Summary: The above threshold deeming rate - a key component of the income assets test - is increasingly higher than the current cash rate.
Key take-out: Divergent cash rates and deeming rates are forcing retirees to take on more risk to match deemed income.
Key beneficiaries: Retirees. Category: Pension.
Deeming rates have always played an important role for people receiving the part age-pension. When working out access to the age pension, either the assets or income test is used to limit a person’s age pension, whichever is the most restrictive.
Deeming is an important element in the income test. Rather than a thorough calculation of the income that comes from a person’s assets, ‘deeming’ is used as an estimation of the total income earned. That is, a person’s financial assets are ‘deemed’ to earn a certain amount of income under the deeming calculations.
Deeming calculations took on extra importance from January 1 last year, with superannuation income streams included in deeming calculations. This means a higher proportion of retirees' assets are assessed under deeming rules – making those rules and rates more important than ever. However, as we will see, deeming rates have failed to keep pace with interest rate cuts, meaning an investor with cash assets is likely to be ‘deemed’ to earn more income than they actually do.
How does deeming work?
As an example of how deeming works, let’s consider a couple with $500,000 of financial assets. Currently, the first $81,600 of assets is deemed to earn income at a rate of 1.75 per cent per annum, with the balance earning income at 3.25 per cent per annum. Step by step, the deemed income is:
- $81,600 x 1.75% = $1428
- Plus ( )
- (500,000-81,600) x 3.25% = $13,958
- Total Deemed Income = $15,026
The figure of $15,026 is used to determine the income test figure for the couple, and therefore how much age pension, or part age-pension, the couple is entitled to.
Deeming rates and the cash rate over time
The following table sets out the historical deeming rates for the past 20 years, compared with the Reserve Bank's target cash rate. The final column is particularly important, comparing the ‘above threshold’ deeming rate with the RBA’s cash rate. It shows that while these have been historically close, that has changed in recent times. Indeed most of the time the deeming rate has been lower than the RBA cash rate, with that reversing recently.
|Below threshold deeming rate (%)||Above threshold deeming rate (%)||RBA cash rate (%)||Difference b/n cash rate & 'above threshold' deeming rate (%)|
Looking at the table, the current challenge for retirees is that the above threshold deeming rate is now substantially different (higher) than the current cash rate. The above threshold rate is likely to be more important for investors, as most investors will have assets well above the threshold rate.
The key problem is this – for an investor holding investments in cash, the income earned from their investments will be ‘deemed’ to be higher than the actual income that they receive. Their age pension will be restricted on the basis of income that is ‘deemed’ to have been earned, rather than income actually received – which is a tough situation for retirees relying on some part age-pension.
Let’s again consider the couple with $500,000 of financial assets, deemed to earn $15,026. National Australia Bank’s current advertised term deposit rate for 12 months is 2.4 per cent, providing $12,000 of income for a $500,000 investment. Sure, people can do better if they look around, however it illustrates the point well; while receiving $12,000 worth of income from one of our big four banks, they are ‘deemed’ for age-pension purposes to have earned $15,026.
There is an argument that retirees can have assets that will provide a higher yield – and certainly Australian shares provide access to income at a level above the deeming rate. The reality is that assets beyond cash and term deposits require people to understand and take on levels of investment risk.
There is a reason that the cash rate is currently at 1.5 per cent (and deeming rates have not been adjusted down from their July 1 level with the most recent rate cut) is because the economic environment is challenging – making it a tough time for retirees to be thinking about additional risk in a portfolio just to try and get their portfolio income to match their deemed income. It seems reasonable that the deeming rate is based on the ‘risk free’ investment rate in an environment and, certainly, over the last 20 years it seems that deeming rates moved in relationship with the cash rate.
The solution seems glaringly obvious – if deeming rates were directly linked to the cash rate, then retirees could feel comfortable that their deemed income would reasonably reflect the earnings on cash investments.
There have been, and will continue to be, changes that seem to make the retirement journey more challenging than ever for retirees – a period of low investment earnings following the Global Financial Crisis, historically low interest rates, restrictions in the asset test proposed for the start of next year, later access to both superannuation (winding back to age 60) and the age pension.
Deeming rates are important to calculations for the age pension income test, and making these rates fairer by linking them to the cash rate ensures one small part of the retirement puzzle is fair and reacting to what is happening in the economy.