Australia's Future Tax System

Retirement Income Consultation Paper

1. The retirement income system

Challenges and opportunities and their implications for the retirement income system

The Panel's Consultation paper sets out the challenges and opportunities that will shape Australia's future tax‑transfer system. The submissions identify the following challenges and opportunities:

  • the type of society in which Australians might choose to live, including considerations about the role and size of government in Australia;
  • increasing globalisation and the changing pattern of world economic activity;
  • demographic change, including changing patterns of workforce participation;
  • climate change, the environment and sustainable economic growth;
  • improving intergovernmental relationships within the Australian federation;
  • improving the process of policy formation and its administration; and
  • the role of technological progress.

While these challenges and opportunities relate to the whole tax‑transfer system, many are also relevant to Australia's future retirement income system. Australia has supported the living standards of retired Australians, especially those unable to save for their retirement, since the early 20th century. While the Pension Review considers the adequacy of these arrangements, this review considers the appropriateness of the retirement income system for individuals able to save.

Superannuation assets are invested globally, with over 30 per cent of assets held at 30 June 2007 invested in international shares and fixed interest securities (Australian Prudential Regulation Authority 2008). Australians' retirement incomes therefore are directly linked to the changing pattern of world economic activity.

The retirement income system has a strong connection with demographic change. It affects the sustainability of the retirement income system and highlights the need to ensure it achieves a reasonable standard of living for the growing number of individuals no longer in the workforce.

Australia's retirement income system

Australia has a three pillar retirement income system with a government funded Age Pension supported by compulsory saving (the superannuation guarantee (SG)) and voluntary saving. This system ensures support for the aged once they are no longer able to work.

The Age Pension provides basic support to those older Australians with no or moderate private income or assets. Its aim is to provide an acceptable standard of living in retirement regardless of an individual's time in the workforce and access to superannuation. The Age Pension also supplements the other income of most retirees. A means test that takes into account a retiree's other income and assets determines the supplementation.

The SG requires individuals to save for their retirement and closely relates an individual's retirement income to their time in the workforce. One reason given by the government for introducing the SG was to counter the possible short‑sighted behaviour of individuals to save inadequately for their retirement. However, compulsory saving may also act to counter the effects of an Age Pension and taxation on decisions to save. The promise of a means‑tested Age Pension may result in people choosing not to save, or to save less than they might otherwise. The tax treatment of long‑term savings can also result in individuals preferring to save less.

Under the SG, 9 per cent of an employee's remuneration is paid into a superannuation fund to support their retirement.1 Although employers are required to make superannuation contributions on behalf of their employees, employees may have borne the cost of the SG through lower wage growth at the time the SG was increased. This was outlined in the government paper announcing the SG:

A major challenge for retirement incomes policy is the need for current consumption to be deferred in favour of future income in retirement … No loss of remuneration is involved in meeting this national challenge. What is involved, rather, is forgoing a faster increase in real take‑home pay in return for a higher standard of living in retirement (Australian Government 1992).

The voluntary savings pillar enables individuals to choose how much they save, and the investment vehicle in which they save, to achieve a higher retirement income. This pillar includes superannuation contributions above the SG and non‑superannuation savings, such as deposits and real estate (which may or may not be used for retirement). Home ownership supports retirement income as owners do not need to pay rent and the home acts as a store of wealth that can be accessed in retirement (for example, through the use of reverse mortgages).

The compulsory and voluntary savings pillars allow individuals to self‑fund higher retirement expenditure than the Age Pension provides. The government supports SG and voluntary superannuation savings through income tax concessions. However, individuals bear more risk, and potentially higher returns, on their SG and voluntary savings than under a government funded retirement income.

In the Australian system, therefore, the Age Pension provides a guaranteed income, while the income generated from the second and third pillars depends on the amount invested and returns on these investments. The level of earnings of an employee determines the superannuation contribution by the employer. The earnings of a person also enables them to make voluntary contributions and accumulate other savings. On average women have lower earnings than men. Many women have greater career interruptions than men, and many are more likely to work part‑time due to caring responsibilities. This means the ability of many women to save and contribute to superannuation is more limited than for many men.

Although the three pillars are referred to as the retirement income system, in many ways the pillars have developed independently of each other. Appendix B provides a history of the retirement income system. The history of the system has influenced the degree of integration between the pillars. For example, different ages apply to when a person can access superannuation and the Age Pension, and there are differences in how benefits are paid. These issues are discussed in Sections 3 and 4.

