Are Aussies living too in the moment?
Australians have a reputation for taking their superannuation (the somewhat technical term for an occupational pension) as a lump sum. The lump sum is used for renovating the house and/or taking a trip around the world. So are Australians more short-sighted than everybody else?
The short answer is no. Australians are like the rest of us: they adapt to the reality of a state pension (what they call Age Pension) and fiscal rules. I had a hunch that there were some perverse nudges or incentives in the system. So when I was invited to speak the annual ASFA conference in Australia it was easy to accept, especially given the conference theme was the pension pay-out phase. For me the conference provided an excellent opportunity to understand the Australian mentality towards pensions better and to learn from their thinking on the pay-out phase.
First generations retiring on DC
Australia was one of the first countries to adapt individual Defined Contribution (“DC”) and made superannuation contributions compulsory in 1992. Many Australians are now approaching retirement with large DC savings and the industry is currently discussing what good should look like in the pay-out phase.
In my mind, the answer is straight forward. For most median income earners, a pension should be a life-long income. The income can be variable and conditional on investment performance and realised macro longevity. The gains from pooling individual longevity risk makes perfect sense to me. I don’t know how long I am going to live and, by removing that uncertainty, I can consume more today because I don’t have to build up personal buffers to avoid outliving my savings.
In Holland and the UK the state pension is the same amount for everyone, but it is not that simple in Australia. The Age Pension design has some strange nudges that do not lead to a robust pay-out phase for many individuals.
Australian Age Pension
The rules appear to be very complicated. For a home-owning retired couple, the following thresholds applies: though their maximum annual Age Pension is around 33,000 Australian Dollars, it is means-tested against income and assets. For income (work, dividends and coupons) above $7,200 and below $72,000 the Age Pension will be linearly reduced. The corresponding interval for assets is above $380,500 and below $755,000, but the family home is exempt.
Once retirement age has been reached, drawing down superannuation either as a lump sum or taking it as income is tax-free. From this perspective, there is no difference between pension savings or other type of savings or assets. All individuals who are eligible for an Age Pension can get a Pensioner Concession Card, which provides discounts on several services including public transport.
So, let’s stop and think about the incentives for a median earner. You are forced to save 9.5% of your income and pay 15% in tax on that amount. Then you have to pay 10% in tax on investment returns during the savings period. At retirement, your pension draw-downs are tax-free, but the Age Pension is means-tested. For a median earner, this could be seen as an implicit marginal tax.
The opening here is the exempt assets, such as the family home. A lump sum looks like a really attractive option; it can be used to renovate or extend the family home while reducing the implicit marginal tax. Or one could use it to fulfil the dream of taking a trip to Europe also with an implicit discount. How often in life, do we get such nudges from government to consume today instead of saving for a rainy day?
The picture for high income earners is rather different. However, I was told that retirees consider it very attractive to have the pensioner concession card. Many of those who are not eligible at all for a state pension will take a lump sum so that they can receive the minimum Age Pension and get the concession card.
The challenges with perverse nudges are that they encourage strange behaviour when individuals and their advisors try to play the system. Constructing attractive pay-out products in that environment is not easy, especially when superannuation savings are viewed, fiscally, as assets and not as deferred income.
Nothing lasts for ever
In 1992, the key reason for making superannuation contributions mandatory was to reduce the budget cost for the state pension and avoid it becoming a general entitlement instead of poverty relief. Personally, I found it difficult to get to grips with the rules around the Age Pension because they have been changed many times over the years by various governments. It seems like these changes have been driven by budget considerations, rather than creating a robust retirement system.
In the next recession, it is likely that there will be changes to the rules to reduce the budget cost of the state pension. Removing the family home from the list of excluded assets would be a direct and efficient approach to reduce the number of people who are eligible for an Age Pension. As this could be contentious, a subtler approach would be to introduce restrictions on the possibility of taking the superannuation as a lump sum.
Most of what appears counter-intuitive is typically driven by the taxes – explicit or implicit. The choices individuals make in retirement in Australia are no different. The current Age Pension, with its implicit taxes and strange incentives, nudges individuals in the wrong direction leaving them vulnerable to future changes.
First things first
The foundation for a robust retirement income is the Age Pension on which the superannuation pay-out must be designed. First things first, the current Age Pension provides the wrong nudges. Ideally, the Age Pension should be simple to understand and nudge individuals to strive for a financially robust retirement. Then, it will be straight forward for the Australian's to design and provide good pay-out solutions of Superannuation.