Source: http://taxreview.treasury.gov.au/content/StrategicPaper.aspx?doc=html/Publications/Papers/Retirement_Income_Strategic_Issues_Paper/Chapter_4.htm
Timestamp: 2016-08-30 14:52:44
Document Index: 652814509

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Retirement Income Strategic Issues Paper - Section 4: Assessment of the Retirement Income System
4. Assessment of the retirement income system
This section assesses the retirement income system against the five objectives outlined in Section 2.1 — broad and adequate, acceptable, robust, simple and approachable, and sustainable.
It presents information and data based on long run actuarial assumptions. It is important to note that specific groups of retirees will do better or worse than the projections in this section depending on factors such as workforce participation, labour income patterns, investment performance, inflation, longevity and whether an individual accesses their superannuation prior to Age Pension age.
4.1 Broad and adequate
In setting the minimum retirement income, the Age Pension plays an important role in the system. The Pension Review considered the adequacy of this payment. The Age Pension will continue to contribute significantly to the retirement incomes of most Australians. About 80 per cent of people aged over 65 years receive some or all of the Age Pension. This is consistent with the then-Government's views when it introduced the superannuation guarantee: 'This Government sees the Age Pension not just as a security net for future retirees but as the keystone of its superannuation policies. It expects that most future retirees will continue to be eligible for the Age Pension (for example, through a part pension) which, with self-provided and tax-assisted superannuation, will allow a higher retirement income than is now generally available.' (Australian Government 1992) By way of illustration, the Age Pension will contribute significantly to the retirement income of a person who has a 35 year work history commencing in 2000. Table 4.1 shows that the Age Pension (on current policy settings) will provide over half the retirement income of a person who earns up to the average income, even after the superannuation guarantee matures. The Age Pension will also provide nearly a quarter of the retirement income of people earning 2.5 times AWOTE — noting, however, this illustration assumes that the person has only superannuation guarantee savings and no other assets or income, which would be unusual for most on higher incomes. Table 4.1: Contribution of the Age Pension to retirement incomes under a fully mature superannuation guarantee
Income as a proportion of AWOTE(a)
Proportion of retirement income from the Age Pension
Proportion of maximum rate of the Age Pension received (per cent)
The retirement income system is still in transition and will not fully mature until the late 2030s when employees retire after a full working life (for modelling purposes, usually assumed to be 35 years) of compulsory superannuation contributions. As the system matures, retirement incomes based on the Age Pension and superannuation guarantee savings will gradually increase. During this transition, the Age Pension will decline as a proportion of retirement income. The superannuation guarantee has not been designed to achieve a particular retirement income benchmark. It does not apply universally, the individual bears some or all of the investment risk, and the accumulated funds do not have to be used to fund a retirement pension. The length of time making contributions, the funding of insurance through superannuation and many other factors also affect retirement incomes. Even so, there is increasing interest in retirement income adequacy, to which the superannuation guarantee obviously makes a contribution. Numerical assessments of adequacy usually provide estimates of the retirement income that might be generated for a hypothetical person who works for 35 years. This reflects the current average length of a working life for a primary earner, including periods outside the labour force (for example, studying or travelling). A replacement rate can be calculated to reflect how much of a person's pre-retirement income they might expect to receive in retirement from the Age Pension and their compulsory superannuation savings. Together with the Age Pension, the superannuation guarantee (when mature) may deliver replacement incomes for people on up to AWOTE of 60 per cent or more (Chart 4.1). Around half of this income will be provided by the Age Pension. Chart 4.1: Illustrative projected replacement rates under the Age Pension and superannuation guarantee(a)
A replacement rate compares an individual's spending power before and after retirement (that is, after tax is paid). For example, a replacement rate of 75 per cent would mean that an individual would be able to spend in a given time period $75 in retirement for each $100 spent before retirement. The illustrative replacement rates are projected for a hypothetical single person who works for 35 years and retires in 2035. It is assumed that at age 65 years they retire and use their superannuation guarantee benefit to purchase a lifetime annuity. The incomes used to calculate the illustrative replacement rates are deflated by the consumer price index to 2008-09 dollars. Actual outcomes will vary depending on factors such as workforce participation, labour income patterns, investment performance, inflation, longevity and whether an individual accesses their superannuation prior to Age Pension age.
