Wednesday, June 17, 2015

Pension reform

The reforms on eligibility for the pension that Labor opposes seem sensible to me, The current eligibility for a part pension (for a couple) is $1.15m in assets whereas under the proposed Coalition-cum-Green  reform this is reduced to $823,000.

Suppose couples want to leave no bequests and that they own a house worth $650,000. Suppose also they retiree at age 65 and know they will live for 25 years to age 90.

The big factor determining their sustainable income is the rate of return on their assets and whether they can engineer a reverse mortgage on their house that yields this rate of return.

Suppose their assets earn a paltry 2% annually real return. Someone just on the old current eligibility limit (without a home) can spend $58,903 annually over the 25 years (or $92,102 if you include the reverse mortgage). With the lower eligibility requirement they can spend $42,154 annually (or $75,448 with the reverse mortgage).

More realistically suppose returns of 5% annually on the investments.  Under the old limit they can (without a home) get income of $81,538 annually (or $127,715 with the reverse mortgage).  Under the lower eligibility requirement they can get $58,393 annually (or $104,000 with the reverse mortgage).

I have used simple annuity formulae* to do these calculations.  The basic idea is that you can draw down the value of assets and draw interest on residual asset values until they hit value zero at age 90.  The Labor Party it seems to me in opposing the Coalition reforms is supporting people who don't really need it.  Of course they want it but it isn't an imperative.

With a bit more effort I could allow for bequests and longevity risk but these will change these calculations in a straightforward way.   Bequests anyway are irrelevant in a situation where you are trying to compute eligibility for basic pension entitlements. Notice too how critically the value of the family home enters these calculations.  Excluding the family home from these asset tests  does not seem defensible if the opportunity to purchase reverse mortgages is available.

(*) It is a while since I have done these financial mathematics but the equation I used is that the sustainable income X * annuity formula given interest rates r and time horizon n, namely a(r,n),  must equal the initially value of the capital asset V so X =V/a(r,n).  I think that's right. 

4 comments:

  1. I tend to agree. The more lax allowances introduced by Howard should have never occurred. He and the government thought the commodity prices would be forever high.

    The cost of Super concessions looks to be more costly than anything in pensions.

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  2. I am a lefty, but I too could not see why Labor was upset. It looks a pretty sensible plan to me.

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