Means test treatment of lifetime annuities

From 1 July 2019, changes to the means test treatment of lifetime annuities for the purposes of determining Age Pension entitlements came into force.

They were designed to remove inconsistencies in the treatment of different types of lifetime annuities, and to level the playing field with account-based superannuation pensions, which are the most common form of retirement income product held by retirees.

The changes meant some people were better off while others lost some of their Age Pension entitlements. As the calculations to determine the optimal mix of lifetime annuity, account-based pension and Age Pension are complex, you may need independent financial advice. The tables at the end of this article may help guide your decision.

The new rules only apply to lifetime annuities bought after 1 July 2019.

Prior to 1 July 2019, all lifetime annuities were treated the same under the means tests, regardless of differences in the way that they allowed access to capital for voluntary withdrawals by investors or the capital that was returned to investors upon death.

This led to the promotion of lifetime annuities designed to allow investors to maintain their capital for lengthy periods at the expense of reduced income, which was viewed as contrary to the purpose of superannuation. The purpose of super is to fund income in retirement rather than allow people to maintain assets in a tax-advantaged environment during retirement.

How lifetime annuities work

Let’s have a brief look at how lifetime annuities work before we look at the means test changes.

When you invest as an individual you are exposed to two main risks in retirement. The risk of adverse market movements means you don’t know how long your investments will last. You also have no way of knowing how long you will live, making it difficult to know what level of retirement savings you will need to provide an income for life.

When you invest in a lifetime annuity, your money is pooled with other investors to deal with these risks. It is essentially a form of insurance where these risks are spread across a large group so that the average return from investing is used to pay an income for the average time that the people in the group live for.

Ideally, to maximise the income that can be paid to people in the group, traditional lifetime annuities provided no access to capital after people invest in them and they began to pay income. This traditional approach resulted in few people investing in annuities on concerns nothing would be returned if they died earlier than the average.

This led to the development of lifetime annuities that provide for a return of capital upon death up until the average lifespan. Many now also allow people to voluntarily withdraw capital before the average lifespan. The trade-off is a lower level of income than those that don’t allow repayments and withdrawals.

Despite paying lower income, lifetime annuities that provide access to capital have generally been more popular than those that do not.

The old assets test

The old assets test used for lifetime annuities that applied up until 1 July 2019 reflected the access to capital that the more popular lifetime annuities (that is, those that allowed access to capital) provided by assuming that assets were drawn down evenly over the average life expectancy.

Compared to the assets test treatment of account-based pensions, the old treatment applied to lifetime annuities was generally more favourable.

Essentially, the assets test treatment differed because account-based pensions are assessed inclusive of any earnings generated by the investments, whereas the assessment of lifetime annuities ignored earnings under the old assets test.

The old income test

The old income test used for lifetime annuities that applied up until 1 July 2019 was designed only to count earnings, rather than the capital that they returned. Lifetime annuities were presumed to return the amount of capital that was invested over the period for which a person would live on average.

For lifetime annuities, the amount of capital invested was divided by the average period over which the income is expected to be paid (that is, life expectancy) and this amount was deducted from the income payments to reflect the return of the capital invested. Only the remainder of the payments after deducting this amount was counted for the purposes of the income test.

For many lifetime annuities, this meant that they were counted as effectively having no income because the amount invested divided by life expectancy gave an amount greater than the actual income payments they provided in most cases.

By comparison, the income test treatment of account-based pensions that are subject to the deeming rules (which assume an income is earned based the amount held in the account multiple by a ‘deemed’ level of earnings), the treatment applied to lifetime annuities was much more favourable under the old income test.

The problem with the old approach

As mentioned, a standardised assets test was applied to all lifetime annuities, regardless of the actual amount of capital investors could access. This led to some non-standard lifetime annuities being developed to take advantage of the standardised assets test treatment.

Because they were treated the same under the assets test as other lifetime annuities with lower capital access, and most lifetime annuities were assessed as having no income under the income test, these lifetime annuities with much higher capital access, like other lifetime annuities, were treated more favourably than allocated pensions. In many cases this led to them providing a higher Age Pension entitlement that would offset, at least in part, the lower income from the lifetime annuity itself.

At the extreme, these non-standard lifetime annuities allowed people to retain access to 100% of the capital invested for up to 15 years after retirement. Standard lifetime annuities and allocated pensions (which require people to withdraw at least a minimum amount each year) did not allow capital to be retained in this way as they only allowed access to a declining amount of capital.

