Inside Story

Unfair, inefficient and expensive: what went wrong with Australia’s superannuation system

The same ministers who scour every nook and cranny to find savings are throwing money at superannuation tax concessions with dubious benefits, writes Mike Steketee

Mike Steketee 18 February 2013 3901 words

“WILL you still need me, will you still feed me, when I’m sixty-four?” It’s a good question, particularly if you are now around twenty-four, which was Paul McCartney’s age when his song was released on the Beatles’ Sgt. Pepper’s album in 1967.

Decades earlier, in 1909, Australia had become one of the first countries in the world to introduce an age pension. Only half the population lived long enough to reach the qualifying age of sixty-five, and those who made it that far could expect, on average, to keep going to seventy-six if they were male and seventy-eight if they were female. Even then, a tough means test saw fewer than one in three actually receive a pension.

Today, almost 90 per cent of Australians make it to sixty-five, and men can then expect to live on to eighty-four and women to eighty-seven, according to government figures. Almost eight in ten of them get a full or part pension, and most receive extra income from superannuation, subsidised by tax concessions while the funds are accumulating and tax-free when they’re paid out. So they’re okay, Jack – while it lasts.

Yes, we are much richer as a nation than one hundred years ago. But we are increasingly careless about how we hand out the wealth. When it comes to working out how we can continue to keep baby boomers in the manner to which they have become accustomed, the figures look downright scary.

The first baby boomers have reached retirement age and the big bulge they create in the nation’s population profile is going to take a long time to digest. In 2010, three million Australians were aged sixty-five or older, but by 2050 that figure will have reached 8.1 million, a much faster growth rate than for the rest of the population. They will make up nearly a quarter of the population, and most of them won’t be paying income tax.

But according to the Actuaries Institute, even these Treasury projections considerably underestimate the size of the problem. “Australian life expectancies are rising much faster than is commonly understood,” says Melinda Howes, the institute’s chief executive. “The figures that are generally reported are life expectancies for males and females at birth.” By the time someone has got to the age of sixty-five, the equation has changed: by definition, they are going to live longer than average. “If you look at a sixty-five-year-old in 2010, the man who thinks he is going to live to seventy-nine is actually going to live [on average] to eighty-six. That is 50 per cent longer than he is expecting.”

Treasury projects improvements in mortality based on past trends. When Howes and her colleagues were writing Australia’s Longevity Tsunami, a study the institute released last year, they used figures from the government actuary that allow for both past and future improvements in mortality. On that data, life expectancy at age sixty-five rose two years – to eighty-six for men and to eighty-nine for women.

Rates of improvement in mortality can vary appreciably, the report cautions. But it says that its projections “may be the best indication that we have and are more realistic than the reported life expectancies.” In fact, it suggests that even those projections could be too conservative. “At every point over the last forty years we have underestimated how fast our longevity is improving,” says Howes. As the report puts it, “The pace of scientific development appears to be accelerating and it is possible that this explosion in knowledge will drive increasingly rapid advances in medicine. These advances may cause mortality rates to fall with increasing speed.”

Australia’s Longevity Tsunami cites medical advances such as the mapping of the human genome, stem-cell research and the 40 per cent drop in heart disease in the first decade of this century. Then there is the development of a “polypill” – a combination of well-known medicines that advocates say could reduce deaths from heart disease and strokes by up to 80 per cent if taken by everyone over the age of fifty-five. And there is growing talk about a “cure” for ageing. All of this is great news for us as individuals but it has consequences that cannot be ignored.

On the other side of the ledger, Howes acknowledges that increasing obesity and diabetes could slow the increase in longevity, just as unforeseen events, such as war, have done in the past. “What we are really saying is that, if we are still underestimating, then here are the implications.” For retirees, the implication is that they will run short of money because they will live longer than they expected. For the nation, the already substantial impact of an ageing population will be even more severe.

Treasury has told Howes it accepts the institute’s findings and will change its assumptions about mortality improvements. As a result, the life-expectancy figures it uses will rise – by about three years – as will the estimated cost of supporting an ageing population.

IT WAS this very trend that the compulsory superannuation scheme introduced by Paul Keating twenty years ago was designed to address. But it hasn’t worked out that way. According to a report released last October by CPA Australia, the body representing the accounting profession, compulsory superannuation “has had a minimal impact on Australians’ capacity to save for a self-funded retirement.” The report says that the government “is effectively funding a $30 billion per annum tax concession that will do little if anything to relieve pressure on the cost of providing the age pension to retirees and the impact on the public purse.”

