A pension pickle - proportion or prioritise?

Strategies

Curtis Dowel
Friday 29 July 2016

The proposed introduction of the transfer balance cap, or ‘pension cap’, of $1.6 million has raised a number of questions regarding how to structure assets where an individual has or will have a superannuation balance in excess of the cap.

One of the most frequently asked questions from an investment perspective is: ‘Should the pension phase asset allocation be skewed towards growth assets?’

The logic behind this question is that if there is a finite amount of capital able to be transferred into tax free pension phase, then this capital should at least be preserved, and optimally maximised over the long term. Maximising the amount in pension phase is preferred to maximise the tax free returns that can be generated.

A summary of the main arguments for and against skewing towards growth assets in pension phase is shown in Table 1 and Table 2.


Table 1 – prioritising growth assets in a pension

The case forThe case against
Growth within a pension is not counted towards the pension cap Income may not be sufficient to meet minimum pension, forcing asset sales
Any capital gains realised within the pension are tax free Assets with higher expected returns carry greater risk. Asset values could fall, potentially causing sales at depressed prices or increased risk of the pension being unable to meet income needs over the longer term
Higher expected returns from growth assets will help sustain the level of pension income If asset prices increase, minimum pension payments also increase, potentially exceeding the client’s income requirements


Table 2 – prioritising defensive assets in a pension

The case forThe case against
Income paid within the pension is received tax free With present low interest rates, income may not be sufficient to meet minimum pension requirements, forcing asset sales and reducing the account balance over time
Effective tax rate of 10 per cent on realised gains (held for 12 months or more) held in accumulation phase The real value of the pension is more likely to reduce over time


To determine whether growth or defensive assets should be prioritised within a pension, we will first look at a simple example, comparing the after tax returns of two assets.


A simple, two-asset comparison

Assume $20,000 is invested into two assets - $10,000 into each. One is a ‘defensive asset’, the other a ‘growth asset’. For illustrative purposes, we will assume the defensive asset earns an income return before tax of five per cent and a growth return of two per cent, while the growth asset earns an income return before tax of two per cent and a growth return of five per cent.

At the end of each year, a withdrawal is made from each investment of five per cent of the balance, representing the minimum pension amount for someone aged between 65 and 74. This is taken from the returns generated, firstly from the after tax income, then from a partial sale of the asset itself, if required.

We will compare the after tax returns of both assets over ten years, where they are invested in the accumulation phase of superannuation and a tax free pension.


Table 1 – Growth asset in accumulation, defensive asset in pension phase

End of yearDefensive assetGrowth assetTotal
1 $10,200 $10,119 $20,319
5 $11,041 $10,596 $21,637
10 $12,190 $11,186 $23,376


Table 2 – Defensive asset in accumulation, growth asset in pension phase

End of yearDefensive assetGrowth assetTotal
1 $10,105 $10,200 $20,305
5 $10,496 $11,041 $21,537
10 $10,893 $12,190 $23,083


Chart 1 shows the balance of each strategy over the ten year period.

Chart 1

The shaded area represents the decision to hold the defensive asset in pension phase and the growth asset in accumulation phase. The line represents the growth asset in pension phase and the defensive asset in accumulation.

The defensive asset is incurring a higher amount of tax within accumulation phase in comparison to the growth asset. This is as a result of the 15 per cent tax levied on income, compared to the effective tax rate of ten per cent on the gains for the growth asset.

The conclusion drawn from this simple two asset comparison is that over a ten year period, based on the above mentioned assumed return rates, the best result is achieved by holding the defensive (income producing) asset in pension phase.


A more realistic case study

Polly is 65 and has accumulated $2.2 million of assets in superannuation, of which $1.6 million will be used to commence a pension, $500,000 is in accumulation phase superannuation and $100,000 is held personally. She requires $60,000 each year to meet her living expenses. Any pension she receives that is surplus to her income requirements will be reinvested in her personal name.
Polly’s risk profile indicates her asset allocation should be 40 per cent in defensive assets and 60 per cent in growth assets.