It could be argued that these non-standard lifetime annuities allowed people to ‘have their cake and eat it too’ by allowing them to maintain high levels of capital deep into retirement and in doing so to unfairly access higher Age Pension entitlements to offset the lower income that these products provided.

Changes to means tests

Under the new means test, rather than treat lifetime annuities according to the actual capital that they allowed access to for the purposes of the assets test, the assets test is determined in reference to a capital access schedule.

This schedule allows for 100% of capital to be returned upon the death of an investor for up to half of the investor’s life expectancy, after which the maximum drops down to the amount given by an even decline in capital over the investor’s life expectancy.

If the capital access provided by the lifetime annuity is equal to or below the amount in the schedule, the amount assessed for the purposes of the new assets test is 60% of the capital originally invested in the lifetime annuity for the period up until life expectancy and 30% of the capital originally invested thereafter.

If the capital access provided by the lifetime annuity is above the amount in the schedule, the amount assessed under the new assets test will be that higher value.

Under the new income test, 60% of the actual income provided by the lifetime annuity is assessed.

Summary of new tests versus old tests

The new assets test which assesses only 60% of the capital invested will provide a more favourable assets test treatment than the old assets test for a little over six years from the time the lifetime annuity commences. Thereafter it provides a less favourable assets test treatment than the old assets test.

The new income test will, in almost all cases, provide a less favourable treatment than the old income test.

Results of new tests versus old tests

The tables below show my calculations (at the time the change came into effect) of the results of the new tests versus the old tests. They show the average percentage of the full Age Pension received by superannuation investors up until age 90 compared to investing entirely in an allocated pension on the basis that they invest in either:

• Various types of lifetime annuities on a stand-alone basis; or
• A combination of 70% into an account-based pension (ABP) and 30% into the lifetime annuities.

It is assumed that investors have no assessable assets or income other than their super and various other standard assumptions are made about earning rates and income payments and other factors. The results are shown for various super balances between $300,000 and $800,000.

Single Homeowner

Lifetime annuity only – Average % of Age Pension received to age 90

	Old difference to AP				New difference to AP
	$300k	$400k	$600k	$800k	$300k	$400k	$600k	$800k
Lifetime annuity – No capital access	2%	6%	14%	18%	-5%	-1%	14%	12%
Lifetime annuity – Declining capital access	2%	6%	16%	21%	-3%	1%	16%	13%
Lifetime annuity – 100% capital access for 15 years	2%	6%	17%	22%	-3%	-4%	-6%	-8%

ABP + lifetime annuity – Average % of Age Pension received to age 90

	Old difference to AP				New difference to AP
	$300k	$400k	$600k	$800k	$300k	$400k	$600k	$800k
Lifetime annuity – No capital access	2%	3%	6%	7%	0%	3%	5%	1%
Lifetime annuity – Declining capital access	2%	3%	6%	7%	0%	3%	6%	1%
Lifetime annuity – 100% capital access for 15 years	2%	3%	6%	7%	0%	0%	-1%	-2%

As you can see, single homeowners did well under the old means test rules in terms of the amount of Age Pension they received if they partly or entirely invested in lifetime annuities compared to investing in an allocated pension. They generally still do well (with some exceptions for lower superannuation balances) if they invest in more conventional lifetime annuities after 1 July 2019, though not quite as well as under the old tests. If they invest in less conventional lifetime annuities, which provide high levels of capital access after 1 July 2019, they may lose some of the Age Pension they will get if they invest in an allocated pension alone.

Single non-homeowner

Lifetime pension only – Average % of Age Pension received to age 90

	Old difference to AP				New difference to AP
	$300k	$400k	$600k	$800k	$300k	$400k	$600k	$800k
Lifetime annuity – No capital access	3%	5%	7%	13%	-5%	-7%	10%	-1%
Lifetime annuity – Declining capital access	3%	6%	9%	16%	-3%	-5%	7%	3%
Lifetime annuity – 100% capital access for 15 years	3%	6%	10%	17%	-3%	-4%	-8%	-9%

ABP + Lifetime annuity – Average % of Age Pension received to age 90

	Old difference to AP				New difference to AP
	$300k	$400k	$600k	$800k	$300k	$400k	$600k	$800k
Lifetime annuity – No capital access	2%	3%	3%	5%	0%	-1%	-1%	4%
Lifetime annuity – Declining capital access	2%	4%	4%	6%	0%	-1%	0%	5%
Lifetime annuity – 100% capital access for 15 years	2%	4%	4%	6%	0%	0%	-2%	-2%

Single non-homeowners will generally qualify for less Age Pension if they invest in lifetime annuities after 1 July 2019 compared to the situation under the old rules whether they invest in conventional or less conventional lifetime annuities with few exceptions to that outcome.

