Turning on the TAPs

If you believe Richard Gilbert and most of Australia’s big fund managers, term allocated pensions (TAPs) are going to cause quite a big splash when they are turned on next week.

With great fanfare, fund managers like ING, AMP and Mariner have proudly launched their TAPs high into the retirement income stream stratosphere, with claims they will change the landscape of the Australian retirement industry after their official September 20 commencement date.

According to Gilbert, chief executive of the Investment and Financial Services Association (IFSA), about half of the association’s 100 member organisations plan to follow suit and launch TAPs — or growth pensions as they are otherwise known — within the next 12 months.

Just how much hype is there?

So much that AMP has embarked on the single biggest adviser education campaign in its history to ensure its TAP distribution machine is well and truly oiled by September 20.

Gilbert, who is now proudly wearing the tag of ‘the father of growth pensions’ because of the years he spent lobbying Canberra to get them approved, even says TAPs are up there with the Hills Hoist and the black box flight recorder as one of Australia’s greatest inventions.

But is the birth of a retirement income stream that enables retirees to access social security and ride the markets at the same time — for better or for worse — really worth all this excitement?

At the very least, it’s easy to see why Gilbert and his members are so enthusiastic.

Twelve years ago only about 20,000 Australians had money in some sort of retirement income stream. Today, almost half a million Australians have invested a total of $47 billion in retirement income streams, according to IFSA’s key industry indicators survey for 2004.

The lion’s share — about 76 per cent — are in allocated streams like allocated pensions. Nine per cent are in annuities and the other 15 per cent are in non-employer termination payment income steams that don’t attract the same taxation benefits as superannuation.

According to IFSA’s report, about $9 billion worth of all these types of income streams are bought out each year. It says by 2006, about $2 billion of those pensions will be TAPs.

If these predictions are anything to go by, financial planners will need to know their TAPs.

First and foremost, advisers are going to need to know what they are.

Mariner technical services manager Kate Anderson says she can define a TAP in four words.

“Basically they’re a non-commutable allocated pension,” she says.

Certainly TAPs share many benefits of an allocated pension like exposure to the markets. In fact, most of the TAPs launched by funds management groups so far are basically a re-badge of the group’s allocated pension product. But what Anderson’s definition fails to describe are the social security benefits TAPs offer.

TAPs allow retirees to invest in securities and claim a full or part age pension — about $12,000 a year — at the same time.

How much of that $12,000 those with a TAP will get depends on the value of their assets. It will also depend on how much money a TAP pulls in on the markets. A bigger capital gain on a TAP will increase the value of the owner’s assets.

According to Centrelink, a homeowner will experience a reduction in age pension if they have assets of more than $153,000. If their assets exceed $309,750 they won’t be entitled to any age pension at all. For non-homeowners, the asset limit for the full pension is $263,000, while the limit for the part pension is $420,250.

From September 20, those buying a TAP will get a 50 per cent assets test exemption, so only half their super will count as an asset for age pension purposes.

For those with money in excess of the lump sum reasonable benefit limit (RBL) of $619,000, TAPs enable retirees to access the higher pension RBL of $1.2 million and qualify for a 15 per cent tax rebate.

Unlike an allocated pension, retirees won’t be able to choose how much they get paid. Yearly payments will be based on the amount they make or lose on the markets.

For example, if the markets perform well in the first year of the pension, the gain will be spread over the length of the rest of the pension. Next year’s payment will be fractionally higher depending on how much longer the pension has left to run. The same rule applies if the markets take a dive — the loss will not be felt all at once, but will be spread across the remaining term of the pension.

As Anderson suggests, whoever buys a TAP will be stuck with it — at least until it runs out. Much like an annuity and unlike an allocated pension, TAPs are non-commutable, which means money in a TAP cannot be taken as a lump sum at any stage.

The length of time a TAP will last will depend on a person’s life expectancy. To reduce the risk of people outliving their money, the Government has allowed people to calculate their life expectancy as if they were five years younger.

