•   The Optimal Use of Capital
•   Account Based Income Streams
•   Defined Benefit Income Streams
•   RBL Strategies
•   Age Pension Optimisation
  

 
The Optimal Use of Capital

The level of capital needed to support an income stream is going to depend on the length of life of the pensioner and their spouse, the level of earnings achieved and the chosen income stream level / increase profile. Let's examine each of these.

It is common in Australia to allow for the probability of dying in accordance with the population tables published by the Australian Government Actuary. The most recent table is Australian Life Table 2000-2. The main table is a snapshot of mortality of Australians over the three year period centred on the 2001 Census. The Australian Government Actuary has also provided information on mortality improvement trends.

We strongly recommend using in calculations a methodology that allows for mortality improvements. This is far more likely to be a better estimate of anticipated outcomes than the snapshot view. The consistency of past improvements and the likelihood of further improvements can be gauged from the following examples of life table estimates over the past century.

Further years of anticipated life:

Table	Male At 0yrs	Male at 65 yrs	Female at 0 yrs	Female at 65yrs
1901-10	55.20	11.31	58.84	12.88
1920-22	59.15	12.01	63.31	13.60
1932-34	63.48	12.40	67.14	14.15
1946-48	66.07	12.25	70.63	14.44
1960-62	67.92	12.47	74.18	15.68
1970-72	68.10	12.37	74.80	16.09
1980-82	71.23	13.80	78.27	18.00
1990-92	74.32	15.41	80.39	19.26
2000-02	77.64	17.70	82.87	21.15
With 25yr Trend in 2001	92.90	19.93	95.70	23.52

We have a calculator to help you with this aspect of deciding for how many years the capital of the pensioner/s will need to last.

A male aged 61 with a spouse aged 58 has a 9.80% chance of reaching age 100. However, there is a 24.4% probability his wife will be alive and a 31.8% chance that at least one will be alive.

The government and its legislation place too much emphasis on the survival probabilities of the younger party and not sufficient on at least one of them being alive. An older male is not likely to outlive a younger female spouse - but he might. This contingency requires an extra capital provision over that of the younger life's capital requirements.

None of the account based pension calculators below are prescriptive in the economic assumptions - they are generic tools - you control the values chosen. However, for our statutory certificate work on defined pensions, these are the economic assumptions I and my colleagues are currently using:

Strategy Description	%Growth Assets	Nominal Rate	CPI	Real Rate of Return	70% Margin Allowance
Stable	0-20%	5.5%	2.5%	3.0%	0.25%
Conservative	20-40%	6.0%	2.5%	3.5%	0.50%
Balanced	40-60%	7.0%	2.5%	4.5%	0.75%
Growth	60-80%	7.5%	2.5%	5.0%	1.00%
High Growth	80-100%	8.5%	2.5%	6.0%	1.50%

These rates are net of an expense allowance.

For more information see the 2007/8 SMSF Computational Support Pack.

 
Account Based Income Streams

Currently we have 6 types of income streams available - two account based forms (allocated pensions and market linked pensions) and four defined designs (lifetime complying, life expectancy, flexi lifetime and flexi term).

The account based income streams are the most straightforward pensions and may be the only ones available after 30 June 2005. I feel from the simplicity of design there needs to be a good reason to choose a defined pension since they may be less tax efficient, require actuarial certificates annually and have greater complexity eg treatment of reserves on death.

However some of the reasons why defined pensions are useful include total control over income stream profile and RBL compression. Slower income emergence may have tax advantages and not all people see the requirements for reserves that probably will not be needed as a disadvantage - it's a resource that can be used for dependants.

On our web site you will find a calculator that will help with account based income streams. However, lets in general terms examine the issue of a suitable design.

With the minimum allocated pension drawdown - capital lasts an appropriate length of time - but has an inappropriate income drawdown shape. The level of income in the latter years is very low.

With the maximum drawdown the shape of the income stream is wrong and the capital is depleted too quickly.

If we change to a targeted amount between the minimum and maximum specified then we can create an appropriate income profile - but the capital is probably still used up too quickly.

Hopefully one of the changes to come out of the current Treasury pension review will be altered pension minimum and maximum factors that overcome this problem.

Allocated pensions will not give us access to the pension RBL.

Can these problems be solved with the market linked pension - also known as a TAP or growth pension?