The cost of this generosity is rising rapidly. In figures released by Treasury in January, the value of superannuation concessions for 2012–13 is a projected $32 billion. In three years’ time, Treasury calculates, this will have jumped to $45 billion. Among the major areas of government spending, this is already the fastest-growing, and it will grow even more rapidly with the increase from 9 per cent to 12 per cent in compulsory super being phased in between 2013–14 and 2019–20. On the current trajectory, the tax concessions will exceed the cost of the pension by 2015–16.

The wealth accumulated through superannuation and other assets will reduce the proportion of older people receiving a full age pension. But the percentage not receiving any age pension is projected to rise only slightly, according to Treasury’s 2010 Intergenerational Report. It estimated that the total cost of the pension will increase from 2.7 per cent to 3.9 per cent of GDP by 2050. The increase in compulsory super from 9 per cent to 12 per cent should reduce the figure somewhat by 2050, but the catch is that the cost of the tax concessions far outweighs the savings on the pension.

Although the main reason for the dramatic rise in the cost of the pension is the ageing of the population, another important factor is that the pensioner means test is generous – very generous. A couple with assets up to $1.05 million – $1.05 million on top of the value of the family home, that is – still qualifies for a part-pension, albeit a minimal one. And couples can also earn a fortnightly income of $2597.60, or $67,538 a year, before they lose the pension altogether.

This was one of the reasons why the 2009 report to the federal government on retirement income recommended against an increase in compulsory superannuation contributions to 12 per cent. The panel that wrote the report, headed by former Treasury head Ken Henry, found that the combination of the pension and the existing 9 per cent rate of compulsory superannuation would give people on half average weekly earnings who’ve worked for thirty-five years a net retirement income about 10 per cent higher than their earnings before they retire. It sounds like nice money if you can get it, but is it the trade-off these people would make if they had a choice whether to sacrifice more of their income when the pressure on their budgets is greatest – when they are paying a mortgage and raising kids, for instance – so that they can enjoy a higher income in their retirement, when their demands are much lower?

As the Henry report points out, the impact of reduced take-home pay to cover superannuation is likely to fall most heavily on low- and middle-income earners because they are less able to draw on other savings. Despite this, the government, with the support of the opposition, is going ahead with the increase to 12 per cent.

The “replacement rate” – the after-tax ratio between retirement income and previous earned income – is lower for those on higher incomes. Compared to 110 per cent for those on half average earnings, it is 71 per cent on average earnings and about 55 per cent on one-and-a-half times average earnings. As the Henry report argued, “there may well be a case for such a person [on above average earnings] seeking a higher retirement income but the case for the government mandating that outcome is much less clear.” Higher income earners typically salary sacrifice on top of their compulsory contribution and thereby gain extra tax concessions. The Henry panel found that employees on incomes two-and-a-half times average earnings made average voluntary contributions of an additional 10 per cent of their income, giving them an expected income replacement rate of about 95 per cent.

The big contributors to the blow-out in tax concessions are self-managed superannuation funds, which mostly have one or two members. The deductions are even more generous than for the retail or industry funds to which most Australians belong, and there are greater opportunities for maximising financial returns. Because the members of self-managed funds are also the trustees, “they are working both sides of the street,” says Alex Dunnin, director of research for the financial information company Rainmaker. “I can set up a trust and the trust buys a property, which might happen to be the building my business is in. I am paying rent to the landlord, which happens to be the trust which happens to be the super fund. And I’m doing it entirely legally.”

Figures released last month by the Australian Prudential Regulation Authority show that total assets of self-managed funds increased almost three-and-a-half times to $439 billion in the eight years to June 2012. They now hold almost a third of total superannuation assets, more than either the retail or industry funds, even though members of self-managed funds make up less than 8 per cent of the total membership of super funds. The average account balance of individual members of self-managed funds in June 2012 was $481,000, compared to $23,000 for those in industry funds and $24,000 in retail funds. Newly released Australian Taxation Office figures for 2010–11 show that 29 per cent of total self-managed assets were in funds with more than $1 million, including 9.5 per cent with between $2 million and $5 million and 0.3 per cent with more than $10 million. In other words, with the help of abundant tax concessions paid for by the rest of the population, 1329 self-managed funds with about 2500 members had accumulated assets of over $10 million each.

Dunnin estimates that at least 40 per cent of the value of the tax concessions is going to the 8 per cent of superannuation fund members who are in self-managed funds. “Overall, we are spending more than $30 billion a year on these tax breaks and the overwhelming majority is going to people who are quite wealthy,” he says. “Is that the job of these tax breaks?”

