In Australia, we are pretty lucky to have a government that has a fairly substantial pension system. Now before anyone starts screaming things like “You try living your life off $700 per week!” and throwing eggs at house*, I’d like to mention that the aged pension is not designed to allow it’s recipients to live like kings but more as a supplement to the savings accrued over a life-time of work. With that being said, I’d like to use this article to demonstrate how the aged pension can be used in conjunction with portfolio passive income to produce a retirement income stream.
What is the aged pension?
The aged pension is made up of the following 3 payments:
- Basic rate
- Maximum pension supplement
- Energy supplement
The maximum pension payment that can received depends on whether a single or a couple occupies a particular residence. The following table outlines the maximum fortnightly payments that can be received:
| Per fortnight | Single | Couple (combined) | |
| Max basic rate | $860.60 | $1,297.40 | |
| Max pension supplement | $69.60 | $105 | |
| Energy supplement | $14.10 | $21.20 | |
| Total | $944.30 | $1,423.60 |
Assets and income tests
To keep things more equitable, the size of a person/couple’s payments are subject to the assets and the income tests. The actual value of the pension payment received will be the lesser of the 2 pension payments calculated under the two tests.
Assets test
The pension payment will be reduced depending on the value of a person/couple’s assets after debts have been subtracted. This value varies depending on whether or not a person/couple owns their own home. The following table shows the maximum value of assets that a household can own before their pension payments are reduced:
| Homeowner | Non-homeowner | |
| Single | $268,000 | $482,500 |
| Couple (combined) | $401,500 | $616,000 |
The pension payment is reduced by $3 per fortnight for every $1000 of assets that a household owns past those set amounts. This means that the fortnightly pension value by the assets test can be defined by the following equation:
Income test
The pension payment can also be reduced based on income earned. Like the assets test, the maximum amount that can be earned depends on the household’s situation. The following table summarizes the income limits after which the pension payments will start to decrease.
| Income limit (per fortnight) | |
| Single | $178 |
| Couple (combined) | $316 |
The value of the pension received is reduced by $0.50 for every dollar of income earned over the values stated in the table above. We can define the fortnightly pension payment using the equation below
With that being said, the income test, is actually aimed more at testing for active income (income from working) as opposed to passive income. If income is earned only passively then the government can apply a deeming rate to your assets to calculate your income. The deeming rates are as follows:
| Single | 0.25% for the first $53,000 | 2.25% over $53,000 |
| Couple (combined) | 0.25% for the first $88,000 | 2.25% over $88,000 |
What I’ve outline above are only the standard pension conditions however there are other factors that the government will consider when assessing eligibility such as disability or hardship. For the full details please refer to Services Australia or speak to a financial advisor.
Generating the pension payment using investments
If we lived in country that did not provide a pension, we would have to generate all retirement income through investments. In order to generate the maximum pension values of $944 and $1,424 per fortnight a household would need a portfolio value of $613,600 (single) and $925,600 (couple) – assuming a 4% withdrawal rate. Hence why I mentioned earlier that we have a fairly substantial pension system.
Using the pension to boost total income
Because of the way that pension payments are reduced gradually by the income and assets tests it is possible to combine the pension payment with passive investment income to help fund retirement. However, because pension payments decrease as assets and income (passive or active) increases this creates an interesting optimization problem. One which my inner engineer feels the need to crunch the numbers and find an optimized solution.
The intent of this simulation is to show how total retirement income, defined as the sum of pension payments and portfolio distributions changes as a portfolio grows. For the simulation I’ve applied the following assumptions:
- Portfolio distributions are 4% after taxation under both the income test and asset test scenarios
- No active income is generated i.e. all income is passive
- The deeming rate is applied for the income test to determine the portfolio required at each government estimated income level
- The households do not have an dependents
- The situation applies to the standard pension
- All members of the household are eligible to receive the pension
- There are 26 fortnights in a year
The 2 graphs below that show total income (pension + distributions) vs portfolio equity; one for the single person household and the second for a couple household. The red line represents the total eligible fortnightly income under the income test. The green line represents the total eligible fortnightly income under the assets test for the non-homeowner case and the blue line represents the homeowner case.
What does the simulation show?
Eligible income under the income test
Looking at the red lines in both graphs we observe that a household will be better off with a larger portfolio even though the pension payment will decrease. This is because for each $1 of extra passive income that can be earned the pension payment only decreases by $0.50.
Furthermore, because of the deeming rate being much lower than the 4% portfolio yield a large portfolio is required to generate a small amount of government estimated fortnightly income. For example, to generate the fortnightly income limit income of $316 ($8,216 p.a) for a couple requires a $447,267 portfolio. However, when we take the fortnightly income generated at 4% by a portfolio of that size it results in distributions of $688 per fortnight. This results in a total possible income (pension + real portfolio distributions) of $2,112 per fortnight under the income test.
The result of this is that the assets test becomes the limiting factor when determining the amount of pension received.
Eligible income under the assets test
Under the assets test the simulation shows that after a household reaches the asset limit the passive distributions increase by less than the amount that the pension falls. In other words, for every $1,000 of additional assets held over the asset test limit the fortnightly pension amount falls by about $3 whereas the passive income received from portfolio distributions increases by about $1.54. This results in the “V” shaped blue and green lines shown in the graphs above.
Taking a specific example: if a homeowner couple had a $506,500 portfolio, they would receive $1,109 per fortnight in pension payments under the assets test and $779 passive income from their investments; the total being $1888. Overall, this is less than what they would earn if they had a $641,500 portfolio where they would receive $704 from the pension and $987 for a total of $1,691.
