Australia's Future Tax System

Retirement Income Consultation Paper

6. A sustainable retirement income system

The challenges of an ageing population increase the focus on the effectiveness and sustainability of Australia's retirement income system. The cost of the Age Pension will increase with a rise in the number of individuals aged 65 years or older and their average life expectancy. A sustainable system would support private incentives for retirement saving. These factors highlight the need for an appropriate level of integration between the Age Pension and superannuation.

It is desirable to ensure that retirement income policy is sustainable and does not add significantly to long‑run budget pressures. The cost of the retirement income system can decrease the ability of the government to pursue other programs designed to improve the economy and the outcomes for individuals. The ageing of the population also increases the need for the retirement income system to detract as little as possible from economic growth.

Summary of key messages from submissions

Some submissions express concern that the current concessional taxation of retirees will make it difficult for future governments to sustain increases in the Age Pension. Others consider the current arrangements to be appropriate, given the need to encourage voluntary saving and to compensate individuals for having their compulsory savings locked away for retirement.

Several submissions recommend gradually increasing the Age Pension age to reflect increases in life expectancy. Others disagree and argue an increase in the Age Pension age is unwarranted in Australia's retirement income system, as its costs are lower than in other countries.

Many submissions discuss the need to increase the incentives for older Australians to remain in the workforce. They propose changes to policies including: exempting earned income from tax and the Age Pension income test; providing an actuarially fair deferred Age Pension; increasing the Age Pension and superannuation access ages; increasing the generosity of the Pension Bonus Scheme; and improving the skills of older workers.

Some submissions propose accelerating the increase in the age individuals can access their superannuation. This may defer their decision to retire and increase superannuation savings, resulting in fewer full‑rate Age pensioners and making the Age Pension more sustainable.

Some submissions propose alternatives to the current means testing arrangements. One proposes having a level of exempt assets then requiring individuals with assets above this level to use them before becoming eligible for an Age Pension. These assets would include the value of owner‑occupied housing above $1 million. Another suggests having more generous arrangements for individuals aged 80 years or older.

The Age Pension

While many factors will impact on the long‑term sustainability of the Age Pension, the most significant are:

  • the ageing of the population;
  • dependency ratios and considerations about intergenerational equity;
  • pension design; and
  • means testing arrangements.

The ageing of the population

The projected increases in the proportion of the population aged 65 years or older, and life expectancy, will increase the number of individuals potentially eligible for the Age Pension and the period they might be eligible to receive it. An increase in the projected value of individuals' superannuation and other assets is expected to only partly offset the effect of demographic change by reducing the proportion of younger Age pensioners.

Under current policy, the proportion of pensioners receiving the full Age Pension is projected to decline, while the proportion with a part Age Pension is projected to increase. Chart 6.1 shows that the proportion of older Australians ineligible for the Age Pension is projected to rise by 3 to 4 per cent, with 77 per cent of older Australians still projected to receive some level of Age Pension. Consequently, Age Pension expenditure is expected to grow from 2.5 per cent of GDP in 2006‑07 to 4.4 per cent by 2046‑47.

Chart 6.1: Superannuation and Age Pension coverage

Chart 6.1: Superannuation and Age Pension coverage

Source: Australian Government (2007).

Dependency ratios and considerations about intergenerational equity

Currently there are five individuals of working age for each individual aged 65 years or older. It is projected that by 2047 there will only be 2.4. Chart 6.2 shows how the number of individuals of working age per person aged 65 years or older is projected to change over time.

Chart 6.2: Number of working‑age individuals per individual aged 65 years or older

Chart 6.2: Number of working-age individuals per individual aged 65 years or older

Source: Australian Government (2007).

The increasing dependency ratio could potentially increase the tax burden on the working‑age population to support existing government programs, including the Age Pension. This will be influenced in part by the growth in the real income of Australians and its distribution between working‑age and older Australians. If the distribution remains constant, the incomes of those in the labour force would be expected to increase.

This raises a question about the extent to which current and future generations of workers should support older generations. This is important in considering pension benchmarks and the extent to which Age pensioners share in improvements in community standards of living through pension increases. Ageing also adds to other costs, such as health care and pharmaceuticals, which increase as individuals age.

Age Pension design

The design of the Age Pension significantly influences its sustainability. The balance between its role as a safety net and as a retirement income supplement affects the costs of the Age Pension. For a given budget allocation, an Age Pension paid to individuals further up the income scale lowers the maximum rate of Age Pension. Increases to the Age Pension also become more expensive because the total amount of the increase flows on to those receiving a part pension.

Other design issues of importance to sustainability include: the type of indexation arrangements (that is wage or price indexation); the age when individuals can access the Age Pension; and eligibility for other services and concessions available to Age pensioners.

