Retirement incomes in Australia in the wake of the global financial crisis H Bateman

Transcription

1 Retirement incomes in Australia in the wake of the global financial crisis H Bateman Discussion Paper 03/10 Centre for Pensions and Superannuation

2 DRAFT Comments welcome Retirement incomes in Australia in the wake of the global financial crisis* June 2009 (revised November 2009) Associate Professor Hazel Bateman Director, Centre for Pensions and Superannuation The University of New South Wales Sydney, Australia * Paper prepared for the conference Protecting Pension Rights in the Economic Crisis, Leuven, Belgium, th June

3 1. Introduction Superannuation funds are poised to post a double digit fall in value this financial year in what would be their worst performance on record and almost double the size of last year s decline (Australian Financial Review, Wednesday 10 June 2009). The Australian economy has not escaped the global financial crisis. Real GDP in Australia grew by only 0.4% over the year to March 2009 and is forecast to fall by 0.5% over , the unemployment rate is forecast to more than double from 3.8% in 2007 to 8.5% in 2011, and a fiscal deficit is expected through to at least 2015, following surpluses for most of the past decade (Australian Government 2009a). Australia s benchmark stock price index, the ASX 200, fell by over 40% in the 12 months to March The severity of this unprecedented economic downturn raises questions about the ability of Australia s multi pillar retirement income system to deliver adequate and secure retirement incomes which address the economic and financial risks faced by retirees. A particular feature of Australia s retirement income policy is the increasing reliance on private defined contributions arrangements, which place much of the risk and responsibility associated with retirement income provision on individual retirement savers. This is exacerbated by the multitude of complex financial decisions relating to fund choice, investment choice, additional contributions, financial advice and benefit choice which these individuals are required to make throughout their lives. While Australia s means tested public Age Pension provides some insulation against design deficiencies and external shocks, this does not come without moral hazard implications. The aim of this paper is twofold. First, to identify the impact of the global economic and financial crisis of on Australian retirement savings, and second, to assess the ability of Australia s multi pillar retirement income system to insulate retirement savers and retirees against economic and financial shocks more generally. 2

4 The paper is set out as follows. In the next section (Section 2) we summarise the impact of the global finance crisis of on the Australian economy. This is followed in section 3 with a discussion of Australia s multi pillar approach to retirement income provision, highlighting possible vulnerabilities in the event of economic and financial shocks. In section 4 we assess the ability of the Australian retirement income system to deliver adequate and secure retirement incomes in the context of the global economic downturn of Section 5 concludes. 2. Australia and the global financial crisis The impact of the global financial crisis of on the Australian economy, while serious, has been less severe than experienced by much of the rest of the world. Real GDP growth in Australia fell from 3.6% in to 0% in and is expected to fall by 0.5% over calendar However, as illustrated in Figure 2.1, these falls are modest in the global context: the Euro economies on average will contract by nearly 4% and the Japanese economy by around 6% over this period. Figure 2.1: Forecast GDP Growth in 2009, Australia and the rest of the world Source: Budget Paper No.1, Statement 1, Chart 1. (Australian Government 2009a). 3

5 Associated with the projected fall in output is a deterioration of the labour market, with the unemployment rate expected to increase from the 3.8% recorded in late 2008 to around 8.5% by However, official estimates suggest that output will recover from 2010, and return to strong growth of over 4% p.a. in 2011 and beyond (Australian Government 2009a, 2009b). The Australian government responded to the global economic downturn with stimulus initiatives designed to bolster disposable incomes (and current spending), increase public investment and encourage private investment. As well, Australia s central bank (the Reserve Bank of Australia)(RBA) initiated a considerable loosening of monetary policy, reducing the cash rate from 7.25% in September 2008 to 3% by April 2009 (RBA 2009). The fiscal stimulus measures, in conjunction with actual and projected falls in revenue (due to lower output and employment), have resulted in a sharp deterioration in Australia s fiscal position. Following nearly a decade of surpluses, the fiscal balance moved into deficit in (of $A32 billion or 2.7% of GDP) and is expected to remain in deficit until However, as illustrated in Figure 2.2 this fiscal deterioration is moderate relative to the rest of the developed world. Figure 2.2: Budget Balance Australia and selected countries ( ) Source: Budget Paper No.1, Statement 1, Chart 2. (Australian Government 2009a). 4

