FNCE20003 Introductory Personal Finance Lecture 7, September 2024, PDF

FNCE20003 Introductory Personal Finance Lecture 7 Funding retirement I Lecturer – Tony Cusack September 2024  Lecture 7 topics The pension problem The Superannuation Guarantee Scheme (SGS) Contributions to superannuation funds Superannuation benefit accumulat...

FNCE20003 Introductory Personal Finance Lecture 7 Funding retirement I Lecturer – Tony Cusack September 2024  Lecture 7 topics The pension problem The Superannuation Guarantee Scheme (SGS) Contributions to superannuation funds Superannuation benefit accumulation September 2024 FNCE20003 Lecture 7 2  The challenge of retirement income to this point, we have focused on the ‘accumulation’ phase of a person’s working life, over which assets are accrued to provide for retirement funding living expenses in retirement therefore involves use of accumulated assets, possibly together with Social Security support – i.e. governments are part of the system given their role, which broadly includes providing social support for community members this means that governments (in addition to current and future retirees themselves) are also faced with the problem of caring for retirees issues relating to generating an adequate Retirement Income Stream (RIS) are sometimes referred to as the pension (broadly defined) problem September 2024 FNCE20003 Lecture 7 3  The pension problem there are traditionally four ‘pillars’ of retiree pension provision: – individual savings – Social Security – state (government) sponsored complementary private schemes – continued earnings in retirement in western countries, there is generally an attempt to avoid a fifth pillar – family support – where children take responsibility for care of their elderly parents a problem arising in recent decades is that providing adequate Social Security benefits is increasingly becoming beyond the resources of governments September 2024 FNCE20003 Lecture 7 4  The pension problem in Australia, this problem was recognised and was a key rationale for the introduction of a state sponsored complementary private pension scheme (in 1992, the “Superannuation Guarantee Scheme”, SGS) it had become clear that the existing system of funding and providing social security in retirement was not sustainable the existing system had worked because until relatively recently, the proportion of persons in OECD countries in working age (say 18-65) and persons over working age (i.e. over 65) was relatively stationary this meant that governments had the option of levying tax at a relatively constant rate to provide a pension on which retirees could live September 2024 FNCE20003 Lecture 7 5  The Demographic Imperative Figure 1. In the diagram, the proportion of retirees/workers remains at about 10% as the population increases September 2024 FNCE20003 Lecture 7 6  The Demographic Imperative however, in most countries today, the proportion of persons over working age is increasing therefore, governments no longer have the tax option, as it would lead to ‘inter-generational inequity’ – workers in successive generations having to pay more and more tax to support the increasing proportion of retirees the solution that most countries have adopted, or are in the process of adopting, is to require its working population to pay for its own retirement by contributing to government regulated funds in most countries these are called ‘pension funds’ – in Australia, they are ‘superannuation funds’ September 2024 FNCE20003 Lecture 7 7  The Demographic Imperative Figure 2. The proportion of retirees/workers is increasing over time as the population increases September 2024 FNCE20003 Lecture 7 8  Life expectancy the driver of this outcome ⇒ increased life expectancy life expectancy at birth estimates represent the average number of years that a newborn baby could expect to live, assuming current age-specific death rates are experienced through his/her lifetime in 2019-2021, life expectancy at birth was 81.3 years for males and 85.4 years for females, but for 2020-2022 it has fallen 0.1 years for each – in the previous 10 years, life expectancy had increased by 1.6 years for males and 1.2 years for females, continuing the long-term trend – this increase in life expectancy at birth reflects declining death rates at most ages post-retirement (remaining) life expectancy has also increased similarly September 2024 FNCE20003 Lecture 7 9  Australia: current life expectancies September 2024 FNCE20003 Lecture 7 10  Long-term life expectancy trend September 2024 FNCE20003 Lecture 7 11  The Demographic Imperative in other words, the population is ageing as people are living longer this means that the proportion of the population aged between age 65 and 85 is significantly greater than it was compared with, say, 20-30 years ago the latest Australian statistics state that the life expectancy of a 65yo female is 22.8 years (i.e. to 87.8yo), while that of 65yo male is 20.2 years (source) over 35% of women and 21% of men are expected to live to age 90 or more critically, the proportion of the population in age range 20-65 years, which provides tax support for the pension expectations of the over 65s, is the smallest it has ever been and will probably keep