The pensioner has no control over the individual year's pension drawings - they will be a fixed amount and could jump around is the market value of assets are volatile. The first worked example will show what happens to the level of pension payments if all the monies are placed in a market-linked contract. It is possible, for example, that the pensioner may prefer a level of pension increase lower than the inflation rate to either take lifestyle needs into account and to make the assets last longer than possible under the market-liked design. It is logical to allocate more resources to the early active years of retirement rather than the later years. The second example shows how this can be improved if the flexibility of a combination of allocated and a growth pension is chosen.

Consider the following situation for a 100% of assets in a market linked pension:

Name:	A. Stute
Date of Birth:	9/10/1942
Sex	Male
Pension Commencement Date:	1/1/2005
Account Balance:	$595,000
Reversionary	Yes
Spouse Date of Birth	1/8/1945
Assumed Earning Rate:	7.5%

The use of a market linked pension on its own causes the capital to run out too quickly.

The use of an allocated pension in conjunction with the market linked pension will allow a few more years to be funded before the money runs out. This together with a rollover along the way to further extend the term (assuming it doesn't generate an RBL creep issue), may be a solution in many cases.

In conclusion we often can produce reasonably appropriate outcomes. They may be a little shorter duration of capital than is desirable, but they can be reasonable solutions, especially if some AP assets are held back to extend the term. However, they certainly don't allow the same control over capital usage as a defined pension. If the government does not allow defined pensions in SMSFs after 30 June 2005, hopefully they will fix the current problems with account based pensions.

 
Defined Benefit Income Streams

These pensions:

•  1.06(2) Life Time Complying
•  1.06(6) Flexi Life and Flexi Term; and
•  1.06(7) Life Expectancy Pension

The main reasons why they may be considered are:

•  Direct control over capital usage and shape of the income streams
•  To achieve RBL compression
•  Smooth run of payments
•  Possible tax deferral reasons on large amounts where marginal tax rates outweigh the drag of taxation on the reserves.

They have disadvantages. They require annual actuarial certificates for adequacy and tax exemption percentage calculation. Since 15% tax is paid on reserves and surplus they can, but not always, be slightly less tax effective. They will tend to leave assets in reserves on death, which is messy.

The future is uncertain. The best estimate value of pension liabilities can be calculated as the product of:

•  A projection of the payment, e.g. pension plus anticipated yearly increases
  
•  Probability of occurrence, e.g. probability of the pensioner being alive, or at least one of the pensioners being alive or a particular pensioner being alive, etc.
  
•  Discount factor - to bring back to a present value at the calculation date.

Calculating 70% adequacy answers are more difficult. With a pensioner and a reversionary pensioner, thousands of different age combinations at death could occur. One way of producing the results is a simulation projection program. Random numbers are generated to simulate the operation of the arrangements and the program is run tens of thousands of times or even millions of times. The resulting empirical distribution of outcomes are then tabulated and observed. Very complex arrangements can be allowed for. A self managed super fund may have two pensions, but the two pensions are not statistically independent. If the first pensioner dies, the reversion on the second pension may disappear. Offsets between longevity risks and investment risks can be allowed for. Simulation programs also have disadvantages. The programs can take a long time to run. You can run the program twice on the same data and get slightly different answers. In order to get closer answers each time, it is necessary to increase the number of iterations - and then the results take even longer to run. In the sample calculators we make available, we have adopted an alternative approach. By dividing outcomes into one year cells, even when you have two lives to consider, the maximum number of cells to calculate is no more than 6 - 10,000. That can be done in the blink of an eye and even take different pension reversion levels into account. A quick but slightly conservative result is generated.

Our website has calculators which help with best estimate and APRA adequacy reserve calculations.

For more information please see the 2007/8 SMSF Computational Support Pack.

 
RBL Strategies

You will notice that the web site has two calculators that will help you with RBL compression exercises. The first is the RBL capital value of a lifetime pension. This is currently written in Visual Basic. We find advisors prefer Excel applications. They are easier to load.

The current RBL application will look as follows:

From the above answer a reduction can be made for undeducted contributions, post 1994 invalidity and concessional component.

Enter Name, Date of Birth, Pension Start Date and Pension amount p.a. If the pension is a single life, click the "Below 50%" option in the Level of Reversion section. A 100% reversion is the other usual choice. Notice that due to these factors being constructed in a time of high inflation, a very different answer will result from the use of an indexation/pension increase rate of CPI versus 3% p.a. fixed.