We will compare two scenarios for Polly.


1. The ‘prioritisation’ method

Given the conclusion we reached in the simple two asset comparison, under this method priority is given to holding defensive assets within her pension account, until she reaches an overall allocation to defensive assets (across pension, accumulation and personal) of the recommended 40 per cent. If her pension does not have sufficient capital to fulfil the 40 per cent allocation, investment into defensive assets will be made in her personal name. Only if she has an insufficient allocation across her accumulation and personal accounts will an allocation to defensive assets be made within her accumulation account.


2. The ‘proportional’ method

Allocation of growth and defensive assets is made proportionally across each investment structure. Within each of her pension, accumulation and personal accounts, she will hold an allocation of 60 per cent growth assets and 40 per cent defensive assets.

In both scenarios, an annual rebalance will occur to ensure the asset allocation across her entire portfolio remains at a 60/40 split between growth and defensive assets.

A comparison of these two scenarios is shown in Chart 2. The shaded area represents Polly’s portfolio over a 25 year period, in real terms, if she were to use the proportional method, while the line represents prioritising the investment of defensive assets in her pension account.

Chart 2

Initially, the prioritisation method produces a very slight advantage over the proportional method. This is consistent with our observations in the earlier simple, two asset example. However, from year six the proportional method becomes the more favourable strategy. Over a 25 year period, the proportional method results in total benefits that are $24,000 more than the prioritisation method.

Table 3

YearTotal assets – prioritisation methodTotal assets – proportional methodDifference
1 $2,221,365 $2,221,221 $ 144
5 $2,307,459 $2,307,272 $ 187
6 $2,328,707 $2,329,051 ($ 344)
10 $2,412,699 $2,416,475 ($3,776)
20 $2,610,145 $2,629,271 ($19,126)
25 $2,710,629 $2,734,633 ($24,004)


This is a contradictory result to the simple two-asset comparison above.


Why does this happen?

Each year the total portfolio is rebalanced back to a 60/40 weighting. The growth assets are assumed to have a higher return relative to the defensive assets, so each year growth assets are sold and defensive assets purchased to ensure the 40/60 weighting is maintained.

In the prioritisation method, all the defensive assets are prioritised to the pension account. The rebalance therefore results in the prioritisation method increasing the level of defensive assets within the pension each year compared to the proportional method.

The continual movement each year of defensive assets into the pension means its expected return reduces over time, eventually converging with the lower return assumption of the defensive assets. This occurs when the pension consists solely of defensive assets.

The lower expected return (which also generates reduced tax savings) results in the pension balance reducing faster in comparison to the proportional method.

Contrast this with the proportional method, where the pension is constantly rebalanced to ensure the ratio of growth to defensive assets within the pension remains at 60/40. Again, the assumed higher return for the growth assets will mean the rebalance will also result in a shift of assets from growth to defensive, but this shift will always result in a 60/40 split within the pension.

The proportional method therefore has a higher balance of growth assets within the pension which produces a higher overall return. This is of course due to the fact we are assuming a higher return for growth assets. Growth asset returns can be volatile and may fall below the returns of defensive assets. If this were to occur, prioritising defensive assets within the pension would produce a higher outcome.

In this more realistic scenario holding defensive (income producing) assets in pension phase does not produce a higher overall return over the long term.

If prioritising defensive assets in pension phase produces a lower long term result than a general proportional asset allocation then logically, under the same assumptions, prioritising growth assets in pension phase should produce a better result.

By making this change Polly’s position is improved over both the original prioritisation method and also the proportional method. Under this ‘growth prioritisation’ method, she will have an end benefit of $2,764,720 – around $54,000 more than if she had prioritised defensive assets.

The comparison of assets between the three scenarios is shown in Table 4.

