I love working on strategies for clients but sometimes you just need a true expert or excellent software to crunch the numbers. I was looking for some ideas on downsizing as it had become clear to me that is was not the panacea to retirement funding that client’s often believe it would be. So I was looking for an in-depth article working through the numbers and Rob van Dalen of Optimo Financial has kindly stepped up to provide the required analysis in our latest guest blog. Rob’s main warning is to do your sums on your own particular situation before leaping in to a downsizing strategy.
Rob van Dalen | General Manager
T 02 8622 2296
rvandalen@optimofinancial.com.au | www.optimofinancial.com.au
Optimo Financial
Suite 204, 10-12 Clarke Street, Crows Nest NSW 2065
PO Box 931, Crows Nest NSW 1585
Do Your Sums Before Downsizing
A popular subject often talked about at family barbecues is; “should mum and dad downsize when they get older?” Often it’s assumed that downsizing is the best option moving forward. To test and possibly challenge this we decided to run a few scenarios through our Pathfinder Financial Optimisation Platform to find out. Read our findings below;
1.1 The Clients
In this example, we look at the case of David and Alice who have recently retired and who will soon both be eligible for the age pension. David was born on 11 April 1953 while Alice was born on 15 November 1952. They have a modest $400,000 in super. Their other assets are the family home valued at $900,000 and personal assets valued at $40,000. They have no debt. They would like to have $50,000pa (increasing at CPI) for living expenses. They are worried that their super is not sufficient to maintain their desired income. Consequently, they have contemplated selling the family home and moving to a cheaper area where they could buy a new home for $500,000. Will downsizing leave them better off?
1.2 Assumptions
We have assumed in the analysis:
· Pension fund returns 5.7%pa;
· House selling costs 2.5%;
· House purchase costs 6% (including stamp duty);
· House prices in the long term increase at 3%pa;
· CPI 2.5%p.a.
1.3 Scenario 1: Retain Current Home
We first examine the scenario where David and Alice retain their current home. In this case, they will receive income from the government pension as well as drawing a pension from their own super. Figure 1 shows the sources of their income over a 20 year period.
David and Alice receive approximately 64% of their income from the age pension and associated benefits (see also Figure 6 below). The remainder is withdrawn from their pension account through withdrawing the minimum amount each year (plus some extra for the first few years until they become eligible for the age pension).
Their age pensions are limited approximately equally by the income and assets tests. After 20 years, David and Alice have a combined wealth of $1,960,000 most of which is from the family home.
1.4 Scenario 2: Downsizing Family Home in 2016/17
The next scenario sees David and Alice downsizing their family home from $900,000 to $500,000 in 2016/17. Their ages enable them to deposit the excess funds generated from the house sale into super as non-concessional contributions. However, a Pathfinder® analysis shows that increasing their superannuation balance reduces their age pension because, unlike the family home, super counts towards the age pension assets test and is deemed for the income test. Figure 2 shows the results of the age pension assets and income tests for David and Alice and we can see that their pension is now limited by the assets test. For a home owning couple, the age pension reduces at a rate of $3 per fortnight for each $1,000 of assets in excess of $575,000. This taper rate was doubled from 1 January 2017, so now has a much larger impact on the pension received.
So in 2019/20, for example, their age pension reduces from $36,337 to $9,004 and they must draw more from their pension account to make up the difference. Their wealth after 20 years is now projected at $1,581,000 or about $379,000 less than in the first scenario.
1.5 Scenario 3: Downsizing Family Home in 2027/28
In the third scenario, we examine the possibility that David and Alice defer the downsizing for ten years, say in 2027/28. Their age pension is initially unaffected until they downsize the family home, but after that time their age pension payments are severely curtailed. Their projected wealth after 20 years is now $1,714,000. This is a better outcome than in the second scenario but is still $246,000 less than if they keep their existing home.
1.6 Comparing the Scenarios
Figure 3 gives a comparison of the annual age pension received in the three scenarios. You can see that the scenario where they retain their current home, yields a higher pension and that their pension drops sharply after the sale of their house in the other two scenarios.
Figure 4 shows the total age pension payments over the 20 years. You can see that by keeping their original family home, their total pension entitlement is significantly higher than either of the downsizing options we analysed.
Figure 5 shows the total wealth over the 20 year period analysed.