6 Coincident with the global economic crisis has been a sharp downturn in asset prices. Again, Australia has not escaped world trends, with the benchmark S&P ASX200 falling by around 40%, in line with movements in other key share price indexes (see Table 2.1). Table 2.1: Share price movements over 2008 Country Index Return, 12 months to end 2008 Australia S&P ASX % UK FTSE % US S&P % France CAC 42.7% Germany DAX 40.4% Japan Nikkei % Source: Superannuation Stakeholder Group (2009). The crisis period also saw falls in other asset prices and returns, including a downturn in house prices and lower yields on government and corporate bonds: the yield on 10 year government bonds fell from 6.45% in June 2008 to 4.57% in June 2009 with similar percentage point falls recorded for corporate bonds. In the next section we outline the main features of Australia s retirement income arrangements, and then assess how Australia s retirement incomes system has performed in the context of the severe downturn in the global economy of Retirement income provision in Australia 3.1 Introduction Retirement income provision in Australia is a multi pillar arrangement comprising a public pension (the Age Pension), mandatory private retirement saving (the superannuation guarantee), voluntary superannuation and other long term saving. Even though superannuation was first` introduced in the 1850s, public pensions in 1909 and the mandatory superannuation guarantee in 1992, Australia s retirement income system is still work in progress. Over the period , retirement income policies are the subject of three comprehensive reviews the Henry review into Australia s Future Tax 5

7 System (AFTS) 2008a, 2008b) 1, the Harmer review of public pensions (Harmer 2008) and the Cooper review of the governance, efficiency, structure and operation of Australia s superannuation system (Super System Review 2009a, 2009b). The Harmer Pension Review reported in May 2009 with changes to the Age Pension announced in the Budget (Harmer 2009, Australian Government 2009a), while the Henry review, which is due to report at end 2009, released preliminary recommendations in May 2009 (AFTS 2009). In addition, the government has announced some short term policy changes to alleviate the impacts of the global financial crisis. Both the longer term and short term policy changes are reflected in the following discussion of Australia s retirement income system. The Age Pension The origins of a national retirement income system in Australia date back one hundred years to the first payment of the Age Pension in The Age Pension was, and still is, a general revenue financed, means tested, safety net payment for the retired, which is provided subject to age, residency, and income and assets means tests. Until the introduction of the superannuation guarantee in the final decade of the 20 th century, the Age Pension was the main retirement policy instrument in Australia. Mandatory private retirement saving the superannuation guarantee The superannuation guarantee was introduced in 1992 as a form of mandatory private retirement saving. All employers are required to make superannuation contributions of at least 9% of earnings on behalf of their employees to a superannuation fund. Employees aged earning more than $A450 per month (around 9% of average male earnings) are covered. The self employed are excluded but have access to tax concessions for voluntary contributions and are eligible to participate in a government co contribution scheme. The mandatory contributions are placed in privately managed 1 The Henry tax review includes a review of superannuation policy design (AFTS 2008c, 2009). 6

8 superannuation funds 2, and benefits can be accessed at the statutory preservation age currently age 55, increasing to age 60 by The superannuation guarantee replaced (quasi mandatory) productivity award superannuation which from 1987 had extended superannuation coverage to workers covered by industrial awards. A preliminary report of the Henry Tax Review recommended against increasing the mandatory contribution rate of 9%, extending coverage to the self employed, or changing the minimum income threshold for mandatory coverage (AFTS 2009). Voluntary retirement saving The Age Pension and superannuation guarantee are supplemented by voluntary superannuation, and other forms of long term saving through property, shares, managed investments and home ownership. Prior to the introduction of award superannuation in 1987 and the superannuation guarantee in 1992, occupational superannuation was generally of the defined benefits variety. However, over the past 20 years most defined benefit schemes have closed to new members and have been replaced with defined contributions arrangements. Voluntary contributions are encouraged by the overall concessional tax treatment of superannuation savings and specific tax concessions for contributions (including the opportunity to salary sacrifice and the government co contribution scheme which provides matching government contributions for low and middle income earners 3 ). The take up of these concessions is quite modest: around 25% of superannuation fund members make voluntary (post tax) employee contributions, 13% of fund members with employer contributions make additional pre tax (or salary sacrifice) contributions 2 Mainly of the defined contributions variety, although defined benefit arrangements comply under certain conditions. 3 The government co contribution provides a matching government contribution of up to 150% of voluntary contributions up to $A1,000 pa. It applies in full to incomes below $A30,342 ( financial year) and partially to incomes up to $A60,342 ( financial year). In the Budget the government announced a temporary reduction in the matching co contribution over the period to , and a reduction in the caps for concessional contributions, as part of a package of measures to minimise the size of the fiscal deficit. 7

