Understanding superannuation and how retirement income works

Have you ever wanted to understand more about retirement income sources and how money works once you officially stop accumulating superannuation? Nicole Pedersen-McKinnon explains the basics of how superannuation income streams work (and how they fit in with the age pension and tax).

By Nicole Pedersen-McKinnon

A plain English guide to retirement income sources in Australia

We are so very lucky, here in Australia, to have had superannuation ticking away since 1992 for us ... In the background of our working lives, so that we can at some stage stop work.

And even if you have not taken much of an interest in where your super was going during this so-called accumulation phase, the system is set up so that your fees should be small and your investments (theoretically at least) sensible.

That’s because if you don’t choose a fund, you automatically go into a simple MySuper product that must charge low fees and invest your money broadly and somewhat safely.

But all those safeguards while you are reserving end when you are retiring.

Yep, it is assumed – though you may have paid little attention to the investment and admin side of super as you built it – that you suddenly know it all when it comes to making it last.

And that’s where a retirement income stream is a beautiful thing.

What you need to know about retirement income streams first

There are a few options when it comes to turning your super investment into income – get across them and you will get more longevity out of your money.

Logically, a retirement income stream can really help you manage your expenses and spending.

But better still, after you turn 60, the earnings on – and income payments from – a pension become tax-free, which can help stretch your retirement savings further.

What you need to know first is that to start a retirement income stream, you must retire and transfer your super from an accumulation account into a retirement account.

You will be able to do this once you reach so-called preservation age – age 55 if you were born before 1 July 1960, up to 60 for those born after 30 June 1964.

Once you have reached your preservation age, you could also start what’s called a transition-to-retirement income stream without retiring (more on the big perks of that one in a mo).

The money you can transfer into a retirement phase account is also subject to a cap of $1.9m in the 2023-24 tax year.

Now knowing those few basics, let’s delve into the available retirement income streams and the advantages on offer, before looking at the impact on any potential Age Pension.

The income streams on offer

1. An account-based pension: flexibility and choice

An account-based pension is one that varies with – you guessed it – the size of your account.

Sometimes known by the older name of an allocated pension, you simply nominate a percentage of your account, beyond a minimum, to withdraw each year – as frequently as weekly if it suits.

The allowable drawdown is set by the Australian Taxation Office (ATO) and calculated based on your age and the account balance. It’s 4% of that balance when you're from preservation age to 65, all the way up to 14% if you're 95 or older.

Your minimum annual payments are determined on 1 July each year but the ability to vary them upwards means an account-based pension is particularly beneficial when you face unexpected expenses or your financial needs change.

(Note that a term allocated pension (TAPs) could also be an option, but only if you are commuting – or ending – a previous TAP. These offer a steady income over a fixed term, with less ability to vary it than a newer-type account-based pension. These don’t have as much flexibility in terms of control over your funds and how they're invested, either.)

Today’s account-based pensions give flexibility and autonomy over your superannuation investments and withdrawal strategies.

But the drawback is that, as open-market investments, they are subject to market fluctuations. If your investments underperform, your superannuation balance might decrease, affecting your ability to maintain your desired income level.

Indeed, with an account-based pension, you can run out of money … literally exhaust your funds because your investment returns have been too low or you have drawn too much.

So, what are your options if you value safety and income certainty over the fluctuations of any invested pension? Well, at the other end of the risk spectrum …

2. An annuity: peace of mind

An annuity provides you with a reliable source of income, paid from monthly to annually, regardless of how markets perform.

In the case of a lifetime annuity, this income is for the rest of your life, regardless of how long you live, thus guarding against the risk of outliving your retirement savings.

But the specific terms and conditions of even lifetime annuities can vary based on the annuity provider and the product you choose.

For example, one option might be a lifetime annuity that indexes your payment to inflation, helping your income keep pace with rising living costs and preserving your purchasing power.

But unless you purchase a more-expensive lifetime annuity with a so-called residual capital value or guarantee (or withdrawal) period allowing you access to your capital early if required, with this type of annuity, when you pass away, the remaining balance of your annuity usually goes to the insurer.

If you die earlier than expected, this could represent a significant loss for you and gain for them.

Your heirs will, of course, miss out.

It’s a big consideration, but some retirees decide the income peace of mind is worth it.

If you are not willing to forego your capital early, you also have the option of a fixed-term annuity – generally between 1 and 50 years – where there is capital returned at the end of the period and you then weigh up afresh the best way to generate income.

Like an account-based or allocated pension, there is still a minimum annual withdrawal worked out at the outset (by multiplying your age-based percentage factor by the purchase price of the income stream).

So, what is a transition-to-retirement pension?

A transition-to-retirement pension, mentioned earlier, is a type of account-based pension.

You don’t need to retire to start one because the idea is that it supplements your income in the final years of working, perhaps because you are phasing back your hours, want to repay a debt or need to cover an upcoming expense.

Note that a regular account-based pension is favourable to a transition-to-retirement one from a tax point of view because there is no tax on earnings within the fund; income generated by either is only tax-free from age 60.

But the big advantage of taking out a transition-to-retirement pension before you retire is to live on your no or low-taxed pension income (which must be in a range between 4% and 10%), then salary sacrifice your wage back into your fund.

Because super contributions are taxed at only 15%, this means higher rate taxpayers especially can come out well ahead (the super contribution tax is 30% if your income and before-tax contributions add to $250,000 or more).

Income streams vs. the Age Pension: the balancing act

Finally, let's talk about how your chosen income stream affects your eligibility for the Age Pension.

The total capital value of most pensions is assessed under Centrelink’s ‘assets test‘. Read more on Age Pension 101.

Since 1 July 2019, only 60% of the nominal purchase price of a qualifying lifetime annuity has been treated as an asset (scaling down to 30% when you hit life expectancy) and 60% of the income counts towards the income test.

The assets test as at September 2023, which includes real estate other than your home, investments, savings accounts and cars, is: ‍

• ‍For singles, the asset threshold for the full pension is $270,500. If your assets are valued above this threshold, your age pension payment is reduced. When your assets reach $583,000 or more, you won't be eligible for the Age Pension.‍
• For couples, the combined asset threshold for the full pension is $405,000. If your combined assets exceed this threshold, your age pension payment will be reduced. Once your combined assets reach $877,000 or more, you won't be eligible for the Age Pension.

For pensions started after 1 January 2015, payments are assessed under the ‘deeming‘ provisions, so the income test doesn’t apply.

This means there could be an opportunity for retirees whose assets are only slightly above the age pension threshold – the more you withdraw from super, the more pension you may be entitled to receive.

And remember, the Commonwealth Seniors Health Card (CSHC) carries lots of discounts and deals. Read more on 5 cards that all Australians should apply for, as well as the 12 amazing benefits for older Australians.

Eligibility is not asset tested; it is income tested – your adjusted taxable income plus a deemed income from superannuation funds that are in pension mode.

If you’re single, the income limit is $95,400 a year and, if you are a couple, $152,640 a year.

Retirement can be the golden era … if your strategy is right.