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The Australian Labor Party went to the 2019 Federal Election proposing a change in policy under which retirees not receiving an aged pension could only offset imputation tax credits against existing tax liabilities.

Some retirees would have been significantly impacted by this proposal, given that most are untaxed and hence able to claim the full value of imputation credits as a tax refund. Such a policy change would effectively have reduced the returns that such retirees receive from investing in Australian equities by the amount of imputation credits, which is about 1.3-1.4 per cent per annum for the market overall. This is a significant number, noting that the expected long-run equity market return might be about 7-8 per cent per annum.

No wonder this policy was a subject of heated discussion, and much consternation from those nearing or in retirement. While the policy has since been abandoned following Labor’s election loss, we believe that the growing cost to the Federal Budget may lead the issue to come back onto the table further down the track.

Our research addresses what full access to imputation tax credits means for Australian retirees in two ways. First, we ask how imputation could affect how retirees might invest. We find that retirees are justified in having a considerable bias toward Australian equities in their portfolio to capture the imputation credits. Then, we estimate how valuable imputation credits are to retirees. We confirm they are indeed quite valuable, potentially the equivalent of a 5-6 per cent increase in spending during retirement.

Our approach involves modelling rational behaviour for a retiree who is funding their retirement out of a retirement savings account (account-based pension) and may access the Government’s age pension under existing eligibility rules. We model retirees with starting balances at age 65 ranging from $25,000 up to $1.6 million (which is the cap on tax-free retirement accounts). We assume that they form their portfolios and drawdown on their retirement savings accounts to maximise their spending outcomes until they die.

We also model two types of retirees with differing preferences. One type prefers a higher level of spending spread over the course of their retirement. The other type has a target spending level, based on either the ‘comfortable’ or ‘modest’ retirement spending standards of the Association of Superannuation Funds of Australia (ASFA). In technical terms, the first type is modelled using power utility, and the second using a reference dependent utility function. The model is run both with and without imputation credits, and the difference is compared.

A clear home bias for Australian retirees

Our first finding is that access to imputation credits engender a considerable ‘home bias’ to Australian equities, largely at the expense of lower exposure to world equities. The exact portfolio breakdown depends on how the analysis is set up, including the assumed type of retiree, their starting balance, and their age.

To illustrate the tenor of the results, consider a retiree with a starting balance of $500,000 at age 65 who targets spending at AFSA comfortable level, which was $42,764 per annum at the time of the analysis. Excluding imputation credits, our modelling suggests that this retiree should divide their portfolio on average over the course retirement into 26 per cent in Australian equities, 33 per cent in world equities and 41 per cent in fixed income. When imputation credits are included, the portfolio breakdown comes out as 46 per cent in Australian equities, 15 per cent in world equities and 39 per cent in fixed income – a notable home bias.

One reason for the sizable switch away from world equities under imputation is that Australian equities offer substantially higher returns for a retiree who can claim the full credits, but without a meaningful increase in the overall portfolio risk. The risk impact is limited because Australian and world equities are substitutes to a large extent. The retiree is swapping one form of equity market risk for another in order to improve their outcomes on a risk/return basis.

We then estimate the value of having access to the full tax refunds from imputation credits to retirees. We do this through converting the uplift in benefit (utility) arising from imputation into three measures that can be readily interpreted. Again, the exact estimates vary with modelling assumptions, so we will convey broad averages across retiree types and starting balances.

We find that imputation delivers an equivalent value of 5-6 per cent increase in spending over the course of retirement; an 8-9 per cent larger superannuation fund balance at the point of retirement; or a 0.6-0.8 per cent per annum increase in returns on the portfolio during retirement. These significant numbers underwrite the consternation among those in or nearing retirement about the then proposed potential change in policy.

Net cost to the Government

We also estimate the net cost to the Government of providing access to imputation tax credits to retirees, accounting for the fact that there will be some offset through reduced age pension payments.

For example, expected net cost per individual over the course of their retirement is about $20,000 for retirees that retire with a $100,000 balance, then rising to around $130,000 for those retiring with a balance of $1.6 million (in 2017-18 dollars).

We also note that the largest benefit in dollar terms accrues to retirees with the largest initial balances, raising some questions around equity.

Given the magnitude of the value, any policy change will meet with resistance

Our study has a number of implications. First, it partly explains the bias towards Australian equities observed in many retirees’ portfolios. The bias might be a rational response to tax effects that lead to differential returns on investment choices, which have similar overall portfolio risk.

Second, we have estimated the value that retirees receive from the imputation system. Given the significant magnitude of the benefit, its removal would likely have some substantive effects. To the extent that imputation credits supplement income in retirement, the loss of tax credits could have exacerbated the problem of the adequacy of superannuation balances for supporting a reasonable level of retirement spending. For future retirees, access to imputation credits in retirement might be seen as an alternative to making higher superannuation contributions while at work. A change in policy might also result in retirees investing less in Australian equities, which would affect the local equity market.

Our research gauges the importance of Australia’s imputation system for those in retirement, both in terms of how it might influence their investment choices, and the value that they receive from having access to imputation tax credits. Given the magnitude of the latter, resistance to any proposal to change the policy should come as no surprise.


Further reading

Butt, A, Khemka, GV & Warren, GJ 2019, ‘What dividend imputation means for retirement savers’, Economic Record, vol. 95, no. 309, pp. 181-199.

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