An indexed pension is an income stream that has income payments progressively increasing in value.
The purpose of this is an attempt to ensure that the pension recipient has the ability to continue covering living expenses, despite the cost of living increasing due to inflation.
Indexed pensions are generally income streams that were initially purchased with a capital sum, or effectively purchased with a capital sum through regular contributions.
Indexed pensions can be otherwise known as annuity income streams or defined benefit pensions.
The payment term of an indexed pension can vary depending on the type of income stream or the objective of the pension recipient.
Indexed Pension Definition
An indexed pension is an income stream paid to the recipient for a predetermined term, or until a specific event occurs.
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The income payments of an indexed pension increase at regular intervals at a predetermined rate, or at a rate based on economic factors (e.g. CPI) at each interval.
How often is a Pension Indexed?
The regularity of pension indexation of an indexed pension, such as an annuity or defined benefit pension, will be determined by the pension provider.
Most types of Indexed Pensions will increase annually or half-yearly.
The Centrelink Age Pension, which is a means tested, social security payment, increases on a quarterly basis.
Types of Indexed Pensions?
A guaranteed term indexed pension pays an income for a predetermined period, such as 5 years, 10 years or 20 years.
A lifetime indexed pension is an income stream that pays you a pension income until you pass away.
A lifetime indexed pension might be fully or partially reversionary.
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This means it may continue to make payments to your spouse or child if you pass away.
A life-expectancy indexed pension pays you a pension until your statistical life expectancy, calculated at the day you start the pension.
Some life-expectancy pensions may allow you to choose to receive payments to life-expectancy plus 5-years, for example.
This can provide comfort if you are concerned about outliving your income. However, it will result in lower annual payments, because they need to be paid for longer.
What is a Non-Indexed Pension?
A non-indexed pension is a pension income stream that pays the same income amount for the eternity of the income stream.
That is, there is no increase in payments over time.
A non-indexed pension is subject to inflation risk and losing purchasing power over time due to inflation.
What is the Pension Index Rate?
This is based on the terms of the indexed pension provider.
You will generally choose the rate at which the payments increase, such as 0% p.a., 3% p.a. or 5% p.a.
Alternatively, you may choose to have your payments increase at the rate of inflation or half of inflation.
The rate chosen will influence your first year payment and the rate at which it increases each year thereafter.
For example, if you chose an pension index rate of 0%, you would receive the same payment in Year 1 as you would in Year 20.
If you chose a pension index rate of 5%, you would receive a much lower payment in Year 1 and a much higher payment in Year 20, compared to a pension index rate of 0%.
Think of it as a see-saw affect, with the left side of the see-saw being the first year of the pension and the right side being the final year.
Choosing a higher pension index rate will lower the left-side and increase the right-side.
Some indexed pension or defined benefit providers do not allow you to choose the indexation rate.
A provider may simply offer indexation terms as the greater of the Consumer Price Index (CPI – inflation) or 5%.
So for example, if your first year payment was $50,000 and the Indexation rate was 5%, the second year payment would be $52,500 and the third year payment would be $55,125 and so on.
Conversely, if your pension does not include indexation, you would receive $50,000 each year for the life of the pension.
The issue here is that your pension will be eroded by inflation.
Each year your pension payments would lose purchasing power.
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For example, let’s assume that your $50,000 pension was not indexed and the inflation rate averages 3% p.a.
The $50,000 non-indexed payment that you receive each year will only be able to purchase the equivalent to what $36,871 is able to purchase in today’s dollars after 10 years.
How to check that your pension is being indexed correctly
You should multiply last years’ income by the indexation rate applied. E.g. If you have been informed by the provider that your pension increased by 4%, you should multiply last years’ payment by 1.04.
The same concept applies for quarterly payments; however the quarterly increase would be 1% based on the annual indexation amount above.
Hopefully this has helped answer your question – What is an Indexed Pension?
If you would like anything clarified or have any further questions about What is an Indexed Pension? or any other superannuation topics, please do not hesitate to leave a comment.