How annuities and the age pension can boost retirement income

One of the perverse aspects of the way the age pension rules work is that there are a group of retirees who are actually worse off in income terms because they have saved too much for retirement and are “too wealthy.”

As I explain here, the interplay between the pension and superannuation means that couples with between $800,000 and $1.2 million may well be living on a lower income than those with less than $800,000 in super.

These are rough numbers that change with personal circumstances but the principle holds true – if you just fail to qualify for a part pension then you may suffer the perverse outcome where those with fewer assets than you may have a higher income to enjoy life with, along with some other pension side-benefits.

Of course, having more money in super gives you the chance to withdraw more of the capital at any time as a way to boost income, so there is still a flexibility advantage in having a super account that is too big to claim a part pension.

There is a way to boost yourself into the ‘sweet spot’

The good news for those who miss out on the part pension is that there is a way of increasing your eligibility apart from spending your capital or squandering your cash – something perhaps accidentally demonstrated by a recent Mercer study into the effectiveness of using annuities in retirement.

I have long been somewhat sceptical of the benefits of annuities, mainly because their structure means their internal rate of return is lower than the average balanced super fund, due to the fact that annuities contain far fewer risk assets.

However, it is hard to argue with the Mercer figures which show that a little-known age pension concession can significantly boost a couple’s chance to land in the income sweet spot earlier and to stay there for longer.

That little known concession is that only 60% of the cash used to buy an annuity is included in calculating eligibility for the age pension, meaning that using an annuity which pays a known amount of income each year until death can significantly boost your chance of qualifying for a part pension.

With more income coming from the pension and arriving earlier, that helps to preserve the amount of capital within super and make it last a lot longer while income certainty is also increased.

How the annuity loophole works

I’ll go through the Mercer research in a bit more detail – it assumes the annuity is bought out of the defensive allocation such as term deposits within super so that growth exposure within super is maintained.

The modelling replaces the term deposits with a CPI-linked annuity that provides an annual payment of $5100 per $100,000, indexed annually.

So, the indexing starts at 0 and rises to 30% as the 67-year-old applicants live until 94, which is the projected lifespan of someone that age.

Two thousand potential retirement outcomes were then projected for each couple, with the researchers finding that the benefits of annuities vary based on lifespan and wealth.

Three hypothetical couples were modelled, all retiring at age 67 with balances of $2 million, $1 million and $500,000 who substitute a portion of their 60:40 portfolio with annuities.

Those in the middle do the best

However, the interesting finding was that the biggest benefit from annuities came not to the poorest or wealthiest couple but to the one smack bang in the middle with a “medium” combined super balance of $1 million.

That benefit came about because of the interplay between the age pension and annuities, particularly the incentive where the government only counts 60% of the value of annuities when it applies means testing for the age pension.

There were still benefits for the hypothetical couples with $500,000 and $2 million in super but they were much more dependent on living a long time – potentially to 100 and beyond.

It is worth pointing out a few things at this stage.

A few caveats

The first is that Mercer was commissioned to do this research by Challenger, one of the major suppliers of annuities, although that is unlikely to have influenced Mercer’s actuarial calculations.

The second thing to note is that annuities are effectively a punt on longevity.

Live long enough and you are doing exceptionally well out of your annuity – die early and your descendants or surviving spouse usually miss out on at least some of the capital that was invested in the annuity.

There are some reversionary annuities that allow for some level of payback on death but in general annuities expire with the death of the person who bought them.

The third thing to note is that it is better to buy an annuity when interest rates are high given their structure as effectively fixed interest investments that need to finance an income stream for an indeterminate amount of time without sending the issuer of the annuity broke.

So, they are conservatively constructed by design.

Happy to roll the longevity dice?

However, if you are happy to roll the longevity dice and like the certainty of income an annuity provides plus the chance to get the Government to help bankroll a great retirement through a part pension, then it is well worth getting a financial planner or accountant to run the numbers for you before reaching pension age of 67.

Who knows, you may be able to structure yourself into the “sweet spot” and give yourself a strong financial incentive to stay fit well into old age!