Couple Homeowner

Lifetime annuity only – Average % of Age Pension received to age 90

	Old difference to AP				New difference to AP
	$300k	$400k	$600k	$800k	$300k	$400k	$600k	$800k
Lifetime annuity – No capital access	0%	1%	5%	12%	0%	-1%	3%	14%
Lifetime annuity – Declining capital access	0%	1%	5%	12%	0%	-1%	4%	15%
Lifetime annuity – 100% capital access for 15 years	0%	1%	5%	12%	0%	0%	-2%	-4%

ABP + Lifetime annuity – Average % of Age Pension received to age 90

	Old difference to AP				New difference to AP
	$300k	$400k	$600k	$800k	$300k	$400k	$600k	$800k
Lifetime annuity – No capital access	0%	1%	2%	5%	0%	0%	4%	6%
Lifetime annuity – Declining capital access	0%	1%	2%	5%	0%	0%	4%	6%
Lifetime annuity – 100% capital access for 15 years	0%	1%	2%	5%	0%	0%	0%	0%

Homeowners who are part of a couple did well under the old means test rules in terms of the amount of Age Pension they received if they partly or entirely invested in lifetime annuities compared to investing in an allocated pension if they had higher superannuation balances. They generally still do well (with some exceptions for lower super balances) if they invest in more conventional lifetime annuities after 1 July 2019, and in some cases do better. If they invest in less conventional lifetime annuities which provide high levels of capital access after 1 July 2019, they may lose some of the Age Pension they get if they invest in an account-based pension alone.

Couple Non-Homeowner

Lifetime annuity only – Average % of Age Pension received to age 90

	Old difference to AP				New difference to AP
	$300k	$400k	$600k	$800k	$300k	$400k	$600k	$800k
Lifetime annuity – No capital access	0%	1%	5%	7%	0%	-1%	-4%	-3%
Lifetime annuity – Declining capital access	0%	1%	5%	7%	0%	-1%	-3%	-1%
Lifetime annuity – 100% capital access for 15 years	0%	1%	5%	7%	0%	0%	-2%	-5%

ABP + Lifetime annuity – Average % of Age Pension received to age 90

	Old difference to AP				New difference to AP
	$300k	$400k	$600k	$800k	$300k	$400k	$600k	$800k
Lifetime annuity – No capital access	0%	1%	3%	3%	0%	0%	0%	2%
Lifetime annuity – Declining capital access	0%	1%	3%	4%	0%	0%	0%	2%
Lifetime annuity – 100% capital access for 15 years	0%	1%	3%	4%	0%	0%	0%	0%

Non-homeowners who are part of a couple generally qualify for less Age Pension if they invest in lifetime annuities after 1 July 2019 compared to the situation under the old rules whether they invest in conventional or less conventional lifetime annuities with few exceptions to that outcome. 

A sting in the tail

Put simply, the changes have led to mixed results in terms of access to the Age Pension, depending on the investor’s personal situation. However, the changes have generally been successful in reducing incentives to invest in non-standard lifetime annuities that provide very high levels of capital access, contrary to the purpose of super to provide income in retirement.

One thing I would like to point out is that the overall results shown above can mask underlying differences in Age Pension entitlements over the course of retirement.

Under the assets test, account-based pensions are assessed on the actual value of assets held and these can be expected to decline over time. In contrast, lifetime annuities since 1 July 2019 are assessed on a fixed percentage of the original amount invested before and after life expectancy. This means that eventually the assets test applied to a lifetime annuity will give a lower Age Pension entitlement than the assets test applied to an account-based pension.

Under the income test, account-based pensions are assessed on the deemed earnings of the assets held. Because these assets can be expected to decline over time, the assessed income will also decline over time. In contrast, lifetime annuities after 1 July 2019 are assessed on a fixed percentage of the actual income they provide. Given this income will be steady or increase over time with indexation, the assessed income will either be steady or rise over time. This means that eventually the income test applied to a lifetime annuity will give a lower Age Pension entitlement than the income test applied to an account-based pension.

Of course, this result will not be true in all cases but the general trend shows that investors in lifetime annuities will generally have higher Age Pension entitlements in the earlier years of retirement but they may well have lower Age Pension entitlements in the later years compared to their entitlements if they invest the same amount in an allocated pension.