FNCE20003 Introductory Personal Finance Lecture 8 2024 PDF

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

FNCE20003 Introductory Personal Finance Lecture 8 Funding retirement II Lecturer – Tony Cusack September 2024  Lecture 8 topics Types and regulation of superannuation funds Accessing accumulated superannuation Superannuation pensions and annuities – pricing of pensions and annuities Taxation of superannuation benefits September 2024 FNCE20003 Lecture 8 2  Main types of superannuation funds a. Corporate funds; run by companies for their employees b. Industry funds; large funds catering for entire industries c. Public sector funds d. Public offer or retail funds e. Small funds (largest sector in the industry) f. Master funds or trusts comprising holdings in groups of funds (a, b and d) September 2024 FNCE20003 Lecture 8 3  Current super funds in Australia September 2024 FNCE20003 Lecture 8 4  4 years ago – funds as at 30 June 2020 September 2024 FNCE20003 Lecture 8 5  Superannuation funds asset allocation September 2024 FNCE20003 Lecture 8 6  Superannuation fund growth estimates September 2024 FNCE20003 Lecture 8 7  Regulation of super funds as previously noted, the statute applicable to super funds is The Superannuation Industry Supervisory Act 1993 (SIS Act), and with only one exception (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 (i.e. ATO deals with millions of customers, mainly individuals, whilst APRA deals with hundreds of medium to large entities) ATO sees itself as “protecting the integrity of the system” (source) September 2024 FNCE20003 Lecture 8 8  Two types of small funds 1. Self-managed superannuation fund (SMSF) – no more than six (until 1 July 2021, it was four) members – usually each member is a trustee (or director of the corporate trustee), who cannot be remunerated – regulated by the Australian Taxation Office (ATO) – see stats 2. Small Australian Prudential Regulation Authority fund (SAF) – maximum of six (also previously four) members – has a corporate trustee (only) – regulated by APRA (like all other funds except SMSF) September 2024 FNCE20003 Lecture 8 9  SMSF v SAF SMSFs and SAFs can be quite similar, but note: – SAFs are subject to APRA regulation, SMSFs are regulated by the ATO – a SAF must have an ‘approved’ trustee, which needs to be a licensed professional trustee company – SMSF trustees must be fund members (either directly or indirectly) – a SAF can include as a member an arm’s length person such as an employee, but a SMSF cannot (only family members) SMSFs are also differentiated on the basis that the members will (must) actively participate in management – S.17A of the SIS Act September 2024 FNCE20003 Lecture 8 10  Self-Managed Superannuation Funds like all super funds, SMSFs are designed to provide tax-efficient retirement benefits to members of the fund (“sole purpose”) a SMSF can be established from an accumulated balance rolled over from an existing super fund – e.g. a lump sum from an industry fund, the member’s accumulated balance – it’s not ‘released’, so no tax will be payable on the lump sum at that time alternatively, it can be established by cash and/or asset contribution the trustee has wide discretion in selection of investments for the fund – as covered, these investments enjoy tax advantages if the fund is established as a CSF under existing SIS legislation September 2024 FNCE20003 Lecture 8 11  Super funds are set up as a trust 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 each super fund must therefore have a trustee appointed trustees have a “fiduciary duty” to the fund member(s) – it’s analogous to the fiduciary duty of financial planners, and similarly the subject of a number of explicit statutory duties 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 September 2024 FNCE20003 Lecture 8 12  SMSF trustees key rule: ‘all members are trustees, all trustees are members’, which means that 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 individuals are eligible to be SMSF trustees provided that they: – are over the age of 18 – do not have a mental disability – are not an undischarged bankrupt (or are not insolvent and under administration) – have not been convicted of an offence involving dishonesty – have not previously received a civil penalty under superannuation legislation – have not been disqualified by a superannuation regulatory body (ATO or APRA) September 2024 FNCE20003 Lecture 8 13  SMSF corporate trustees as noted, a corporate trustee (company) can be used to meet the ‘all members are trustees, all trustees are members’ requirement in this case, all fund members must be directors of the trustee company companies are eligible to be SMSF corporate trustees provided that: – they have not been deregistered by ASIC – they do not have any directors or other responsible officers who are disqualified individuals – they have not had a receiver or provisional administrator appointed to manage their operations a corporate trustee is recommended, as SMSF trustees have legal exposure