Retired actuary John De Ravin crunches the numbers on owning a home and the Age Pension.
Last Thursday, retired actuary and author John De Ravin explored the outlook for retirees who own their home and for those who rent. It prompted this query from YourLifeChoices member Dennis:
“I just read your interesting article about home ownership vs renting and I found it very informative and well explained for people like myself without your extensive financial knowledge. My question relates to a third or fourth scenario where a retired couple over 65, who have owned their own home for more than 10 years, sell the house and put the government allowed $600,000 into super. How does that compare to your two examples, if they then rented or borrowed to purchase another property?”
Mr De Ravin supplied this extensive explanation.
Dennis, let’s think about your scenario in two stages. First, the sale of the family home to increase your superannuation balance and, second, the repurchase of a principal residence but using mainly borrowed funds.
A. Sale of family home
This essentially means moving from ‘own’ to ‘rent’, but it has the additional advantage that proceeds can be transferred to super whereas after age 65 there are only limited ways of getting additional funds into super. Let’s summarise the advantages and disadvantages:
- produces additional funds for investment to support lifestyle
- the proceeds (subject to the $600,000 limit) may be deposited to superannuation, where there are tax advantages for couples who would otherwise be paying some tax
- maybe the couple wants to sell the house anyway (e.g. it’s too big to maintain, or to move closer to children, or to move to a preferred location, etc).
- sale costs (agent’s commission, other costs of sale)
- effectively an asset, which was formerly the principal residence, has been converted to a financial asset (inside and/or outside the super fund) and whether inside or outside a super fund, the asset will be counted for the purposes of the assets test. Depending on the couple’s circumstances, this may adversely impact the amount of Age Pension they are entitled to receive
- some loss of security of tenure because the couple will now be at risk of a lease not being renewed.
B. Repurchase of a new principal residence but mainly with borrowed funds
- regain security of tenure
- because the property was purchased mainly with borrowed funds, most of the additional funds released by the sale of the former home can remain invested (either inside or outside superannuation), so more investment income should be available
- the new principal residence can be of a size, style and location that the couple may prefer to the former home.
- purchase costs (stamp duty, legal expenses, other costs of purchase)
- the loan for the new property will need to be serviced, which will drain most of the income from the addition to the investable funds
- because the new mortgage loan is against the principal residence, it is deducted from the value of the house (which isn’t included in the assets test anyway). So, only the part of the new property investment costs that is met by the purchaser (excluding the borrowed part) will result in a reduction of asset-testable assets.
So, while there may be some justification for A followed by B above, the use of a mortgage to purchase the new property has the disadvantage for some couples that it reduces their Age Pension even though they are now homeowners again.
Let’s consider a very simplified example. We’ll ignore sale and purchase costs and let’s just assume that the former house was sold for $1 million and the new one was bought for $1 million using 100 per cent borrowed funds – not realistic but a way to highlight the key point. Also let’s assume that before they sold the former home, the couple had $250,000 in funds (maybe inside super, maybe outside but let’s assume inside).
So, before they sell their former home, the couple’s balance sheet is:
Net assets: $1.25m
Asset testable assets: $250,000
At this point they will be getting the full Age Pension.
After they sell, their balance sheet will be:
Other financial assets: $400,000
Net Assets: $1.25m
Asset testable assets: $1.25m
They now will not be entitled to receive any Age Pension.
When they buy their new residence with $1 million in borrowed funds, their balance sheet will be:
Other financial assets: $400,000
Net assets: $1.25m
Asset testable assets: $1.25m
So, they are now homeowners again, but unlike their previous situation, they now will not be entitled to receive any Age Pension. They have $1 million more in investable assets matched by $1 million in additional liabilities, but their additional assets are testable and their additional liability is not a deduction from the assets test. This is not a good outcome.
But what if the Age Pension isn’t an issue?
In the above example, it was assumed that the couple selling their previous home, contributing $600,000 to superannuation and then borrowing to buy a new principal residence, were entitled to receive the Age Pension before they sold their original home. But what about a couple who were never going to receive any pension (perhaps because they have significant other assets comfortably exceeding the upper limit for the assets test)?
