The workbook used throughout this article is available here.
The Coalition and the Greens have cut a deal to implement the Government’s proposed changes to the pension system, specifically through the “Asset Test”. After the Greens repeatedly said there was no deal. This is what makes politics interesting, apart from watching “The Killing Season” of course.
As you’ll have probably seen elsewhere, the major change is to the “taper rate,” but there are also changes to threshold levels at which the full and part pension are paid. If you want to read some neutral coverage of the deal, you can try this article from the AFR, the positive spin from the Government here, positive spin from the Greens, and Labor calling it either a dirty deal, a grubby deal or sometimes both filthy and dirty. (Political disclaimer – For the avoidance of doubt, I am not associated with any political party and seek to criticise all parties equally when the opportunity arises, such as my critique of both Labor and Liberals alike for the metadata retention regime.)
The major spin on this story is that it sounds pretty reasonable – for each $1000 of additional relevant assets you have, you only lose $3 per fortnight of pension entitlements. For a big number of assets, you only lose a small number of income. This could be seen in the same light as these graphs though, which seek to make changes look big or small, despite having the same figures.
To get away from the spin, let’s look at what the changes actually mean in hard dollar terms, and in particular look at how much those extra assets have to earn to replace the pension reductions.
I’ve used a pretty simple approach to modelling the asset test. First, make an assumption of how much extra assets you have and calculate how much pension you would lose based solely on the taper rate. Second, make an assumption of how much income you generate from the extra assets. Then, assume that for every dollar of pension you lose, you will replace via the income from the extra assets and, if necessary, drawing on the assets. So if you lose $2000 of pension in a year, earn $1,500 in interest, you will reduce your capital by $500. I’ve then looked at the capital balance over time taking into account different investment returns.
On the rare occasions that I actually venture into a bank branch, it seems that there are always retired people at the front desk (quite often a queue) trying to work out how long to rollover a term deposit for. So it seems reasonable to look at replacing the lost pension with bank deposits.
A quick look at a couple of bank websites shows term deposit rates of 2.00% to 3.05% for terms up to a year, or variable rates of up to 3.25% for at-call accounts.
Using a hypothetical capital amount of $100,000 and earning interest of 3% p.a., you would earn $3,000 in the first year, but your pension would be reduced by $3,911 under the old taper rate of $1.50/1000, and $7,821 under the new 3/1000 taper rate. Under both systems you would be drawing on your capital to make up for the pension reduction. As you do, the annual pension reduction would decrease in line with your capital decrease. Under the 3/1000 system, it would take 14 years to deplete half your capital, whereas under the old 1.5/1000 system, it would take 76 years. But hey, if we all live to 150, this could be important.
Under both systems, you are facing an effective marginal income tax rate of more than 100% – 130% under the old system, and 261% under the new 3/1000 system. And high income earners and companies think they have it bad. Essentially, if you have the assets that put you in the part-pension stage (rather than having already fully lost the pension), there is little point putting that money in the bank – you may as well put it in higher risk / higher return assets if you’re going to lose more in pension than you will actually earn.
If your aim is to maintain your capital rather than draw on it, then you’ll need to invest your money in higher returning assets. Under the old system, you would need to earn 3.91% p.a. to maintain your capital, but you will now need to increase that to 7.82% p.a.
Maintain real value
Want to maintain the real value of your capital. Assuming inflation is 2.5% (the middle of the RBA’s target band of 2-3%, and marginally above the March 2015 CPI excluding volatile items of 2.3%), then your money needs to earn 6.41% increasing to 10.32%. These rates compare to long-run average returns of 7.6% p.a. and 11.4% p.a. over 10 and 30 years respectively from the Australian share market. So it could be a pretty tough task to maintain the real value of your capital. If you are investing your money well and achieving the 10.32% needed to maintain the real value of your capital, then the good news is that your effective marginal tax rate has now fallen to only 76%.
Pension calculations – winners and losers
The principal the government is taking with this change is that the pension is not there to assist people to maintain their asset base during retirement and pass on a windfall gain to the next generation. You’re welcome to argue the fairness or not of this approach, but I’ll just stick to the raw numbers.
With any change in welfare or tax, there are winners, losers and neutrals. The results here are slightly different to those published by the government as they do not take into account any indexation or any supplements to the pension that an individual or couple might be eligible for.
If you currently receive the full pension (because your assets are below the current threshold), then there is no change – you’ll still receive the full pension as the thresholds are increasing.
If you receive no pension, then you’ll still get no pension. And you’re more interested in any changes to income taxes on retirement earnings than changes to pension rates.
If your assets have you sitting in between the current and new thresholds for the full pension, then you’re a winner. So for example, if you’re a couple that own your own home and you have relevant assets between $286,500 and $375,000 you’ll now be able to receive the full pension rather than a part-one.
If you’re above the new full pension threshold, then your part pension will increase if you’re below the neutral threshold in the table below.
If your asset position sits above the neutral threshold in the previous table then sorry, you lose out from this change. The roughly $30 per fortnight increase in the base level of the pension might help a little, but even that is wiped out by another $10,000 of relevant assets.
“Official” figures estimate that around 170,000 pensioners will receive an increased pension post 2017 (taking into account the $30 per fortnight base rate increase). This apparently leaves 325,000 people worse off, either with reduced or eliminated pensions. This is not taking into account the income test that also serves to reduce pensions, with a number of the people who might otherwise be better off because of the asset test changes, having their pensions actually unchanged because they are limited by the income test anyway.
Conclusion and Consequences
It’s worth remembering that I have only looked at the immediate effect of the changes – more detailed modelling undertaken by Industry Super Australia and Rice Warner indicates that over time the changes will reduce the pension significantly for people earning average incomes and below.
I’ve also made no comment (or come to any personal conclusion) on the fairness of the changes. While the effective marginal tax rates inherent in the asset taper are extremely high, it could be argued that a significant portion of the retiree’s assets were probably accumulated through superannuation, so they had a concessional tax rate applying on the way up, and it is only fair that the capital is reduced over time to pay for retirement rather than relying on the pension.
And you never know, this could be good for the economy as people nearing retirement age quickly spend money so that they have lower assets come retirement. There’s a couple of extra points of GDP. On the downside, if you’re at or near pension age, here is another reason (apart from the hassle, stamp duty, moving costs, etc.) not to downsize your house until you really, really need the cash. So now even young people might be worse off through pension reductions.
Disagree with anything I’ve said? Leave a comment below and correct me.