The Federal Government appears determined to reduce the budget deficit, and the age pension is one of many potential targets. Although pension reform would be highly unpopular with many voters, some sort of reform over the next 5 to 10 years is likely. This article outlines the issues at a high level and poses an important question for financial planners and those designing the default strategies for super funds.
Is the age pension fiscally sustainable?
The fiscal sustainability of the age pension system was explored in the Intergenerational Report (2010) in which Treasury calculations forecast that age pension expenditure will rise from 2.7% of GDP to 3.9% in 2050. This doesn’t sound like a big difference but that 1.2% represents nearly $20 billion per annum in today’s terms (Australia’s GDP is currently around $1.6 trillion). The potential for variation in these types of forecasts is huge as many economic factors need to be estimated. This projection takes into account two offsetting factors: the higher proportion of elderly people qualifying for the age pension, countered by a more mature superannuation system.
In fact, current annual expenditure on the age pension is similar to the amount of estimated superannuation concessions (approximately $38 billion and $32 billion respectively in the 2012/13 budget). It is important that any policy review takes account of both retirement savings policy and age pension policy in combination.
Past reviews
Australia hasn’t been short on financial reviews. Of the recent reviews which addressed the retirement savings and retirement income sector (‘Harmer’ Pension Review (released 2009), ‘Henry’ Australia’s Future Tax System Review (2009), and ‘Cooper’ Super System Review (2010)), only the Harmer Review looked at the age pension in-depth. None of the reviews looked at the combination of retirement income policies (super, drawdowns and age pension), meaning that none have considered retirement income policies from a lifecycle perspective.
The Henry Review looked at post-retirement income policies excluding the age pension. The Cooper Review looked predominantly at superannuation but highlighted the need for a whole of life focus from superannuation funds. The Harmer Review considered the age pension in detail under the principles of supporting a basic acceptable standard of living, being equitable across the population, targeting those who cannot support themselves, promoting workforce participation and self-provision, and a system which is sustainable.
The upcoming ‘Murray’ Financial System Inquiry may also consider retirement incomes policy.
Possible areas of reform
The obvious candidates for reform include:
- age pension amount
- indexing approach – the age pension is indexed on a triple-referencing basis against the greater of wage growth, inflation and a pensioner’s inflation measure. The referencing to wages (likely to be the fastest growing reference) represents a view in the Harmer Review to preserve a pensioner’s standing in society rather than a strict poverty aversion focus
- age eligibility, particularly given increasing life expectancy
- means testing (assets) – the current assets test which excludes the family residence
- means testing (income) – while income means testing affects the size of age pension payments, the design of the income means test also impacts the incentives people have to work in retirement
- form of retirement income – there has been debate about favouring income sourced from longevity risk hedging products such as life annuities when performing the age pension income means test, or making such products compulsory for a portion of one’s retirement savings.
The impact on financial plans
Any changes to the age pension will impact the outcomes of millions of Australians. It would also affect the advice provided by financial planners and the design of default options of superannuation funds. While a financial plan is personalised taking into account the situation of the individual, a default option is more like a mass financial plan for a large collection of people with different characteristics, each of whom the super fund knows little about. Both groups need to use the same toolkit.
The possibility of age pension reform should be reflected in the design of a financial plan or a default option. In designing a plan, we acknowledge that it is best practice to consider the range of possible outcomes from many important factors such as markets returns, mortality outcomes (including idiosyncratic and systemic effects), inflation, savings levels and real wage growth. We know we should consider different outcomes for these factors and assess whether the projected outcome is acceptable. The better practice groups go to great lengths to model different potential scenarios.
Hopefully the outcomes of a designed plan are robust to variability in these factors. The age pension structure itself should be one factor considered as part of this robustness test, especially when these plans often cover 30 years or more. The test could consider different age pension scenarios and assess what retirement financial outcomes would look like. It makes for a better, more robust design.
For many the age pension will be a major component of their retirement financial outcome, so if we model the variability in all these other factors but assume the age pension remains constant, aren’t we potentially ignoring the elephant in the room?
David Bell’s independent advisory business is St Davids Rd Advisory. In July 2014, David will cease consulting and become the Chief Investment Officer at AUSCOAL Super. He is also working towards a PhD at University of NSW.