Beware the lure of the lump sum

In days gone by, one incentive for choosing a lump sum over an indexed pension was concern about an early death.
In days gone by, one incentive for choosing a lump sum over an indexed pension was concern about an early death.

Poor investment returns over the past five years have, understandably, increased the attractions for CSS, PSS and MSBS members to draw indexed pensions rather than lump sums from their superannuation funds. The federal government has now joined the party, adding further attractions via substantially reduced tax liabilities, particularly in the lower-income ranges.

This is the result of the threefold increase in the personal tax threshold from $6000 to $18,200 a year. The low-income tax offset also ensures that an annual income of $20,542 is free from tax. Between this income and $37,000 a year, a marginal tax rate of 20.5 per cent applies, meaning that an indexed pension of $37,000 a year now attracts a tax liability of $3374, or 9.1 per cent of the income received.

After the age of 60, taxable indexed pensioners become eligible for a non-refundable tax offset of 10 per cent of their taxable pension. This offset results in a tax-free pension of as much as $39,500 a year.

The 10 per cent tax offset was introduced in 2007 as part of the changes that exempted from tax all funded pensions received after the age of 60. For PSS and MSBS members, this exemption adds to the attractions of converting their member contributions and accumulated interest to an indexed pension, rather than taking it as a lump sum.

The PSS pension is a highly attractive option compared with those available in the private sector. At age 60, PSS members can convert their accumulated member contributions to a lifetime indexed pension, with an accompanying surviving partner benefit, to get an effective inflation-indexed 9.1 per cent annual yield. This is twice the return available from privately bought lifetime annuities, and the payment is a commitment of the triple-A rated federal government. There is no safer, higher-yielding, retirement investment available today in Australia.

Taking the full, indexed pension option from the PSS and MSBS will maximise the tax-free income available after age 60. Between ages 55 and 60, tax liabilities are also reduced via an annual deduction for the member contributions to the fund, and a 15 per cent tax rebate on earnings on those contributions.

After 60, the first $39,500 of indexed pension is tax-free, whether it is an unfunded employer benefit or a funded member-component pension. For higher levels of annual pensions - for example, a $60,000 pension made up of a $20,000 annual member component and a $40,000 unfunded employer pension - the tax liability is minute. In the above example, it's about $500. Extra tax is, of course, payable if retirees have other income.

These favourable tax advantages emanate in large part from the government's decision to allow PSS and MSBS members to convert their lump-sum benefits to an indexed pension. The PSS also rewards members who opt for the maximum 10 per cent personal contribution by giving them a higher, unfunded employer benefit than they would receive for a lower contribution rate.

Before the introduction of the 2007 tax changes, the government realised that the indexed pension benefits offered to members who contributed more than the standard 5 per cent were too generous. This resulted in the decision to close down the fund to new members from July 1, 2005.

While there's a natural tendency for some people to want to take their money as a lump sum, the reality is that, with increasing longevity and growing uncertainty about investment returns and safety, government-provided indexed pensions are a highly attractive investment option.

In days gone by, one incentive for choosing a lump sum over an indexed pension was concern about an early death. Now, after the global financial crisis and with continuing uncertainty about investment returns, the concern for people taking a lump sum is that they will outlive their money. Indexed pensions remove any uncertainty about money being available in retirement, even at very advanced ages. The latest tax changes are icing on the cake for those public servants lucky enough to have been employed before the 2005 decision to close off access to indexed pension benefits.

Daryl Dixon is the executive chairman of Dixon Advisory.

This story Beware the lure of the lump sum first appeared on The Sydney Morning Herald.