As part of the 2019/20 Federal Budget, the Government announced an intention to legislate a new covenant for super funds, which will require trustees to have a retirement income strategy in place for members. After an initial consultation in June 2018, all went quiet on the retirement income covenant front, until now.

With the release of the Retirement Income Review report in late 2020, the Government has reconfirmed its intention to legislate a retirement income covenant with effect from 1 July 2022 and some super funds have already started introducing new products in line with the covenant.

In this article, we look at the latest developments relating to the retirement income covenant and review the Comprehensive Income Products for Retirement (CIPR) framework.

Please note this article is based on the latest Australian Government Treasury consultation paper released on 19 July 2021 and the final implementation of the framework is subject to legislation passing.

What is the retirement income covenant?

At its core, the retirement income covenant is a requirement for super funds to develop a retirement income strategy for their members.

The need for the covenant was highlighted in the Retirement Income Review, which found that while, on average, people are retiring with sufficient assets to support their retirement, the capital saved during their working lives is not used ‘efficiently’ throughout retirement.

Given that the second-largest source of wealth, behind the family home, is superannuation, much focus was placed on retirees’ interaction with their superannuation through retirement.

Currently, most super funds have a single pension offering – the classic account-based pension. This income stream provides a minimum pension requirement that increases with age and does not provide any longevity protection.

While appropriate management and financial advice in relation to an account-based pension can help individuals make optimal use of their savings, the Retirement Income Review found many people do not seek advice at retirement and would treat the minimum drawdown requirement as a ‘suggestion’ from the Government as to how much they should be spending in retirement.

In addition, the minimums required for an account-based pension create an inverse cash flow pattern, compared to expected retirement consumption. That is, the minimums start quite low and increase over time. In practice, an individual would tend to decrease their spending as they get older. This is also somewhat intuitive as fresh into retirement, ambitions for travel and expenditure tend to be higher than when your client ages and may not have the health to support the same level of activity.

The Retirement Income Review also put forward that while individuals have capacity to use their funds more efficiently, concerns around the longevity of their capital can prevent members, particularly those unadvised, from drawing additional funds – even if doing so would not significantly jeopardise their longer-term ability to fund their retirement.

When super is your ‘nest egg’, people become reluctant to draw down on their capital, even if this is what the system intends.

As part of their retirement income strategy, trustees are expected to determine cohorts of members and consider their retirement income needs, including consideration of both tax and social security benefits.

This holistic undertaking is not simply about optimising the amount of capital or income a person may achieve over their requirement, but also consider things such as requirements to access capital. This needs to be balanced with managing longevity and investment risks. Trustees are also expected to provide guidance and tools for members to self-serve at a basic level.

However, the latest consultation has done away with the ideas of requiring a ‘default’ retirement income stream product and a minimum number of CIPRs that must be offered by a fund for the trustee to ‘nudge’ their members towards at an appropriate time. Even setting aside the advice-related problems with nudging, a default retirement product – particularly one that may provide only limited access to capital – could lead to sub-optimal outcomes for members.

The Productivity Commission also highlighted this in its report into the efficiency of superannuation, noting that the retirement phase is fundamentally more complex than accumulation phase.

What could the retirement income covenant mean for financial planners?

The retirement income covenant is the responsibility of the super trustee. However, financial planners may encounter some changes:

• As clients are nearing retirement, they may start receiving more targeted communications from their super fund. This could include estimates of a client’s retirement income based on their super balance, and maybe an estimated age pension benefit. As a super fund is not privy to the same level of information as a financial planner providing holistic retirement planning advice, this communication could concern your clients – if the fund estimates a substantially lower level of income than what you and your client have been working towards.
• As trustees develop their retirement income strategies, this could involve the development of new innovative income streams that conform to the CIPR requirements. This could create a new set of income stream structures financial planners would need to consider beyond the account-based pension.