9 Australian Bureau of Statistics (ABS 2008), and only around 20% of those eligible have made contributions under the government co contribution scheme. However, in aggregate, voluntary contributions (that is, in addition to the mandatory 9%) account for around 7% of wages and salaries (Connolly 2007). As well, around 85% of retirees own their own home. Table 3.1: Retirement income provision in Australia Age Pension a. Superannuation guarantee Voluntary retirement saving Payments commenced: 1909 Established: 1992 First introduced: 1850s Contributions: Non contributory Potential coverage: Available to males aged 65 and over and females aged 63.5 and over (increasing to age 67 from 2017 for both males and females), subject to income and assets tests. Funding: General revenue Benefits: 27.7% average male earnings (single), 41.3% average male earnings (couple). Indexed to greater of CPI, a pensioner price index and average male earnings. Taxation: Taxed, but subject to tax offsets. Actual coverage: Around 75% of persons of eligible age receive some Age Pension. 56% of age pensioners receive the full rate of Age Pension. Contributions: 9% earnings (paid by employer) Potential coverage: Employees aged earning at least $A450 per month 8 Contributions: average 7% earnings Encouraged by: overall tax concessions (since 1915), salary sacrifice, government co contribution for employees and the selfemployed on incomes less than $A60,342. Funding: Individual accounts in privately managed superannuation funds Benefits: Preserved to age 55 (increasing to age 60), no early withdrawals, choice of lump sum or income stream. Taxation: Contributions taxed (T), superannuation fund earnings taxed (T), benefits free of tax if age 60 and over (E) Actual coverage: Mandatory and voluntary superannuation 96% full time employees, 80% part time employees, 73% casual employees and the self employed. Source: Bateman and Piggott (2009), Australian Government (2009a, 2009c). a. Changes to the Age Pension were announced following the release of the Harmer Pension Review in May 2009, including: an increase in the Age Pension age to 67 from 2017 for both males and females,; an increase in the single Age Pension from 25% to 27.7% (and for couples from 40% to 41.3%) of male total average weekly earnings, an increase in the income test taper from 40 cents to 50 cents, and indexation of Age Pension payments to a Pensioner and Beneficiary Living Cost index.

10 In 2009, more than 90% of Australian workers were covered by mandatory and voluntary superannuation. This represents around 96% of full time employees, 80% of part time workers, and 73% of casual and self employed workers. Total superannuation coverage has doubled since the introduction of the mandatory (and quasi mandatory) arrangements from the late 1980s. The main features of the Australian retirement income arrangements are summarized in Table The Australian superannuation industry Since 2005 most Australian retirement savers have been able to choose the superannuation fund into which their contributions are made (previously this was an employer decision), and many superannuation funds offer considerable choice of investment options. The Australian superannuation industry is characterized by its diversity. There are three quite different types of superannuation funds: not for profit superannuation funds, forprofit (retail) superannuation funds and self managed superannuation funds. The former group is further distinguished into single employer funds (corporate funds), multi employer funds (industry funds) and funds for public sector employees (public sector funds). As well, retirement saving accounts (RSA) offered by financial service providers are available as a low cost alternative. Over the past few decades there has been a move away from defined benefit towards defined contribution funds, and from closed funds to public offer funds (that is, funds open to the general public). There has also been substantial industry consolidation, with the number of superannuation funds (excluding self managed funds) decreasing from more than 5,000 in the mid 1990s to less than 500 by A recent trend has been the closure of traditional corporate funds in favour of contracted out arrangements with retail funds, and rapid growth of self managed funds. As a result, the current 4 The discussion of Australia s retirement income system draws on Bateman, Piggott and Kingston (2001), Bateman and Piggott (2009) and Bateman (2006). 9

11 superannuation industry reflects features of the previous voluntary arrangements, the mandatory superannuation guarantee and recent industry developments. The current structure of the industry is summarized in Table 3.2. Table 3.2: The Australian superannuation industry at June 2009 Assets ($A billion) Number of funds Member accounts ( 000) a. Fund type Not for profit Corporate Industry ,213 Public sector ,002 Total For profit Retail ,376 Self managed superannuation funds b , Other c ,919 Total d. 1, ,252 32,006 Source:: Australian Prudential Regulatory Authority ( APRA) (2009a, 2009b). a. June b. Includes small APRA funds. c. Includes single member approved deposit funds, pooled superannuation trusts and balance of life office statutory funds. d. Includes Retirement Savings Accounts, which account for $A1.3 billion of assets across 8 providers. In June 2009, aggregate assets of Australian superannuation funds totaled $A1.08 trillion (or more than 100% of GDP). Due to the sharp fall in equity prices over , this is 13.2% lower than the peak of $A1.24 trillion recorded in December 2007, but represents a recovery from the $A1.02 trillion recorded at end March Overall there has been substantial growth in superannuation assets over the past decade from $A245 billion or 40% of GDP in 1997 (APRA 2007). While existing and potential superannuation fund members are allowed to choose and switch superannuation funds, few elect to do so. Industry estimates indicate that in 2007 only 2.5% of members actively changed their superannuation fund and that most new fund members default into a fund chosen by their employer (Ernst and Young 10