Consider a couple who sell their existing home, then contribute $600,000 to superannuation. There are two options, either the couple can continue as renters, or they can then purchase a new home (say, to the same value as their old home) but borrow $600,000 against their new home because they can’t afford the full cost of the new home due to their $600,000 contribution to superannuation. Are they better off than before, or not?
If they sell their home and rent, they will have additional investment income from the additional $600,000 inside superannuation and from the remaining proceeds of selling their home, outside superannuation. Of course, they lose security of tenure and they will also incur expenses of sale of their home. After that, the issue is whether the investment return on the proceeds of selling their home are sufficient to pay the rent where they now decide to live.
If they choose to live in a property of similar value to their former home, typically rental yields are in the range of 3 per cent to 5 per cent per annum. So, if they are paying (say) 4 per cent of the proceeds of selling their house as annual rent on their new home, in order for the ‘sell and rent’ to be the right decision, the return on their investments would have to be at least 4 per cent to pay the rent plus the annual capital appreciation they could have made by retaining their former house.
Also, if they invest substantially in ‘growth assets’, whether inside superannuation or outside super, they must accept that there will be some volatility in the value of those assets.
But the earnings on the additional $600,000 that is inside super (in their account-based pensions) will be tax-free (subject to the Transfer Balance Cap of $1.6 million per person), which will help boost their investment return.
What if after selling their home and making the $600,000 contribution to super, they buy a new home, with partly borrowed money (assuming that they can obtain a loan)?
Apart from the issue of the substantial expenses of sale of their original property and purchase of the new one, the key financial question is whether they can achieve a return inside superannuation on the $600,000 contribution that exceeds the cost of borrowing the $600,000 for their new mortgage.
Currently, mortgage interest rates in Australia are very low, with mortgages being available (depending on the couple’s credit ratings, the loan-to-valuation ratios and which lending institution they borrow from) at interest rates between 2 per cent and 3 per cent per annum. On the other hand, some high quality superannuation funds have earned in excess of 8 per cent (even in accumulation phase, where they are paying tax on earnings) in their ‘default’ or ‘balanced’ investment options for the past three decades (although it is possible that investment returns over the next 10 to 20 years may be a bit lower given the current low interest rate environment).
So, from a technical perspective over the longer term, it may well be that a couple would be better off to have the extra $600,000 in superannuation, and pay the cost of borrowing the $600,000.
As noted above, there is no tax on an account-based pension (subject to the transfer balance cap limits). But there are a number of practical considerations to bear in mind.
First, the higher return inside superannuation is achieved only by taking some risk: that is to say, sometimes, the couple’s superannuation balance will fall, perhaps significantly (as we have seen, for example, as a result of the COVID-19 crisis). So, the couple would need to be able to tolerate the market value fluctuations in the additional investments.
Second, mortgage interest rates may not be low indefinitely; when the economy recovers, it seems likely that at some point interest rates will increase again.
Third, unless the couple can obtain an interest-only mortgage, then even though interest rates are only between 2 per cent and 3 per cent per annum, the total monthly mortgage repayments (including capital repayments) may be of the order of 6 per cent or more of the borrowed amount, which means a lot of the cash flows from the additional investments will go to financing the mortgage.
Finally, if there might be a sudden need to withdraw a large part of the $600,000 (for example to fund a Refundable Accommodation Deposit at an aged care facility) at a time when markets have performed badly, there is a significant risk that the investment return achieved in the meantime by the superannuation fund might be lower than the interest payable on the mortgage.
John De Ravin’s book, Slow and Steady, is available from his website for $39.95.
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Disclaimer: All content on YourLifeChoices website is of a general nature and has been prepared without taking into account your objectives, financial situation or needs. It has been prepared with due care but no guarantees are provided for the ongoing accuracy or relevance. Before making a decision based on this information, you should consider its appropriateness in regard to your own circumstances. You should seek professional advice from a financial planner, lawyer or tax agent in relation to any aspects that affect your financial and legal circumstances.
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