Time to come to terms
There are alternatives to nibbling away at your stockpile of retiree capital, writes David Potts.
Having fled the sharemarket after it crashed for the safety of term deposits, many retirees are suffering a financial death by a thousand cuts.
Well, eight cuts to be precise since the Reserve Bank began cutting interest rates 21 months ago.
Term deposits that were then paying as much as 7 per cent are down to only about half that, an income cut that has savaged many retirees.
Scottish-born John Beattie, 66, a retired Qantas baggage supervisor, had his small pot of super virtually wiped out by the global financial crisis.
He has a small British pension but lives mostly off his stockpile of term deposits.
As a result he's been whacked three times - once by the market, then by the Reserve Bank and finally the Tax Office because, being outside super, the interest he earns is taxable. He's going backwards just from tax and inflation, let alone low interest rates that just got lower.
He dreads what will be on offer in November when one of his term deposits that had been paying 5 per cent matures, and the impact of his wife, Maureen, retiring next year.
"We're going to have to tighten our belts and I'm still paying tax - it's criminal," John says.
"I applied for a pension and was going to get $2.08 a week and Centrelink asked me to come in for an interview. I said for that amount I couldn't afford the bus fare!"
Eventually Centrelink relented and is paying him $40 a fortnight.
What really rankles is that not only is the interest taxable, but also the loss he's making from his shrinking capital can't be claimed as a deduction, as it could be for shares or negative gearing.
On the bottom tax rate of 20.5 per cent, including Medicare, a term deposit needs to pay 3.8 per cent just to break even according to Mitchell Watson, research manager at Canstar. On the top marginal rate it would have to pay 4.67 per cent, which is just short of the best rate on a five-year term deposit.
Apart from low-yielding government bonds, the only other virtually risk-free alternative to a term deposit would be an annuity.
Even then, annuities are taxed like term deposits if they haven't been bought with money from a super fund.
But they pay more - a Challenger 10-year term annuity is paying 5.35 per cent, less an adviser's fee - and can be friendlier when it comes to the Centrelink income test for the pension. They can also be indexed against inflation.
If you're not prepared to take some risk, all that's left is to spread your savings into different terms and in the most tax-effective way.
"The first rule is staggering the maturity dates. Then when you suffer the ups and downs of rate changes it doesn't affect all your money," Suzanne Haddan, managing director of BFG Financial Services, says.
That includes setting a small amount aside for the five-year term, and not being seduced by at-call online accounts.
"When you go to a bank, the long-term rates aren't as good as the short-term ones. But that's telling you the banks think rates will drop again."
Haddan suggests putting about 10 per cent of what you've set aside for savings into a five-year term.
The rest should be spread across shorter maturities. The varying maturity dates offer some protection against falling rates.
Besides, stuffing everything into the highest term rate is bound to be self-defeating because of a trap the banks set called dual pricing.
The bank offers a much higher rate than on the nearby terms to snare you in. When it matures, the new rate might only be half what you were getting.
Also, think about setting something aside for some blue-chip shares.
"Look at whether there's a portion to protect you that could be committed to blue-chip investments. Just a small portion will do. Don't go in boots and all too quickly," Haddan says.
The fact is the sharemarket has delivered good returns in the aftermath of the GFC after taking dividends into account.
True, values on average aren't within a bull's roar of their peak - they've still got about 25 per cent to go - but those who hung on are better off than they were then thanks to the steady and increasing flow of dividends. They've been a less volatile source of income than interest from a term deposit.
Fixed-interest returns are so low it's hardly taking on a huge risk investing in, say, some bank stocks, which have been paying high and rising dividends while almost doubling your return with the 30 per cent tax credit from franking.
"It's staggering the number of people who think dividends are related to the share price. They think if the shares drop 50 per cent, so does the dividend. Even very high income earners often don't realise dividends are paid as cents per share, not a percentage," Paul Moran, managing director of Paul Moran Financial Planning, says.
Cherie Byrne, who is 62 and retired, relies on the interest on her term deposits and two mortgage loans to solicitors. "I dread every rate cut. I do feel boxed-in because I'm eating into my capital every year," Cherie says.
She's also hit by a quarterly PAYG tax bill on her interest.
"I'm really squeezed. I don't want to go out to work. I've got friends in their 50s and they feel exhausted and downtrodden," Cherie says.
She is wary of the sharemarket after the joint DIY super fund run by her late husband "went up in smoke" in the GFC.
Unlike John Beattie, Cherie has one other option to make life a little less financially fraught.
Even at 62, it's not too late for her to take advantage of the tax breaks in super.
She could invest in a diversified balanced fund through her own or another super fund.
"Cherie could put the money in a deposit with Westpac-owned Asgard that would be fee-free and tax-free by contributing to super," Moran says.
Truth is it's never too late - well, up to 65 anyway - to contribute to super, even if you're not working. Instead of salary-sacrificing you make a voluntary contribution - in this case just by switching money from a term deposit into an account-based (aka allocated) pension.
Even ignoring the potential for growth, which is non-existent with a term deposit or the like, the tax savings can make all the difference.
For example, a 60-year-old retiree with $600,000 invested would be $76,000 better off over 10 years thanks to the earnings on an account-based pension being tax-free, Canstar says.
"That's a conservative figure on a low earning rate of just 3.8 per cent. I really hope that it's a wake-up call for those getting closer to retirement who have perhaps been reluctant to look at their retirement-income options," Canstar's Mitchell Watson says.
Canstar rates different account-based pensions based on fees, investment options and returns at canstar.com.au.
While saving through super is always more tax-effective, exactly which portfolio you choose within the fund "should be a strategic decision", Moran says. "It's inappropriate to be in shares if the price drops 20 per cent and you're going to sell at the bottom. A share investment should be forever."
A catch with an account-based pension is you have to draw out a minimum 4 per cent of the balance each year up to age 64, then 5 per cent a year from 65 to 74, increasing further as you get older.
Though that could sometimes mean selling some units in the fund in a weak market to meet that rule, more often than not it will be up, providing a tax-free capital gain.
Besides, think of the tax you'd be saving. The income within an account-based pension is tax-free when you're 60 and retired, as are any withdrawals.
Incidentally, the money taken out can always be put back in or invested in a term deposit.
Even the annual fee of about 1 per cent pales into insignificance relative to the return.
The average "conservative balanced" fund returned 11.3 per cent in the year to June 30 after taxes and fees, according to SuperRatings.
Over three years the return has been an annual 7.1 per cent.
While that says nothing about the next three years, an account-based pension is more likely to come closer than a term deposit.
Falling returns: Average term-deposit rates
Howto boost income
Stay in cash and term deposits
Plus Safe, and rateswill eventually rise.
Minus Worst return.
Buy an annuity
Plus Guaranteed income that is Centrelink-friendly.
Minus Lowreturn for a long time.
Invest in a fixed-interest fund
Plus Better return, more liquid than a term deposit.
Minus Not tax effective.
Plus Get money upfront.
Minus Your home becomes partially mortgaged.
Buy franked blue-chip shares or fund
Plus Good yield and tax effective.
Minus Values can drop at times.
Gointo super pension
Plus Tax-free, and a big choice of investment options.
Minus After-65 work test applies.