Using retirement funds more efficiently
- On 31/03/2021
Legislating for retirement incomes
The world-renowned Australian superannuation system has been incredibly successful in delivering consistently strong real rates of return for members in the accumulation phase. Even the worst performing funds have delivered higher returns than most members could have done themselves. Once the current legislative process to weed out poor performers has been achieved, we can expect average returns to be even stronger.
Australia is a relatively young nation and, until quite recently, the numbers of retirees were small. This has resulted in limited effort being invested into retirement products and services, leaving the outlook murky for consumers.
The first comprehensive look at retirement was Australia’s Future Tax System (the Henry Review). The 2009 report included a comment that:
While superannuation generates assets for retirement, current arrangements do little to ensure that those assets can be used for income purposes throughout the years of retirement. As people live longer, there is a growing risk that individuals will exhaust their assets before they die. The lack of products that retirees can purchase to insure against longevity risk is a structural weakness in the system.
The Henry Review contained many sensible recommendations for tax reform, but it was largely ignored by government.
In December 2014, another review, the Financial System Inquiry, issued its final report. Amongst other things, it concluded that the greater risk for retirees was not running out of money, but holding too much back:
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 contributes to a lower standard of living for Australians in retirement and, for some, during working life — meaning people may have to save more than they did previously to reach the same level of retirement incomes.
To overcome this problem, the Inquiry introduced the concept of a Comprehensive Income Product in Retirement (CIPR). If implemented, pooling via a CIPR would allegedly smooth income better over the retirement years. After much consultation and little progress, CIPRs are currently scheduled to start in July 2022.
Another failure has been the delayed introduction of the Retirement Income Covenant. This was to have been legislated by July 2019 and would provide rules for trustees in developing “appropriate” retirement products. For instance, under the proposed measures:
Trustees should assist members to meet their retirement income objectives throughout retirement by developing a retirement income strategy for members.
It has been a tortuous process to implement some of these recommendations. Sadly, government has been unable even to legislate for the Inquiry’s Objective of Superannuation. This has opened the door to many recycled and poorly informed ideas about using our retirement savings for other purposes.
To try and resolve the problems, the government set up a Retirement Income Review in September 2019 and it released its comprehensive report to government in July 2020. It was released publicly in December 2020. The report made no recommendations, but it made several observations, including one that retirees do not consume (all) their retirement savings. This means they use their retirement benefit inefficiently and have lower living standards than they could.
How do retirees spend their money?
Common practice is to split people into three groups based on their eligibility for the Age Pension at the time they retire. Those who are well-off and are above the threshold to receive any Age Pension when they retire, those with moderate balances who will start with a part Age Pension and then generally move to a full Age Pension later in life, and those with low balances who will be on a full Age Pension throughout retirement.
We know that people entering retirement with large balances tend to draw as little as possible from their pension accounts. This is logical as it makes sense to leave as much of your assets as possible in a tax-privileged vehicle like an account-based pension. Many of these retirees have assets outside superannuation so drawing the minimum pension payments each year does not mean that they are leading lives which are too frugal.
Beyond their lifetime, data suggests that these retirees allocate some of their superannuation as a bequest. They know they have more than they can spend and often invest heavily in equities or property. Over the recent past, earnings have exceeded 5% a year in real terms and many of these retirees have more savings ten years into retirement than they did when they retired!
The position for those with moderate balances at retirement is different. Analysis suggests that they do appear to be frugal, and they are often too conservative with their investment allocation. For instance, the operation of the assets-test on the Age Pension means they will receive a higher pension if their superannuation return is negative. This means that this group could take on higher investment risks and use the Age Pension as a put option.
People retiring on the full Age Pension tend to use their superannuation benefit as a nest egg to be used in emergencies. This group comprises many low socio-economic retirees who have poorer mortality than wealthier retirees which necessitates a different investment and withdrawal strategy to account for their reduced life expectancy.
In assessing the outcomes delivered to these cohorts, it is useful to look at the experience of those people aged 65 to 70 in 2000. At that point most of the cohort would have been in retirement for a few years, and nearly half were on a full Age Pension. This group retired before the SG went to 9% so many had little accumulated savings in superannuation.
Table 1 shows their dependency on the Age Pension as they grew older.
Life expectancy would have been slightly under 20 years in 2000, so it is not surprising that half died by 2020. A large percentage of these members would have had some superannuation when they died. However, this was more likely caused by their early death rather than any frugality.
Table 1. People aged 65 to 70 in 2000
Table 2 clearly shows that the proportion of the population on a full Age Pension grows over time. This is counterintuitive as the mortality rate of full Age Pensioners is higher due to socio-economic factors. Therefore, we would normally expect a higher proportion of those retiring on a full Age Pension to die early. The fact that the proportion increases is due to the wealthier cohorts, with lower mortality, surviving and reducing their asset bases so that they eventually become eligible for the full Age Pension.
The trend shows that people do spend quite a bit of their accumulated superannuation early in retirement – more self-funded retirees shift to part pensions over time, and more part pensioners shift to become full pensioners. Overall, the behaviour appears rational and does not point to unnecessary frugality.
Table 2. Dependency of survivors
We also looked at those in the population aged between 65 and 70 in 2005 and 2010. The proportion of those on a full Age Pension dropped significantly in this time due to much higher superannuation balances at retirement. From 48% of new retirees in 2000, to 41.8% in 2005, and 36.0% in 2010. While the experience since then is short, there has still been a clear trend to the proportion of self-funded individuals reducing as retirees age, and higher dependency on the Age Pension.
Despite the overall quality of the RIR Report, its comment that people don’t draw down enough of their superannuation is based on some small studies which coincided with high investment returns. The overall dependency on the Age Pension does increase with age but some simple steps could be taken to improve the expenditure patterns in retirement. These might include:
- Increasing the drawdown rate from 5% to 6% between ages 65 and 75 to encourage higher drawdowns from a tax privileged environment earlier in retirement.
- Making those over age 65 drawdown from their accumulation accounts as well as pension accounts – this will reduce those funds not needed for retirement but held in a tax-privileged environment.
- Introducing default CIPRS for those with more than (say) $200,000 account balances at retirement to encourage smoothing of their retirement income over the remainder of their life.