12 2008). However, choice of superannuation fund does matter. Not for profit superannuation funds (corporate, industry and public sector funds) have consistently outperformed for profit retail funds (but not necessarily corporate fund funds) under a range of metrics including, expenses (Chant West 2009), return on assets (APRA 2007, 2009a) and risk adjusted performance (Coleman, Esho and Wong 2006; Ellis, Tobin and Tracey 2008). 5 Once in a superannuation fund, most members are offered choice of investment option. Investment choice menus range from short lists of multi manager diversified options (given generic names such as conservative, balanced, growth etc ) to longer and more complex menus comprising multi manager diversified investment funds, single manager diversified and specialist investment funds and even individual shares. In 2008 the number of investment options ranged from 1 to 2,432 (APRA 2009c) with the typical not for profit superannuation fund (that is, corporate, industry or public sector fund) offering 8 10 investment options and the typical retail (for profit) superannuation fund offering 112 options. Most not for profit and some for profit superannuation funds offer a default option for those members who do not actively choose. However, it is not clear that Australian retirement savers are equipped to undertake this important decision making. In aggregate around 50% of superannuation assets are placed in default options (APRA 2009a: Table 17). For industry funds this is even higher at over 80%. 6 Failure to choose an investment option or choice of an inappropriate investment option does matter. Asset allocation determines the risk/return characteristics of the retirement savings and therefore the expected accumulation at retirement (and beyond 5 However, the efficacy of such comparisons has been criticized. Caveats on comparative superannuation fund performance metrics relate to: the diversity of retail funds relative to not for profit funds, the impact of member directed investments, differences in demographic composition, employer sponsor subsidization of expenses, differences in data reporting methods, and different levels of service between fund types (such as the extent of financial advice and choice). 6 The extent to which this is an active or passive choice is unclear, as the default option is generally also the balanced option on the investment choice menu. 11

13 for account based pensions). Table 3.3 reports the average asset allocation of the default options offered in superannuation investment choice menus in This allocation is spread across all asset classes, and highlights the exposure of Australian retirement savers to risky assets (which comprise 62 75% of average default fund assets) over the period of the recent global financial crisis. This raises questions about both the ability of retirement savers to make appropriate investment choices, as well as the institutional design and composition of investment choice menus. Table 3.3: Asset allocation default strategy Asset class Assets (%) Australian shares 29% International shares 23% Listed property 3% Unlisted property 7% Australian fixed interest 11% International fixed interest 6% Cash 9% Other assets 13% Total 100% Source: APRA (2009b), Table Retirement Benefits The mandatory private retirement saving arrangements (introduced over ) are still immature so most Australian retirement savers currently reach retirement with a modest superannuation accumulation and eligibility for the public Age Pension. In 2009, average superannuation accumulations at retirement were $A140,000 for men, around $A65,000 for women and around $A175,000 for a retiree household (ASFA 2009) 7. However, average accumulations at retirement will increase as workers reach retirement with progressively more years of mandatory and voluntary superannuation contributions. 7 However 70% of retirees have less than the average. 12

14 Current policy does not mandate the type of retirement benefit to be taken with this retirement accumulation. Options include lump sums, phased withdrawal products and annuities. The take up of public and private retirement benefits in Australia in 2009 is summarized in Table 3.4. Table 3.4: Retirement Benefits in Australia June 2009 Benefit Type Public Age Pension Private retirement benefits Lump sum Income stream Coverage 75% eligible aged receive some Age Pension. 56% of Age Pensions paid at the full rate. 56% of benefits paid 44% benefits paid Life annuity Negligible 61 policies sold in 2008 Term annuity 6% (market share by assets) Account based pension 94% (market share by assets) Superannuation pension a Na a. An indexed lifetime pension paid by some defined benefit plans. There is no publically available information on the market share of superannuation pensions. Source: Plan for Life Research (2009) and APRA (2009a, 2009b). The Public Age Pension The Age Pension is payable to women from age 63.5 (increasing to age 65 by 2014) and to men from age 65. The eligibility age will increase to age 67 for both men and women from The Age Pension is indexed to the higher of prices and wages growth and is set at 27.7% of male average weekly total earnings (AWOTE) for single retirees and 41.3% for retiree couples. 8 Net replacement rates are higher as the Age Pension is exempt from income tax. Eligibility for the Age Pension brings with it access to other payments and allowances, including: a pharmaceuticals allowance, the pension concession card, a telephone allowance and discounts on public utilities. 9 Age Pension recipients are also eligible for a 8 The Age Pension amounts increased in September 2009 following recommendations of the Harmer Review announced in the Budget from 25% AWOTE for single pensioners and 40% AWOTE for each of a retiree couple (Harmer 2009, Australian Government 2009b, 2009c). 9 Since September 2009 these benefits have been consolidated into the pension supplement. 13