reducing (at a slower rate?) – the problem is more acute in other more rapidly aging countries September 2024 FNCE20003 Lecture 7 12  The Demographic Imperative currently there are 5 people of working age for every person over 65 – this is down from historical levels by 2031, it is forecast that there will be less than 3, and: – nine out of ten men will reach age 60 – nine out of ten women will reach age 65 – around 50% of the population will spend at least 25 years in retirement – around 40% will spend 35 years, etc. the odds of longevity are improving, as the ‘force of mortality’ is declining September 2024 FNCE20003 Lecture 7 13  The Demographic Imperative for retirees, two risks arise from the ageing issue: – longevity risk: the risk that you outlive your retirement lump sum by surviving into old age (as previously noted, longevity is only considered a risk in finance …) – inflation risk: the risk that inflation will rise significantly over a lifespan, eroding the purchasing power of your income stream (associated with longevity risk) funding retirement pensions by taxation would require an ever-increasing tax burden on each generation of workers; i.e. ‘intergenerational tax inequity’ obliging workers to fund their own future retirement in part by compulsory savings was seen as a method to avoid intergenerational inequity (and problems arising from that) September 2024 FNCE20003 Lecture 7 14  The Economic Imperative the demographic imperative is not the only one behind the need for a national savings scheme in many countries in Australia’s case, national savings had traditionally been insufficient to fund desired investment / spending programs however, with the additional pool of compulsory savings that super provides (currently around $3.85 trillion), there is an additional source of investment funds available to augment other national savings https://www.superannuation.asn.au/resources/superannuation-statistics https://www.apra.gov.au/publications/quarterly-superannuation-statistics September 2024 FNCE20003 Lecture 7 15  The Economic Imperative with all of this available cash, it is easy to appreciate that super funds play a major part in financing growth in the economy, as this cash is invested in: – equities, i.e. on ASX, including new issues of shares – bond issues of companies and governments (= debt capital) – property investment and development – infrastructure projects it therefore provides significant liquidity to the ASX, bond markets, etc. in summary, government sponsored savings schemes meet two major economic objectives – demographic and economic September 2024 FNCE20003 Lecture 7 16  Background – RIS systems traditionally, in many countries, there were/are two tiers of RIS provision (typically provided or coordinated by government): Tier 1: social security – e.g. Age Pension – a basic pension for which all may apply (but which may be means-tested) – this is still the system in Australia, UK, US, Canada, Ireland, etc. Tier 2: a 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 entitlements – note that different schemes provide different retirement benefits September 2024 FNCE20003 Lecture 7 17  The Superannuation Guarantee Scheme in 1992, a study by the country’s main economist (Dr Vince FitzGerald) provided the rationale for the introduction of a nationally coordinated RIS strategy – essentially based on the Demographic Imperative the outcome was that the Australian (Keating Labor) government initiated the Superannuation Guarantee Scheme (SGS) in the same year the main points of the SGS were (are): – a fixed proportion of every employee’s salary (originally 3%) should be compulsorily contributed to an investment account in their own name, to provide for retirement income; and – the proceeds of investment could not be accessed until genuine retirement September 2024 FNCE20003 Lecture 7 18  Superannuation scheme retirement benefits 1. Defined Benefit (DB) plans, where the amount of retirement benefit depends on how long you have been in the scheme and the proportion of salary you contributed over that time – this benefit is usually designated as a multiple of ‘Final Average Salary’ – it is not directly related to superannuation contributions 2. Accumulation schemes, or Defined Contribution (DC) plans, which provide an accumulated amount at the end of your working life – you must participate to provide yourself with an amount to fund your RIS, which will be directly related to the contributions that you make – Australia’s superannuation system is focused on accumulation (DC) schemes September 2024 FNCE20003 Lecture 7 19  Schemes work in tandem in most industries in Australia (and many other countries), DB schemes have been phased out, so the majority of workers are in DC schemes – this means the retirement lump sum, and therefore RIS, is far from certain since state-sponsored complementary private schemes have not been in place long, social security and private pension schemes must work in tandem i.e. most recent retirees have not participated in a scheme for long enough to generate a lump sum that fully funds an adequate RIS – in fact, this will continue to be the case indefinitely in many countries – accordingly, whilst some governments would prefer