Summary of key messages from submissions

Most submissions endorse the three pillar system. However, many propose changes, such as increasing the level of compulsory saving and altering the way the pillars are integrated.

Other submissions suggest that the retirement income system should allow individuals to save in retirement, encourage individuals to work into retirement, and facilitate transitions between work, self‑funded retirement and the Age Pension.

One submission questions whether the concept of retirement is out‑of‑date given Australia's healthier aged population. It questions the overall benefits of having a retirement income system that supports the leisure of individuals who are capable of working.

Other submissions suggest that consideration be given to extending the superannuation system into a life‑long savings account which can also be used for such things as education and housing.

Some submissions argue that compulsory saving has increased Australia's national saving, which may have the potential to insulate Australia from global restrictions on credit.

Objectives for a retirement income system

Guiding objectives can help set the parameters for the retirement income system. Possible objectives for a retirement income system are:

  • it should be broad and adequate, in that it protects those unable to save against poverty in their old‑age and provides the means by which individuals must or can save for their retirement;
  • it should be acceptable to individuals, in that it considers the income needs of individuals both before and after retirement, is equitable and does not inappropriately bias other saving decisions;
  • it should be robust, in that it appropriately deals with investment, inflation and longevity risk;
  • it should be simple and approachable, in that it allows individuals to make decisions which are in their best interests; and
  • it should be sustainable, in that it is financially sound into the future and detracts as little as possible from economic growth.

These objectives place various responsibilities on individuals and the government. Sections 2 to 6 discuss each of these objectives with regard to the retirement income system.

The evolving retirement income system

The relatively recent increase in the SG to 9 per cent, in 2002, means that the SG will affect retirees in different ways. For example, the standard of living of retirees will significantly improve during the transition to a mature SG system in 2037 (after 35 years of work).

Table 1.1 shows how replacement rates for individuals will change over time (based on the Age Pension and SG savings). A replacement rate compares an individual's spending power before and after retirement (that is, after tax is paid). For example, a replacement rate of 75 per cent would mean that an individual would be able to spend $75 in retirement compared to $100 before retirement.

Table 1.1: Replacement rates for an individual aged 60, 40 and 20 years in 2008
who retires at age 65 years(a)

Income as a proportion of AWOTE(b) Individual's age (in years) in 2008
0.75 63 83 89
1.0 54 73 78
1.5 43 61 67
2.5 30 49 60
  1. Appendices D and E provide further discussion of replacement rates and how they are calculated.
  2. AWOTE is average weekly ordinary time earnings and is approximately $1,150 a week.

Source: Australian Treasury projections.

The average replacement rate in OECD countries is currently 84 per cent for a 20 year old earning the average wage and retiring at the eligibility age for a pension. However, concerns regarding the sustainability of some retirement income systems around the world have seen reforms such as increasing the Age Pension age, reducing incentives for early retirement and changing the way benefits are calculated and indexed. These reforms will result in the average replacement rate falling to 70 per cent by 2040 (Martin and Whitehouse 2008).

The transition to a mature SG system will shift the system from one where superannuation supplements the Age Pension to one where the Age Pension supplements superannuation. Table 1.2 shows how the Age Pension will decrease as a proportion of retirement expenditure over time. The Age Pension will continue to be an important source of income for median income earners (around 75 per cent of average weekly ordinary time earnings (AWOTE)) and average income earners. It will also support the retirement income of higher income earners during the transition to a mature retirement income system. The Age Pension will continue to support the retirement income of individuals earning over twice AWOTE even after the SG is mature.

Table 1.2: The changing retirement income system(a)

Age Pension as a proportion of retirement expenditure over time

Income as a proportion
of AWOTE(b)
Year of retirement
(at age 65)
0.75 79 68 59 50
1.0 73 60 50 41
1.5 63 48 36 26
2.5 59 38 24 15
  1. Appendices D and E provide further discussion of replacement rates and how they are calculated.
  2. AWOTE is average weekly ordinary time earnings and is approximately $1,150 a week.

Source: Australian Treasury projections.