Although their projected replacement rates are lower, people on higher pre-retirement incomes are projected to have a higher level of income in retirement from the Age Pension and the superannuation guarantee (Chart 4.2). For example, a person with a pre-retirement income of two and a half times AWOTE might be expected to have a disposable income in retirement of approximately $60,000 per year. Someone with a pre-retirement income of AWOTE may have a disposable income in retirement of approximately $43,000 per year.6
Chart 4.2: Illustrative projected average disposable income in retirement under the Age Pension and superannuation guarantee(a)
Figures relate to retirement income in the year 2035, expressed in 2008-09 dollars. The illustrative real retirement incomes are projected for a hypothetical single person who works for 35 years. It is assumed that at age 65 years they retire and use their superannuation guarantee benefit to purchase a lifetime annuity. The illustrative average retirement incomes are deflated by the consumer price index. Projections are of disposable income, after tax and means testing are taken into account. Actual outcomes will vary depending on factors such as workforce participation, labour income patterns, investment performance, inflation, longevity and whether an individual accesses their superannuation prior to Age Pension age. In the chart, the full rate of pension is shown as $26,000 compared with the existing rate of about $15,000. This reflects the modelled annual 1.6 per cent increase in the value of the pension, reflecting wage related indexation.
AWOTE is average weekly ordinary time earnings and is around $1,150 per week ($60,000 per year). Around half of workers earn less than three-quarters of AWOTE. Source: Treasury projections.
People on higher incomes also generally undertake higher levels of voluntary saving through the third pillar. Chart 4.3 shows illustrative replacement rates for a hypothetical individual who salary sacrifices into superannuation at the average rate for an employee of their age and level of remuneration. Including the third pillar generates higher illustrative replacement rates for higher income earners.
Chart 4.3: Illustrative projected replacement rates including the Age Pension, superannuation guarantee and average salary sacrificed amounts for employees(a)
A replacement rate compares an individual's spending power before and after retirement (that is, after tax is paid). For example, a replacement rate of 75 per cent would mean that an individual would be able to spend in a given time period $75 in retirement for each $100 spent before retirement. The illustrative replacement rates are projected for a hypothetical single person who works for 35 years and retires in 2035, making average salary sacrifice contributions for an employee of their age and level of salary and wage remuneration. It is assumed that at age 65 years they retire and use their superannuation guarantee benefit to purchase a lifetime annuity. The incomes used to calculate the illustrative replacement rates are deflated by the consumer price index to 2008-09 dollars. Projections are of disposable income, after tax and means testing are taken into account. Actual outcomes will vary depending on factors such as workforce participation, labour income patterns, investment performance, inflation, longevity and whether an individual accesses their superannuation prior to Age Pension age. AWOTE is average weekly ordinary time earnings and is around $1,150 per week ($60,000 per year). Around half of workers earn less than three-quarters of AWOTE.
Excluding the self-employed from the superannuation guarantee significantly reduces the second pillar's coverage. However, the Age Pension covers the self-employed who have limited means to save for their retirement and around two-thirds of self-employed people make voluntary superannuation contributions (ABS 2008a). Wealth accumulated in their businesses also can be considered a form of voluntary savings. Capital gains tax exemptions exist on the sale of a small business where the business has been held for 15 years and the person is retiring or the person is aged 55 years or older and the proceeds from the sale of a small business are paid into a complying superannuation fund, an approved deposit fund or a retirement savings account in certain circumstances (up to a lifetime limit of $500,000). The outcomes from the superannuation guarantee and voluntary saving are strongly linked to workforce participation. Work patterns vary markedly due to gender, skills, individual work preferences and opportunities and migration. Groups with more varied work patterns, such as women, tend to experience lower retirement incomes. Some submissions argue these patterns result in deficient retirement incomes.
