Retiree clients with minimal retirement savings and an unencumbered family home may see unlocking equity from their principle residence as the only way to generate additional income for a comfortable retirement. Common ways to access equity in the family home include selling the property or using an equity release product i.e. a reverse mortgage. However, a commercial reverse mortgage can have high costs including the interest rate, upfront/ongoing and exit fees. As an alternative to a commercial reverse mortgage, clients may wish to consider the Pension Loan Scheme (PLS), the Government’s version of a reverse mortgage.
In this article we provide insight on how these two strategies compare – downsizing the home and using surplus proceeds to generate a retirement income stream via the superannuation system versus retaining the home and generate income via the PLS.
STRATEGY ONE: DOWNSIZE TO A CHEAPER HOME AND MAKE A DOWNSIZER CONTRIBUTION
A client aged 65 and over who meets the eligibility requirements can choose to make a downsizer contribution into their superannuation of up to $300,000 (for each member of a couple) from the proceeds of selling their home. To qualify a client or their spouse must have owned the property for more than 10 years and be able to claim at least a partial capital gains tax (CGT) main residence exemption on the disposal unless acquired pre-CGT – please refer to the ATO website for a detailed explanation of the eligibility rules.
Once downsizer contributions have been made clients can use the amount to commence an account-based pension (ABP) provided it does not cause them to exceed the $1.6 million transfer balance cap.
An ABP is flexible and tax efficient as lump sums can generally be withdrawn from the product at any time and both the pension payments and earnings on assets supporting the income stream are tax free. One of the downsides of this product is that ABPs are means tested by Centrelink and likely to reduce a client’s Age Pension entitlement.
STRATEGY TWO: PENSION LOAN SCHEME
Under the PLS, eligible pensioners can choose to top-up their fortnightly Centrelink pension by up to 1.5 times the maximum rate of Age Pension (including any relevant supplements) and can improve their standard of living. For example, a couple receiving the maximum rate of Age Pension (currently $37,013.60 p.a. as at 1 July, 2020) can increase their entitlement to $55,520.40 p.a. which is close to 90% of what a couple aged around 65 will require to live a comfortable retirement lifestyle according to the Association of Superannuation Funds of Australia (ASFA) Retirement Standard.
A big advantage of the PLS is that it is a relatively simple Government administered scheme providing additional fortnightly income. It can be stopped and adjusted at any time (subject to repayment of the outstanding loan) and the interest rate (currently 4.5% pa) is generally lower than interest rates offered on commercial reverse mortgage products.
The PLS can help clients avoid the need to sell property when market conditions are unfavorable and it can provide additional income for clients who receive a reduced rate of Age Pension; for example, clients living on a farm with acreage in excess of two hectares whereby the assessment of excess land reduces or eliminates their Age Pension entitlement.
The additional Age Pension amount accrues a debt due to the Commonwealth and is secured against a nominated property. The debt is subject to compound interest rate (4.5%
p.a. commencing from 1 January, 2020) applied fortnightly.
A maximum loan amount applies and when reached, PLS payments will cease and interest will continue to accrue until the loan is repaid. The maximum loan amount is not fixed and is recalculated every 12 months in January or July, following a person’s birthday to adjust for the higher age component available. The maximum loan amount is determined based on a set formula depending on various factors including the amount of equity held in the property and the age of the applicant. Refer to the Guide to Social Security Law 220.127.116.11 for formula and age component amounts.
All or part of the debt can be repaid at any time however this usually occurs after the property is sold.
Adam and Amanda are both 70 years of age, their family home is worth $1.2 million and the only other assets they have are a term deposit of $50,000 and home contents of $10,000. They are struggling financially as their only source of income is the full Age Pension (currently $37,013.60 p.a. as at 1 July 2020). They would like to access the equity in their home and seek to compare accessing the PLS at the maximum rate (1.5 times the maximum Age Pension) versus an equivalent income stream generated by making a downsizer contribution and commencing an ABP.
Consider the following two strategies:
- Utilising the PLS to increase their entitlement to 1.5 times the maximum Age Pension. They receive $55,052.40 of Age Pension in year one, meaning they effectively borrow $18,038.80 p.a. indexed in-line with Age Pension.
- Downsizing to a smaller apartment and releasing $600,000 of equity. They each make a $300,000 downsizer contribution into superannuation and commence an ABP. Under the Assets test, their Age Pension reduces by $20,163 in year one. They increase their ABP pension payment, ensuring they achieve $55,052.40 per annum of income.
To ensure a like-for-like comparison, we have kept the cashflow under both scenarios the same i.e. any reduction in the age pension is compensated by adjusting drawdowns from each person’s ABP. Table 1 shows a comparison of the two scenarios after 20 years.
Source: Aus Unity
A significant contributor to this outcome is the effect of the ABP reducing the Age Pension under the assets test if they were to utilise the downsizer and ABP strategy. In the first year alone, their Age Pension is reduced by $20,163 in comparison to the PLS scenario. Cumulatively, implementing the downsizer and ABP strategy results in a reduced Age Pension of $145,650 over 20 years.
Table 2 shows a summary of some simulations considered. Through these simulations, it’s worth noting that clients don’t need to achieve exuberant returns from their ABPs to get a better outcome than the PLS, unless the annual growth rate of real property is high.
Source: Aus Unity
WORDS OF CAUTION FOR PLS
Like a commercial reverse mortgage, it is imperative for anyone considering the PLS to understand the effect of compound interest on the outstanding debt. The total accrued interest can be very substantial as the outstanding loan amount is generally repaid many years after commencement, usually on death of the client. For example, a single pensioner on the full Age Pension who borrows an additional 50% of the Age Pension (approx. $12,567 p.a. indexed to 4% p.a.) under the PLS will accrue a debt of approximately $178,916 after 10 years, $326,656 after 15 years and $530,230 after 20 years. This could have a significant impact on the amount of assets that is ultimately left to the estate of the client.
When accessing the PLS, clients should also note any impact for aged care purposes. While the fortnightly top-up amounts under the PLS are not assessable for aged care purposes, the accrued debt against real property used as security reduces available assets that can be used to pay accommodation or ongoing aged care costs. Where a resident is required to pay an agreed advertised price upon entering a residential aged care facility, the amount which has not been paid as a lump sum is used to calculate an ongoing accommodation cost payable by the resident based on the prevailing interest rate.
Yvonne Chu is head of technical services and professional development at Australian Unity.