Table 4 – comparison of scenarios

YearTotal assets –prioritise defensive assets in pensionTotal assets – proportional methodTotal assets –prioritise growth assets in pension
5 $2,307,459 $2,307,272 $2,306,855
10 $2,412,699 $2,416,475 $2,418,333
15 $2,511,947 $2,524,957 $2,533,136
20 $2,610,145 $2,629,271 $2,651,411
25 $2,710,629 $2,734,633 $2,764,720


In these scenarios, the overall impact is relatively small (less than two per cent over 10 years). When considering a prioritisation strategy the cost to the client of the implementation and ongoing maintenance in light of the gross benefits obtained should also be contemplated. As well, the risk associated with prioritising certain asset classes within each phase of superannuation and the general risk of asset classes not achieving expected returns should be considered, as these may impact on the outcome of the strategy.


Consideration of individual assets

The analysis above involves a general, high level view of asset classes rather than specific assets. There may be many reasons for a specific asset to be held in either pension or accumulation phase. The most convenient time to make these types of decisions will be when commencing the pension or, for existing pensions in excess of the pension cap, when restructuring prior to 1 July 2017.

The decision to hold an asset in pension or accumulation phase may be based on the individual characteristics of that particular asset. For example, assets that generate little or no income and have high growth potential may be selected for the accumulation phase.

Reasons for this include:

  • little or no income means there is minimal or no annual tax impact while held in accumulation phase
  • the lack of income does not cause minimum pension requirement issues, and
  • a tax benefit (capital loss) may arise if the asset is realised at a loss in accumulation phase, whereas no tax benefit would arise in pension phase.

Self managed super funds may choose to segregate the assets in the fund. There is no requirement for an asset supporting a segregated pension to always support the pension. If an asset’s expected income or growth prospects materially change, there may be cause to move the asset from one phase (eg pension) to another (eg accumulation).

The Explanatory Memorandum to the legislation introducing segregation in 1989 noted that the ability to transfer assets to and from a segregated current pension would be permitted, however it also noted that doing so to avoid capital gains tax could have Part IVA (anti-tax avoidance) consequences.

Those clients with existing pensions in excess of the $1.6 million pension cap will typically seek to reduce the pension value to within the cap by 1 July 2017.  In doing so, not only should the future prospects of each asset be considered, but also their unrealised capital gain or loss position. Those assets with losses or low unrealised gains may be better held within accumulation phase.

However, caution should be used in restructuring pension assets to comply with the proposed pension cap. Where assets with large unrealised gains are sold within pension phase and shortly afterwards repurchased in accumulation phase, some risk exists that the Australian Taxation Office (ATO) may apply Part IVA.  Although not specific to this situation, consideration should also be given to the ATO’s views on ‘wash sales’ as outlined in Taxation Ruling TR2008/1.

When considering a prioritisation strategy the cost to the client of the implementation and ongoing maintenance in light of the gross benefits obtained should also be contemplated.

Conclusion

The proposed $1.6 million pension cap, and the possible need to keep some superannuation assets in the accumulation phase, has prompted discussion about which asset classes should be held in pension phase and accumulation phase.

Our analysis shows that prioritising growth or defensive assets in pension phase provides only a small difference in the portfolio value over the long term, when compared to holding assets in the determined asset allocation proportions.

Any improvement should be weighed up with the additional risk borne by having a higher proportion of growth or defensive assets in a single structure and the increased complexity and potential cost involved in managing a portfolio in this manner.

Some SMSF trustees may wish to select individual assets to be held in pension or accumulation phase due to the particular characteristics of the asset.

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Appendix

  • Average Weekly Ordinary Time Earnings (AWOTE) = 3.50 per cent
  • Consumer Price Index = 2.50 per cent
  • Earnings rate of defensive assets = 4.33 per cent after fees but before tax
  • Earnings rate of growth assets = 7.89 per cent after fees but before tax
  • Pension payments are assumed to occur halfway through the year
  • Income needs increase by AWOTE
  • Tax thresholds increase by AWOTE

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