The Government has adopted 43 of the 44 recommendations of the Financial System Inquiry (FSI). These recommendations had received wide support, and as I said in an earlier blog (21 January), ‘they should be relatively easy for the Government to adopt’. Indeed, the surprise would have been if the Government had not been supportive (whoever was Prime Minister and Treasurer).
Overall the net result should:
- Strengthen the resilience of the financial system
- Lift the value of the superannuation system and retirement incomes
- Modestly promote some more competition
- Lead to some improvement in customer treatment
- Enhance regulator independence and accountability
In this posting I will concentrate on the first two points, which have received most public comment and which are the most significant.
Resilience of the Financial System
Our financial system weathered the GFC exceptionally well, but nonetheless the Government has accepted the FSI view that “Australia’s financial sector regulatory framework needs to be stronger than those of other comparable countries”. In particular, Australia’s banks provide close to 90 per cent of the domestic credit to businesses and households. Furthermore, compared to other countries, Australia’s banks are especially dependent on off-shore financing, while their lending portfolios are heavily concentrated on home lending, with mortgages accounting for 60 to 70 per cent of their domestic lending.
The main change to improve the resilience of the financial system has been the requirement for the banks to hold increased capital. In addition, risk weights, leverage, loss absorbency and regulators’ crisis powers will be addressed by the regulators and the Government. These changes should reduce the possible future need to call on the government guarantee and consequently for taxpayer funded bailouts. They should also reduce the advantages that the four major banks have over their competitors, thus increasing competition with better outcomes for consumers. Certainly, the present level of competition is insufficient to hold down charges (see more below), and one wonders if these changes will make enough difference.
In fact, the banks anticipated the Government’s support for these changes to their capital ratios and moved to improve them before the government announcement. What is of concern, however, is that the increased cost of the extra capital has been passed on, or even more than passed on in the case of Westpac, through higher interest rates to borrowers. Furthermore, the return on shareholders’ funds for the four major banks in Australia is already just about the highest among all comparable countries. Thus the major banks could easily have absorbed the higher costs of their greater security instead of passing them on to their customers. Indeed, that would seem to be only fair as their shareholders are now facing less risk, and normally the return on capital should reflect the amount of risk.
Clearly the oligopolistic competition among the four major banks is not working in the customer’s favour. Calls by the Government, media and of course the banks themselves, that these interest rates are competitively set and should be left to the market fail to recognise that the evidence clearly proves that the present oligopolistic form of competition is falling far short of the text book ideal of pure competition.
Now some financial pundits are suggesting that the Reserve Bank will need to lower its interest rate just to offset the unjustified increase in mortgage rates. But this really would be a case of the tail wagging the dog, if monetary policy is going to be set in response to unwarranted decisions by the commercial banks. Indeed, in these circumstances one wonders if stronger regulatory powers might not produce a better result, if this is how our banks are going to behave if left to themselves.
Superannuation and Retirement Incomes
The objective of the superannuation system
Since the introduction of compulsory superannuation back in 1992, superannuation has become one of the success stories of Australian policy. Superannuation funds now account for as much as $2 trillion of savings, and even though the compulsory system is still only half way to maturity, the retirement incomes of middle income households have already improved significantly. Overseas assessments rate the Australian retirement incomes system as being the second or third best in the world. Nevertheless, improvements in our retirement income system have been recommended by the FSI, and these can and should be made.
Most importantly, the Government has accepted the FSI recommendation that the starting point for reform is to establish clearly the objective of the compulsory superannuation system and enshrine it in the superannuation law. This will act as a guide regarding superannuation’s purpose against which policy proposals can be assessed. This should in turn improve the policy debate and avoid some of the past policy mistakes.
At this stage, however, the Government has still left open what that objective for superannuation might be. The FSI recommended that the objective of superannuation should be to provide “income in retirement to supplement or substitute the age pension”, and there is an emerging consensus that superannuation should be directed to providing a retirement income and not other benefits, including bequests. Nevertheless, there will be a lot of further debate about:
- what constitutes an adequate retirement income
- the implications for the amount of compulsory saving and how superannuation balances might be used in retirement; and
- the extent to which superannuation should be matched by reductions in access to the age pension.
Perhaps the most worrying issue yet to be settled in regard to the purpose of superannuation is the extent to which superannuation should act to reduce the call on the Age Pension. Unfortunately both sides of politics in their response to the FSI recommendations have expressed their desire that as many retirees as possible should live off their superannuation and not rely on the Age Pension or even a part Age Pension. In principle limiting access to the Age Pension in this way may seem like a good idea, but practically its advocates merely demonstrate their ignorance of how the pension and superannuation systems actually interact. Furthermore, it was never the expectation of the then government, as can be seen from the second reading speech when compulsory superannuation was introduced, that it would lead to a significant reduction in the number of people drawing an age pension. Instead, it was expected – correctly – that compulsory superannuation would lead to more part-pensions and less full pensions, but not much reduction in the total number of pensioners.
The reality is that the present age pension for a couple cuts out at around average weekly earnings, and more than 80 per cent of the workforce earn less than this amount. So if this majority of retirees receive a superannuation weekly payment that is a bit less than their previous income, they must inevitably have access to a part pension in their retirement. The only alternative way to prevent most retirees having access to a part age pension would be to:
- reduce the age pension,
- increase the rate at which the age (and other) pensions are reduced as private income increases above the already high rate of 50 per cent, or
- substantially increase the rate of compulsory contributions to superannuation.
