Could the change in the Age Pension assets test make it safer to take more risk?
07 Nov 2016
On 1 January 2017 reductions to the assets test limits for the Age Pension will be introduced. It is estimated that 300,000 people will lose all or some of their pension. In the worst cases singles will lose $9,721 pa and couples $14,002 pa.
Many retirees have already endured pain in recent years as interest rates have fallen to historic lows. For many the Age Pension assets test changes will compound this income loss.
How will the changes impact the rest of your retirement?
If you are asset tested and homeowners with counted assets above $291,000 (single) or $453,500 (couple), you will see a reduction in your Age Pension. And for single homeowners with tested assets over $542,500 and home owning couples with assets exceeding $816,000 you will no longer receive any age pension support.
But there is a silver lining.
Currently, as your assets reduce, the age pension provides the equivalent of 3.9% pa income. For example, if your assets fall in value by $10,000, your age pension entitlement increases by $390 pa. From 1 January 2017, this asset test taper rate doubles, meaning that as your assets reduce, the age pension will provide the equivalent of 7.8% pa income, nearly three times term deposit rates. This represents an increase in entitlement of $780 pa for a $10,000 fall in asset value.
This is a significant change and has the potential to act like a put option (a financial instrument that helps protect you in falling markets). It also requires a change of thinking regarding your retirement investment strategy.
The first instinct may be to find ways to reduce the level of counted assets such as improving your home (a non-tested asset), going on a holiday, gifting within the allowable limits or buying a long-term annuity with a depleting asset value. However, many of these options potentially compound the problem you are trying to fix – that is they reduce your cash flow further.
Is reducing your assets the best strategy?
There is however another strategy where you don’t have to reduce your assets. The strategy is to take more risk specifically by increasing your allocation to growth assets, such as shares and property. This concept is challenging but let’s consider the following.
Under the new asset test rules, accepting more volatility with your retirement assets could not only reward you over time (with a higher long-term return), but if markets drop and you fall into the new asset limits, you will receive an effective Age Pension return of 7.8% pa on top of your dividend income, while you wait for the markets to recover. The dividend yield on Australian shares is currently 4.6% pa with imputation credits adding a further 1.7% pa.
So what could your investment strategy look like?
If you are currently in a defensive investment position, then you should consider shares carefully. You need to ensure you have a high level of diversification plus still have sufficient funds in low risk assets (like cash and term deposits) to draw from when your shares fall. Holding seven years worth of living expenses, or 10 years if you are ultra-conservative, in low risk assets would substantially reduce the need to sell your shares before they recover their value.
A well-considered strategy should:
- cover 7-10 years of your future living needs through low risk investments
- give you higher income from your shares, with tax credits
- add diversification through international shares and property/real estate investment trusts (REITs)
- provide an effective put option (or protection) if share markets fall, represented by the Age Pension.
To test the effectiveness of the investment strategy and how it can work to your advantage, let’s look at John and Patricia who are homeowners. They have $800,000 in counted investment assets and their living expenses are $50,000 per annum. They currently receive an age pension of $14,746 pa however after 1 January 2017 it is expected to fall to $1,248 pa.
We will compare three different options open to them:
- Investing $800,000 (100%) in low risk term deposits and cash (defensive assets only)
- Investing $500,000 in low risk/defensive investments and $300,000 in higher risk investments (shares and REITs) with long-term returns (forecast market returns)
- Investing $500,000 in low risk/defensive investments and $300,000 in higher risk investments (shares and REITs) with a repeat of the past decade of actual returns, from 2007 to today (2007-2016 repeat). Importantly this period includes the GFC.
- A 2.5% interest rate per annum on the low risk/defensive investments.
- Where there is a cash flow shortfall (that is, where interest income, dividend income and any age pension does not meet the living needs), the shortfall is drawn from the low risk/defensive investments, leaving the shares alone.
- The higher risk investments are invested as follows:
- Options 2 and 3 retain the conservative 10 years of annual expenses in low risk/defensive investments.
- Asset and income test calculations apply and assume full income testing applies to all assets (ie no grandfathering on any account based pensions)
From the below chart the best outcome for John and Patricia is the forecast market return and the next best is taking on risk and enduring a repeat of the GFC. The shaded area represents the value-added by the Age Pension.
The chart below breaks down the contributions to cashflow for John and Patricia’s living needs. It shows that there is a larger Centrelink contribution in the 2007-2016 repeat, a lower draw on their own capital and a higher end asset value.
So it makes sense for John and Patricia to take on risk since both the forecast market returns scenario as well as the 2007-2016 GFC repeat scenario will see them better off than if they were to be in defensive assets only.
The changes to the Age Pension Assets test on 1 January 2017 are significant and may require a change of thinking regarding investing your retirement assets. Paradoxically for some, it could mean that by taking more risk with your retirement assets not only could you reward yourself over time (with a higher long-term return), but if markets drop, you could receive an effective age pension return of 7.8% on top of your dividend income. You also don’t need to panic and sell your shares when they are falling because of your buffer in defensive assets. And when the sharemarket recovers, you don't need to repay the extra age pension you received when it was down.
Now is the time to revisit your options and seek professional financial advice. A properly structured and monitored retirement plan can improve your ability to achieve your objectives. Education and quality advice can take the emotion and fear out of share investing, build in contingency plans, improve your lifestyle, reduce your stress and even allow you to have greater wealth to pass onto your beneficiaries.
If you have friends or family who are aged 65-75, own their own home and have all their retirement savings in cash and term deposits, then perhaps this type of strategy could help them. For more information have them contact us.
1 Age Pension: 300,000 plus Australians lose entitlements from January 2017, 15 June 2016, SuperGuide
2 ASX300 Ex-A REIT Index, weighted average dividend to price using 12 month historical net dividends per share.
3 Based on indicated dividend yield, dividend franking percentage and the current stock price.
4 Based on actual returns in the GFC, replicated. 2018 = 2008, 2019 = 2009, etc.
5 S&P/ASX 300
6 MSCI World
7 FTSE EPRA/NAREIT Developed TR Hdg AUD
8 S&P/ ASX 300 A-REITS