to phase out social security retirement benefits completely, it won’t be possible for the foreseeable future September 2024 FNCE20003 Lecture 7 20  Key features of the SGS employers are required to deduct a contribution directly from an employee’s gross salary (initially 3%, currently 11.5% and increasing to 12%) the contributions are deposited into an approved Complying Superannuation Fund (CSF) account in the employee’s name employees have some choice in respect of the type of investment fund into which monies are directed, otherwise defaulting to a MySuper account the employee has no access to the accumulated balance until he/she reaches ‘preservation age’ at the earliest, with limited exceptions as noted, super funds provide a source of investment monies in the economy, which is consistent with the second (economic) imperative of the system September 2024 FNCE20003 Lecture 7 21  Complying superannuation funds (CSFs) the SGS introduced the concept of CSFs, which are essentially the types of funds to which the regime applies for a superannuation fund to qualify as a CSF, 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 (SISA, or SIS Act), and (2) having had its regulated status confirmed the application for regulation must be in writing upon 1st tax return lodgment – in compliance with the SISA, i.e. a regulated fund not in breach of SISA September 2024 FNCE20003 Lecture 7 22  Complying superannuation funds (CSFs) why is it a good thing to be a CSF? the key reason is that CSFs are eligible for concessional (favourable) tax treatment on: 1. contributions into the fund – 15% tax instead of marginal tax rate 2. earnings, dividends and realised capital gains within the fund – taxed at 15% on earnings and dividends (reduced by franking credits), and a 10% maximum on CGs 3. lump sums and pensions taken from the fund: 0% (zero) tax if the amount withdrawn arose from a ‘taxed’ source (most common) September 2024 FNCE20003 Lecture 7 23  Non-complying super funds on the other hand, non-complying funds are taxed at 45% regardless of the reason for its being deemed non-complying non-complying funds (during a particular year) include: – non-resident funds – regulated funds contravening SISA and not ‘pardoned’ by APRA / ATO – super funds that do not elect to become regulated (very rare, maybe none) in some cases, funds can escape non-compliance status notwithstanding a breach of SISA (‘pardon’) however, even in such cases, there will be penalties applied for contravening SISA (these are in addition to the punitive tax rate if no pardon is received) September 2024 FNCE20003 Lecture 7 24  Economic impact of SGS comprehensive superannuation statistics are provided by ASFA on a regular basis (latest report) as at 31 March 2024, the total amount invested in superannuation was $3.85 trillion, i.e. $3,852,000,000,000 (an increase of > 10% in the quarter) as the figures indicate, the SGS has significantly raised national savings since its introduction – recall that there was insufficient funding for desired investments in the economy prior to the SGS – as noted, the SGS has had a positive impact on the ASX (mainly), debt markets and infrastructure investment September 2024 FNCE20003 Lecture 7 25  Minimum SGC contributions Source: http://www.superguide.com.au/how-super-works/superannuation-guarantee-rate September 2024 FNCE20003 Lecture 7 26  How does the SGS work in practice? employers are required to deduct the 11.5% contribution directly from an employee’s gross salary and deposit it into an approved (CSF) account that has been set up in the employee’s name employers are required to provide a minimum number of investment options for members, but employees are not obliged to make a selection – if, as a new employee, you already has an account with a super fund, this fund is ‘stapled’ to you as you move from job to job – in this case, your new employer will make Super Guarantee (SG) contributions into your stapled fund – if you don’t have an existing account with a super fund, your employer will put your SG contributions into a MySuper account in your name September 2024 FNCE20003 Lecture 7 27  Contributions to super how to get money into a fund: 1. a contribution is new money paid into the fund 2. a rollover is the transfer of a benefit into another fund rather than taking it as a lump sum withdrawal to be a member of a super fund, you must be eligible to contribute contributions can be made: – by an employer, from the salary package (main one) – personally (using after tax money) – on behalf of a spouse – under certain (limited) employment awards or agreements September 2024 FNCE20003 Lecture 7 28  Contributions to super in broad terms, the following are the allowable contributions to super: 1. Concessional contributions mandated (compulsory) employer contributions additional (voluntary / salary sacrifice) contributions from remuneration other rules relating to contribution, e.g. for those aged over 65 or spouses 2. Non-concessional contributions after-tax contributions or ‘undeducted’ contributions, sourced from after- tax income or personal sources tax treatment differs based on the source of contributions September 2024 FNCE20003 Lecture 7 29  Acceptable contributions – concessional