15 Health Card and rental assistance. The key features of the Age Pension are summarized in Table 3.5. Table 3.5: Features of the Age Pension Features Detail Eligibility age 65 years (males), 63.5 years for females (65 by 2014). Increasing to age 67 (males and females) from Financing General revenues. Currently 2.7% GDP. Amount: Single rate Couple rate 27.7% average male ordinary time earnings. 41.3% average male ordinary time earnings. Indexation Indexed to the greater of the consumer prices, the Pensioner and Beneficiary Living Cost Index and average male earnings. Income test Age Pension withdrawn at 50 cents per dollar of private income above an income test free threshold currently $A142 per fortnight for singles and $A248 per fortnight for couples. Maximum fortnightly private income to receive a part Age Pension ($A1, single/ $A2, couple). Concessional treatment for employment income introduced from September Assets test Age Pension withdrawn at $A1.50 per fortnight for every $A1,000 of assets above thresholds which differ between home owners/renters and by single/couple. Assets thresholds for homeowners of $A178,000 (single) /$A252,500 (couple), for non homeowners of $A307,000 (single) /$A381,500 (couple). Tax treatment Age Pension taxed subject to tax pensioner tax offset (ie effectively tax free). Pension Supplement Concessions for public utilities and other benefits. Additional benefits Access to Health Card, rental assistance etc. Source: Australian Government (2009b, 2009c), Harmer (2009). The Age Pension is means tested by both income and assets with the test paying the lower rate of Age Pension applying. Under the income test the Age Pension is withdrawn at the rate of 50 cents for each dollar of income above the income test free amount. The assets test reduces the Age Pension by $A1.50 per fortnight for every $A1,000 of assets (excluding the retirees own home) above statutory asset thresholds which differ 14

16 between home owners and renters and by singles and couples. 10 Currently around 75% of Australians of eligible age receive some Age Pension with 56% of Age Pensioners paid at the full rate. Private retirement benefits Australian retirees can choose to take their retirement benefits as a lump sum, and/or a phased withdrawal type product and/or a term or life annuity. 11 Phased withdrawal products were first introduced in Australia in 1985 and are now the most popular form of retirement benefit. They are currently provided as products called account based pensions and transition to retirement pensions. 12 Both products allow retirees to invest their retirement accumulation in an investment portfolio according to their risk preference and to decide how much income they want to receive annually. Retirement benefits paid from an account based pension are tax free for persons age 60 and above and, where minimum age based annual drawdowns are satisfied (as specified in Table 3.6), the earnings on the underlying assets are also free of tax. 13 Table 3.6: Account based pensions minimum drawdown by age Age Per cent of account balance under age 65 4% % % % % % 95 and over 14% Source: Superannuation Industry (Supervision) Amendment Regulations 2007 (No.1), Schedule The retiree s own home is excluded. 11 In addition, those retiring from a defined benefit pension plan may receive a superannuation pension. 12 Hybrid products have also arisen from time to time in response to regulatory incentives. Term allocated pensions (TAPs), also known as market linked income streams, were introduced in September 2004 in response to changes in the tax, Age Pension means test and regulatory requirements. TAPs had a similar account structure to allocated pensions, but a similar term structure to a life expectancy term annuity. TAPs are no longer marketed following further legislative changes in September For detail on account based pensions see Bateman and Thorp (2008). 15

17 Transition to retirement pensions are available to persons with a preservation age of between 55 and 60. These products allow access to superannuation benefits by nonretirees and are designed to encourage partial withdrawal from the labour force. Transition to retirement pensions must be taken as an income stream under which no more than 10% of assets can be withdrawn annually. While these non annuitized products give retirees considerable flexibility, they do expose older Australians to market (or investment) risk, which has been exacerbated by the quite risky asset allocations chosen, as well as longevity risk and inflation risk. In the absence of compulsory retirement income streams, the initial approach of the Australian policymakers was to use tax, Age Pension means test and regulatory incentives to encourage the take up of income streams with longevity features (that is, life annuities). Despite these concessions, however, demand for life annuities remained very low. As a result, policy changes over time have gradually extended the suite of incentives to non annuitized products such as the account based pensions so popular today. Future incomes in retirement With almost all employees now covered by the superannuation guarantee, many workers with additional voluntary superannuation coverage and improvements in the vesting, portability and preservation of superannuation benefits, the composition of retirement income will change in future years as more Australians retire with a working life of superannuation contributions. Official estimates indicate that, under a mature superannuation guarantee, a single male on median earnings with 35 years of mandatory contributions could expect to retire with a total (Age Pension plus superannuation) replacement rate of 78% 14. Reliance on the Age Pension will fall, but its design as a means tested safety net with fairly flat tapers implies that the retirement 14 After 35 years of contributions, assuming inflation of 2.5% pa, wages growth of 1.6% pa and superannuation fund earnings of 6.5% pa. [AFTS (2009), Table F.1, Table 4.1.] 16