Setting the retirement income parameters

The parameters of the future retirement income system will depend on its desired outcomes. Box 1.1 sets out reasons why the government may get involved in the retirement savings decisions of individuals. The Age Pension will affect how the system achieves its desired outcomes. An Age Pension intended to supplement retirement income will influence retirement income differently to one designed as a safety net.

For example, if the intention of the system is to achieve a replacement rate of expenditure before retirement, an Age Pension that supplements retirement income will mean the compulsory savings rate can be lower than if the Age Pension is a safety net for those unable to save. A universal Age Pension (not means‑tested) would reduce the overall levels of compulsory savings and concessions required to reach a given replacement rate. In this system, the total cost of government intervention would depend on the level of support to be provided to individuals through tax concessions and the Age Pension. If a universal Age Pension were to be paid, equity issues would have to be considered.

Alternatively, if the intent of the retirement income system is to ensure a minimum level of income for the duration of an individual's retirement, the Age Pension would act as a safety net. Individuals would then decide to save more if they wanted a higher retirement income. In this case the government could choose to fully fund this income or require individuals to partly fund it based on means.2

Box 1.1: Why do governments have retirement income systems?

The reasons why governments establish a retirement income system include:

  • Equity — the community may consider the retirement income of some retirees to be too low. Equity can be targeted in a number of ways. For example, governments can require people to save a minimum amount of income for their retirement and/or redistribute taxes to retirees with low incomes.
  • Risk — markets may not provide sufficient opportunities for people to reduce the amount of risk they bear. A common market problem is 'asymmetric information', where potential borrowers know more about their ability to repay loans than lenders. Due to this information asymmetry markets may under‑provide financial products such as reverse mortgages or life and income insurance. Government can also use the retirement income system to spread risk between itself and individuals, as well as between different groups in the community and between younger and older generations.
  • Myopia (short sightedness) — some people may not effectively plan for their retirement, for a variety of reasons. Different reasons may require different policy responses. For example, providing more information about the future costs in retirement may enable people to better plan their financial arrangements.
  • Institutional failure — some institutions may set poor incentives for saving. For example, income taxes reduce the value to saving and future consumption and therefore encourage less saving. Government may need to redress such institutional failures through retirement income policy.

International retirement income systems

Similar to Australia's Age Pension, other OECD countries provide a taxpayer funded minimum retirement income which is typically expressed as a percentage of average earnings. In many countries such pensions are means‑tested. This supports individuals whose connection with the workforce does not allow them to provide for themselves in retirement.

These countries also have an additional element to their retirement income system aimed at maintaining higher incomes in retirement, which is generally linked to earnings from work. The design of this element varies across countries in terms of: the source of funding (employee, employer, or government); whether it is based on defined benefit or defined contribution schemes; whether it is administered by the government or the private sector; and indexation arrangements (whether through price, wage or other adjustment mechanisms).

The majority of OECD countries have national social insurance systems, which pay a guaranteed retirement income (a defined benefit) and may be funded by individual contributions and levies on wages, and supplemented from government revenue. The guaranteed retirement income is normally an after‑tax replacement of an individual's before‑retirement income, dependent on eligibility criteria such as their time in the workforce and period of contributions. This income is also supported by voluntary employer or employee retirement funds in some countries.

Other OECD countries finance this element through mandatory defined contribution schemes. In Australia this is done through the SG. Under these schemes, individuals fund a proportion of their retirement income by making contributions to a superannuation fund. Unlike the social insurance model, the risks associated with investment, longevity and inflation are borne by the individual. However, these systems reduce the risk that future governments will alter entitlements, as may occur under a national social insurance system.

The World Bank promotes multi‑pillar retirement systems as outlined in Appendix C.

Consultation question

Q1.1 In considering the future of Australia's retirement income system, which objectives are relevant in setting retirement income policy? Does the current system of the Age Pension and compulsory and voluntary savings meet these objectives? If not, how should the system be changed to meet these objectives?

1 SG does not have to be paid if an employee earns less than $450 a month or on the amount of earnings above $38,180 a quarter. It also does not have to be paid to employees aged 70 years or older and certain employees under 18 years.

2 To purchase an Age Pension on the market, a 65 year old male would have to invest $289,000 (Dunsford and Wickham 2008). This figure would be higher if it included the other concessions provided to Age pensioners. Dunsford and Wickham estimate this cost would reduce to $240,000 if the individual purchased the Age Pension from the government, as the government can be less conservative with its investments than a private company.