Australia's Future Tax System

Retirement Income Consultation Paper

Appendix D: Measures of retirement outcomes

Replacement rates

Replacement rates compare an individual's spending power before and after retirement. The proposition underlying the replacement rate concept is that an individual's standard of living in retirement should be a reasonable proportion of their standard of living during their working life.

Replacement rates can be calculated for an individual or compared with an income benchmark. The appropriate type of replacement rate will depend on how much of an individual's retirement income is made up of the Age Pension.

If an individual has a greater reliance on the Age Pension, a more appropriate comparison is between the Age Pension and the net income of a worker on the minimum or average wage. The Pension Review will consider this issue.

Where the individual has spent a long period in the workforce and has saved during that period, their level of expenditure before and after retirement is a more relevant comparison.

Replacement rate methodologies

Replacement rates can be calculated using a range of methodologies, which can generate a range of results. Differences between results can, in turn, affect the assessment of retirement income system outcomes. For example, a replacement rate based on income before tax may underestimate the effectiveness of the retirement income system, especially where retirees pay less tax than when they were working.

Replacement rate projections can be significantly affected by the period taken into account in their calculation. This can be either the spending in the first year of retirement or an average over a certain period. Table D.1 shows how the period of expenditure in retirement compared to expenditure in the last year of working can affect replacement projections.

Table D.1: Effect of retirement expenditure period on replacement rates

Income as a proportion of AWOTE(a) Average over retirement/last year work
%
First 10 years retired /last 10 years
work %
First 5 years retired/ last 5 years work
%
First year retired/ last year work
%
0.75 79 87 84 82
1 68 78 74 71
1.5 56 66 63 60
2.5 51 61 57 55
  1. AWOTE is approximately $1,150 a week.
  2. Australian Treasury projections.

Budget standards

Budget standards are another way of measuring the outcomes of the retirement income system. They involve developing detailed household budgets that specify the items a household needs to achieve a particular standard of living. However, budget standards can be controversial. For example, a standard of living may meet the needs of some households but be insufficient or excessive for others. As such, value judgments play an important part in the establishment of a budget standard. For this reason there will always be an element of controversy surrounding the standard.

Budget standards based on survey data are affected by what items are included in the basket of goods and services. For example, in some standards the budget can include all items that 50 per cent of the surveyed households would consume. However, in reality, the majority of the population may choose between these items. Including all these items it the budget will overestimate the standard. The circumstances of the assumed household will also affect whether the standards are applicable to other groups. For example, a standard based on a home owning household is unlikely to be relevant to a household that rents.

Budget standards lose relevance if they are not regularly updated for inflation and the items included in the budget. Over the medium to long term the standard needs to be adjusted to account for changes in consumption trends and community living standards.

Wellbeing

Replacement rates and budget standards only seek to assess the effectiveness of the retirement income system on the income it provides. They do not capture the value a retiree places on not having to work (that is, leisure) and other services they may receive. Wellbeing measures look beyond income and explore how retirees perceive their retirement.

Retiree wellbeing is more complicated to measure then replacement rates or budget standards. The Household Income and Labour Dynamics in Australia survey (2004) asks retirees about their wellbeing with the last results released in 2004. The Melbourne Institute is currently updating this survey on retiree wellbeing. However, these results are not currently available.