Longevity and super withdrawal rates - Part 1

A key feature of our superannuation system is the ‘minimum withdrawal rates’ which apply when a super account is in the pension phase. The effect of these rules (explained below) is to force super members to withdraw a specified amount of their super balance each year.

In our low interest environment, many super members are worried these rules force them to withdraw ‘too much’ from their super accounts, increasing their exposure to longevity risk (otherwise known as ‘running out of money’).

For some the minimum withdrawal rules bear a cost, but for others they’ll have little impact on the chances of them running out of cash. We’ll explain the difference with the help of some case studies but, first, let’s take a look at the rules.

The minimum withdrawal rules

When taking a pension (superannuation income stream), your super is only exempt from tax if you make the age-based minimum withdrawals set out in Table 1. There are some minor concessions (explained in marginal tax rates (and a 5 per cent interest rate) he’ll be earning $4,000 a year – small enough to remain below the tax free threshold. Even higher yielding investments are unlikely to see him paying any tax at this point.

In this example, Andrew won’t pay any tax on his earnings outside super until he is in his late 80s and only a small portion of his earnings will be taxed – at the lowest rate (19%). There’s a slight cost, but it’s miniscule and decades away (at age 65). For Andrew, the minimum withdrawal rates are an annoyance, but they’re not really a problem.

Eventually, he’ll end up with most of his assets outside of super, but the minimum withdrawal rates will have had very little impact on the overall balance, or his longevity risk.

Case study two – starting with non-super assets

Let’s repeat the example of Andrew, but give him starting assets outside super of $300,000. Assuming he earns 5% on this balance (and he doesn’t have any other income), he won’t be paying any tax on day one.

But as he saves his ‘excess withdrawals’ he’ll add to this balance. By the age of 70 he’ll be paying some tax and, by the age of 85, he’ll end up with an average tax rate (across both super and non-super) just under 10%.

With a starting ‘other savings’ balance of $300,000, the super minimum withdrawal rates eat away at Andrew’s overall wealth. When he started with no assets outside super, the impact was negligible. Now (based on the same assumptions) his final super balance will be roughly 5-10% lower than it might have been without the minimum withdrawal rates.

But this is in a circumstance where his overall balance is still growing, because he’s saving money and (despite the withdrawals) paying a very low average rate of tax. The minimum withdrawal rates might cost him some money but they still won’t have much impact on Andrew’s longevity risk.

Note that we’ve eliminated inflation and growth from our example, but including it would have generally improved the result for Andrew, since the super balance (being higher) would grow quicker than the assets outside super.

Extrapolating to other situations

That’s the situation for Andrew, but how does it play out in slightly different scenarios? Consider the following:

1. If you spend more than the minimum withdrawal rates (and you need to source the funds from super) then they aren’t a problem, since your spending would force you to take the money out of super anyway.
    
2. If your wealth is less than Andrew’s the withdrawal rates should be less of a problem, since it will take even longer to build up your non-super assets to the point where tax needs to be paid on the earnings. But that assumes your spending patterns are similar to his. If you spend very little, you may build up non-super assets at a faster rate but your superb saving skills are likely to protect you from any longevity problem.
    
3. Let’s say Andrew was married to Betty. Assuming they’ve got an even spread of assets (both inside and outside super) then the analysis above should apply to each of them, since super and tax both operate on an individual basis. But if one has more super or non-super assets than the other, it might become a problem earlier.
   
   Of course they could alleviate this by taking a lump sum withdrawal from the larger super account and using the funds to make a non-concessional contribution to the smaller super account (say Betty’s). In this case Betty would need to ensure she can access the contribution cap, so she needs to be under 65 (limit $450,000 in 3-year period using ‘bring forward rule’), or over 65 and meet the ‘work test’ (limit $150,000 per annum and no ‘bring forward’). If Betty had fewer assets outside super they could transfer some to her name or, if this isn’t possible, they should at least make sure that all super withdrawals are invested by Betty.

You should always seek financial advice on your personal circumstances before implementing these types of strategies but a particular word of caution applies here for those income tested for the aged pension. Moving funds from an older spouse to a younger one reduces the Centrelink Deductible Amount (which is based on life expectancy) and some of the aged pension might be lost.

When minimum withdrawal rates are a problem

Despite the concerns about the minimum withdrawal rates in a low interest rate environment, in isolation they’re actually less of an issue when earnings are low. This is because it takes a lot longer for assets outside super to generate enough income for tax to become payable. However, this assumes interest rates remain low – if they were to spike down the track it could accelerate a tax bill.

Unless you have a very large super balance, or a lot of assets outside super, the minimum withdrawal rates are unlikely to cause you a significant cost or change your longevity risk dramatically (if at all). The good news is that this means they should have the least impact on those least able to bear longevity risk.

In Part 2 of this article, we’ll explore some examples where it is a problem and highlight some strategies for dealing with it.