International comparisons (such as the Melbourne-Mercer Global Pension Index) rank the Australian retirement income system highly based on three broad criteria of adequacy, sustainability and integrity. However, despite that endorsement, there are a number of shortcomings which were highlighted by the recent “Financial System Inquiry” (FSI) or “Murray Inquiry”.
The main focus of the FSI in the areas of superannuation and retirement income was on improving efficiency in the accumulation phase and increasing risk-pooling in the retirement phase. These have the potential to increase retirement incomes substantially, and reduce age pension related government budgetary pressures. The recommendations of the FSI, together with other recent reforms, should enhance sustainability and adequacy.
Compulsory superannuation for eligible employees was introduced in Australia in the early 1990s in the form of employer contributions on behalf of employees into defined contribution (accumulation) funds. While most employees can choose a preferred fund, employers select a default fund for those not exercising choice, generally from limited list of funds specified in industrial awards. An increasing number of individuals have elected to establish self-managed superannuation funds. Superannuation contributions and earnings attract significant tax concessions, including (generally) no tax on earnings or withdrawals from individual accounts which are in retirement mode.
Despite substantial growth in superannuation assets over the past two decades, a large majority of retirees are expected to remain at least partly dependent upon the universal, but means tested, government age pension.
One fundamental problem identified by the FSI is a lack of member-driven competitive pressure to induce lower fees and costs and improve efficiency in institutional funds, particularly for default funds. Consequently, the Inquiry recommended that the effect of recent regulatory reforms on efficiency and competitiveness be reviewed before 2020. Absent significant improvements, considerations should be given to introducing a formal competitive process (such as tender or auction) for allocating new employees into default funds. (Those recent reforms sought to introduce a cost effective, simple default fund product, improve transparency and governance and streamline administrative arrangements.)
Another major concern is that superannuation assets are not being efficiently converted into retirement incomes due to a lock of longevity risk pooling and overreliance on account based pensions. Evidence suggests that the major worry among retirees and pre-retirees is exhausting their assets in retirement. An individual with an account based pension can reduce the risk of outliving their wealth by living more frugally in retirement and drawing down benefits at the minimum allowable rates (which a majority of retirees do).
The Inquiry also noted that many retirees find it challenging to navigate the transition to the retirement phase of superannuation. The task of managing multiple financial objectives and risks in retirement is complex and the quality of financial advice can vary significantly.
Accordingly, the Inquiry recommended that institutional super funds be required to offer their members a “pre-selected” comprehensive retirement income product which, where appropriate, includes a regular and stable incomes stream, longevity risk management and some flexibility. A product involving some mix of an account-based pension and deferred annuity is one such example, and the longevity risk pooling provides an opportunity for higher consumption streams for participating retirees. There is, of course, no free lunch, as beneficiaries receive lower inheritances from residual super balances. This is consistent with another of the Inquiry’s recommendations to shift the focus of the system from tax-preferred wealth accumulation and estate planning to provision of retirement income by setting clear objectives for the system.
Offering a “pre-selected” product was preferred to a system where individuals are “defaulted” or mandated into a specified product. This maintains consumer sovereignty, while positively influencing retiree choice towards taking up products that include some longevity insurance. A default solution also faces practical complications given retiree diversity.
Further detail on Prof Kevin Davis’ contribution to Reform’s conference on the long view of UK pension reform can be found here