Retirement incomes for people with broken work patterns reflect their lower income and superannuation guarantee contributions over their working life. Using any one year of pre-retirement income is unlikely to provide a good indicator of the overall standard of living prior to retirement for a person with a variable work pattern. Their average income over their working life is a better indicator, as it balances years where they worked a lot and years where they worked less. Compared to their lifetime income, replacement rates based on the Age Pension and superannuation guarantee savings for people who move in and out of work, may be similar to those for people who have a long work history at the same wage (Chart 4.4). The Age Pension will also tend to be more important for these people. Chart 4.4: Illustrative projected replacement rates (compared to average lifetime income) for a person with a broken work pattern under the Age Pension and superannuation guarantee(a)
A replacement rate compares an individual's spending power before and after retirement (that is, after tax is paid). For example, a replacement rate of 75 per cent would mean that an individual would be able to spend in a given time period $75 in retirement for each $100 spent before retirement. These illustrative replacement rates are calculated by comparing average disposable income over an individual's entire lifetime (rather than in their final year of work) to their average disposable income during retirement. Average disposable income over an individual's lifetime provides a better measure of the pre-retirement standard of living for a person with variable work patterns. The base case illustrative replacement rates are projected for a person with a 35 year working life and retiring in 2035 are calculated on the same basis in this chart to provide a comparable benchmark. They are considerably larger than those shown in Chart 4.1. The illustrative replacement rates are for the Age Pension and superannuation guarantee. 'Broken work pattern' illustrative replacement rates are projected for a hypothetical person, aged 36 years in 2006. It is assumed they have no work history before age 36, part-time work between ages 36 years and 44 years, full-time work between ages 45 years and 49 years and part-time work between ages 60 years and 64 years. It is assumed that their partner's income means they do not receive income support in the years they do not work. Incomes used to calculate the illustrative replacement rates are deflated by the consumer price index to 2008-09 dollars. Actual outcomes will vary depending on factors such as workforce participation, labour income patterns, investment performance, inflation, longevity and whether an individual accesses their superannuation prior to Age Pension age.
An assessment of equity in the retirement income system needs to take into account interactions with the broader tax-transfer system. Further, the assessment should consider the outcomes for individuals and families over their lifecycle, and between generations, including between future retirees and those taxpayers who will be funding the Age Pension and other publicly provided benefits. Basing the assessment on a subset of policy settings at a point in time may be misleading.
The overall treatment of an individual under the retirement income system depends on a broad range of factors. These include: taxation of superannuation contributions; taxation of earnings during accumulation and during retirement; government superannuation co-contributions; access to the Age Pension, including means testing; caps on superannuation guarantee contributions; and caps on concessional contributions and non-concessional voluntary contributions. The overall treatment also depends on factors such as access to other concessions in retirement (such as health, transport and utilities concessions) and access to subsidised aged care and health services. Obviously the distributional implications of some components are difficult to assess. The assessment provided here is of some elements of the present retirement income system. The Panel will undertake further work to improve its assessment of the distributional implications of the retirement income system for its final report.
Tax concessions Many submissions indicate concern about the fairness of superannuation taxation arrangements — in particular, a concern that higher income earners receive greater concessions than low income earners.
Superannuation guarantee contributions and earnings are taxed at a flat rate of 15 per cent. From one perspective, this means that the superannuation contributions of all people are treated equally. The concession addresses the bias otherwise present in income taxes favouring current over deferred consumption. From another point of view, it gives rise to a tax benefit, relative to the treatment of other earnings, that is larger for higher income earners with higher marginal tax rates (Table 4.2). Table 4.2: Personal income tax rates and superannuation contribution tax rates(a)
Statutory personal tax rate
Superannuation contribution tax rate(per cent)
$6,001 to $34,000
$34,001 to $80,000
Rates are for 2008-09.