Consider for example a member of a self managed superannuation fund with a RBL problem - assets are more than the pension RBL as follows:

Name:	Mr. A. Sample
Date of Birth:	7 October 1944
Marital Status:	Married
Spouse Date of Birth:	7 July 1946
Total Assets:	$1,450,000
Undeducted Contributions:	$150,000
Benefits Previously Taken:	Nil
Transitional LS RBL:	Not Applicable
Transitional pension RBL:	Not Applicable
Investment Strategy:	Growth
Pension Commencement:	1/8/2004

We have to ensure that in order to access the pension RBL, that the value on the RBL basis of the complying pension is at least half the total RBL value. The problem is that the RBL is different to the value of assets allocated. A suggested approach is as follows:

• Choose an RBL value a little less than half the assets less the undeducted contributions with an upper maximum of half $1,238,440 in 2004/5.

• Work out from the RBL Calculator what level of initial pension this is, for the chosen increase and reversionary attributes.

• Work out from the lifetime complying pension calculator what assets are needed to satisfy the high probability of adequacy requirement.

• Calculate what remains in the allocated pension component which normally also included the undeducted contribution.

• Check that the RBL value of the complying lifetime is greater than allocated pension RBL value. Repeat steps above until desired balance is achieved.

• Work out range of income that can be generated from the allocated pension assets so that total income range can be presented to the client.

Option: Lifetime, 100% reversion, CPI pension increases:

	Lifetime	Allocated
Initial Pension Amount	$34,500	$40,380 to $80,770
RBL PVF	17	-
RBL Value	$586,500	$585,000
Best Estimate Value (Tax)	$571,775	$735,000
Plus Adequacy Reserves	$124,049	-
Plus Surplus	$19,176	-
Account Value	$715,000	$735,000

The undeducted contributions have been included as part of the allocated pension.

It would be necessary to look at other combinations of reversions and increases.

A strategy using flexi or 1.06(6) pensions can be used when amounts are only a little above the lump sum limit and compression to the lower limit is desirable to allow some commutation rights. Commutations of flexi pensions have a variety of disadvantages and constraints not examined here.

For more information please see the 2007/8 SMSF Computational Support Pack.

 
Age Pension Optimisation

The calculations required here include how the 50% "asset test exempt" value provisions are assessed at outset and over the term of the income stream, how income streams are treated for asset deprivation issues and the optimization of the income/asset tests.

Consider the following example:

Name:	John Sample
Date of Birth:	1/5/1939
Sex:	Male
Spouse Name:	Jill Sample
Spouse Date of Birth:	1/6/1939
Date of Calculation:	01/10/2004
Total ETP Components:
Undeducted Contributions	$205,000
Post 83 Component	$305,000
Additional Financial Assets:	$70,000
Non Financial Assets:	$20,000
Home Owner (Y/N)	Yes
Gifted in past 5 years	Nil

This couple has $600,000 in assets and so would not be entitled to an age pension. All SMSF assets are in John's name.

The client prefers (say) a mixture of allocated and market linked pensions are desired.

This couple can't get the maximum pension because even if the full SMSF assets are used for a market linked pension, the asset test would be:

50% of Market Linked	$255,000
Plus Financial Assets	$70,000
Plus Non Financial Assets	$20,000
Total	$345,000

This is $127,500 above the full pension allowance i.e. $3 x $127.50 = $382.50 p.f. reduction in the pension payment to be received from Centrelink. Please note these limits are probably now out of date.

For the income test, if the Samples choose the longest duration i.e. 26 years, then the market link pension will be $22,580 in the first year. The amount of income that will be counted is:

	p.a.	p.f. (26.07)
22,580 - 510,000 / 26 =	2,964.62	113.72

The assessed income is:

Market Linked	$113.72 p.f.
Financial Assets	$106.33 p.f.
Total	$220.05 p.f.

This is $4.05 above the full rate i.e. pension is reduced by approximately $0.80 p.f. The asset test dominates - the level of age pension that will be paid is $775.20 - $382.50 = $392.70 p.f.

The focus is often to work out what the age pension entitlement will be in the immediate future. These SMSF pensions result in the use of capital over a period of time. Consequently while no immediate entitlement may exist at outset, future entitlement could be predicted under current rules and a few assumptions. The other aspect is that the optimal structure may be different to that of the immediate view.

We have commenced work on a calculator to investigate this issue. Please watch our website for more information.

For more information please see the 2007/8 SMSF Computational Support Pack.