Superannuation myths unbundled

Several pervasive myths are obscuring a clear picture of sensible reform in superannuation in Australia today. These myths have created a monumental ball of string that should be unbundled. Once sorted, we should kill off the myths. Otherwise, as Michael Rice observes, Australia will be set up for poor retirement outcomes and superannuation policy driven by misinformation.

Australia’s superannuation system has three key building blocks:

• the Age Pension
• our mandatory employer contributions (now 9.5% of salaries)
• tax concessions to encourage voluntary contributions.

Over decades, many changes to all three have created uncertainty for people saving for their retirement.

Prime Minister Abbott tried to bring stability with his recent Captain’s Call that there will be no further changes under his government. Unfortunately, this has led to confusion within his Cabinet and the superannuation industry as there are several reforms currently being considered. These include the recommendations from the National Commission of Audit, the Financial System Inquiry, Treasury’s Retirement Income Review and the forthcoming Tax White Paper Task Force.

It is difficult to see how we can get meaningful reform without change to tax concessions and to the eligibility for the Age Pension. Of course, change brings some winners and some losers – and those in the latter group all vote!

Myth #1: Tax concessions are equal

There is a perennial debate on the value of tax concessions. Treasury provides a figure of about $32 billion but this assumes that, in the absence of any tax incentive for superannuation, people would simply draw salaries and pay tax at their marginal rates. In practice, the removal of tax concessions on superannuation would allow the government to slash personal tax rates anyway. Further, taxpayers would simply seek other ways of minimising their tax, possibly through negative gearing of property or shares.

One defence of tax concessions has been to show that the majority (about two-thirds) of concessions are made to taxpayers earning between $37,000 and $180,000. However, this means the small number of taxpayers (2.3%) earning more than $180K receives most of the rest of the concessions! So, commentators simply use the statistics which back their story…

Myth #2 Franking credits are defunct

Australia has a system of providing imputation credits for franked dividends to avoid double taxation of company profits. There is an ongoing debate about the merits of franking credits for the economy. One positive feature is the encouragement of patient long-term investors (including superannuation fund members and retirees) to participate in the growth of the domestic economy.

One submission to the Tax White Paper argues they should be abolished because members approaching retirement need to worry about sequencing risk and a high allocation to equities in retirement! Of course, this is rubbish – retirees MUST hold significant levels of growth assets to protect themselves against inflation risks (and partially against longevity risks too).

Dividends (including the associated franking credits) provide a solid source of reliable income for retirees with relatively low levels of volatility. For those retirees who are prepared to live off their income and consume capital by taking profits occasionally, they provide protection against inflation and longevity risks.

All superannuation funds should fight to keep franking credits!

Myth #3: Lump sums don’t prevail

Another commentator in a recent opinion piece in a national newspaper claimed that the payment of lump sums was the greatest problem of the Australian superannuation system. No doubt this comment is based on the erroneous assumption that everyone takes out their money the day they retire and they are subject to sequencing risk.

Rice Warner conducted research recently for Colonial First State that showed that about 85% of the value of all retirement benefits is reinvested into pensions. At least one-third of the balance is invested in bank term deposits (which is a different form of saving) and most of the rest was used for debt reduction (which is also a form of saving).

Further, we are often told retirees spend their money quickly to fall back on the Age Pension. In fact, those who have account-based pensions are generally conservative about spending their money. The average amount taken as pension payments each year is about 7%.

Myth #4: Mandatory Annuities are the panacea

From time to time, commentators repeat the error made in the Henry tax review of calling for mandatory annuitisation. The logic is that mortality is pooled and all of the benefit will be used for retirement income since there will be no leakage from bequests.

Unfortunately, lifetime annuities have the greatest sequencing risk of all products since the price paid is subject to prevailing interest rates on the day of retirement. They are also relatively poor value as a long-term investment.

The best time to buy these products is late in life (say from age 80) when the product and utility value is better.

Myth #5: Bequests

Several commentators have considered that there is ‘leakage’ from the system if benefits are not used for retirement incomes. The argument is that benefits need to be used for retirement incomes or the concessions made are wasted.

Clearly, lump sums have the potential for leakage, though as shown above this is not the case in practice.

Another form of leakage is when a retiree dies leaving a residual benefit which is passed on as a bequest for family or charities. As funds develop better ways to pool mortality, the amounts left will reduce over time. However, the logical way to address large bequests is to claw back concessions by adjusting the tax rate for benefits passed to non-dependents on death in retirement. A variation could be to allow the benefit to pass tax-free to a superannuation account of a family member.

Public Policy

Rice Warner is of the firm belief that industry must kill off the many myths and recognise that they can lead to poor public policy. As more than half of people retiring this year are going to live for more than 20 years, they need to share in the equity risk premium provided by growth assets. Many current solutions solve the wrong problems and this will lead to a reduction in living standards through lower earnings over the retirement years.

Michael Rice, CEO