Australia's Future Tax System

Retirement Income Consultation Paper

4. A robust retirement income system

The way the retirement income system deals with risk affects its robustness. These risks include: governments failing to provide entitlements (political risk); sustained falls in the market price of assets (investment risk); increases in the cost of living (inflation risk); and the individual outliving their capital (longevity risk). The amount of risk borne by the government and the individual is an important consideration in setting the framework of the retirement income system.

Summary of key messages from submissions

One submission argues that the move away from the pooling of risks, as exists in defined benefit funds, has moved more risks to individuals. The submission states this affects confidence in the superannuation system and attitudes to risk.

Many submissions argue that the retirement income system needs to deal better with the risk associated with individuals outliving their assets. Most suggest that individuals be required to take all or part of their superannuation as a guaranteed income for life. It is argued that the government should issue bonds which product providers could buy to support these products. Others propose greater concessions, such as the return of an assets test exemption, to encourage the take-up of income streams.

Some submissions state that requiring individuals to take income streams is consistent with the existence of tax concessions to support superannuation.

One submission argues retirees should not have to draw down their superannuation assets, to provide them with flexibility to prolong their assets.

Another submission identifies the benefits that housing can play in combating longevity risk, given the owner does not have to pay rent.

Investment risk

In developing a multi‑pillar system, the World Bank (1994) recommends that governments consider workers' exposure to investment risk within reasonable bounds. The way Australia's retirement income system deals with investment risk will become more important as the SG becomes as a greater proportion of retirement income.

Investment risk has two elements. The first involves inappropriately allocating assets during the accumulation of an individual's benefits. Over the long‑term, investments in low‑risk, low‑return assets can reduce the benefits that an individual can take into retirement. This will affect their ability to deal with longevity and inflation risks.

A higher level of investment risk can be positive as individuals can receive, on average, higher investment returns than from a system based on more conservative investments.

The second involves the impact that substantial falls in investment returns have on an individual once they retire. A rule of thumb is that a diversified portfolio of assets will experience a negative return once every seven years. As life expectancies increase, retirees could expect assets to fall perhaps two to three times over their retirement. The effect of a fall in investments can be magnified depending on how soon it occurs before or after they commence retirement.

The government shares investment risk through the interaction of the Age Pension with other retirement income. During periods of negative returns, a loss of income may be made up, in part, by an individual being eligible for some, or more, Age Pension at a rate of 40 cents in each dollar of lost income. Where investment returns rise, the income test allows the government to share in these returns through reduced Age Pension outlays. Investment returns also affect Age Pension outlays through the assets test.

Longevity and inflation risk

As superannuation becomes a larger part of an individual's retirement income, their standard of living will be determined by how they choose to draw their benefits. This choice can have a considerable influence on how they deal with the risks of inflation and longevity.

Life expectancy is an uncertainty in an individual's retirement planning. Many individuals tend to underestimate how long they will live. For many, increasing life expectancies pose a risk to the maintenance of their income.

Better integration between the Age Pension and the SG, including the age an individual can access their superannuation and how they draw down their capital, can limit these risks.

Access to superannuation

The length of the draw down period is a significant factor in determining an individual's income over their retirement. The draw down period is determined by when an individual starts to take their superannuation, how long they live and when they exhaust their assets.

The earlier an individual accesses their superannuation, the higher the risks associated with longevity and inflation. Currently, an individual can start accessing their superannuation from age 55 years. From 2015, this will gradually increase, reaching age 60 years by 1 July 2024 for individuals born after 1 July 1960, which is still below the Age Pension age of 65 years.

Aligning the eligibility age for superannuation to the Age Pension age would reduce the period individuals need to draw on their superannuation, thereby reducing the risks associated with longevity and inflation. However, some individuals have a working life interrupted by illness, unemployment or caring, for whom it may be inappropriate to delay access to their superannuation.

Draw down of superannuation

The Age Pension is a right to an income stream (depending on eligibility requirements) and cannot be commuted to an asset. By contrast, superannuation savings are a right to an asset and individuals have a choice in how they draw it down.

Requiring an amount of superannuation savings to be taken as an income stream would better integrate the Age Pension and the superannuation system and provide greater protection against longevity and inflation risks. Income streams could be purchased to receive a set income for life (a lifetime annuity) or a flexible income based on the balance of an account (an allocated pension).

Annuities provide the greatest protection against longevity risk, but Australia does not have a well‑developed annuity market. Annuities can also protect against inflation if they are indexed. As annuities are a set income, they provide less flexibility on how an individual can draw down their capital. They also tend to be invested in less risky assets, which may not satisfy the risk preferences of all individuals.