September 2024 FNCE20003 Lecture 8 14  Specific trustee duties act impartially invest promptly and prudently exercise discretions properly seek advice obey terms of trust deed protect assets not act under direction keep proper accounts act in best interest of beneficiaries act with reasonable skill and diligence avoid conflicts of interest sign an undertaking that they have act personally read and understand the trust deed act unanimously avoid compliance errors September 2024 FNCE20003 Lecture 8 15  Super fund Trust Deeds super fund Trust Deeds must contain provisions that are in compliance with the SIS Act, including: – precise definition of benefit types and payment procedures – a written investment strategy, describing the sorts of investments are that the fund is allowed to undertake – process for admission and removal of members – procedures for amending the trust deed – procedures for winding up of the fund, etc. each Trust Deed must also explicitly state that the fund’s sole purpose is providing retirement benefits September 2024 FNCE20003 Lecture 8 16  Sole Purpose Test as noted, it is a fundamental requirement that a regulated fund is maintained solely for provision of retirement benefits to members – i.e. funds are required to meet the Sole Purpose Test specifically, this rule means that funds must operate to provide: 1. retirement benefits accumulating prior to retirement or meeting another condition 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 (e.g. industry, retail), this rule is very unlikely to be breached, but the risk of breach increases for small funds September 2024 FNCE20003 Lecture 8 17  Sole Purpose Test regulators treat the sole purpose test as a very strong test, and deem it breached if current member (or other) benefits are provided – highlighted by the finding in the Swiss Chalet case the consequences of a breach can be significant, e.g. non-complying status in practice, it has been established that related benefits may be provided, as long as the core benefits above are provided, e.g. – provision of life insurance (but see ATO ID 2015/10) – provision of benefits to a contributor to the fund on termination of employment – provision of benefits in the case of ill-health September 2024 FNCE20003 Lecture 8 18  Lecture 8 topics Types and regulation of superannuation funds Accessing accumulated superannuation September 2024 FNCE20003 Lecture 8 19  Accessing accumulated superannuation to access an accumulated superannuation balance, a condition of release must be met (next slide) the main conditions of release are retirement from the work force (but not in all cases) or reaching age 65 without retiring when a condition of release is met, the accumulated balance can be withdrawn free of tax in full or in part, for any purpose (e.g. to pay off a mortgage, go on a holiday, give money to children, etc.) however, since the key objective of the accumulation is to satisfy the need to provide a pension or ‘retirement income stream’ (RIS), retirees need to be careful how they spend accessed super $ September 2024 FNCE20003 Lecture 8 20  Conditions of release as noted, an accumulated super lump sum may be accessed only when a ‘condition of release’, defined as one of the following, is met – retirement on attaining preservation age (which is 60 for all born after 1 July 1964, and earlier for those born before that date; minimum 55, if born before 1 July 1960) – (genuine) termination of employment on or after age 60, irrespective of future employment intentions – reaching age 65 (no other conditions) – death – becoming permanently incapacitated ** – being able to demonstrate severe hardship ** – ‘compassionate grounds’ ** September 2024 FNCE20003 Lecture 8 21  Conditions of release by far, the most commonly met conditions of release are (i) retirement after age 60, or (ii) reaching age 65 without retiring ** the final three grounds are usually very strictly interpreted / applied – e.g. qualifying on compassionate grounds usually relates to terminal illness, such as contraction of cancer and need of palliative care – note, these will often be taxed differently to other withdrawn benefits – in 2020, there was a Covid-19 “early release” scheme allowing some access the rules also allow for the payment of a ‘non-commutable’ income stream during a period of temporary incapacity (again, very limited) and one other note also ‘transition to retirement’ (TTR, or ‘TRIPs’) arrangements September 2024 FNCE20003 Lecture 8 22  RIS – how much is needed? now to the question that keeps arising: how much is needed? it obviously varies with personal circumstances: expenses, lifestyle expectations, location, family situation, life expectancy, and health ASFA ‘Retirement Living Standards’ for 65-85 year-olds as at June 2024, p.a. – Comfortable lifestyle $73,337 (couple) $52,085 (single) – Modest lifestyle $47,731 (couple) $33,134 (single) – these figures assume that the retirees own their own home outright and are relatively healthy (note: the numbers are lower for >85 