a fund can accept mandated employer contributions, in most cases regardless of the employee’s age or number of hours the employee works, to a maximum of $30,000 per year (up in increments from $25,000 in 2020/21) the main payments in this category are SGS compulsory payments, which are paid on behalf of any employee aged less than 70 the other common type of concessional contributions are salary sacrifice contributions, which are voluntary extra contributions from salary – i.e. in addition to the 11.5% mandated contribution, employees can ask employers to ‘salary sacrifice’ additional contributions, but note they are counted towards the concessional (before-tax) contributions cap of $30,000 September 2024 FNCE20003 Lecture 7 30  Salary sacrifice contributions like the SGS compulsory payments, salary sacrifice contributions are pre-tax to the employee, and are therefore subject to the 15% contributions tax example: assume a gross salary package of $90,000 meaning there will be a compulsory contribution of $10,350 (11.5% of $90,000) – tax on the net $106,800 taxable income = $16,276 (assumes no deductions, etc.) under a salary sacrifice arrangement up to the concessional contribution limit, an extra contribution of $19,650 will be made ($30,000 – 10,350) this leaves $60,000 taxable income and total tax (including CT) = $12,935.50 → a tax saving of ($16,276 – $ 12,935.50) = $3,340.50 → however, this tax saving is retained in the super fund September 2024 FNCE20003 Lecture 7 31  Acceptable contributions – concessional Other acceptable concessional contributions: – Personal super contributions – SG shortfall components / award contributions under an industrial agreement – payments from SHASA (superannuation holding accounts special account) – under age 65 without restrictions; contributions on behalf of a spouse aged under 65 also allowed – between 65 and 70, if “gainfully employed at least on a part-time basis”*; contributions on behalf of a similarly employed spouse can also be accepted – between 70 and 75, if person is gainfully employed on at least on a part time basis, but spouse contributions not allowed if spouse is over 69 * defined as working at least 40 hours in a period of not more than 30 consecutive days September 2024 FNCE20003 Lecture 7 32  Limitations on concessional contributions prior to 1 July 2017, the general concessional contributions cap was $30,000 p.a. to age 49, and $35,000 for over 49s (down from age 59), but now the maximum of $30,000 applies to all any contributions in excess of the relevant cap will attract punitive tax treatment (in essence, the excess is taxed at individual MTR and not the 15% concessional CSF rate but, the rules are too detailed for this course) note that special rules apply to employees aged over 65, and to individuals with salary income over $260,870 p.a. – i.e. $260,870 x 11.5% = $30,000 – however, carry-forward provisions apply from 1 July 2018 September 2024 FNCE20003 Lecture 7 33  Acceptable contributions – non-concessional non-concessional contributions, also known as after-tax contributions or undeducted contributions (UDC), are sourced from after-tax income or other personal sources – e.g. savings, gifts, inheritances, lottery or gambling winnings, etc. no tax is deducted from such contributions when made to the super fund the reason for this is that the contributor hasn’t claimed a tax deduction, or received any other type of tax concession, on the money contributed however, any earnings that a super fund derives from non-concessional contributions are usually* taxed at the super fund rate of 15% September 2024 FNCE20003 Lecture 7 34  Acceptable contributions – non-concessional a limit of $120,000 is placed on non-concessional contributions (UDC) in any one year(up from last year, but down from $180,000 since 1 July 2017) – the non-concessional contributions cap is set at four times the concessional contributions cap, moving with indexation current arrangements allow persons under 75 (previously 65/67) to bring forward two years of UDC in any one year so, a member is now able to contribute up to $360,000 in the current year – this is subject to a cap of $1.66m (indexed) if a member brings forward UDC to the maximum, he/she is not able to make further UDC in the following two years September 2024 FNCE20003 Lecture 7 35  Acceptable contributions – non-concessional exemptions from the non-concessional contributions cap include: (i) proceeds from disposal of an eligible small business, in the form of either the “Small business 15-year exemption” or the “Small business retirement exemption” (both exemptions apply up to a lifetime limit of $1.782m. indexed) (ii) “downsizer” contributions from selling your home (iii) contributions made from a settlement resulting from permanent injury or disablement the transfer of an overseas superannuation balance is also typically exempt non-concessional contributions cannot be split with a spouse (see next), but it’s probably not difficult to structure to achieve the desired outcome September 2024 FNCE20003 Lecture 7 36  Contributions splitting since January 2006, contributions into a superannuation fund may be split with a member’s spouse (if also a member of the fund) this can be useful