However, identifying who benefits from these concessions is not a simple matter. For many lower income workers in receipt of income support or family payments, the superannuation guarantee and earnings tax rate is even more concessional because they face a higher effective marginal tax rate than the top marginal tax rate.7
In contrast, the 15 per cent contributions and earnings taxes provide only a small concession for lower income earners who do not receive income support and face marginal tax rates of 0, 15 per cent or 16.5 per cent (including the Medicare levy). A single person working full-time for the minimum wage receives only a very small concession from the superannuation tax system. The 15 per cent contributions tax also provides only a small concession for discretionary superannuation contributions by lower income people, regardless of whether they receive income support. For the purposes of means testing of income support payments and family payments, current legislation will include in income salary-sacrificed (and tax deducted) superannuation contributions made at the discretion of an individual. This will mean that the size of concessions for these contributions is not dependent on whether an individual is eligible for income support and family payments. Accordingly, discretionary salary sacrificing (and tax deductibility) will provide little or no concession for lower income earners and larger concessions for higher income earners.
The co-contribution provides a higher rate of concession than salary sacrificing. There is no particular rationale for the co-contribution rate. Although it has a relatively high rate of concession, the co-contribution only applies to the first $1,000 of voluntary contributions per year. This compares to an annual cap of up to $50,000 on salary-sacrifice contributions (or $100,000 under transitional arrangements).
In practice, the benefits of the superannuation concessions are accessed mainly by higher income earners, who have greater capacity to undertake voluntary saving. In 2005-06, around 5 per cent of taxpayers had remuneration over $100,000, and they made around 24 per cent of concessional contributions to superannuation.
Table 4.3 outlines a projected superannuation contribution pattern for 2009-10. Table 4.3: Projected concessional superannuation contributions by remuneration (2009-10)(a)
Annual remuneration(b)
Average annual contribution ($)
(per cent of remuneration)
Proportion of people making a contribution above $25,000
1,048 10.4
2,342 7.7
4,121 8.4
6,435 9.2
9,504 10.7
13,285 12.2
17,393 13.5
22,372 15.0
27,929 16.5
27,111 14.3
31,263 13.2
35,488 10.3
40,192 9.1
46,347 4.4
Treasury projections for 2009-10. Projections are based on 2005-06 data. Contributions in subsequent years were impacted by policy changes and are a less reliable basis for projecting contributions in 2009-10. Projections are adjusted for significant policy changes since 2005-06 (the introduction of the $50,000 concessional contributions cap and $100,000 transitional cap) and for changes in wages and population. The table includes both employees (and the superannuation guarantee and salary sacrifice contributions made by their employer) and the self-employed (who can make deductible contributions). Remuneration is taxable income plus salary sacrificed amounts plus fringe benefits. The average contribution rate can be below 9 per cent, as the definition of remuneration used in the table is different to the income base used to calculate the superannuation guarantee and the table includes people who are not covered by the superannuation guarantee.
The projections show that higher income earners make larger concessional contributions on average. The projected average rate of contribution also increases as remuneration approaches $180,000 per year. The average rate of concessional contributions falls for people with remuneration above $180,000 per year, in part due to the caps on concessional superannuation contributions (currently $50,000 per year for people aged under 50 years and $100,000 per year for people aged over 50 years). People on higher incomes are projected to continue to be much more likely to make large contributions. Of people making more than $25,000 per year in concessional contributions, over 70 per cent have total remuneration above $100,000 per year. Of people aged over 50 years contributing more than $50,000, around 93 per cent have total remuneration above $100,000 per year.
In contrast to the level of contributions made by higher income earners, only a quarter of low income people eligible for the superannuation co-contribution made voluntary superannuation contributions. The equity of existing tax concessions for voluntary contributions is also influenced by the inability of some employees to access the tax concession because their employer does not offer salary sacrifice. During retirement, earnings on superannuation savings receive preferential tax treatment compared to other savings, as they are tax-free. This is likely to provide a greater concession to individuals with greater superannuation savings.
