How can we best ensure that retirement incomes are adequate?

Nov 30, 2020

The present superannuation contribution (SG) rate of 9.5 percent can finance an adequate retirement income for most middle-income people, provided they fully draw down their savings. Logically, therefore, any action to stop further increases in the SG rate should be contingent on accompanying policies to remove the present impediments to using retirement savings efficiently.

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The recently released Report of the Review of Retirement Incomes found that “The Australian retirement income system is effective, sound and its costs are broadly sustainable”.

For low income earners, it comes as no surprise that the age pension ensures an adequate retirement income sufficient to maintain a standard of living consistent with prevailing community standards; although even then this finding depends upon them owning their homes.

However, for the majority of retirees, with middle to higher incomes, the Review’s finding that they have sufficient income to maintain their living standards in retirement is more contentious.

In fact, there are three aspects of the retirement income system that need to be considered before deciding whether it generally provides an adequate retirement income:

1. How is an adequate retirement income defined for most working people, and what should be the balance between their income before and after retirement?

2. How efficiently are savings being used to support retirement living standards?

3. Where there are gaps and the retirement income is insufficient, what is the best way to improve that retiree’s income?

What is an adequate retirement income?

For working people, who are contributing their savings towards their retirement income, the aim should be to maintain a reasonable balance between living standards in working life and retirement. It is further estimated that maintaining living standards in retirement requires a replacement rate of 65-75 percent (that is the post-retirement disposable income is about 65-75 percent of the pre-retirement disposable income).

Until now it had been widely considered that this replacement rate would only be possible for a middle-income earner if their contribution rate was as high as 12 percent of their salary over their working life of about 40 years. However, the Review found that with a 12 percent SG contribution rate, “Most lower-to-middle income workers will have replacement rates that exceed the [65-75%] benchmark. They may be foregoing more working-life income than is necessary to maintain living standards in retirement.”

It makes no sense, of course, to compel workers to sacrifice their present living standards to pay for an increase in their present living standard after they retire. Instead, the purpose of superannuation should be to smooth incomes consistent with spending needs over the worker’s life span.

Critical to this assessment, is whether the SG contributions eventually come at a cost to the employer or the employee. Certainly, the original intention when compulsory superannuation was introduced, was that the cost of superannuation would not be absorbed by employers but would be absorbed into the overall wage cost. Furthermore, the evidence examined by the Review indicates that about 80 percent of any increase in SG contributions will come out of wages, at least over time.

At present, the superannuation guarantee (SG) contribution rate is legislated to increase from its current rate of 9.5 percent of salaries in five equal stages to 12.0 % in 2025. But some Government members have now seized on the Review’s findings and are pressing for the legislated increase in the SG to 12 percent to be abandoned.

On the other hand, Paul Keating (the original architect of compulsory superannuation) has objected that the legislated increases in the SG should continue as the employers are well placed to absorb the costs. What matters, however, is not the ability of employers to absorb the costs, but whether they will have to, and in a climate of slow wage growth already, it seems very doubtful that this will happen. Instead, any increase in the SG will largely come out of present living standards.

How efficiently are retirement savings used?

What seems to be less widely appreciated, however, is that the Review’s conclusion that an SG contribution of 9.5 percent is sufficient, depends critically on its view of the ‘optimal’ way to use savings including the assumption that “retirees will run down their superannuation assets by age 92”. “It is also assumed that they will not leave bequests and will purchase a longevity product at retirement that provides them with an income from age 92.”

Whether these assumptions represent an optimal way to run down savings is open to debate, and in any event, as the Review found, neither of them are valid at present. “Most retirees die with the bulk of their wealth intact.” Furthermore, according to the Review, “Assisting retirees to use existing assets more efficiently, and draw down their assets in retirement, can have a bigger impact on improving retirement incomes than changes to the SG rate.”

However, as the Review concluded, unfortunately, the Australian debate has focused almost exclusively on “the accumulation phase of the retirement income system and insufficient attention is given to the retirement phase”.

To me, the most important conclusion from the Review is that this situation needs to change. Specifically, it is proposed that if the Government seeks to retract the legislated increases in the SG rate above 9.5 percent, or even above a compromise rate of 10 percent, it should be contingent on accompanying policy changes to ensure that retirees’ savings are used much more efficiently in future. Without these policy changes, superannuation will not achieve its primary purpose of providing an adequate retirement income.

The thrust of the required policy changes should represent an effective response to the factors which inhibit people from presently drawing down their assets in retirement. The Review found that these factors include:

· The complexity of the system and the lack of guidance on how to maximise retirement incomes

· A reluctance to consume funds that are called ‘investments’, ‘savings’ or ‘nest eggs’

· Adopting the minimum drawdown rates required for a superannuation pension account

· Concern about possible future health or aged care costs

· Concerns about outliving savings.

Of the proposals canvassed by the Review to address these concerns and improve the use of retirement savings, I most favour:

· Requiring superannuation funds to provide regular estimates of an individual’s retirement savings expressed in terms of an income stream rather than a balance at retirement. This should help people to make better decisions about the use of those retirement savings.

· Amending the minimum drawdown rates so that income is delivered earlier in retirement when people are more likely to consume it, rather than the current drawdown rates, which are highest at ages 85-90.

· At retirement, guiding people towards products that deliver an income stream and provide protection against market fluctuations and outliving savings.

Each of these proposals would help retirees to use their savings more efficiently to support their living standards, but I think the third is probably the most significant. However, at present, the availability and take-up of these products that deliver an income stream are very low. Changing this situation may well require the Government to mandate that superannuation funds offer these products and/or that the Government provides indexed annuities itself.

In addition, I think more needs to be done to improve cohesion between superannuation and the age pension and also between the retirement income system and health and aged care to address retiree’s fears about having an adequate income later in their retirement. The latter may involve a firmer requirement that residential assets must be used when purchasing residential aged care, although this requirement would ideally be accompanied by improved access and take-up of products that allow the release of home equity into income streams.

Gaps in the system

So far this discussion has concentrated on the needs of the majority of people who do retire with sufficient savings to potentially achieve an adequate retirement income. There are however two important categories of retirees who are not well catered for at present and who have no prospect of an adequate retirement income:

· People who rent and do not own their own homes

· People forced into involuntary retirement in their late 50s and 60s before they are eligible for the age pension at age 67, and who have no realistic prospect of regaining employment.

In fact, fixing these problems is relatively straight forward. Both rent assistance and the JobSeeker Payment should be increased significantly. Also plugging these gaps as proposed is much more targeted and effective than further increasing the SG. And while the Review for some inexplicable reason does not strongly support these increased payments, the vast majority of informed opinion think this should be a priority.

Without changes to improve the efficiency of retirement savings and filling the key gaps in coverage of the retirement income system, living standards of retirees will most often be inadequate without an increase in the SG. On the other hand, these proposed policy changes represent a more effective way of achieving that objective than increasing the SG to as much as 12 percent.

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