On 1 January 2017 reductions to the asset test limits for the age pension will be introduced. It is estimated that 300,000 people will lose all or some of their pension. In the worst cases singles will lose $9,721 per year and couples $14,002 per year.
Under the current rules, as a client’s assets reduce, the age pension provides the equivalent of 3.9 per cent per year income. For example, if their assets fall in value by $10,000, their age pension entitlement increases by $390 per year. From 1 January 2017, the asset test taper rate doubles, this means as their assets reduce, the Age Pension will provide the equivalent of 7.8 per cent, which is nearly three times current term deposit rates. This represents an increase in their entitlement of $780 per year for a $10,000 decline in the value of their assets.
The silver lining
The changes to the assets test are significant but an alternative to most media articles that suggest spending more money, is to take more risk with their investments by increasing their allocation to growth assets, such as shares and property.
This could reward them over time as their long-term return should be higher but if in the interim share markets fall and the drop in their assets makes them eligible for the Age Pension, they will receive an effective Age Pension return of 7.8 per cent per year on top of your dividend income from their growth assets. The dividend yield on Australian shares is currently 4.6 per cent per year with imputation credits adding a further 1.7 per cent per year.
What could this investment strategy look like?
If your client’s are currently in a defensive investment position, then they should consider shares carefully. They need to ensure they have a high level of diversification and still have sufficient funds in low-risk assets (like cash and term deposits) to use when and if their growth assets fall. Holding seven years’ worth of living expenses, or 10 years if they are very conservative, in low risk assets would substantially reduce the need to sell their shares before they recover their value.
John and Patricia – a case study
To test the effectiveness of the investment strategy and how it can work to your client’s advantage, let’s look at John and Patricia. They are homeowners, have $800,000 in counted investment assets and their living expenses are $50,000 per year. They currently receive an age pension of $14,746 per year, but after 1 January 2017 it is expected to fall to $1,248 per year.
We will compare three different options open to them:
- Investing $800,000 (100 per cent) in low risk term deposits and cash (defensive assets only)
- Investing $500,000 in low risk/defensive investments and $300,000 in higher risk investments (shares and REITs) with long-term returns (forecast market returns)
- Investing $500,000 in low risk/defensive investments and $300,000 in higher risk investments (shares and REITs) with a repeat of the past decade of actual returns, from 2007 to present (2007-2016 repeat). Importantly this period includes the GFC.
Assumptions:
- A 2.5 per cent interest rate per year on the low risk/defensive investments.
- Where there is a cash flow shortfall (that is, where interest income, dividend income and any age pension does not meet the living needs), the shortfall is drawn from the low risk/defensive investments, leaving the shares untouched.
The higher risk investments are invested as follows:
- 50 per cent Australian shares, 40 per cent international shares , 6 per cent international REITS and 4 per cent Australian REITs.
- Fees of 1.5 per cent per year are charged for product and advice
- Options 2 and 3 retain the conservative ten years of annual expenses in low risk/defensive investments.
- Asset and income test calculations apply and assume full income testing applies to all assets (ie no grandfathering on any account based pensions)
The case study demonstrates that John and Patricia ought to invest in some growth assets because they will ultimately be in a better position than if they were only invested in defensive assets.
Phillip Gillard, Principal and Private Client Adviser, Shadforth Financial Group