Additional notes on assets
At the FFE house when we refer to assets, we tend to only refer to our investment portfolio and leave items such as cars and computers out of the picture. However, it is important to note that the government may take these items into consideration when calculating a household’s assets. This implies that the asset test limits may be reached earlier than expected. In addition to this, due to such ‘assets’ not being income producing a distribution rate of 4% may be on the high side.
Additionally, something that is very important to note is that the principal home is not counted under the assets test. In addition to this, there is no upper limit to the value of the principal residence that will cause a reduction in pension payments.
What does this mean for retirement savings targets?
Active income
To me, the income test implies that the Australian government is encouraging Australians to continue to work (earn an active income) after they reach the pension age. For example, if a single person’s assets are less than the assets threshold, they can earn an income of up to $2,067 per fortnight before the pension is cut off completely. Whether they are willing and able to do so is an entirely different story.
Passive income and the assets test
When dealing with passive income using a 4% distribution rate an optimal solution is to only accumulate assets up to the asset test limit. As stated above this is because of the way that the assets test reduces pension payments at a faster rate than distributions increase. The following table summarizes the maximum total passive income that can be earned per fortnight:
| Household situation | Pension | Portfolio Distributions | Total | |
| Single homeowner | $944 | $412 | $1357 | |
| Single non-homeowner | $944 | $742 | $1687 | |
| Couple homeowner | $1424 | $618 | $2041 | |
| Couple non-homeowner | $1424 | $948 | $2371 |
The biggest issue with this ‘optimal solution’ is that the amount of money collected may not be enough to fund your lifestyle. For example, if you are a single person that owns their own home you need to be able to survive on $35,282 per year.
If you intend on generating more income that what is stated above you’ll need a much larger portfolio. Assuming a 4% distribution rate, using your portfolio to generate the same level of income as listed in the table above you will need:
| Household situation | Asset test limit | Portfolio equity required |
| Single homeowner | $268,000 | $882,050 |
| Single non-homeowner | $482,000 | $1,096,550 |
| Couple homeowner | $401,500 | $1,326,650 |
| Couple non-homeowner | $616,000 | $1,541,150 |
When I look at these numbers, I find it a little off putting. To put this into context, taking the homeowner couple example, their total passive income would be roughly the same if their portfolio was $401,500 or $1,326,650. Between these two figures is a sort of ‘no man’s land’ where they are actually being penalized, in the form of reduced pension payments, for building a larger investment portfolio.
What can be done about this?
So, if you find yourself stuck between the maximum asset limit and the values listed above what can you do about it?
If you’ve been able to reduce your expenses to be able to survive on the passive income levels listed above then reducing the value of your portfolio would provide you with more total income, due to receiving higher pension payments. It would also provide you with the material benefits of spending the proceeds that come from the asset sales. As discussed earlier the principle residence, regardless of value, is not counted under the assets test. This implies that you could spend your capital upgrading your principal residence or purchase a more expensive home as a method of reducing your asset value.
If reducing expenses is not an option then you’ll either have to get busy building an investment portfolio or working to make up the shortfall. As I have discussed in a previous article, earning an active income from part time work can greatly reduce the amount of money that you need to have invested. It can also help to give people a sense of purpose, connection and value in society.
Another option would be to increase rate of distributions from your portfolio by choosing assets that have a higher yield. It is important to remember that this may increase portfolio risk which reduces the probability that your investments will last the duration of your retirement.
Concluding thoughts
The Australian pension system is a generous scheme when you take into consideration the size of the investment portfolios required to generate similar levels of retirement income. When used to in conjunction with investment portfolio distributions it can provide a substantial source of income. For example, a couple that owns their own home and has $401,500 in assets could potentially receive a total income of $53,073 p.a. ($37,013 in pension payments + $16,060 in portfolio distributions).
The ‘no man’s land’ that exists between the asset test limit and the minimum portfolio value required to generate that level of income exclusively is something that you need to be mindful of when planning your finances. While the results of this simulation may seem discouraging, I would actually consider them to be empowering because they can help to facilitate decision making around either reducing cost of living or targeting a sufficiently large investment portfolio.
One of the major factors that contribute to success in personal finance is using information to plan for your future. What we do today will have a dramatic effect on our financial lives in 10, 20 or even 30 years’ time. So, if you’re relatively early in your personal finance journey I think it would be a smart move to aim for a fully self-funded retirement that does not rely on the aged pension at all. This way you will be less reliant on the government to fund your retirement which results in a greater level of freedom. In addition to this you won’t need to wait until you’re old enough to receive the pension.
Engineer your freedom
*If you are struggling to live off the pension payments you should be eating those eggs, not throwing them at my house 😛
References
Services Australia, 2020, Age Pension, Australian Government Services Australia, viewed 9/8/2020, <https://www.servicesaustralia.gov.au/individuals/services/centrelink/age-pension>
Services Australia, 2020, Incomes test for pensions, Australian Government Services Australia, viewed 9/8/2020, < https://www.servicesaustralia.gov.au/individuals/services/centrelink/age-pension/how-much-you-can-get/income-test-pensions>
Services Australia, 2020, Assets test, Australian Government Services Australia, viewed 9/8/2020, < https://www.servicesaustralia.gov.au/individuals/services/centrelink/age-pension/how-much-you-can-get/assets-test>
Services Australia, 2020, Deeming, Australian Government Services Australia, viewed 9/8/2020, <https://www.servicesaustralia.gov.au/individuals/topics/deeming/29656#howwe>