year-olds) September 2024 FNCE20003 Lecture 8 23  Lecture 8 topics Types and regulation of superannuation funds Accessing accumulated superannuation Superannuation pensions and annuities – pricing of pensions and annuities September 2024 FNCE20003 Lecture 8 24  Superannuation pensions and annuities pensions and annuities are probably the most effective ways to provide a RIS the technical difference between them is that: – pensions are provided from a super fund, by drawing directly on the fund – annuities are purchased from an annuity provider such as a Life (insurance) Office, bank or commercial provider e.g. Challenger Financial Services, Australia’s biggest provider of annuities broadly speaking, annuities can be purchased by anyone at any age to provide an income stream so, an annuity can be purchased as a RIS using funds from the ‘released’ super accumulation (i.e. a Condition of Release must have been met) September 2024 FNCE20003 Lecture 8 25  Superannuation pensions and annuities technically, (superannuation) pensions are known as account-based RIS – income payments directly from retiree’s superannuation fund account – the specific basis for payment is defined in a trust deed and depends on the member’s eligibility on the other hand, annuities are known as non account-based RIS – income payments made by 3rd party providers / sellers of income streams – the RIS payments arise from a personalised contract (policy) between the seller (e.g. 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) September 2024 FNCE20003 Lecture 8 26  Account-based pensions so, a super fund (account-based) pension is a RIS that is funded by drawing regularly on the accumulated lump sum individuals are, to a large degree, free to choose the amount they take in the form of a pension each year (it can even be 100%) however, a minimum drawdown amount will be required to ensure that the capital is generally drawn down over time – the minimum pension payments are set out as a percentage of the Pension account balance, based on age of the pensioner (next slide) – no maximum will apply (with the exception of pensions commenced under Transition-To-Retirement arrangements, not covered in this course) September 2024 FNCE20003 Lecture 8 27  Minimum pension income percentages pensions drawn in excess of the minimums are tax-free September 2024 FNCE20003 Lecture 8 28  Account-based pension standards the minimum standards for account-based pensions require: – 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, as noted) – an amount or percentage of the pension cannot be prescribed as being left-over when the pension ceases – 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 September 2024 FNCE20003 Lecture 8 29  Account-based payment standards in the first year, the minimum required payment is pro-rated based on number of days remaining; thereafter, it is 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) – typically, there is no maximum payment specified, unless TTR involved (then 10% maximum) or Fund Deed imposes a maximum (rare) commutations are allowed at any time may be reverted on the death of recipient, but only to a dependent September 2024 FNCE20003 Lecture 8 30  Account-based pension issues account-based pensions carry more risk than (non-account) fixed term and lifetime RIS, as the balance can be drawn down to zero quite quickly the tradeoff to this risk is their potential for better capital growth and returns, plus 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 they can be used to deliver both basic income and discretionary income – the latter is extra drawings, if required (e.g. emergencies) – this typically is not an available option with non-account based RIS September 2024 FNCE20003 Lecture 8 31  Non-account based RIS as noted, non-account based RIS are those 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 member or reversionary beneficiary; or – a specified fixed 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 (uncommon) September 2024 FNCE20003 Lecture 8 32  Types of non-account based RIS fixed term, or term certain, annuities – commutable income stream payable for a fixed term and priced based on the recipient’s age at commencement life, or lifetime, annuities – paid for as long as the purchaser / annuitant is alive (and stops as soon as the annuitant dies) – compared to term certain annuities, they are relatively expensive – their pricing is based on actuarially determined life expectancies (e.g. the Australian Government Actuary’s mortality table) September 2024 FNCE20003 Lecture 8 33  Non account-based RIS issues the key variables driving the amount of RIS from annuities are: 1. purchase price, i.e. the amount of lump sum used to purchase 2. term of the annuity 3. implicit market interest rate the first two are self-explanatory, e.g. the larger the amount spent on the annuity, the higher it will be, and the longer the term of the annuity, the lower will be each annuity payment the 3rd element is essentially the interest yield (return) on the