CIPR framework

The framework for trustees to develop CIPRs (also called innovative income streams) has been in place since 1 July 2017, with the introduction of Superannuation Industry (Supervision) Regulations 1994 (SIS Regulation) 1.06A. This regulation takes a step away from the standard pension and annuity practice of prescribing a reasonably strict payment framework, and instead has the following broad requirements:

• The benefit cannot meet the account-based pension standards.
• A payment cannot be made before the client meets one of the following conditions of release:
  • Retirement.
  • Death.
  • Terminal medical condition.
  • Permanent incapacity.
  • Reaching age 65.
• A payment must be made at least annually throughout the life of the account owner or reversionary beneficiary.
• The amount of the payment is determined in a way that makes sure the payments are not unreasonably deferred after they start, having regard to how the payment amount is determined.
• The maximum amount that can be commuted after the income stream has commenced is no greater than as calculated under SIS Regulation 06B.
• The benefit can only be transferred on death to an eligible dependant who can receive an income stream, under SIS Regulation 6.21(2)(b), (2A) or (2B).
• The benefit cannot be used as security for a borrowing.

Note an innovative income stream can also be purchased on a deferred basis, as long as the payments do not start before a relevant condition of release is met, and the benefit can only be commuted if a condition of release is met that would allow for the cashing of an accumulation phase benefit.

These are the minimum standards, meaning that it is not a requirement that a CIPR commence payment once a condition of release is met, but simply that the rules of the income stream do not allow for payment before the relevant condition of release is met. Each income stream can have a different payment start date, even within the same fund.

Maximum commutation amount under SIS Regulation 1.06B

If a CIPR is commuted before it has commenced paying an income stream, within 14 days of commencement of payments or if the owner passes away within the first half of their life expectancy, the fund can commute the ‘access amount’, which is defined as the maximum amount available for commutation on the date the client met the relevant condition of release, plus any additional contributions to the income stream after that date.

Depending on the rules of the income stream, this can provide limited protection for individuals (or the beneficiaries) to receive at least some of their funds should they pass away before the halfway mark of their life expectancy, or if their circumstances change when they reach a condition of release.

However, in any other case, the maximum commutation is limited by the following formula:

In this context:

• Life expectancy period is the number of days during the ‘complete expectation of life’ as calculated under the Life Tables of the holder of the benefit at the retirement phase start date (i.e. the date the member meets an eligible condition of release).
• Remaining life expectancy is the number of days from commutation to the end of the life expectancy period.

In practice, this formula provides a reducing rate of capital that can be accessed over the lifetime of the income stream that is not linked to investment return over time. It is worth remembering this is the maximum allowable amount and a specific product can determine a lesser value for an income stream.

The intent behind these rules is to allow trustees to develop income stream products that broadly provide a consistent level of income throughout a member’s lifetime, although the trade-off is reducing access to capital over the lifetime of the income stream, and a limited return of capital if the individual passes away over halfway through their expected retirement. This fundamentally results in super trustees pooling capital for these account types, using any excess amounts from one member to supplement the shortfall for another.

A type of income stream that satisfies CIPR requirements is an immediate lifetime annuity. These are pooled products which provide a very consistent income stream for the lifetime of the member but come with substantial restrictions to capital access compared to an account-based pension.

Social security treatment of CIPRs

To further encourage trustees to develop CIPRs, the Government passed changes to social security law in 2019 to provide a new category of income streams with their own income and assets test considerations. It is important to note these requirements are separate from the super law definition of CIPRs discussed above, and instead rely on their own definition of assets-tested income stream (lifetime).

Largely, these rules align with the requirements noted above, particularly in terms of access to capital. However, the means testing concessions do not require the CIPR to be purchased in super, allowing individuals who have wealth outside of their super to invest in a lifetime income stream and obtain the same social security treatment as those using super. As a result, non-super annuities can fall under this new definition and have a differing social security treatment. This definition only applies for income streams commenced after 1 July 2019.

From an income test standpoint, an assets-tested income stream (lifetime) has 60 per cent of the gross annual payment included under the ordinary income test. Whilst this is meant to be concessional, given the current historically low deeming rates, this may actually result in a higher income test. Additionally, the traditional annuity ‘deductible amount’ calculation may have provided a lower level of assessed income, as the new calculation effectively treats 60 per cent of the gross payment as being income, with only 40 per cent reflecting a return of capital.