18 benefits of most retirees will still comprise a part Age Pension and a superannuation benefit. Government estimates indicate that between June 2009 and June 2050 the proportion of people receiving the full Age Pension will decline from 42% to 28.3%, while those on part Age Pensions will increase from 33% to 45.3%. The proportion of elderly receiving no Age Pension is expected to increase only marginally from 25% to 26.4% (Department of Families, Housing, Community Services and Indigenous Affairs 2008, Harmer 2009). 3.4 Discussion As individuals move into retirement they are faced with a number of economic and financial risks including replacement risk, investment (or market) risk, longevity risk, inflation risk, annuity risk, contingency risk, default risk and political risk. Under Australia s mixed retirement income system, retirement benefits available to address these risks include superannuation benefits and the publicly provided Age Pension, where the superannuation benefits are predominantly taken in a non annuitized form as lump sums or increasingly account based pensions. The extent to which these privately and publicly provided benefits address the economic and financial risks faced by retirees is summarised in Table In sum, neither the private component of Australia s retirement income arrangements (mandatory and voluntary superannuation) nor the publicly provided Age Pension, adequately address all the economic and financial risks in retirement when considered in isolation. Most private retirement saving in Australia is of the defined contributions variety and is associated with individual investment choice. Defined contribution arrangements expose retirement savers to investment risk which, in Australia, under current practice, has been exacerbated by possibly inappropriate choice (or no choice) of investment 15 Most superannuation is of the defined contributions variety. However a number of current retirees receive benefits from defined benefit plans, and some workers still belong to defined benefit arrangements. 17

19 option. As discussed earlier, many retirement savers do not actively choose an investment option and their contributions are placed in default options, which, on average are weighted around two thirds to three quarters in risky assets. With the popularity of non annuitized retirement benefit products, exposure to investment risk continues into retirement with similar asset allocations chosen for account based products. As well, the minimal take up of annuitized products leaves Australian retirees exposed to both longevity risk and inflation risk. However, the increasingly popular account based pensions do provide cover for contingency risk. The absence of a cap on draw downs allows large and lumpy withdrawals to meet unexpected contingencies such as health and/or aged care expenses. Table 3.7: Australian retirement income arrangements and retirement risks Economic and financial risks in retirement Superannuation Age Pension Replacement risk: the risk of not adequately replacing pre retirement income Investment risk: the risk of unevenness in income due to the volatility of investment returns Longevity risk: the risk of outliving one s financial resources Inflation risk: the risk of erosion of purchasing power no Yes Annuity risk: the risk that low interest rates will be locked in when an annuity product is purchased Contingency risk: the risk associated with an uninsurable event, such as unexpected health expenses Default risk: the risk of default of a benefit provider Highly likely Highly likely Political risk: the risk of government policy changes which eliminate or dissipate benefits Of the remaining risks, while the 9% mandatory contribution rate was endorsed by the Henry Tax Review (AFTS 2009), there are widespread views that this is insufficient for workers on very low incomes and/or with broken work patterns (ASFA 2009, Industry Super Network 2009). And, while a sound regulatory regime and competent regulators yes no no na yes no No Yes Yes Yes No No 18

20 (the Australian Prudential Regulatory Authority, the Australian Securities and Investment Commission and the Australian Taxation Office) minimises default risk, any system is susceptible to political risk, as governments have the capacity to change the rules over time. 16 Public retirement income provision in the form of the Age Pension also fails to comprehensively cover the economic and financial risks in retirement. Replacement risk is not met by a single pension of 27.7% of average male earnings (or 41.3% for couples) although the design of the Age Pension as a lifetime income stream indexed to average male earnings provides coverage against investment risk, longevity risk, inflation risk, and annuity risk. As well, possible default by government is minimised by the modest Age Pension payments (with the current fiscal cost of the Age Pension of 2.7% of GDP expected to increase to only 4.6% in 2050 Treasury 2007), although, as with the privately provided superannuation benefits, the Age Pension is susceptible to political risk, as governments always have the capacity to revise policy settings over time. However, when taken together, the public and private arms of Australia s mixed retirement income system collectively address the main economic and financial risks faced by retirees. In particular, the means tested feature of the public Age Pension ensures that retirees are insured against the failure of the superannuation arrangements to address investment risk, longevity risk and inflation risk. Currently, this insurance is provided to the 75% of retirees in receipt of a full or part Age Pension. In the next section we investigate the effectiveness of these arrangements in the event of a severe global economic and financial shock. 16 The conclusions here may be different for the few remaining defined benefit arrangements in Australia. In this case the sponsors (employers) would bear investment risk, and where benefits were paid as lifetime indexed pensions, longevity risk, inflation risk and annuity risk would be covered. Retirees could be exposed to contingency risk although many defined benefit arrangements provided a combination of a lump sum and a superannuation pension and to default risk. 19

21 4. Australian retirement incomes and the global economic and financial crisis The sharp downturn in Australian and international share markets since early 2008, as well as lower cash and fixed interest yields and falling property prices translated into historic negative growth in Australian superannuation assets. In this section we report the impact of the global economic and financial crisis on superannuation assets and identify the impact of this severe downturn for Australian retirement savers and retirees. 4.1 The performance of Australian superannuation funds Australian asset markets have not escaped the global meltdown. As discussed earlier, the benchmark share price index, the ASX 200, fell by over 40% in As illustrated in Figure 4.1, this had severe implications for superannuation with total superannuation assets falling by 18.2% between December 2007 and March Figure 4.1: The Australian Superannuation industry, total assets ( ) $A billion Source: APRA (2007, 2009a) By type of superannuation fund this represented a fall of 13.2% in industry fund assets, 26.8% (corporate funds), 20.3% (public sector funds) and a decrease of 23.9% in retail fund assets (APRA 2009b). 20