lump sum – analogous to the interest rate on a mortgage loan, but fixed not variable – the interest rate level has a significant impact on the amount of RIS received September 2024 FNCE20003 Lecture 8 34  Choosing the appropriate RIS near retirees are therefore faced with some decisions as to how best to maximise their RIS most are reluctant to take equities (or property) market risk with their accumulation, so will typically not take it as a lump sum and invest as we have noted, if the lump sum accumulation is low, the Age Pension might be available to supplement the RIS from that lump sum next, we will go through the pricing of purchased annuities – will focus on term certain annuities, not life annuities (more expensive) – the same pricing formula could be applied to determine the amount to draw down under an account-based pension September 2024 FNCE20003 Lecture 8 35  Pricing of annuities (and pensions) note that these are priced as an ordinary annuity, which is characterised by the following features: i. the periodic payments occur at the end of regular intervals (e.g. at the end of each month or year) ii. the effective rate of interest, i, per payment interval remains fixed for the term of the annuity (thus the adjustment term in the formula) iii. the term is a fixed number, n, of regular intervals recall pricing of an ordinary annuity, e.g. An = R[1- (1+r)-n]/r in these circumstances, the unknown variable is R, which can be determined via the known variables September 2024 FNCE20003 Lecture 8 36  Annuity example a retiree looking to spend $300,000 on a 15-year annuity available at a yield of 5.5% p.a. would be required to pay (PV of $1 p.a.): a15,0.055 = (1-1.055-15)/0.055 = 10.0375809 interpretation: the purchaser must pay $10.0375809 for each annual dollar of this annuity (this would change if period changed) so, $300,000 would provide an annual amount of $29,887.68 paid at the end of each year, i.e. 300,000 / 10.0375809 = $29,887.68 annual annuities are not common in practice September 2024 FNCE20003 Lecture 8 37  Term certain annuities and pensions more practical than an annual payment is an annuity payable at regular intervals, i.e. p times a year – predicated on a fixed rate of interest – payable for a fixed term – can be indexed in various ways – there are restrictions on this if they are ‘complying’ annuities (this is only relevant to certain pre-2007 annuities – we will ignore these, as no new complying annuities can be bought) can have a residual capital value (RCV) at the end of term – this would have the effect of reducing the amount of annuity stream purchased September 2024 FNCE20003 Lecture 8 38  Cost of term certain annuities example: a 20-year annuity payable monthly (p = 12) calculated at a yield of 6.19%, costing $100,000 as both (i) unindexed, or (ii) indexed at 3.0% p.a. in the first year, $A(1/12) is payable at the end of each month (i) for 20 years or (ii) for the first year – for (ii), in the first month of the 2nd year, this amount is indexed to $A(1.03/12), which is then payable at the end of each month throughout the 2nd year, etc. for each annual dollar of unindexed annuity over 20 years, the up-front cost is $11.61206 and the indexed annuity costs $14.70708 (see next slide) these figures derive from the formulae explained on the next few slides – e.g. the formula underlying calculation (ii) is a growth annuity formula September 2024 FNCE20003 Lecture 8 39  Unindexed term certain annuity unindexed, given i = 0.0619, n = 20 and p = 12: an:i(p) = where i(p) = p[(1+i)1/p-1] (to preserve annual i, given monthly payments) i(p) = 12{(1.0619)1/12-1} = 0.0602103, so i/i(p) = 1.028 and a(p)n:i = 11.61206 accordingly, total unindexed income amount p.a. = (100,000 / 11.61206) = $8,612 and monthly unindexed income stream = $8,612 / 12 = $717.67 September 2024 FNCE20003 Lecture 8 40  Indexed term certain annuity indexed (rate of indexation g% at the start of each year after the first): an:i:g(p) = again: i(p) = 0.0602103 and i/i(p) = 1.028, so a(p)n:i:g = 14.71708 accordingly, monthly indexed income stream in first year = (100,000 / 14.71708) = $6,794.83 / 12 = $566.24 monthly amount in the 2nd year = $566.24 x (1.03) = $583.22 … and monthly amount in the 20th year = $566.24 x (1.0319) = $992.89 September 2024 FNCE20003 Lecture 8 41  Term certain annuities assume a 65 year-old decides that she requires a 25-year annuity and a RIS of $2,000 per month (p.m.), indexed at 3% the unit cost due to extra 5 years rises from a(12)20:0.0619:0.03 = $14.71708 to a(12)25:0.0619:0.03 = $17.19387 for each dollar of annuity in the 1st year for a RIS of $2,000 p.m., she would need to pay ~$413,000 (17.19 x 24,000) – if she had access to a higher interest rate, e.g. 8% p.a., this annuity would be less expensive – she would only need ~$345,000 to provide $2,000 p.m. – if the interest rate was only 3.75%, the cost would be ~$540,000 these examples highlight the importance of market interest rates in determining the amount of RIS by annuity September 2024 FNCE20003 