if there is a large disparity in incomes, as often the wife (in the typical case) will have lower super assets – her balance can be boosted by contributions from the husband changes introduced recently have made contribution splitting less effective than before, but there are still benefits in circumstances where the specific rules in this area are met in addition, certain low to middle income employees may be eligible for a government co-contribution (up to $500) September 2024 FNCE20003 Lecture 7 37  Super benefit accumulation the main theme of this subject is that the objective of those in accumulation phases (i. to iv.) is to maximise the amount of lump sum (super) benefit the total amount of lump sum benefit that is accumulated in an employees’ super account to retirement will depend on a number of factors, including: – contribution level (recall that contributions in addition to the obligatory 11.5% can be ‘salary sacrificed’ at concessional tax rates to boost the final lump sum) – asset allocation and long-term yields – income level and growth – taxation of contributions and fund earnings – time in the SGS scheme September 2024 FNCE20003 Lecture 7 38  Forecasting accumulation under the SGS the question thus arises as to what level of benefit accumulation is likely – i.e. how can we determine the amount to be accumulated for retirement? to answer this, we need a method of taking into account all variables that will contribute to the accumulation, such as contribution rates, return on investment, length of accumulation, etc. such model of expected accumulation value (EAV) can be calculated by the following formula, which essentially determines the FV of an accumulation over n years based on all relevant variables (contributions, earnings, tax, and so on) there are many online EAV calculators available September 2024 FNCE20003 Lecture 7 39  Expected Accumulation Value (EAV) EAV = SS x CR x (1-tc) x {r/r(p)} x {(1+r)n - (1+g)n}/(r-g) where r(p) = p{(1+r)1/p - 1} and – SS is annual starting salary – CR is contribution rate, i.e. proportion of annual gross salary contributed to fund – tc = tax on contributions – r is expected net annual compound earning rate of the fund note that implicitly accounted for in r is tax on fund earnings, realised capital gains and management fees (hence, net) – p is the number of times per year the fund adds contributions to the fund; used in r(p) = p{(1+r)1/p -1}, – n is the number of years of accumulation – g is the expected annual compound rate of salary growth September 2024 FNCE20003 Lecture 7 40  EAV example consider a new employee aged 23, starting a new job at a gross salary of $60,000 p.a. under SGS, 11.5% of this gross is contributed quarterly in arrears into an investment fund, which averages 9% p.a. return net of taxes and fees – a 9% p.a. return is based on the long-term studies of equities returns tax on contributions is 15% and average rate of salary growth is 4% p.a. – note: in practice, Average Weekly Ordinary Time Earnings (AWOTE) growth has been a little more than this, so the assumption is reasonable Find the expected accumulation over 35 years September 2024 FNCE20003 Lecture 7 41  EAV example EAV = SSCR(1-tc){r/ r(p)}{(1+r)n - (1+g)n}/(r-g) where r(p) = p{(1+r)1/p - 1} so, plugging the known variables: EAV = 60,000  0.115  (1-0.15)  {0.09/ 0.09179}  {(1.09)35 - (1.04)35}/(0.09-0.04) = 1,995,706 i.e. the expected accumulated value is $1,995,706 in ‘n = 35 years’ money (FV) – note, it would be $1,648,627 at a 9.5% contribution rate – also, it would be $3,224,614 if over 40, not 35, years (at 11.5%) September 2024 FNCE20003 Lecture 7 42  Current worth of the accumulation if the RBA meets its 3% p.a. inflation target, then purchasing power would be deflated by 1.03-35, to a factor of 0.3554 – this is because $1.00 of today’s money will need $1.00×1.0335 in 35 years’ time to maintain purchasing power (1.0335 = 2.81) the SGS accumulation of $1,995,706 would be worth about $709,200 in today’s money i.e. $ 1,995,706 / 1.0335 = $709,241 – this obviously has implications in relation to funding costs in retirement as noted, if the contribution was for 40 years instead of 35, EAV increases to $3,224,614, with purchasing power of about $988,500 in today’s money September 2024 FNCE20003 Lecture 7 43  Factors that will increase an accumulation in respect of the accumulation formula: – a higher earning rate (r) – a higher rate of salary growth (g) – staying in the scheme longer (n) – a higher employer contribution rate (CR) – reduced taxes on contributions / fund earnings (tc) in addition: – making after-tax undeducted contributions (UDCs) e.g. from bequests, lottery winnings, bonuses and other unexpected windfalls – use of salary sacrifice September 2024 FNCE20003 Lecture 7 44  Factors that will reduce an accumulation in respect of the formula: – diminution in r, g, CR, n, etc. and increase in taxes periods of non-contribution (unemployment, family-raising) poor choice of long-term investment portfolio (‘choice of fund’) and/or investment manager unexpected changes to the SGS – i.e. legislative risk divorce (splitting of super assets; note that up to 40% of Australian marriages end in divorce …) September 2024 FNCE20003 Lecture 7 45