Over time, indexing the Age Pension to male total average weekly earnings will increase its value in real terms. Currently the single rate Age Pension is $14,765 a year. In 2057, the value of the Age Pension will be $28,310 (in today's dollars). The income limit for a part Age Pension will increase from $40,501 to $74,312 by 2057. Chart 6.3 shows how the rate of Age Pension and the income limit is projected to increase over time.

Chart 6.3: Age Pension amount and income limit over time(a)

Chart 6.3: Age Pension amount and income limit over time(a)

  1. In 2008 values.

Source: Australian Treasury projections.

Some submissions raise the need to increase the Age Pension age, given increases in longevity. The Age Pension age has been 65 years since it began in 1909. In the 1901‑10 life tables, the life expectancy at age 65 years was 11.3 years for a male and 12.9 years for a female. Based on the 2004‑06 life expectancy estimates, this has increased to 18.5 years for a male and 21.6 years for a female. A proposal in submissions to address this issue is to link the Age Pension age to increases in longevity. This would reduce the costs of financing the Age Pension by those able to work, and, if combined with an increase in the access age for superannuation, ensure the draw down period does not increase as life expectancies increase.

Other submissions suggest the need to increase the Age Pension age is not as great as in other countries, given the lower costs of our Age Pension. One submission states that the increase in life expectancy has not been matched by an increase in the quality of life of many individuals. These individuals are still likely to need to be assisted by other income support payments. Any increase would need to be phased in so individual retirement plans can be accommodated.

The means tests

Means tests are the primary way in which the Age Pension is targeted as a safety net. They also determine the amount of support the Age Pension provides to those with private income and assets.

Means testing comprises an income test and an assets test. The income test withdraws the Age Pension at a rate of 40 cents per dollar of income above the free area ($138 per fortnight for singles, $240 per fortnight for couples), which is generous by OECD standards. The assets test withdraws the Age Pension at a rate of $1.50 per fortnight for every $1,000 in assets above the threshold (which differs for singles and couples, as well as between home owners and non‑home owners). The test resulting in the lowest rate of Age Pension determines the pension paid.

At the current pension rates, means test free areas and taper rates, a couple can have income up to $67,650 per year and assets up to $873,500 (in addition to their family home which is exempt from means testing) and still receive a part pension and a range of other concessions and services.

The structure of means testing is based on a number of principles:

  • the income test assumes that the need of a person for support from the Age Pension can be determined by their level of income;
  • the assets test is designed to ensure that individuals who have substantial assets (that produce low levels of income) use their assets to support themselves in retirement.
  • the combined operation of the two tests targets payments based on need.

The basis of these assumptions for superannuation are less clear. Unlike other savings, superannuation is used by individuals to save income during their working life for use in retirement. As a consequence, as reflected in annuities, a superannuation 'income stream' comprises both earnings on the asset and withdrawals of capital.

Means tests reduce the cost of the Age Pension. However, these tests increase effective tax rates, which affects people's decisions to work and save. The setting of the means tests should therefore reflect the effect they have on these decisions. Increasing means testing will only improve the sustainability of the Age Pension if it has lower efficiency costs than raising tax revenue to fund the Age pension.

Alternative means test arrangements

The Age Pension and superannuation systems are intended to have complementary roles but they were developed and operate largely in isolation of each other. As illustrated in Table 1.2, under current settings an individual with private earnings of two and a half times AWOTE will derive some 15 per cent of their retirement income from the Age Pension, even with a fully mature superannuation system. The need to examine whether to better integrate the Age Pension and superannuation systems raises wider issues about the social security means test.

The social security means test aims to ensure that Age pensioners use their assets productively and therefore decrease their need to call on the taxpayer for support. This approach underpins the 'deeming' rules used to assess the income from financial assets such as shares and bank accounts. Under this approach, a standard rate is applied to customer's financial assets irrespective of the amount that is actually earned.

This approach could be extended, for example, by deeming an income flow from most superannuation assets. This would enhance targeting of the Age Pension to those with the least means, while preserving the capacity of individuals to draw upon their superannuation savings in a flexible way. An alternative approach would be to design the means test to encourage not only the productive use of assets, but the draw down of assets over the course of an individual's retirement.

A further consideration is whether the income test and assets test could be merged into one. This might be achieved through a single income test which deems income on all assessable assets, or through a single assets test similar to that recommended in submissions. Related to this is the issue of whether the means test taper rates should be flat or progressive.

Financial products and the retirement income system

While individuals cannot borrow directly against their superannuation, they could receive a loan on the basis that this can be repaid with their superannuation. This behaviour limits the effectiveness of the retirement income system, as it converts intended future consumption into current consumption. Such a strategy would reduce retirement incomes and reduce the effectiveness of policies to limit access to superannuation, as well as the rationale to give superannuation tax concessions to support future consumption.

