cost of the premium) Indemnity: security or protection against a loss or other financial burden Seeks to restore insureds to their position that existed prior to a loss Peril: the cause of a loss Hazard: a condition that creates/increases the chance of loss 1. Physical hazard: physical condition 2. Moral hazard: insured party actively gets involved in a risky event to cause a loss, knowing that it is protected against the risk and the other party will incur the cost 3. Morale hazard: arises due to carelessness or indifference to a loss because of the existence of insurance Insurance policies Under an insurance policy, one party (the insurer) indemnifies the other party (the insured) against a specified amount of loss, occurring from specified eventualities within a specified period T