22 4.2 Defined contributions superannuation As explained in section 3, most Australian retirement savers (that is, those in defined contribution funds) are offered investment choice (in both the accumulation and decumulation phase) and the majority choose or default into balanced investment options which comprise around two thirds to three quarters risky assets. As a result, one would not expect the large falls in domestic and international share markets (and the lower returns and yields for other assets) to be completely mirrored in returns on superannuation assets. By way of example, Table 4.1 reports returns for balanced superannuation fund investment options for the past 1, 3, 5 and 7 years. The median balanced option reported a return of minus 17.5% over the 12 months to March 2009, compared with falls in Australian and international share markets of around 40% over the same period. In other words, Australian retirement savers who elected or defaulted into the balanced option have been partially insulated from the full extent of the crash in domestic and international share prices. Table 4.1: Balanced investment option superannuation accumulations returns to end March 2009 a 1 year 3 years 5 years 7 years Upper quartile Median Lower quartile Source: Chant West (2009). a. Based on returns of 50 of the largest superannuation funds (net of investment fees). The impact of the global economic and financial downturn was not restricted to the accumulation phase of retirement saving. With the increasing popularity of accountbased pensions, Australian retirees were also exposed to falling asset prices. Table 4.2 reports annual returns for balanced investment options in account based pension products. The median account based pension fund, which comprises around two thirds 21

23 to three quarters risky assets, reported a return of minus 19.8% over the 12 months to March Table 4.2: Balanced investment option account based pensions returns to end March 2009 a 1 year 3 years 5 years 7 years Upper quartile Median Lower quartile Source: Chant West (2009).a. Based on returns of the largest superannuation funds (net of investment fees). In sum, defined contributions superannuation also exposes retirees to investment or market risk. 4.3 Defined benefit superannuation The trend away from defined benefits to defined contributions superannuation has left very few defined benefit plans open to new members. However, defined benefit plans still play a role for some retirees and workers close to retirement. In 2008, the superannuation industry regulator APRA conducted a survey of defined benefit fund and found that 16% of fully defined benefit funds and 20% of hybrid defined benefit/defined contribution funds were in an unsatisfactory financial position (APRA 2009a). It is likely that these funds are now in a worse financial position following the global financial crisis and a number of large defined benefit plans have announced revised funding plans (Taylor 2009). 4.4 Impact on retirement savers (and retirees) The global economic and financial crisis resulted in negative returns on superannuation assets and subsequent falls in superannuation balances over , in both the accumulation and decumulation phase of retirement saving. We now identify the impact of these trends on Australian retirement savers. Three groups will be considered in turn 17 The inferior returns for account based pension portfolios are due to the higher fees associated with these products. 22

24 young retirement savers, retirement savers approaching retirement (old retirement savers) and retirees who are drawing down their retirement accumulations (retirees). Young retirement savers While young retirement savers will have seen their superannuation balances (net of new contributions) fall by around 20% between December 2007 and March 2009, it would not be unreasonable to expect superannuation fund returns to recover in the medium term. For example, immediately preceding the crisis conditions of , typical balanced options recorded growth of 15.7% in 2007 and 14.6% in But, even if superannuation returns recovered to the long run average of around 6.5% p.a. for the rest of the accumulation phase, the additional contributions required for young retirement savers (currently around 30 to 40 years old) to make up for the losses experienced in the current downturn, would still be of the order of 1 to 2% p.a. for every year between now and retirement. 18 However, young retirement savers have the time and flexibility to increase their labour supply (and therefore aggregate contributions) and recover from the recent market shock before they reach retirement age. Retirement savers approaching retirement (old retirement savers) The implications for old retirement savers is less favourable. This group have less time to recover (in terms of years left to save for retirement) and less human capital flexibility (in terms of the ability to work longer hours, find a higher paid job or take a second job). Retirement savers aged in their 50s, who have experienced two years of negative fund returns, would need to either increase their contribution rate, or delay retirement to make up for their losses. Figure 4.2 illustrates the contribution rate required for retirement savers in their 50s, to generate the expected pre crisis retirement accumulation at age 60 under a 9% contribution rate. For example, a retirement saver aged 49 before the crisis would need to contribute nearly 19% of earnings each year (or more than double the mandatory rate) between the ages of 51 and 60 to catch up. A 18 That is, to achieve the same retirement accumulation at age 60 as would have been expected in the absence of crisis conditions. 23

