Finding the most suitable income stream

Last year's government changes to the assets-testing of complying income streams have expanded product choice for retirees. Deborah Wilson examines a quantitative method for comparing alternative complying income streams and consider the fixed-rate versus indexed income stream issue in light of current market conditions.

The complying income stream market now offers a number of alternatives for advisers and their clients, including non-indexed, CPI-indexed or hybrid-payment products.

In structuring a plan incorporating such products, advisers should apply detailed analysis beyond mere comparison of first-year payments in determining the most suitable type of complying income stream for a client's portfolio.

The comparison process we advocate is more rigorous than just comparing a headline rate or annual payment. It involves:

1. Determining representative rates currently available across product type and term (fixed-term only were considered here for ease of analysis);

2. Making a reasonable assumption of inflation over the term to model CPI-indexed options;

3. Adjusting for any DSS benefits available; and

4. Discounting total cash flows to make comparisons in today's dollars.

Comparing the first-year payments across different income-stream market segments underscores a basic tenet of these products - that non-indexed options have a higher initial payment than indexed versions - and therefore provides no rational basis for a decision.

It's not until we view these options in the context of income generated over the entire term that we are operating on a level playing field.

With an assumed inflation rate of 3 per cent, current market quotes for a $100,000 investment give the results in Figure 1 and show that the total payments from an indexed pension exceed those of a non-indexed pension across all terms. The longer the term, the wider this difference becomes.

Also, we know the annual payments from indexed pensions should at some point overtake those of the non-indexed pension (the cross-over point).

Figure 1 plots the cross-over proportion - the proportion of the total term elapsed when the cross-over point occurs.

At terms of 15 years or more, this is around 33-34 per cent, meaning that for the final two-thirds of the term, a CPI-indexed pension will give a higher total income.

Analysis on raw numbers alone is sensitive to the inflation assumption and does not take into consideration the time cost of money. Including that factor lets us compare income streams which differ in the amount and timing of payments by converting them back to a single value in today's dollars - the net present value (NPV) of the income stream.

Calculation of NPV requires using a discount rate. Figure 2 shows a range of discount rates (the more aggressive the investor, the higher the rate) applied to both CPI-indexed and non-indexed income streams and calculates the inflation rate needed to make the total payments made under either option equal.

This gives a threshold rate, which describes the underlying inflation rate needed for a CPI-indexed income stream to give the same NPV as a non-indexed stream. If inflation is above the threshold rate, the indexed income stream is superior. If it is lower, the non-indexed income stream will produce a better result.

Although it's important to thoroughly analyse these income streams on a stand-alone basis, we must recognise that these products are commonly purchased on the basis of the associated Centrelink benefits to the investor. So consolidated analysis, which includes income from all sources, will capture the overall benefits of each product type.

Figure 3 shows a case study to illustrate this effect. It calculates Centrelink benefits for a single, female home-owner with accumulated retirement benefits of $200,000. The complying pension strategy allocates half into a complying fixed-term pension and the remainder into an allocated pension drawing minimum income with an assumed annual earning rate of 7 per cent and assumed inflation at 3 per cent.

It shows that, in the current environment, CPI-linked income streams offer better value than non-indexed. It also illustrates that comparisons which exclude the time cost of money and Centrelink benefits do not give the full picture.

<I>Deborah Wilson is technical services manager, Advance Funds Management.