People cease to be covered by the superannuation guarantee when they reach age 70 years. This may result in people aged 70 years or older receiving lower total remuneration, for a given wage level, than people aged under 70 years. The Age Pension means test comprises two components — an income test and an assets test. The two tests treat savings differently, and within the income test, the treatment of savings can differ depending on the form in which they are held. This means that individuals with similar levels of wealth can be paid different rates of pension. For example, while a person may have their pension reduced under the income test on the basis of assets they hold in their bank accounts or in a share portfolio, assets of the same value in non-income producing holiday houses, art collections and jewellery do not reduce pensions under the income test. While the assets test treats these assets uniformly, it may or may not apply depending on an individual's wealth and their mix of assets.
Equity between generations is also an important consideration for the design of the system. The ageing of the population and increasing life expectancies will affect how governments finance services and payments, including those made to retirees. These decisions can affect the level of services to, and the taxes paid by, different generations. The effects on future generations are hard to assess. However, increasing the cost of the retirement income system and imposing those costs on future generations would diminish intergenerational equity.
The framework of the system influences how it deals with shocks, such as the global financial crisis, and systemic changes in the demographic, social and economic environment, such as increases in life expectancy. The spread of risk between the public and private sectors is a strength of the system. Too much reliance on the public sector can increase the cost of the system, affecting its sustainability and the ability of the government to keep its promises to individuals. Too much reliance on the private sector can expose people to excessive risk when saving for their retirement. Market risk
The global financial crisis has served to highlight the risk characteristics of the Australian retirement income system. With financial markets significantly repricing risk, and reassessing the global economic outlook, asset prices and the retirement savings of many individuals have fallen sharply. This highlights the inherent market risk associated with some forms of savings, something that is particularly significant for individuals relying primarily on the earnings and drawdown of their savings to fund their income in retirement. Of course, the Age Pension means test acts to ameliorate the impact for some retirees, as reduced private earnings result in an increased rate of pension payment.
While some retirees, and people on the cusp of retirement, may choose to undertake additional employment to increase their income, for others this is not a feasible option. People who are further from retirement have a longer time to recoup recent losses and build their retirement savings.
The system provides a range of investment options and products that enable people to choose the level of investment risk on their savings. Some commentators have speculated that large losses to superannuation savings may reduce confidence in the retirement income system and reduce voluntary superannuation saving. On the other hand, previous generations affected by financial crises have tended to become more risk averse and have relatively high rates of saving.
An emerging issue is how the current system caters for the risk that a person may outlive their savings. Continuing to allow a person to use their superannuation to finance an early retirement exacerbates this risk, due to the longer period over which a person's savings need to last. Individuals find it unattractive to insure against this risk, with the main product available (lifetime annuities) being unpopular amongst retirees. The rate of return on these products is low, in part because these products are supported by safe but low return investments and in part because the people taking them up consider they will have a long life. This makes it difficult for providers to spread risk.
4.4 Simple and approachable While the distribution of risk between the private and public sectors is a strength of the system, it imposes more responsibility and obligations on individuals in managing their retirement income. An individual must make decisions on the appropriate way to invest their money, both before and after their retirement. For many, retirement will be the first time they are dealing with both the tax and transfer systems. They must take into account how their decisions will affect their eligibility for the Age Pension. The current dual income and assets tests can result in people with the same wealth receiving different rates of pension, which can influence how a person chooses to hold their assets. The removal of tax on most superannuation benefits in 2007 simplified the taxation arrangements. However, complexity remains. For example, there are circumstances where the different concessions provided to pre-tax contributions (deductions) and after-tax contributions (the superannuation co-contribution) require people to prescribe a split between these contributions to maximise their concession. Targeting concessions, such as by limiting who can claim a deduction on their superannuation contributions, also complicates the system. The preferential taxation treatment of superannuation savings has seen a number of rules inserted into the superannuation system to limit the cost of the concessions. These rules include work tests for people aged 65 years or older, caps on contributions and the thresholds for the co-contribution. These rules assist in the sustainability of the concessions but they also produce complexity for both the industry and individuals. There are also rules relating to the splitting of contributions between couples, which can add further to complexity.
A key concern with a complex system is its regressivity — that is, complexity is most likely to have a greater effect on people who are least able, or have the fewest resources, to deal with it. A system that minimises the decisions required of individuals with lower financial capacity may be more acceptable than one that imposes equal cost on all individuals.
