How an Allocated Pension Works
Allocated Pensions are, according to the MLC website, the most popular type of retirement income streams. They offer a tax effective way of withdrawing money from superannuation and are treated kindly by the Centrelink income test. They also provide the allocated pension owner with a reasonable degree of flexibility. Given their popularity, it is worth taking the time to understand how they work, in case they should suit your circumstances.
Allocated pensions have to be started using superannuation money. With the rules for contributing to superannuation more relaxed than ever before, just about anybody under the age of 65 should be able to contribute money to superannuation.
An allocated pension is designed to provide an income stream. Each year a person is able to withdraw an amount of income, between a minimum and maximum value. I generally suggest the withdrawal of the minimum amount each year, as this will ensure that your income lasts further into retirement. Let us work through the calculations behind an allocated pension as we progress through this article. In this case, let us assume a 67 year old lady who is retiring with an allocated pension that has $500,000 in value at the start of the first year. The 'pension factors' for the first years income for a 67 year old, which can be looked up from an allocated pension table, are - minimum 14.9, maximum 7.6. To work out the minimum allocated pension we divide the account balance ($500,000) by the factor (14.6) and then round the resulting income to the nearest $10. This gives us an income of $34,250. The maximum allocated pension is $500,000 divided by 7.6, which is $65,790.
Let us assume that the person draws the minimum pension for the year of $34,250. After withdrawing that amount of money there is $456,750 remaining in their allocated pension account. Let us assume that over the course of the year investment returns are very good, and the assets in the allocated pension account increase in value by $44,250. At the end of the year the allocated pension account would also have increased by that amount to $510,000. That means for the next year, when the allocated pension owner is now 68, the minimum and maximum income streams are calculated using an allocated pension account value of $510,000.
There are a couple of points to make here. One is that every allocated pension is invested in some assets, and the investment returns of those assets will be important to the ability of the allocated pension to keep making payments. If the assets chosen are too conservative, say 100% invested in cash, then the lower investment returns will mean the allocated pension account may diminish in value more quickly. Conversely, if too much of the account is invested in more volatile asset classes, then the allocated pension account may decrease significantly in value during a period where investment returns are poor.
The second point to make here is that they investment returns from an allocated pension are tax free.
Tax Efficiency of an Allocated Pension
There are three ways in which an allocated pension is particularly tax efficient. The first is that a proportion of a persons income stream may be able to be withdrawn tax free each year. The second is that on all taxable income withdrawn from an allocated pension there is a 15% pension rebate. The third is that investing your superannuation money into an allocated pension income stream will avoid any lump sum withdrawal tax.
The tax free portion of an allocated pension comes about when a person has made personal contributions to superannuation, and has some 'undeducted contributions' in their superannuation fund. There is a particular strategy, called the withdrawal and recontribution strategy, that should ensure that all people have at least a level of undeducted contributions in their fund equal to the tax-free threshold for a lump sum withdrawal from superannuation. This tax-free threshold is currently $129,751 (2005/06 year). It increases each year. Let us assume that the 67 year old in this example has this amount of undeducted contributions in their fund equal to this tax-free threshold. This can be withdrawn tax-free from the fund. In the case of an allocated pension the tax-free threshold is calculated by dividing the undeducted contributions ($129,751) by the person's life expectancy. In this case we look at the life expectancy tables for a 67 year old female, and find that the life expectancy is 19.49 years. 129,751/19.49 is $6,657. So each year $6,657 of allocated pension payments are tax-free. This $6,657 level remains the same every year, unless lump sum withdrawals taken from the allocated pension mean that it has to be recalculated.
The remaining taxable allocated pension payments attract a 15% tax rebate. Let us assume that the minimum allocated pension of $34,250 is taken. $6,657 of this is tax-free. This leaves $27,593. This income is entitled to a 15% pension rebate of $4,139. This pension rebate will reduce the income tax payable.
To get an idea of the situation let us see what that means. Firstly, $6,657 of income is withdrawn tax-free. Secondly, there is a tax-free threshold on the income tax scales of 15%. This means that the first $6,000 of income is also tax-free. The next tax bracket of $6,001 to $21,600 has a tax rate of 15%. This effectively means that the 15% pension rebate will negate all the tax paid. So the summary to this point is:
If there were two people in a couple, this could be doubled to over $56,000 tax-free. (Actually, these figures are the basis behind many of the 'earn $50,000 tax-free in retirement' seminars that you see. Having read this you now no longer have to spend the time going to the seminar!)
When the full calculation is done for this person's taxable income of $27,593, the tax payable in the 2005/06 financial year is $4,137. This is less than the pension rebate of $4,139, so no tax is payable. In this example the person has received an allocated pension of $34,250 and not had to pay any tax.
The last level of an allocated pension's tax efficiency lies in the fact that you have not had to take a lump sum withdrawal from superannuation, so have avoided this tax. The tax rate for a lump sum withdrawal of Post June 1983 component (which originates from employer contributions and salary sacrifice contributions made after June 1983) is 0% for the first $129,751 and then 16.5% for the remainder (being 15% plus 1.5% medicare levy). In the example here, where we are considering a person with $500,000 in superannuation, they would have to pay $61,091 if they were to withdraw this as a lump sum from superannuation. It stands to reason that this is a lot of money to lose in taxation, and this money is then no longer available to help fund their retirement. Rolling superannuation money directly into an allocated pension reduces the need to pay this lump sum tax.
Favourable Treatment for Centrelink Income Test
When an allocated pension in purchased, the initial investment is the 'purchase price' of the pension. In this case $500,000 is invested in an allocated pension, therefore this is the purchase price. This purchase price is divided by the person's life expectancy, 19.49 years, to provide an annual amount that is not assessable for centrelink purposes. In this case $25,654 is not assessable as income for centrelink purposes. To put it another way, of the $34,250 allocated pension payment in this example only $8,596 is assessable income for centrelink purposes.
Allocated Pension Provide Flexibility
I mentioned that I consider allocated pension provide a deal of flexibility. They do that through the choice of investments you can make, the ability to choose between a minimum and maximum payment each year and the ability to withdraw lump sums from your allocated pension at any time.
You can invest your allocated pension assets in any mix of investments you choose. If you want to invest 100% in cash you can. If you want to invest 100% in Australian shares you can. And if you want to invest in a mix of asset classes that will provide a reasonable long term return with moderate volatility, then you can as well.
We saw that the person in this example had the ability to choose income between $34,250 and $65,790. While I suggest that taking the minimum each year is a good strategy, there may be some years that you wish to withdraw a little more, say to purchase a car or take a holiday.
You can also take lump sum withdrawals from an allocated pension if you need. While there may be some tax to pay, you still have the ability to access the allocated pension money as you need to.
You Don't Have to Spend it All!
On disadvantage of an allocated pension is that you have to withdraw more and more every year until eventually you will have withdrawn all of your account balance. There is no real need to panic, if you withdraw the minimum pension each year then most people estimate that you will not run out of assets until you are over 100 years of age! A strategy to get around this is to start to build an investment portfolio outside of superannuation with the excess allocated pension income you receive each year. That is, while you are forced to withdraw a little bit more from superannuation each year, you are not forced to spend it! By saving and investing a little bit of your income each year you continue to improve your financial situation.