What is the optimal system for funding retirement?

Australia's retirement system may be the envy of international policy-makers, but its combination of mandatory savings and a government means-tested age pension may not be producing the best outcome.


In The Australian Retirement System: Seven Alternatives , a new paper from the Centre of Excellence in Population Ageing Research (CEPAR) at UNSW Business School, a key finding is that individuals with a decent superannuation fund balance may leave the workforce early and go on the age pension a few years later.


​"Under means-tested pension programs, there is an incentive to decrease your assets and income to maximise your age pension. Superannuation makes the incentive worse because you can get a lump sum superannuation payout at 60 which you can then spend before starting an age pension at 65," said lead researcher, Jessica Loke.


One further outcome from the Australian retirement system, which presently relies on a compulsory contribution by employers of 9.25% of their employees' wages into a superannuation fund, is that there is a decline in working hours at age 60 after gaining access to superannuation and then again at age 65 in order to maximise their age pension payout, said Ms Loke.


The findings come as the government is trying to increase workforce participation, including keeping people at work longer by increasing the preservation age for superannuation to 65 and lifting the age pension entitlement age to 70 as a way to boost individual retirement savings balances and reduce the fiscal burden.


At present, eligibility for the age pension starts at 65 for anyone born before July 1952. It is steadily increasing by six months every two years, until it reaches 67 in 2023.


Super access as a policy lever

With Australia's ageing population placing increasing demands on the retirement income system, the Productivity Commission recently set out to analyse when and how individuals access their superannuation.


The preservation age – the age at which people can access their superannuation savings after retirement – is considered by some to be an important policy lever in managing the transition to an older Australia.


Preservation is based on one's birthdate. For a person born before 1 July 1960, it is age 55 and for a person born after 1 July 1964, it is age 60.


The Commission found that raising the preservation age encourages some people to work longer and accumulate more superannuation.


This is a good news option for the government because, according to the Productivity Commission study, there would be annual fiscal improvement to the budget bottom line of around $7 billion by 2055 and there would be a modest improvement in workforce participation.


Once they have access to their superannuation savings, individuals can either take the money out in a lump sum and spend it as they wish or set themselves up to draw down an income from the accumulated savings.


While there has been some concern that retirees will squander their savings and rely on the age pension to fund their lifestyle, the Commission found that those most likely to take the lump sum option are people with superannuation balances of less than $10,000.


According to the Commission, most retirees are prudent in their drawdown behaviour.


Seven alternatives

While the Australian retirement system may be open to exploitation, the CEPAR paper found that it has better economic outcomes and improves people's social wellbeing more than alternative combinations of existing systems, including pay-as-you-go (PAYG) pension plans, superannuation and means-tested pension payments.


The CEPAR study looked at the cost and impact on aggregate economic variables such as labour supply, consumption, savings and the social welfare of individuals from seven alternative retirement systems to the Australian system.


This included a means-tested benefit system; a PAYG system; a PAYG system with mandatory superannuation; no public benefit program; a system with only mandatory superannuation; a means-tested and PAYG benefit program; and a means-tested and PAYG benefit program with mandatory superannuation.


"The best outcome for society is when PAYG and superannuation is combined. Here everyone gets a pension payout but it's not linked to retirement workforce participation so it doesn't have the same disincentive to stop work as means-testing," said Ms Loke.


It is the cheapest system with an age pension program and produces a welfare gain, she said.


Welfare implications

The welfare implications are an important element of a retirement system as they are a measure of whether people are able to work less and spend more under different policy options.


Under the alternatives presented, the highest welfare gain exists where superannuation is the primary option, which the study attributes to the taxation benefits that workers can claim under superannuation.


That is, the superannuation contribution amount is subtracted from the individual's assessable income for income tax calculations. As such, individuals pay less income tax than they would otherwise.


Where fund members start to lose out from either working less because of the need to accumulate more, or having the ability to buy more because they have saved more, is when the retirement system is pure means testing, pure PAYG and a combination of means testing and PAYG.


Overall the paper shows that superannuation not only forces people into action, it is to their own benefit.


Demographic evolution

Recognising that making decisions around retirement age and age pension eligibility will always be politically unpalatable and difficult for governments to make, BT Financial Group CEO Brad Cooper recently recommended setting the access age to superannuation and the age pension against an actuarial benchmark of life expectancy to make it easier for the system to evolve with society.


"As the average life expectancy of our population rose, access to superannuation and age pension would also rise. This would allow our system to adapt itself to Australia's changing demographics, and not be reliant on the politics of the day to make changes," Mr Cooper said.


Based on the present system and an average life expectancy at retirement of 86, access to superannuation is set at 60, or 71% of average life expectancy, and pension access at 67, or 79% of average life expectancy.


As average life expectancies increase, we could calibrate these access ages in line with the increase, said Mr Cooper.


To further remove superannuation from the political football field and shift its focus from short term to long term, Mr Cooper also suggested incorporating it as part of the Intergenerational Report (IGR) rather than the federal Budget.


Published every five years, the IGR has a much longer time horizon of 40 years compared with four for the Budget. It also contains the important demographic, actuarial and financial information that would help policy-makers set superannuation policy against long-term adequacy and longevity benchmarks, said Mr Cooper.


While there is little doubt that the existing superannuation system has been a success, delivering a number of benefits, it is also a system that is constantly evolving with a view to some of the alternatives. The question remains as to the best way to support that evolution.


See the report The Australian Retirement System: Seven Alternatives at http://www.cepar.edu.au/media/166901/25-the-australian-retirement-system-seven-alternatives.pdf


23 September 2015.