Given the very long timeframes associated with retirement income decisions, consistency in policy settings is important to individuals' planning and achievement of desired retirement incomes. Consistency of policy is also a desirable feature of a low cost and understandable system. Frequent policy changes can increase the administration costs of product providers and the costs of advice for individuals. 4.5 Sustainable The high reliance on private self-funding and the means tests applying to pensions combine to make Australia's retirement income system more fiscally sustainable than most other systems, in the context of an ageing population. However, substantially increased fiscal costs are nonetheless projected over coming decades. Significant challenges will result from Australia's changing demographics, driven by low fertility rates compared to the 1950s and 1960s and increased longevity, with only a partial offset from migration.
The increasing proportion of aged people in the total population presents a twin challenge. Firstly, it is becoming more difficult to ensure the retirement system is adequate, in part because many more people are living to a very old age. Secondly, it affects the fiscal sustainability of the retirement income system and other programs supporting the welfare of aged people. The second intergenerational report (IGR2) (Australian Government 2007) projected that, on existing policy settings, Australian Government spending would increase by 4¾ per cent of GDP by 2046-47, due in part to demographic change.8 The Productivity Commission (2005) has projected that state government expenditures could increase by 0.8 per cent of GDP by 2044-45. A rough estimate of the increases in social spending that are driven by population ageing is outlined in Table 4.4, based on the projections in IGR2. This table isolates the demographic component of health and aged care. Around a quarter of the projected increase in health spending over the period to 2046-47 is estimated to be due to demographic change. The remaining three-quarters reflect the cost of improvements in, and wider availability of, advanced health technologies such as the development of new drugs and diagnostic techniques. The demographic component accounts for around three-quarters of the projected increase in total aged care spending. The Productivity Commission's projections for state government expenditures did not include information that the Panel could use to isolate the spending increases that are driven by demographic change (although it is likely to be the major factor).
Table 4.4: Demographic related increases in Australian Government social spending(a)
Projected demographic related increase
(a) Health projections reflect IGR2 projections of increased health spending, net of the impact of health technology (around three-quarters of the projected increase in IGR2). The projected increase in aged care spending is net of the impact of factors other than demographics (around a quarter of the projected increase in IGR2). Projected Age Pension increases are from IGR2.
Source: Calculated from IGR2.
In order to ensure long term fiscal sustainability, some combination of higher workforce participation, increased productivity growth, reduced expenditure or increased tax to GDP ratios, will be required to respond to these projected spending increases. To put the projected social spending increases in perspective, in 2007-08, a 3.7 per cent of GDP increase in spending would have been equivalent to a third of the revenue raised from personal income tax, the entire revenue raised by the GST or the entire Australian Government health budget. If the Australian Government were to compensate the states and territories fully for their spending increases (as projected by the Productivity Commission) this would be equivalent to 7 per cent of personal income tax revenue or 20 per cent of GST revenue in 2007-08.
The outcomes of the retirement income system should be delivered at least cost to productivity, since pursuing economic growth is an important strategy in meeting the costs associated with demographic change. This has important implications for the design of superannuation, taxation and pension arrangements, all of which influence a person's decisions to work and save, affecting economic efficiency and growth.
6 Note that these projected disposable income estimates refer to a future year when AWOTE (even when discounted to today's dollars) will be considerably higher than the present level of $60,000 because wages are projected to grow faster than prices. 7 For example, the 15 per cent superannuation guarantee contribution tax is more concessional for a middle income earner on a 31.5 per cent marginal tax rate (including the Medicare levy), who is also subject to the 20 per cent Family Tax Benefit Part A taper and the 4 per cent low income tax offset shade-out, than it is for a higher income earner facing a 46.5 per cent tax rate (including the Medicare levy). This is because superannuation guarantee contributions are not included as income for the purposes of determining eligibility for these benefits. 8 The IGR2 analysis is the latest publicly available analysis at the time of writing. The Charter of Budget Honesty Act 1998 requires the Government to produce an IGR at least every five years. IGR2 was released in April 2007.
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