Allocated pensions provide more flexibility on the draw down of capital and the way capital is invested. On average, a diversified portfolio will deliver investment returns above inflation protecting the retiree from inflation risk. Longevity risk depends on how quickly the individual draws down their capital. Investment risk also affects how an individual deals with longevity and inflation risks.

The proportion of superannuation that an individual would need to assign to an income stream is a threshold question. Alternatives include requiring an individual to take all their superannuation as an income stream at the time of retirement, or requiring individuals to insure against living beyond their life expectancy by putting aside part of their superannuation to purchase an income that commences from a particular age.

Other countries have designed their systems to provide insurance against longevity and inflation risks. The national 'social insurance' models in other countries provide a defined retirement income. In Chile, which has a privately funded retirement income system similar to Australia's, benefits must be used to fund a monthly income benefit equal to 70 per cent of the individual's most recent wage. Only the amount exceeding this benefit may be taken as a lump sum. Private employer retirement savings vehicles in the United Kingdom restrict access to lump sums to 25 per cent of the value of the benefit, with the rest to be taken as a lifetime annuity.

Allowing access to lump sums provides flexibility for events outside normal retirement income needs. Such flexibility may be a relevant feature of a retirement income system. Requiring superannuation to be taken as an income stream would limit this flexibility.

Housing

Home ownership is a significant factor in retirement planning and can be used to counter investment, longevity and inflation risk. Instead of receiving investment income, a home owner receives the benefit of not having to pay rent during their retirement. Housing is therefore a form of voluntary retirement saving.

Accommodation costs in retirement can be financed through the purchase of a home or by saving through another vehicle (with those savings to be used on housing in retirement). The approach an individual chooses to take will be influenced to some degree by the tax arrangements applying to the available options. Where home ownership is more concessionally taxed, this is likely to encourage greater ownership than if the tax treatment of housing and the alternative savings vehicle are similar. However, issues other than taxation are likely to influence an individual's decision to buy a home. For example, owner‑occupied housing may provide benefits before retirement. It may also be regarded as less risky than other investments, as well as providing greater protection against increases in rent.

In addition to not having to pay rent, an individual can access the equity in their home through downsizing or through a reverse mortgage. These products allow an individual to convert the equity in their home to either a lump sum or a stream of payments. The access to capital in a home can also provide insurance against the risk of exhausting other assets while still alive. The reverse mortgage industry is still in its infancy in Australia, with approximately 1.4 per cent of individuals over the age of 60 years holding a reverse mortgage (SEQUAL 2008). The value of the market is approximately $2 billion, made up of over 33,700 reverse mortgages, with an average value of $59,000 per mortgage (Trowbridge Deloitte 2008).

Investment in the family home can result in the home being a significant asset (perhaps an individual's only significant asset) that can be drawn against in retirement. Payments from a reverse mortgage on a primary residence are treated as a loan for the purposes of the tax system and are therefore not treated as income for tax purposes.

However, if a reverse equity mortgage is taken as a lump sum, the first $40,000 is exempt from the Age Pension assets test for up to 90 days. Amounts over $40,000 are assessed under the assets test if held as an assessable asset. The whole amount is immediately assessed under deeming rules if held in a financial investment. If taken as a stream of payments, the amount drawn down is not counted in the income test.

The social security system provides additional assistance to individuals who are non‑home owners. Individuals who receive the Age Pension and do not own their home may qualify for Rent Assistance if renting in the private rental market. The maximum payment is $107.20 per fortnight for a single individual with no children and $101.00 for a couple with no children.

Owner‑occupied housing is exempt from the assets test. Non‑home owners can accumulate higher non‑housing assets ($124,500) without affecting their eligibility for the Age Pension. Implicitly valuing a person's home at a maximum of $124,500 can discourage Age pensioners from making decisions to move into more preferred housing arrangements, as it may reduce their total income because the additional income they earn by selling their house does not make up for the reduction in their Age Pension.

A broader discussion of the treatment of housing within the tax‑transfer system is in Section 11 of the Panel's Consultation paper.

Consultation questions

Q4.1 At what age should an individual be able to access their superannuation and at what age should they become eligible for the Age Pension?

Q4.2 What is the role of individuals in dealing with investment and longevity risk in accumulating and drawing down their retirement income? Do financial markets provide the means to deal with these risks? If not, is there a role for government to address these shortcomings?