Once you have retired, it is tough trying to figure out how much income you should draw out of your superannuation each year.
Most Australians use – or plan to use – their accumulated superannuation to provide a regular income stream in retirement (called an account-based pension). The majority of retirees are conservative and only withdraw the minimum allowable rate specified by the Australian Taxation Office (ATO).
Australian retirees who choose an account-based pension from their superannuation fund are required by the ATO to take a minimum pension payment each financial year.
The minimum payment is calculated at the start of the financial year as the account balance multiplied by a percentage that increases with age. The percentage starts at 4% for retirees under age 65 and increases up to 14%.
While many retirees are vaguely aware of these percentage based minimums, most don’t think of their retirement income that way. Most retirees think in fixed dollar terms – something like “my income in retirement will be around $25,000 a year”. Most retirement income simulators take a similar approach, picking a fixed dollar level of income and then projecting retirement outcomes.
THE RISKS OF A FIXED RETIREMENT INCOME FROM AN ACCOUNT-BASED PENSION
One of the biggest problems with account-based pensions is that you can run out of money. It is all well and good thinking “my retirement income will be $25,000 a year” but what if the account runs dry? The account might run out because you live longer than you expected or because investment returns are worse than you expected, or perhaps some combination of the two.
Which brings us to the ATO’s minimum pension table. This simple tool, which is designed to make sure superannuation is used for income rather than bequests, is actually a surprisingly sensible way to deal with both poor investment returns and the “bad” news of living longer. Believe it not, there is some financial wisdom behind the ATO’s minimum withdrawal table.
POOR INVESTMENT RETURNS
Take the risk of poor investment returns. Poor investment returns mean that your account balance is lower than you, or your financial adviser, expected. But the minimum drawdown table applies a percentage to your (now reduced) account balance to determine your income. In other words, the minimum drawdown table automatically lowers your pension if you have had poor investment returns. And of course, it increases your pension if your returns are better than expected.
The ATO’s minimum pension table automatically adjusts your income to reflect good and bad investment returns.
LIVING LONGER THAN EXPECTED
The minimum pension table also adjusts for the “risk” of living longer than expected. The low percentages for younger retirees and high percentages for older retirees reflect different life expectancies. For example, the minimum pension of 4% of your account balance below age 65 suggests you will need payments for around 35 years. Contrast this to the 7% minimum at age 80, which suggests you will only need payments for another 17 years.
As you age, your life expectancy shortens, and the ATO minimum pension table adjusts accordingly.
But there is a compromise. The automatic adjustments for investment returns and life expectancy mean that your income is not fixed. Your income may never run out, but it can certainly reduce if you experience poor returns or live longer than expected.
What does that look like in practice? Let’s assume you retired at 65 with a lump sum of $500,000 and you thought you would earn 6% pa in retirement and live to age 90.
Assuming you wanted your income to increase with inflation at, let’s say, 2% pa, your starting fixed annual income should be $32,000.
What happens if your average earning rate is only 4% pa, and you actually live to 100?
The blue bars in the chart show fixed pension payments at $32,000 a year in the early years. However, the account balance rapidly diminishes and runs out half way through retirement. At this point, superannuation pension payments cease. (We have ignored the Age Pension for now to keep things simple). Remember, in our example the account balance runs out partly because investment earnings are not high enough, and partly because you live longer than you initially expected.
The red bars are based on the ATO table. Admittedly:
- They are a little jagged (because the ATO scale is a little crude);
- Income levels start a bit lower; and
- Income levels drop over retirement
However, at least they last throughout retirement.
So don’t dismiss the ATO’s minimum pension table. It is a useful tool for taking some of the guess work out of your retirement income calculations. It helps to manage both the risk that your investment earnings are worse than you expected, and the risk that you live longer than you expected.
Jonathan Shead is head of investments at State Street Global Advisors.