Six tips for your pension shift

Your investment strategies in pension mode are likely to change.

Summary: Moving from accumulation to pension phase will probably require a change in investment styles. That’s because strategies that have worked for you in the past might not hold the same weight when the taxation of your investment funds is fundamentally changed.
Key take-out: Keeping tax in mind in the last few years before you start your pension, and in the years after, is critical.
Key beneficiaries: SMSF trustees and superannuation accountholders. Category: Superannuation.

An important positive about tax rules is that they largely don’t change too much. If you know what the rules are, you can plan for them and play them to your advantage.

For SMSF trustees, tax events occur regularly. Many events you can’t control, but some you can. And a SMSF gives you more control than what you would traditionally get through an APRA-regulated fund, which is one of the reasons we love them so much.

From the perspective of investment, the two main tax events are when a fund receives income and when it has a capital gain.

One of the trickiest, but ultimately most rewarding, times is around when a fund transitions from one that pays tax to one that doesn’t. That is, when it shifts from accumulation to pension phase.

Keeping tax in mind in the last few years before you start your pension, and in the years after, is critical. But also, the investment strategies that have worked for you in the past might not hold the same weight when the taxation of your investment funds is fundamentally changed. Or, simply, you might want to rethink them.

Here are six things to consider in that pre- and immediate post-pension period.

  1. Selling an asset around pension time

Pension funds don’t pay tax on earnings or gains. As discussed regularly here, it would rarely make sense to sell an asset with a big capital gain just before you switch on a pension.

If you sell before you switch on the pension, then there would be capital gains tax (CGT) to pay. If you sell after the pension starts – and that asset is backing the pension – there is no tax to pay.

This is a one-off decision. Holding on to the sale will often make sense. Unless you believe that the asset could fall further in value in your lead-up to starting a pension than the CGT that you would pay on disposal.

  1. Accumulation: Income and gains are taxed differently

In the accumulation phase, there are two main tax rates. Income is taxed at 15%, while assets sold for a gain incur CGT. This is taxed at 10% for assets held for longer than a year (this is a one-third discount on the income tax rate).

Obviously, capital gains tax is only charged if an asset is sold. You could have a capital gain on an asset of $100,000, but if you never sell the asset you never pay tax. And if you sell in pension phase, as above, there is no tax to pay.

(Outside of super, the best you can hope to do is to sell assets when your assessable income has reduced, most often after retirement.)

Income tends to be more stable and more likely to be paid. Capital gains are risk based (and may never materialise).

It is often said that young members should be more focussed on growth assets than income assets. They should have more of their money in shares and property than cash and fixed interest. That’s largely because shares and property tend to have better overall performance.

But a benefit that is not talked about as often is the lower tax rate charged on gains of 10%, or potentially 0%. But the lower tax rate – and the fact that gains aren’t taxed until sold – is a real advantage.

  1. No tax in pension

Obviously, SMSF trustees should always consider tax in their investment strategies. But if you were no longer paying tax on income, would it change your strategy? Should a trustee previously driven by gains over income change their investment strategy in retirement based on tax?

There are good reasons to suggest it should. Consider the following income stream.

We have a fully franked dividend of 4.9%. Grossed up, that’s 7%.

If you are in accumulation phase, you would get back an extra 1.05%, for a total return on that income stream of 5.95%. A super fund in pension phase would get back the total difference of 2.1%, making their after-tax return 7%.

The same, in reverse, would apply to an unfranked income stream (such as a term deposit, though you won’t get 7% in the current deposit environment). A 7% income stream to a pension fund would be 7%, while in accumulation, the net after-tax return would be 5.95%.

The question for trustees to answer is ... if you’re paying less tax on your income, would that change your investment strategy? There’s a bonus 1.05% income to be earned, which is obviously a more appealing investment.

It should be factored into the risk/reward exercise you do with any investment, if nothing else. It doesn’t mean that in pension phase that all of your investments should be switched from growth-based investments to income-based. But the higher, after-tax, returns should become a consideration, when weighing up the risk inherent in any investment.

Prior to going into pension, you were weighing up an after-tax income return of 5.95%. Now, in pension phase, the same investment will provide 7%, with no extra risk. The extra guaranteed return would have to come into consideration against the risks involved in chasing capital gains.

It might, even should, make you a little more inclined to take the income, even if only for an increased portion of your portfolio.

  1. The surety of income

Income streams from investments are almost always more certain than capital gains.

Take two extremes:

One investor is going for an all-growth approach. The investment doesn’t pay income, it keeps reinvesting the income to produce a better and better company/business/asset. The rate of return on the investment, over a 10-year period, is 9%.

A second investment pays income of 5% annually, and manages to eke out capital growth of 4% a year.

At the end of 10 years, the former strategy returns a $100 investment into approximately $237. The second strategy will be worth approximately $221 – the difference is, roughly, the tax paid, plus some compounding. After 20 years, the first investment is worth $560, while the second is worth $488.

While this is unlikely to show identical returns, the point is to show you that the tax paid adds up.

That’s the difference of tax in accumulation – and assuming the asset isn’t sold.

However, in pension phase, the income tax is no longer paid. The returns would be identical. The risk would, obviously, remain the same. But the surety of the higher income stream investment, and the likely lower volatility, should be more appealing in pension phase.

Incomes tend to be more secure. And weighing up the surety of income – in whatever guise – is an important element of weighing up your investment-manager duties as trustee.

  1. Proposed pension fund tax

The proposal by the former Gillard/Rudd government to tax pension funds earning more than $100,000 a year has not been legislated. It might be dead. But I don’t believe a stake has actually been driven through its heart yet.

It is a tax that would, unfairly, hit property investors. Property investors have large assets, which cannot be sold off in chunks in the same way shares can.

A property with a capital gain of more than $150,000 would see a pension fund pay income tax under the (hopefully dead) proposal. (The $150,000 would receive a one-third discount reducing it to $100,000. If there is other income in the fund, the pension fund would pay tax at a lower gain on the property.)

However, if an investor had $150,000 in gains sitting in bank shares, they could sell them over a number of financial years, reducing the prospect of the pension fund having to pay tax.

  1. Changing risk profile

As people age, their willingness to take a risk tends to reduce.

Young people have little or nothing to lose, particularly in super. Taking bigger risks early in life can lead to greater rewards. Loading up on shares and properties makes sense.

Older people have worked hard, taken risks, and have a lot to lose. They are usually, necessarily, going to be more cautious. When does that happen? For most, probably around the time they retire is when they will notice the change. But it should be a gradual thing over many, many years.

If it’s leading into retirement, then a lowering risk profile would suggest a higher likelihood to income-based assets.

The change to your investment strategy doesn’t have to be sudden. It probably shouldn’t be. But most people will slowly switch from growth to something more defensive over time.

It would rarely be “all or nothing” and it would usually be a process that takes several years. But there is a changeover period to be planned for in the last few years before a pension is turned on.


The information contained in this column should be treated as general advice only. It has not taken anyone’s specific circumstances into account. If you are considering a strategy such as those mentioned here, you are strongly advised to consult your adviser/s, as some of the strategies used in these columns are extremely complex and require high-level technical compliance.

Bruce Brammall is director of Castellan Financial Consulting and the author of Debt Man Walking. E: bruce@castellanfinancial.com.au
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