Lecture 8 42  Retirement phase arrangements recall that when a condition of release is met, the member can access the accumulated lump sum and has choices in how to deal with it at the point in time when the member decides to withdraw from the lump sum, the member account is in ‘retirement phase’ the assets comprising the member’s account balance (to fund the pension) are held in an account in the fund designated ‘pension account’ (note: cap) key point: earnings on this account are tax exempt, as are the pension payments if the minimum pension is drawn note also that it is still possible to keep contributing to super in retirement phase, even if a pension is being drawn from the released benefits September 2024 FNCE20003 Lecture 8 43  Retirement phase arrangements that is, if the member is still working at least part time but has also met a condition of release (e.g. is aged over 65), then s/he can still contribute to an accumulation account in the fund in these circumstances, the member will have two accounts in the super fund: a pension account and an accumulation account this is not possible in accumulation phase, only in retirement phase – i.e. when a pension is taken after meeting a condition of release earnings on the pension account assets remain tax free, but earnings on the accumulation account are taxed at 15% (as are the contributions) the fund trustee must be careful in maintaining the different accounts September 2024 FNCE20003 Lecture 8 44  Superannuation and the Age Pension as previously noted, the Age Pension operates as a ‘safety net’ for retirees who provide for their own pension from a lump sum – it is the same in many overseas systems current data shows that many Australian retirees are still reliant on the Age Pension for at least some of their RIS accordingly, the interaction between the Age Pension and superannuation remains important this means that FPs should maintain a detailed knowledge of precisely how the Assets Test and Income Test apply to determination of Age Pension entitlements in different circumstances September 2024 FNCE20003 Lecture 8 45  Lecture 8 topics Types and regulation of superannuation funds Accessing accumulated superannuation Superannuation pensions and annuities – pricing of pensions and annuities Taxation of superannuation benefits September 2024 FNCE20003 Lecture 8 46  Superannuation taxation recall that tax incentives on superannuation relate to four different stages: 1. Concessional contributions: when you, or your employer, makes concessional (before-tax) contributions, they are taxed at the concessional rate 2. Non-concessional (after-tax) contributions and co-contribution: indirectly, when you make a non-concessional (after-tax) contribution – although this type of contribution does not directly receive any tax incentives, the investment earnings on these contributions are concessionally taxed (see next) 3. Investment income on super fund investments: when your super fund earns income on fund investments 4. Superannuation benefit payments: when your super benefit is released September 2024 FNCE20003 Lecture 8 47  Taxation of super fund benefits it follows that the income tax system applicable to individuals is not directly applicable to super fund benefits the circumstances, nature and timing of access to super fund benefits will drive the taxation consequences as noted earlier, in most cases, no tax will apply to super benefits that are accessed after a condition of release has been met however, there may be a tax liability on one or more components of an accessed benefit, depending on specific circumstances – under the rules, a distinction is made between “taxable component” and “tax- free component” of accumulated super benefits (too much detail for this course) September 2024 FNCE20003 Lecture 8 48  Taxation of death benefits technically, lump sum death benefit payments will be tax free if paid to a death benefits dependant (dealt with Division 302 of the ITAA) – this covers spouse, children under 18 at time of death, and other persons who are financially dependent on the deceased any taxable component of a lump sum (uncommon) paid to a non-dependant will be taxed at 15% the taxation of a death benefit that is paid as a ‘reversionary pension’ will depend on the age of the reversionary beneficiary – reversionary: reverts to a nominated beneficiary September 2024 FNCE20003 Lecture 8 49  How tax applies to your super in summary, to work out how your super withdrawal will be taxed (if at all), you need to know: – your preservation age and the age you will be when you get the payment – whether any of the money in your account is taxable (uncommon) – whether you will get the payment as an income stream or lump sum these factors determine whether you: – pay any tax on the withdrawal (for example, whether it is taxable income) – get tax offsets that reduce the amount of tax you pay see: https://www.ato.gov.au/individuals/super/withdrawing-and-using-your-super/tax-on-super-benefits/ September 2024 FNCE20003 Lecture 8 50