Under the assets test, setting aside deferred CIPR products, there are two stages of assets test concessions:

• From commencement to the threshold day, 60 per cent of the purchase price is assessed.
• From the threshold day onwards, 30 per cent of the purchase price is assessed.

The threshold day is the longer of:

• Five years after commencement, or
• The client’s 84th birthday – this is calculated from the average life expectancy of a 65-year-old male at commencement.

In combination this provides a reasonably consistent level of means testing, with only one change in the assessed value of the CIPR, compared to a six-monthly amortisation of value that applies to non-CIPR annuities. Conversely, over the longer term, the CIPR means testing may result in a higher level of assets being included for means testing – especially in the case where a client outlives their life expectancy.

Back to the future?

The idea of a broadly consistent income stream is not revolutionary. In fact, the original super income stream was a lifetime income stream funded from a pool of investments managed by the trustee – the classic defined benefit.

However, over the last few decades, there has been a marked and deliberate shift away from a defined benefit system to a defined contribution system, which by its very nature shifts the retirement funding risk from the trustee (who has to pay a lifetime income stream for its members) to the clients (who must each manage their capital individually). In this context, clients are sacrificing their own salary, or making contributions from the sale of their home or their small business – and a CIPR is putting the return of that capital back to members at risk.

We have seen various attempts over time to provide a more structured drawing of super benefits, namely complying pensions and term allocated pensions from the early 2000s. Over the past 15 years though, these income streams have become less ‘fit for purpose’ and many clients who made decisions based on the law in, say, 2004, may have entered into products that no longer meet their needs. Due to the restrictive nature of some of these products, these members are not currently able to exit these arrangements.

As part of the 2021 Federal Budget, there is a proposed two-year window to allow individuals in these legacy income stream products to exit these arrangements and move into more suitable products.

Whist this is a fantastic outcome for clients who have been all but forgotten during the myriad of changes to super over the years, it does provide a precedent for decisions made to exchange access to capital for a lifetime income stream, which could create greater issues in the future. Whether CIPRs are destined for a similar fate is yet to be seen.

Josh Rundmann is Technical Services Manager, IOOF.

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QUESTIONS

To answer the following questions, go to the Learn tab at moneyandlife.com.au/professionals

1. Which of the following is not a requirement for a CIPR under super law?

1. The benefit must provide an annual payment.
2. The benefit cannot begin making payments until an eligible condition of release is met.
3. The benefit must be accessible in part, at any time.
4. The benefit cannot be used as security for a borrowing.

2. Sally purchases a CIPR on 1 July 2021. She is 75 years old at the time. What is the threshold day for the CIPR?

1. Sally’s 80th birthday.
2. 1 July 2026 (i.e. five years after purchase).
3. As Sally was over 65 at the time of purchase, the income stream does not have a threshold day.
4. Sally’s 84th birthday.

3. What is the date the concessions for an assets-tested income stream (lifetime) became effective?

1. 1 July 2019.
2. 1 July 2017.
3. 20 September 2016.
4. 1 January 2015.

4. After the pension has commenced but before the threshold day, what is the correct means test treatment of an assets-tested income stream (lifetime)?

1. 60 per cent of the gross income is included as income and 40 per cent of the purchase price is included as an asset.
2. 40 per cent of the gross income is included as income and 60 per cent of the purchase price is included as an asset.
3. 60 per cent of the gross income is included as income and 60 per cent of the purchase price is included as an asset.
4. 40 per cent of the gross income is included as income and 40 per cent of the purchase price is included as an asset.

5. At age 66, Tony is concerned about how he is going to fund his retirement. He talks to his financial planner, Beth, about the suitability of income products for his retirement. Which of the following would most likely be defined as a CIPR?

1. An income stream that provides a death benefit of 50 per cent of the purchase price up to age 100.
2. An income stream that provides a fixed annual payment for life with no ability to commute after five years.
3. An income stream that provides a fixed level of income for 30 years.
4. An account-based pension where the member has selected an annual pension above the minimum.