For example, a male retiring at 65 has a life expectancy of 18 years. With a TAP they can use the life expectancy of a 60-year-old, which is 22 years.

TAPs can also be paid out on death to a spouse or other related beneficiary, either as a lump sum or as a continuation of the pension.

The big question for financial advisers is exactly what type of clients will want a TAP.

The common wisdom is that because TAPs find the middle ground between an annuity and an allocated pension, they will probably suck in clients from both types of income streams.

On one hand, there are those in an annuity dissatisfied with the lower returns generated by fixed interest who want to hit the markets without losing their age pension. And then there will be those in allocated pensions prepared to sacrifice the right to commutability and payment flexibility to access the age pension.

It is also worth keeping in mind that retirees will not have to put all their eggs in the one basket. It will be possible for them to invest some money in a TAP and some in an allocated pension or an annuity to get the best of both worlds.

Matrix Planning Solutions adviser Geoff Martin thinks the biggest market may develop from the allocated pension side.

“The big market is probably going to be those people who are being removed from the age pension by assets testing, but are close,” he says.

Martin is talking about investors with assets over the $153,000 cut-off for age pension entitlement. They will now be able to buy an allocated pension close to that amount and put the rest into a TAP, which has a 50 per cent exemption from the assets test (see case study one).

From September 20, the asset test exemption will be reduced from 100 to 50 per cent on all complying annuities.

Martin says even if they get just $1 in pension, retirees taking out a TAP with an allocated pension will still qualify for fringe benefits.

He says another advantage of a TAP as one of two income streams is that when investment markets perform badly, investors will be able to draw more out of their allocated pension to make up for the smaller income flowing from their TAP.

ING executive director Ross Bowden agrees that TAPs will eat into the allocated pension market as people seek a higher social security benefit.

“This will depend on what rates are on offer in term or life annuities at that particular point in time, but in a low rate, low inflation environment, TAPs are likely to prevail,” Bowden says.

There is another group advisers can target. These are people lucky enough to have so much money in super that the age pension will be out of the question. But they will still be able to reap the tax benefit from a TAP to access the higher pension RBL.

Currently those with super savings over the lump sum RBL of $619,000 will lose their 15 per cent tax rebate. In order to access the higher pension RBL of $1.2 million and still get the 15 per cent rebate, retirees must lock up at least 50 per cent of their super in a complying annuity product.

Up until September 20, most retirees with more than $619,000 could employ one of two strategies to maximise their super payments.

One was to go for the higher pension RBL of $1.2 million and put half their cash in an allocated pension and the other half in a complying annuity.

The second option was to buy two allocated pensions, one with $619,000 and the other with the excess amount.

All the money in the first pension would receive the tax rebate, but the pension with the excess would not. Now retirees with more than $619,000 will have the option of putting half their cash in an allocated pension and the other half in a TAP (see case study two).

ING technical services manager Andrew Lowe thinks the old two allocated pension strategy will still make a lot of sense for clients who exceed their RBL by a modest amount “because the alternative is putting 50 per cent into a complying income stream including a TAP and I think commutation restrictions will be a disincentive to that,” he says.

But for those clients who are significantly over the lump sum RBL, Lowe thinks TAPs are a “fantastic opportunity”.

“You get to retain your exposure to market sectors and you get a transparent type of income stream arrangement.”

As for those with less retirement savings, Lowe agrees with Martin in thinking that in the short-term TAPs will draw more retirees from the allocated pension side.

“Clients who are currently getting a reduced pension entitlement who don’t want a conventional complying income stream I think will transfer from an allocated pension into a TAP from September 20,” he says.

Lowe says he is seeing a lot of clients who are concerned they will lose the 100 per cent asset test exemption if they buy an annuity or a TAP after September 20 rushing to buy annuities right now.

“For that reason I suspect we won’t see people coming across from annuities for a while because I think we’re seeing a pull forward of that demand in the period leading up to September 20,” Lowe says.