The government’s recent criticism of the use of superannuation as an inheritance vehicle raises the question of why older people still have such large balances.
Last month, social services minister Scott Morrison called upon pensioners to “use up” their super balances during their lifetimes rather than hanging on to it to provide a tax-effective inheritance to the next generation.
While the government has now indicated that it does not propose to make any change to increase pension drawdown rates for the time being, it is worth considering the general point he was making at the time.
To the extent that we have a shared understanding of the purpose of super (and I’d argue there’s work to be done on this!), there would probably be broad agreement that it’s not supposed to be an estate planning vehicle.
So are people who don’t spend their super during their lifetime being deliberately annoying or breaking the rules in some way?
Why do people end up still having so much in super when they die?
One reason is simple mathematics.
The minimum drawdown rates for account-based pensions are simply not designed to make super run out very quickly.
The graph below shows how the balance of an account-based pension would change over time (the blue line, graphed against the left hand axis) if the client started with $1 million, achieved investment earnings of 5 per cent per annum and always took the minimum pension possible (red bars, graphed against the right hand axis).
Despite following all the rules, the client would have more than $500,000 (50 per cent) of their original capital left some 30 years later.
Of course, $500,000 in 30 years’ time will be worth a lot less than $500,000 today! But even if we adjust the figures to allow for inflation, it will be over 20 years before the pensioner has used up more than 50 per cent of their capital.
So it’s not surprising that clients could have significant sums left in super when they die.
But there’s perhaps an even more important point that these figures don’t show.
Until 2007, it was compulsory to start drawing super at some point – generally at 65 or slightly later for those still working. Importantly, though, super had to come out some time (it was called 'compulsory cashing').
For some reason that requirement was quietly dropped as part of the 2007 changes to super. I have no idea why. It means that those with very substantial wealth can (and do) just leave their super accumulating indefinitely. They don’t start a pension because that would mean allowing some of their wealth to leave the most concessionally taxed environment available.
While starting a pension might lower the tax paid on investment income in the fund to nil per cent, even the 'accumulation fund' rate of 15 per cent is pretty good when the alternative is personal or company rates of tax.
The biggest issue they face is dying with a large taxable component – at which point there is a risk their children will face a 15 per cent (plus Medicare) tax on the capital they inherit. (And while 15 per cent on income doesn’t sound like much, 15 per cent on capital hurts.) But even that is manageable – many were able to organise their super well enough around 2007 to maximise their tax-free component so this 15 per cent tax on death has little impact. Others are just careful to make sure they withdraw large sums once they reached a very advanced age (in the extreme, just before death).
I’d suggest we review whether it is appropriate to have dropped compulsory cashing before we worry too much about adjusting account-based pension drawdown factors.
Meg Heffron, head of customer, Heffron SMSF Solutions
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