A comparison by the Australian Treasury of the Australian Bureau of Statistics' Survey of Income and Housing from 1995‑96 and 2005‑06, shows more seniors (individuals aged 55 years or older) are carrying mortgage debt later in life. This debt also tends to be larger, both in real terms and as a proportion of the value of the underlying house. The proportion of individuals in this age group who were still paying off their mortgage more than doubled, from 7 to 15 per cent over the 10 year period. The proportion of seniors with a mortgage less than $50,000 fell from almost 70 per cent to less than 40 per cent, while the proportion with mortgages over $200,000 rose from 3 per cent to 16 per cent.

Workforce participation by older workers

Retirement income systems have a range of incentive effects including on workforce participation. The ageing of Australia's population places greater focus on how the retirement income system affects individuals' decisions to participate in, or leave the workforce, especially for individuals of working age.

There are three main groups whose participation decisions could be influenced by changes to retirement income policy settings. The first is those individuals who may have retired but may be willing to return to the workforce. The second is those individuals who use the system to retire earlier than might otherwise have been possible. The third is younger members of the workforce whose participation may be affected by the level of tax on their earnings. Each group is likely to respond to different aspects of the system.

The majority of individuals currently aged 65 years or older have already left the workforce and may be receiving an Age Pension and/or income from their superannuation. For those wanting to participate, the returns from work have increased in recent years due to the senior Australians tax offset and increases in the low income tax offset, in conjunction with the tax exemption of superannuation benefits. Submissions argue that exempting earned income from the Age Pension income test would further reduce disincentives for older Australians to continue working.

In 2007‑08 around 27 per cent of men aged 65 to 69 years and 6 per cent of men aged 70 years or older are in the workforce. Eleven per cent of women aged 65 to 69 years and 2 per cent of women aged 70 years or older participate in the workforce. These rates are projected to increase slightly over coming decades based on current policies.

The second group may be responsive to policy changes that affect when they can access their superannuation. In 2007‑08 around 78 per cent of men aged 55 to 59 years and 58 per cent of men aged 60 to 64 years were participating in the labour force; while around 61 per cent of women aged 55 to 59 years and 36 per cent of women aged 60 to 64 years were doing so. Australian Treasury projections indicate that participation rates for these age groups may increase significantly over the coming decades.

Of men aged 60 to 64 years, those not in the workforce due to ill health or disability comprise 30 per cent. Those performing home duties or caring for children, an ill person or a disabled person comprise over 13 per cent, while retirees comprise 41.5 per cent (ABS 2006). Of women aged 60 to 64 years, those not in the workforce due to ill health or disability comprise over 10 per cent. Those performing home duties or caring for children, an ill person or a disabled person comprise 47 per cent, while retirees comprise just over 30 per cent. Removing disincentives to work for individuals within this age group could delay their retirement decisions or encourage them to re‑enter the workforce.

Policies to encourage greater workforce participation by older workers need to consider the potential impacts on younger workers' decisions to participate. For example, a universal Age Pension would remove the work disincentives of current Age pensioners who are concerned their work income will reduce their Age Pension. However, if the cost of the Age Pension were to result in higher personal tax rates, this may reduce participation incentives for both older and younger workers. Although the consequential disincentives may not be as strong for younger workers as they are for older workers, the larger number of younger workers facing disincentives could result in an overall negative impact on participation.

Pension Bonus Scheme

The Pension Bonus Scheme was introduced on 1 July 1998. It provides an incentive for older Australians to defer claiming the Age Pension and remain in the workforce. The scheme pays a tax‑free lump sum to registered members when they eventually claim and receive the Age Pension.

The scheme's rules include that an individual must be registered in the scheme, must meet the work test requirements for each year of deferral, and claim the Age Pension and the bonus within 13 weeks of failing to meet the work test. An individual is not eligible for a pension bonus if the individual receives any Age Pension or any other income support payment, other than Carer Payment, after reaching Age Pension age. Some individuals may be better off receiving a part‑rate pension and concessions while they continue to work.

As at November 2008, the maximum bonus an individual could receive is $34,344.30 (single) and $28,686.50 (each member of a couple). This is based on an individual receiving a full‑rate Age Pension after having completed a full five years in the scheme.

Consultation questions

Q6.1 The Age Pension serves two roles, as a safety net for individuals who are unable to sufficiently save for their retirement and as an income supplement for many individuals who do save. What should be the role for the Age Pension and means testing in a future retirement income system and what impact does this have on its sustainability into the future?

Q6.2 In what ways does retirement income policy affect workforce participation decisions and what, if any, changes might reduce disincentives to work? Does the sustainability and cost of the retirement income system affect the workforce decisions of younger generations of workers?

Q6.3 What impact could financial intermediation have on the effectiveness of retirement income policy?