25 retirement saver aged 55 at the time of the crisis would need to contribute around 34% of earnings each year between the ages of 57 and 60 to catch up. Figure 4.2: Percent contributions to catch up following global financial crisis % contribution Age at time of crisis Note: This table shows the annual contributions required to enable a retirement saver to retire at age 60 with the same retirement accumulation as expected in the absence of the global economic and financial downturn. Assumptions: Worker on average weekly earnings ($A60,000) in 2009, 9% superannuation guarantee contributions (pre crisis), superannuation fund earnings at the long run average of 6.5% pa, inflation 2.5% pa, real wages growth 1.6% pa, fees/charges 0.75% of assets. In the absence of the public Age Pension, the failure to make catch up contributions, or to delay retirement, would lead to a long term reduction in retirement benefits and therefore living standards. Since the majority of Australian retirement savers convert their superannuation accumulation to an account based pension at retirement, we illustrate this fall in retirement income in terms of account based pension payments. Figure 4.3 illustrates annual payments from an account based pension based on fund returns pre and post the crisis conditions. We assume that the account based pension is purchased at age 60 and has payments consistent with the minimum drawdown schedule (See Table 3.6). The pre crisis case is illustrated by the solid line. Returns on superannuation and account based pension assets follow pre crisis long term trends. The post crisis case is illustrated by the dashed line. Here we assume negative returns on superannuation assets at ages 49 and 50 consistent with recent market conditions. As 24

26 illustrated, the market shock of has resulted in lower account based pensions throughout retirement and therefore has long term implications for retirement income adequacy. Figure 4.3: Annual account based pension payments, pre and post crisis conditions Note: This table reports the minimum annual payments from an allocated pension before and after the global financial and economic crisis. The pre crisis accumulation at age 60 is $A865,223. The post crisis accumulation (due to returns of 6.9% at age 49 and 13.4% at age 50) is $A679,881. This assumes 36 years of superannuation contributions for a male on average weekly earnings. For economic assumptions see Figure 4.2. Retirees Retirees, by definition, have no or little capacity to make catch up contributions or to work longer, and therefore have little capacity to recover from the sharp reduction in their private retirement assets. Figure 4.4 illustrates the impact of the two years of negative returns on account based pension assets on the annual private pension payments of retirees. We assume here that the retiree was age 64 in the first year of negative returns and has an account based pension with annual payments consistent with the minimum drawdown schedule. An important outcome is that the economic and financial shock early in retirement leads to lower retirement incomes throughout retirement. Even, at age 80, (15 years after the crisis conditions) the post crisis annual account based pension payment would be 29% less than the pre crisis payment. 25

27 Figure 4.4: Impact of the crisis on account based pension payments pensioner age $A Age account based pension account based pension post crisis Note: This table reports the minimum annual payments from an allocated pension before and after the global financial and economic crisis, for a retiree with an accumulation of $A500,000 at retirement at age 60 and age 64 at the beginning of the downturn in international and domestic share markets. For economic assumptions see Table 4.2. These examples illustrate the sharp drop in retirement incomes for the 25% of Australian retirees who rely solely on private retirement incomes. However, the remainder of Australian retirees are eligible for either full or part rate Age Pensions even in non crisis conditions. The role of the Age Pension of providing insurance against market risk is explored next. 4.5 The Age Pension in crisis conditions The Australian Age Pension is probably more sustainable than many other public pensions as it is set at a modest rate and funded from general revenues rather than being linked to employment and/or earnings. The Age Pension currently accounts for around 2.7% of GDP, and is expected to account for only 4.6% of GDP by 2050 (Treasury 2007). 26

28 A key feature of the Age Pension is that it is means tested. As a result, any fall in private income and/or assets as a result of the global financial and economic crisis would increase eligibility (except for the very wealthy). For example, under the current income test, each $A1 decrease in private retirement income per fortnight would increase Age Pension eligibility by 50 cents for those on incomes up to and including $A1, per fortnight. Similarly, under current assets test rules, each $A1,000 decrease in assets will increase the fortnightly Age Pension by $A1.50. In this case, the maximum assets (excluding the family home) before the Age Pension is fully withdrawn is $A626,000 for single retiree homeowners and $A928,000 for retiree couple homeowners. As such, the Age Pension plays an important role as a form of insurance against market shocks. For example, consider the retirement saver age 49 at the time of the financial crisis illustrated in Figure 4.3. In the absence of the means tested Age Pension, this retirement saver would need to contribute close to 19% of earnings each year (rather than the mandatory 9%) between the ages of 51 and 60 to catch up. However, if the retirement saver failed to make catch up contributions, he would enter retirement with lower income and assets, and therefore greater eligibility for the Age Pension. Now consider again the retiree illustrated in Figure 4.4 who is age 64 at the beginning of the crisis. We assume here that the retiree had a retirement accumulation of $A500,000 (at age 60), which was used to purchase an account based pension with annual payments as required under the minimum drawdown schedule. This retiree would be eligible for a part Age Pension to supplement his private pension payments as illustrated in Figure 4.5. More precisely, under pre crisis conditions, in the first year of retirement, the retiree would receive an account based pension of $A20,000, a part Age Pension of $A7, (compared to a full rate of $A16,010.80), and a total retirement income of $A27, (or around 46% of average male earnings). 27