The first point to note is the importance of the age pension towards retirement income, depending, of course, on the particular circumstances. Figure 6 shows the composition of retirement income over the 20 years analysed for Scenario 1.
1.7 Conclusions
In this example, the age pension plus estimated concession card benefits contribute about 64% to income while the account based pensions contribute about 36%. The second point is that downsizing the family home may not result in improving the overall situation as an increase in payments from a private pension may be more or less offset by a decrease in the age pension.
1.8 Pathfinder Learnings
In our Pathfinder® analysis, we find, perhaps surprisingly, that a couple could be considerably worse off by downsizing the family home. Any funds added to super by the income generated from downsizing could be dissipated by a reduction in the age pension. In addition, the costs of sale and repurchase of a family home are significant.
The age pension can provide a buffer between retirement savings and lifestyle expenses.
For persons eligible for the age pension, downsizing the family home may leave you worse off financially because of the impact of the age pension income and assets test.
Thank you Robby
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Liam Shorte B.Bus SSA™ AFP
Financial Planner & SMSF Specialist Advisor™
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Victor Clarke
/ September 12, 2017This article, in common with most similar articles, does the analysis based on a conservative asset mix. That seems to be the default advice that financial planners give to clients.
In my view, that advice is based on a wrong assumption. It forgets that the Aged Pension acts as a fantastic “stop loss” policy for everyone in that age range. Effectively the pension is a large “defensive” asset that allows people to take a more aggressive investment strategy. See this article from Cuffelinks that explains this very well
https://cuffelinks.com.au/age-pension-worlds-greatest-annuity/
A far better strategy would be to invest the majority of the money more aggressively (portfolio heavily weighted towards equites rather than fixed interest / cash).
Under this strategy, over the long run the portfolio would be likely to generate say 10% made up of dividends 4.5%, benefit of imputation credits 2% and capital gains 3.5% (nil tax as money in pension). The couple can live on the 6.5% and bank the capital gain, or if they want also draw down some of the capital over time – resulting in far higher outcomes (with theoretically more risk).
Four ranges of outcomes potentially arise:
1. market goes up and down, but over time grows at an average of 3.5% (conservative compared to history). They can spend the income of 6.5% and their assets grow at 3.5% – income is much higher than relying on the pension as the main income source.
2. market goes into a crash, and say falls 35%. In this scenario, actually their income probably only declines 10% as even in crash situations all that happens is dividend yields blow out, and most of the dividends they received previously continue. If they ride the crash out, all our history tells us that over time the asset values will recover (although it may take time). They still are much better off, and may get a little more pension than they were previously to partly cushion the decline.
3. market crashes 35% and asset values never recover in their lifetime, and dividends also fall 35% (or even worse they sell all their equities at the bottom of the crash and it does recover. Yes in this scenario their income is less than outcomes 1 and 2, and their assets are 35% less than under your scenario. However their income is likely more than the conservative scenario, and to the extent it declines, their pension income increases to partially offset. Remember though this is a relatively unlikely outcome, providing they don’t sell the assets at the bottom of the market!
4. Doomsday scenario. Market crashes 75% and never recovers in their lifetime. Yes total wealth is blown up, but they still have similar income to your scenario. So the kids lose out on an inheritance, but the couple are protected. A very unlikely scenario (but of course feasible).
People really need to think about what is their goal – in my view it should be about maximising income across the remaining lifetime. A conservative asset mix is just a way of ensuring that income declines over time with inflation and protecting assets (but exposing them to inflation) for the next generation. A more aggressive asset mix will deliver far better income outcomes for the retirees, most likely deliver higher asset values, and in the event of a doomsday scenario they are unlikely to be much worse off due to the protection of the age pension.
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SMSF Coach - Liam Shorte
/ September 12, 2017Hi Victor, while I agree with your premise that retirees should look to maximise income, most financial planners find that people need the “sleep factor” more as they age and when Alan Kholer comes on the news at 7pm and says the markets have dropped, people really worry and some panic. I do believe education and transparency of portfolio is the key. You can show most retirees all the projections in the world and that will not matter a damn if they are scared. At Verante we work on a educating clients over the long term to take a Moderate or 50/50 approach to investing in retirement and ensure they have 3-5 years cash flow in defensive assets supported by a shares and managed fund and/or property portfolio. So I believe a happy point can be found somewhere between the traditional Conservative model which is very much promoted int he USA and your Aggressive Model. Thank you for contribution to the debate.
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