- On 24/08/2020
- age pension
While we wait for the Retirement Income Review’s report on superannuation, there has been a flow of media coverage on whether we should increase mandatory employee contributions (the superannuation guarantee, or SG) from the current 9.5% to the legislated 12% ultimate rate. Some commentators have even suggested we move to a universal Age Pension like New Zealand so we can eliminate the unpopular means-testing of our own government pension.
Many arguments are emotional and/or made by parties with vested interests. The costs and benefits can be varied by changing the assumptions and discount rates, so there is no clarity or agreement about the right path.
The key to resolving these arguments lies in determining whether it is better to pre-fund retirement benefits or simply pay all benefits on a Pay-As-You-Go (PAYG) basis. The theory is important as any increase in the SG will add to pre-funded benefits and will ultimately reduce government PAYG pensions.
Should retirement benefits be pre-funded?
Private pensions in Australia have always been structured to be pre-funded on the grounds that a company’s promise is worthless if they run into financial difficulties. Therefore, pension trust funds were established to protect employees from potential company failure. In Australia, the assets of all superannuation benefits are held in trust funds.
There is a funding choice for governments in that they will be around to meet the benefits later. So, they could simply meet pension payments from their annual budgets as they do with all other social security benefits.
In considering this choice for public pension funding, it is worthwhile reflecting on the design of post-war retirement systems some 75 years ago. Most countries were in bad shape due to the economic black hole left by the war (WWII). For example, some countries needed to provide retirement incomes after the war but had had no funds. Thus, they adopted a PAYG approach across the economy because they had no alternative.
The PAYG versus pre-funding discussion became a serious policy debate in the 1970s. At that time, the question was relevant for public pension provision in Europe. Some 30 years after the end of WWII, the countries of Europe began to think about preparing for the bulging baby-boomers who were going to add significantly to pension costs within a generation.
The conclusion from this debate was that pre-funding was the preferred approach, but PAYG would be needed for those who could not accumulate sufficient assets prior to retirement. A pre-funded system has the advantage that it is independent from the volatility of yearly cash flow, which gives it resilience. While this is beneficial, it does not show up in the usual value-for-money financial modelling which is generally short-term and does not look at the long-term benefits. As an example, tax concessions to increase superannuation show up as a cost to government now but are offset by reduced pension payments in future years – the concessions are in the Budget but the pension savings are not measured and are well into the future.
The many benefits from a pre-funded system include:
- Pre-funding improves inter-generational equity.
- Pre-funding reduces the impact of unforeseen wage inflation which blows out unfunded benefits not backed by assets (note, the Age Pension has been linked to average weekly earnings since 1975).
- Pre-funding improves retirement saving as many people will not voluntarily save for future events.
- Pre-funding provides more control to consumers.
- Pre-funding helps build capital markets which help to boost domestic economies.
- Pre-funding removes pressure on future taxpayers. It is more efficient for taxpayers as costs are smoothed.
Given these advantages, in theory all retirement benefits would be better being pre-funded, but there is always a trade-off against current affordability and conflicts with other priorities (including the costs of transitioning from one system to the other).
Is pre-funding always beneficial?
Some still argue that the government should focus on short-term financial needs and not pre-fund retirement benefits that are not payable for many years. Yet, if the assets set aside grow by more than wage inflation (from the individual’s perspective) or GDP (from the government’s perspective), there is a genuine financial saving in addition to the above benefits.
In Australia, many large superannuation funds have delivered an annual 5% real return over inflation for 25 to 30 years. This has provided valuable retirement benefits for employees, even with lower levels of SG throughout their careers so far. Clearly, the pre-funding has been beneficial during this period.
Now the return on assets is unlikely to be that good in future, but even if returns only match wage inflation, it will be beneficial for individuals and governments alike. If we do have a lengthy period of poor returns from a global recession, that will be unfortunate. However, some would argue that the forced saving combined with the tax concessions for superannuation will still make pre-funding viable for consumers.
The SG system (which is private sector pre-funding) has reduced the cost of providing Age Pensions to levels far below most other nations. With the SG at 12%, the lower cost of future Age Pensions will allow the government to spend more on other critical areas – such as Aged Care.
Where should we position the SG?
Greater resilience means lower risk in the system – less risk for members and retirees, and less risk for the government. This is one of the key advantages of the SG system – it smooths costs and improves benefits through real returns. Self-sufficiency also reduces the cost to government over the long term.
This hypothesis suggests we should push the SG as high as possible. At 15% over a career, we might get most Australians largely off the Age Pension, but there is a trade-off with other expenditure needs. The Paper by Rice & Bonarius suggested the SG be set somewhere within a range of 10% to 15% with the higher number keeping more people off the Age Pension. We should also note that the steep taper rate on the Age Pension causes a problem for many people entering retirement, even though the impact reduces in later life as they draw down and spend more of their benefit.
The current policy of 12% fits neatly into this range. However, following the GFC, in 2014 the government deferred the increase in the SG rate from 9.5% to 10% until 2021. We have only had a 0.5% change in the last 18 years, and it is now only scheduled to get to 12% in 2025. It is likely that there will be further public debate about delaying it further due to the current economic crisis.
It still makes sense for the SG to go to 12% but we need to recognise that wage rises are likely to be low for a few years, and any increase will cut into disposable income for many people. We do want certainty, and it would be better for the government to call for another delay rather than cutting it off altogether at a lower level.
It is time for rational holistic thinking on the subject. Society could accept a delay in these difficult times, but why not think more laterally and tie any future SG increases to the forthcoming personal tax cuts to minimise the impact on disposable income.