Mercer's David Knox

Given the review of retirement incomes, announced by Treasurer Frydenberg last week, it is timely to ask: What is the role of the age pension in Australia’s retirement system?

Let’s begin with the poor. The initial purpose of the Government pension (or first pillar) of any retirement system within a developed economy is to alleviate poverty. Simply put, older people with limited financial resources should be able to live out their final years with dignity and some financial security.

The level of the Australian age pension, measured as a percentage of the average wage, is above the OECD average for basic pensions and significantly above the minimum pension paid in both the UK and the USA.

The Australian age pension is also means tested, with the tests based on both income and assets (excluding the family home). The objective of means testing is to ensure that the pension is paid to those who need it and not paid to those with reasonable financial resources. In turn, this reduces the cost to the Government and hence to the taxpayer.

However, this is where it gets complicated for many Australian households, both before and after retirement.

For example, if I save more for my retirement (whether inside or outside super), then I may receive less age pension. So the question becomes: Is the extra saving worth it?

But in retirement, it gets even trickier!

Let’s assume I have a reasonable super benefit (say $500,000) and I want to receive a level income (in inflation-adjusted terms) for the rest of my life (say 25 years). However, as I drawdown my super, I will be entitled to receive more age pension!

So that leaves me with a few options, including the following two:

Option one is to take a level inflation-adjusted benefit from my super every year. But, this means that my age pension will gradually increase so that my total income increases as I get older. This is what the Grattan Institute model assumes so that the retiree’s income increases with age! In terms of an ideal retirement system, such an outcome does not make sense.

Option two is to recognise that as my age pension will increase in future years, I can afford to draw down my super at a faster rate in the early years (that is, above both the minimum drawdown rules and an annuity-style benefit). However, most retirees are risk averse and don’t want to spend their super too quickly. Furthermore, the rate at which one should draw it down under this option is almost impossible to calculate, given future uncertainties.

In brief, the means-tested age pension makes retirement planning for middle Australia, with their increasing super balances, extremely difficult.

We need a better system where super and the age pension work together and are not two unrelated components within our system.

One approach would be to provide the age pension to everyone as they do in the Netherlands and New Zealand. Under this approach, every dollar you save you keep, as there are no means tests. It would make retirement planning so much easier!

Of course, such an approach would mean every aged person would receive the taxable pension so the costs would increase significantly.

Perhaps there is a middle way, where half the pension is paid to everyone and the balance is income tested. Denmark has such a system.

The advantage is the universal part pension gives everybody a base to build on while the means-tested pension ensures that no-one lives in poverty. Another advantage is that the means testing will cease at a lower level of assets or income than currently, as it would only apply to half the pension. This means that many retired Australian households would not be subject to any means testing and there would be a much clearer incentive to make some extra savings for your retirement.

As Australia is heading towards having the lowest pension cost of any OECD country, we need to be willing to be bold, think outside the square and so improve our overall retirement income system.

 

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