MANY people would argue that it is fair enough that they get a tax deduction on their superannuation. After all, if you’re a wage earner then the government is making you put aside 9 per cent of your salary, and a higher percentage in the future – money you cannot get your hands on until you are at least fifty-five.

What that argument ignores, though, is the large-scale redistribution of wealth that is taking place within the superannuation system. In reality, it’s people on lower incomes who have a right to feel cheated. And if you’re young, you have a right to feel doubly dudded. The tax concessions are distorted not only in favour of people on higher incomes but also to advantage older generations.

The tax deduction for super operates like a flat tax, with contributions and interest earnings taxed at 15 per cent from the first to the last dollar of income. That means the deduction is worth much more to those on higher incomes, who pay marginal tax rates of 38.5 per cent and 46.5 per cent.

From this financial year, the government is offering some extra assistance to lower-income earners by refunding the 15 per cent tax on super through a rebate. But no tax is payable now on incomes up to $18,200, meaning that the rebate does no more than return the penalty tax already paid on super contributions. Above this, the rebate is worth up to $500 a year when incomes reach $37,000, at which point it cuts out.

Those on $180,000 save more than seven times as much through the super concession – $3807 – and above $180,000 the savings are greater again. Treasury calculated last year that the top 1 per cent of income earners receive an average of $510,000 in retirement support from the government, all of it through tax concessions, compared to $250,000 for the bottom 10 per cent, almost all of it through the age pension. Still, there can’t be too many Australians earning incomes below $37,000, can there? Well, according to the government there are 3.5 million of them – people in jobs, that is, not retirees or those solely on welfare benefits.

In short, the super tax system works in the opposite way to most government benefits: the higher your income, the more you get from the government. Ken Henry calculated in 2009 that the top 5 per cent of taxpayers received 37 per cent of the value of the super tax concessions.

IF THE government believes that forcing people to set aside some of their income for later life warrants a tax concession, then it should at least make sure that people use the money for retirement. At the moment, people retiring have the option of taking all their superannuation as a lump sum, spending it and then going onto the age pension.

Moreover, the tax concession should be a fair one. Who says so? Among others, Peter Costello and his successor as treasurer, Wayne Swan. In his first budget speech in 1996, Costello said that “a major deficiency of the current system is that tax benefits for superannuation are overwhelmingly biased in favour of high-income earners.” He made a start on tackling the issue by doubling the tax on super contributions to 30 per cent for those on incomes above $85,000, a figure that was raised each year in line with wages growth. But he later changed his mind and ended up significantly increasing, not decreasing, the inequity of the system – first by removing the surcharge and then by abolishing the tax on superannuation income taken from age sixty.

In 2009, Swan pointed to the contradiction between the regressive impact of superannuation tax concessions and an income tax system that is designed to be progressive. His attempt to deal with this lapse from what he called “our ideal of fairness” was typically timid and incremental: he introduced the rebate for lower-income earners and lowered the caps on concessionally taxed voluntary contributions. He also brought back Costello’s 30 per cent super tax, but only on incomes above $300,000, or just 1.2 per cent of taxpayers.

The tax concessions discriminate between generations, too. Because superannuation income is tax-free from age sixty, once again, the higher your income, the more tax you save. As Bank of America Merrill Lynch economist Saul Eslake puts it, “I can’t think of any single policy reason, as distinct from a baser political motive, why people over the age of sixty or sixty-five should pay less tax on the same amount of income than people under the age of sixty-five.” The politics are driven by demographics: the rapidly rising numbers of baby boomers who are retiring. Over the next decade and a half, more than 60 per cent of the total assets of superannuation funds are expected to shift from pre-retirement accumulation accounts to retirement benefit accounts.

Surely compulsory superannuation at least has increased retirement incomes, even if it has cost the government, aka taxpayers, a packet? Only if it is used for its intended purpose. Extraordinarily for a government-subsidised retirement income system, there is no requirement that superannuation benefits be used as retirement income. And often they aren’t.

The CPA Australia study uncovered an increasing tendency for people approaching retirement to take on more debt – at the very time they would be expected to reduce it – and to use their superannuation lump sum to pay it off. For households in the fifty to sixty-four age bracket, superannuation grew by 48 per cent in the eight years to 2010 but property debt rose by 123 per cent and other debt by 43 per cent. CPA Australia made the link between superannuation and debt levels by comparing retirees with those still in the workforce, using figures from the Household Income and Labour Dynamics in Australia survey, which has tracked 7682 households every year since 2001. In 2010, the average household debt of people between sixty and sixty-nine who hadn’t retired was $119,000, while for retired households it was $50,000. At the same time, superannuation for the non-retired averaged $304,000 compared to $238,000 for the retired, even though other financial assets were about the same for both groups.