It is doubtful whether any of these ways of reducing access to the Age Pension are actually desirable or politically practical. So in setting the objective of the superannuation system we should focus on achieving an adequate retirement income, and forget about the consequences for expenditure on the Age Pension.
Reforms affecting post-retirement incomes
The other really important recommendation by the FSI, which the Government has also endorsed, is the proposal to introduce new income stream products that can better protect retirees from longevity and the other risks. At present retirees draw down on their superannuation balances after retirement, either as a lump sum, or as regular payments from their individual superannuation account. This means that the retiree has to calculate how long they will live and adjust their draw-down rate accordingly if they want to maintain their standard of living. In addition, they must handle the inflation and investment risks that will affect the value of their superannuation balance.
The evidence strongly suggests that retirees are mostly risk averse and try to ensure that their money doesn’t run out while they are still alive. As a result, they typically leave a sometimes substantial balance in their fund when they die, but this comes at a cost of an unnecessarily low living standard through their retirement, and also a lack of security.
In future the default option for a retiree will be a comprehensive retirement income product (CIPR), selected by their fund’s trustees. Individual retirees will still be able to opt out if their circumstances and preferences are different. But for those who agree to participate, the longevity and other risks will effectively be pooled, and this should encourage the financial system to develop new products that will provide much more secure retirement income streams to retirees. In addition, the Government has agreed to “continue to work to remove impediments to retirement income product development”.
While these are important and welcome reforms to the post-retirement arrangements for superannuation, there remains some doubt whether the pooling of the post-retirement risks will work sufficiently on a voluntary basis. Time will tell, but it may be if voluntary pooling doesn’t work sufficiently well, then some form of mandatory pooling will be proposed. The difficulty with compulsion, however, is that the circumstances of different retirees can vary significantly as can their circumstances through their retirement. Thus it will be difficult to design a limited number of common post retirement products that suit everyone, but that is what mandatory pooling would impose.
Other superannuation reforms
The other major reforms of superannuation that the FSI proposed and the Government has (enthusiastically) endorsed relate to the governance and regulation of the system. The key changes are:
- all funds must in future have a majority of independent directors
- competitive allocation of new default fund members to MySuper products, that have emerged as key savings instruments during the accumulation stage, and the same would presumably apply for the allocation of retirees to funds offering the proposed CIPRs
- amendment of the choice of fund arrangements by removing the deemed choice in certain industrial agreements and determinations.
Clearly these changes are intended to reduce union influence over superannuation, notwithstanding that the present arrangements seem to be working well. On the other hand, it is hard to disagree, in principle at least, with more choice and competition. My personal view is that if the industry funds, where unions presently supply up to half the Board members, are truly as competitive as claimed, then I doubt that the changes will make all that much difference.
The big prize for the retail, non-union, funds is a bigger share of the default market. If they are to win this bigger share, however, they should have to drive their costs and charges down. In that case the broader competition should benefit members, and that would be good. Indeed, a reduction of 30 basis points in charges, could on average accumulate over 40 years into an extra $40,000 that will significantly increase each retiree’s income.
The key FSI recommendation that was not accepted by the Government was the FSI proposal to stop superannuation funds from borrowing directly. This is despite the risks that such borrowing presents to the resilience of the financial system, with much of that borrowing being invested in possibly over-inflated property. According to the Government the presently available data are not sufficient to justify significant policy intervention, but it will monitor the situation further.
This decision effectively means that the Government has chosen to ignore the expert advice from the FSI, which clearly did consider that the data were sufficient when they made their recommendation. However, any prohibition on self-managed superannuation funds borrowing to increase their investments would have been unpopular with the relatively well-off owners of these funds. One cannot help wondering therefore whether that may be the real reason why the Government has failed to act on what is a potentially significant risk to financial stability.
Finally, action to reduce the inequities and costs involved in the superannuation tax concessions was not part of the FSI mandate, but it did advise the Government that action should be taken. It is to the credit of the Turnbull Government that it has now decided that this issue should be considered as part of its Tax Review. On the other hand, a review of the superannuation tax concessions should never have been prevented by the Abbott Government; indeed even the former Treasurer, Joe Hockey, in his valedictory speech to the Parliament called for these tax concessions to be reviewed.
All in all the new Turnbull Government has got off to a good start with its first major set of reforms covering the financial system. The net result should be better performance by what is now one of Australia’s biggest industries that greatly influences our overall economic performance. This reform package, however, was not a real test of the Government’s economic credentials. Frankly almost all the decisions involved were not controversial, and the few exceptions affecting superannuation governance and competition were strongly supported by the Government’s own constituency.
The real test for this Government will come later when it reveals its intentions regarding Budget repair, tax reform, and the future of federalism. Innovation policy will also be important but less controversial, while workplace reform will most probably involve more legislation to curb the power of unions, but no-one has yet shown that such attempts in the past have ever made much if any difference to productivity.
Michael Keating is the Chairman of the newly formed Committee for Sustainable Retirement Incomes which is an independent, non-partisan committee that has been established to act as a catalyst for public debate about retirement incomes through the development of evidence and policy advocacy.
 Michael Keating is the Chairman of the newly formed Committee for Sustainable Retirement Incomes which is an independent, non-partisan committee that has been established to act as a catalyst for public debate about retirement incomes through the development of evidence and policy advocacy.