Michael Keating. The Financial System Inquiry. Part 2: Superannuation and Retirement Incomes

Jan 20, 2015

I am reposting Part 2 of this important series which you may have missed during the holiday period. John Menadue.

Australia’s retirement income system is based on three pillars:

  • A means-tested age pension funded from general revenue which alleviates poverty by guaranteeing a base level of income support for retirees
  • Compulsory saving through the superannuation guarantee which was introduced in the early 1990s
  • Additional voluntary superannuation saving.

This system has received considerable support from overseas authorities, such as the OECD and the World Bank, as providing a model for other countries to follow. Compared to most European and North American countries Australia’s system has a much lower level of unfunded promises and thus limits the risks to future tax payers. Australia’s retirement incomes system is also more flexible and provides better assistance for those on very low incomes and/or who have had broken work histories.

The Financial System Inquiry (FSI) focused on the superannuation system, which is the newest pillar of the whole retirement incomes system, and is not without its problems. But it is important when reviewing superannuation to consider its role within the provision of retirement incomes more generally and how superannuation reacts with other elements of that retirement income system.

Since the introduction of compulsory superannuation some 20 odd years ago the total assets of superannuation funds have increased by 2685 per cent from $59.6bn in September 1988 to $1598.8bn in September 2014.  Indeed, for many people superannuation is now their second most important asset after housing. Not surprisingly the finance industry has now become a strong supporter of compulsory superannuation, and advocates a further increase in the rate of this form of saving. The FSI also found that superannuation has been a major source of financial strength and stability as the funds cannot be quickly withdrawn, and the superannuation funds themselves typically have low levels of debt. Indeed, the 2014 Melbourne Mercer Global pension index rates Australia’s superannuation system second out of 25 countries.

On the other hand, there are a number of criticisms of our present approach to superannuation policy. First the FSI considered that superannuation policy suffers from a lack of clarity around its objective to provide income in retirement to substitute for or supplement the Age Pension. The Inquiry therefore recommended that the superannuation system’s objectives should be enshrined in legislation with public reports on performance and how policy proposals are consistent with achieving these objectives over the long term.

Second, the FSI is critical of the efficiency of the superannuation industry, and the report convincingly demonstrates how the administrative costs of superannuation funds have remained too high. Thus the FSI found that the size of the average fund increased from $260m in assets in 2004 to $3.3bn in 2013, but average fees only fell by 0.2 per cent over the same period, with two thirds of the estimated benefits from scale and lower margins being offset by increases in fund costs. While the FSI acknowledges that recent reforms to MySuper may result in lower administration costs in future, the evidence produced by the FSI suggests that these reforms may still not fully succeed. Instead the FSI recommends more competition so that if costs have not fallen sufficiently by 2020, new default members of superannuation funds should be allocated to MySuper products by a formal competitive process.

Third, the FSI found that ‘superannuation assets are not being efficiently converted into retirement incomes due to a lack of risk pooling and an over-reliance on account based pensions’. This means that individuals are exposed to considerable risk from longevity and inflation, so that they are cautious and have a lower standard of living in retirement than is necessary. The FSI accordingly recommends introducing a comprehensive income product for retirement (CIPR). The FSI considers that ‘managing the longevity risk through effective pooling in a CIPR could significantly increase private incomes for many Australians and provide retirees with greater peace of mind that their income will endure through their retirement, while still allowing them some flexibility to meet unexpected expenses’.

Fourth, as is well known, the tax concessions in the superannuation system are not well targeted and are most inequitable, with more than half the value of the concessions accruing to the top twenty per cent of income earners.  As a result the return on investment in superannuation is about four times as high for people on the top marginal tax rate as for people on a zero tax rate, after taking account of the tax concessions and means testing of the age pension entitlement.  Furthermore, quite a lot of the superannuation savings of high income people may represent a way of sheltering future bequests to their children from taxation, which is inconsistent with the objective of providing an adequate income in retirement.

The FSI considers that this inequality in the taxation of superannuation has contributed to policy instability, causing most of the many changes to taxation arrangements for superannuation, and that the inequality thus undermines long-term confidence in the system. Differences in the taxation of different forms of income and saving also lead to distortions in resource allocation, and because the superannuation tax concessions are not well targeted to improving retirement incomes they increase the cost of the system to taxpayers. Furthermore, given the present and future Budget outlooks, there must a question about the sustainability of the present system of taxation for superannuation, as there are a number of options for improving the cost-effectiveness and fairness of the system while at the same time generating significant Budget savings.

Although the FSI does not make specific recommendations for changing the tax arrangements for superannuation, as these are outside its scope, it does canvass two options for improvement:

  1. Reduce the cap on the amount of contributions that attract concessional taxation treatment (currently $540,000 over three years) to reduce the extent that very rich individuals could avoid tax in the future, and implement the recommendation by the 2009 Henry review of Australia’s Future Tax System to tax superannuation contributions at marginal rates less a flat-rate rebate.
  2. Levy additional earnings taxes on superannuation account balances above a certain limit.

Of these two options the first may be better – it is less complex administratively, and would achieve the equity objective for superannuation, with a consistent concession to all contributions irrespective of a person’s income.  In the absence of other changes to personal tax, the effect of this proposal would be to reduce contributor’s disposable income, but retirement incomes would increase as the fund would no longer pay contributions tax, and so the effect would be similar to requiring employees to make an additional contribution to superannuation. As such phasing in this option may therefore be a better alternative to the proposed phased increase in the contribution rate from the present 9.5 per cent to 12 per cent.  Furthermore, if in addition, the tax on superannuation earnings was halved to 7.5 per cent, as also recommended by the Henry Review, then the retirement income for a median income earner was projected by the Henry Review to result in replacement rates of as much as 88 per cent and a replacement rate of 76 per cent for an average income earner.

Overall these reforms to superannuation should be strongly supported. They would make a very substantial contribution to a less expensive and fairer retirement incomes system. For the average male wage earner the FSI has calculated that its reforms would have the potential to increase his retirement income by around 25 to 40 per cent (excluding the age pension) – no mean achievement, and at less cost after reform of the tax concessions than the present system.

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