The latest Australian Prudential Regulatory Authority statistics show that virtually equal amounts of super benefits, $35 billion in each case, were taken out in lump sums and pensions in 2011–12. If this seems extraordinary in a system that is supposed to provide for people for the rest of their lives, it at least is an improvement on the two-thirds taken out as lump sums in 2004–05. One reason for this, says the authority, is that, as retirement benefits grow, people are more likely to take at least some as income.

THESE shortcomings in the superannuation system are well-known, if seldom publicly acknowledged.

In November, Treasury secretary Martin Parkinson probably went as far as a bureaucrat could in questioning the system’s sustainability, especially given that Swan has declared tax-free super benefits off limits. “With the Commonwealth budget coming under increasing pressure over the next few decades, the fiscal sustainability of all policies, including superannuation, will demand greater public scrutiny,” he told the Association of Superannuation Funds of Australia. “This scrutiny will be even more important to the extent that existing concessions are seen to favour some at the expense of the majority.”

Without a change in policy, in other words, future generations are unlikely to get anything nearly so generous as the current super tax concessions. So there’s another reason to feel put out if you were born after the baby boom, even if you’re not on a lower income.

With a shrinking percentage of taxpayers supporting an increasing proportion of non-working Australians as the population ages, governments are supposed to be coming up with ways to save money. And they have produced a few: the pension age for women is rising gradually from sixty to sixty-five, bringing it into line with that for men; and, starting in July 2017, a pension age of sixty-seven for both men and women will be phased in over six years. Between 2015 and 2025, the age at which superannuation benefits can be accessed will rise from fifty-five to sixty. And there has been the tinkering at the edges of superannuation concessions detailed above.

But compared to the amount of sacrificed revenue pouring into superannuation, these are minor adjustments. There is speculation that the government, which has promised to find major savings to pay for Labor priorities such as the national disability insurance scheme and education reform, will look again at the super tax concessions in this year’s budget. But on past form, any measures are unlikely to affect more than a small number of the super-wealthy. Tony Abbott has made it harder for the government to be bold, particularly in an election year, by ruling out any “negative, unexpected changes” to the super system in the first term of a Coalition government – except, that is, for his previously announced decision to abolish the rebate for low-income earners, costing them up to $500 a year.

There is an obvious point that should attract wide agreement: superannuation, particularly that mandated by the government and supported by tax concessions, should be used for the purpose for which it is intended – that is, income during retirement. If politicians are too timid to ban lump sums outright, they at least should be prepared to put a ceiling on them – say $50,000 – with retirees required to take the rest of their super as income. Australia’s Longevity Tsunami is just one recent report to urge the government to change the system so that retirees use a larger portion of superannuation benefits as income.

This would be one small step towards tackling the long-term sustainability of a retirement income system in which the cost of tax concessions is ballooning. The more revenue given away, the higher the burden on the working population, whether through tax increases or spending cuts.

Other perverse incentives will need to be removed as well. An Australian Bureau of Statistics survey in 2010–11 found that the average age of retirement for those who had stopped working in the previous five years was 61.4. One reason for the relatively low figure is that people can access their super from age fifty-five. Although it does not become tax-free until age sixty, it is another encouragement for people to use their super for purposes other than retirement income, increasing their reliance on the pension.

Melinda Howes and her co-authors would like to see eligibility for the pension tied to rises in life expectancy, with the superannuation preservation age fixed at three to five years below the pension age. The “preservation age” will be raised from fifty-five to sixty in steps between 2015 and 2025 – a move in the right direction when it comes to sustainability. But a bolder step would see it continue to go up to sixty-seven, in line with the future pension age.

Australia has received fair warning about the consequences of failing to tackle these issues: part of the financial crisis facing governments in Europe and the United States stems from inadequate provision for ageing populations. Our problem is not as severe, both because the population is not ageing as rapidly as in many other countries and because we have a means-tested welfare system, albeit generously so.

But political timidity in the face of the long-term trends in Australia will lead us down the same slippery slope. Perhaps the best hope is that we will be rescued by a revolt by a younger tax-paying and voting generation who get mad and are just not prepared to take it any more. •