The pre-saving myth of superannuation

It baffles me that an area of economic research with very important policy applications has produced more than 45,000 articles and still comes to a general consensus that is completely incorrect.

I’m talking about the macro-economic effects of superannuation.

The incorrect consensus, one that is drummed into economics PhDs across the world every year, is that a fully-funded social security system has no effect on the relationship between the capital stock in successive periods, while pay-as-you-go systems reduce capital accumulation and leaves future generations worse off, with lower consumption possibilities.

Translated, that means that a pension system that requires individuals to save through their lifetimes, to fully fund their retirement, is better than a system where the current generation of workers simply pays the current generation of retirees a pension through the tax and transfer system (a pay-as-you-go model).

Why is it better? Because it encourages investment that would not have occurred if people were not forced to save. And in macro-economic models, saving equals investment and investment always means construction of new physical capital.  Surprisingly you can’t simply buy an existing asset from someone else in the model.  And that’s why it is wrong. Since almost all investments to fund pension schemes are transfers of ownership of existing assets – shares, bonds and property.

A simple analogy should suffice to demonstrate the point. Think of a family household with two generations – working aged children and their retired parents.

Under a pay-as-you-go system the working age children simply give the parents an allowance to spend out of their own income.  Simple enough. Under the fully funded system, the working age children save for their own retirement by buying assets in the marketplace.  In this case, the house (and importantly the land it resides on) is the only asset.  Currently the retired parents own the house.  So the children incrementally make small payments on the home to the parents, and the ownership transfers the children.  The  interesting macro-economic question is whether this changes the incentives for the children to work, and the owners of capital (the children and parents) to invest in improving their home.

Common sense would say that both systems offer similar incentives and have identical costs to the working generation.  Under a fully funded system however, there may be less incentive to work because of the enforce delay on spending one’s earnings.  Or possibly more, since people are earning less for a given amount of work, and labour supply curves are often downward sloping.

At a macro-level the cost is simply under utilisation of resources.  If parents retire earlier they might be better off in terms of utility, but there is a cost to society (a very small one) of them not working.  If they retire later, under both systems, then the overall cost is lower.  To put it another way, output would be higher if everyone retired for a shorter period of their life.  There is nothing surprising or interesting in that statement.  If a fully funded system is poorly funded and social security is very low it may encourage later retirement.

What it interesting is what happens when we examine the effects of transitioning from pay-as-you-go to fully funded.  The children in the household not only pay for their parents during the transition period, they must also buy the house from them.  That means the parents get twice the income – once from the transfer, and once from the asset sale. Only after that generation has lived with less than their fair share does the system become fair again for the third generation.

The generation facing the transition needs to work more for the same income, and may retire later due to tightening of social security for unfunded pensioners.

The net effect of a transition between the systems is to transfer wealth from the working generation to the retiring generation. Policies such as this deserve the criticism they receive about intergenerational fairness.  The same logic applies to transition from fully funded to pay-as-you-go university eduction.  In this scenario the working age generation benefits by not having to fund the younger generations education.

I’m not the only one to say this.  More rigorous and formalised mathematical analysis also reveals that same problem.

Pareto-improving transition to a funded system is not possible because any instrument applied to the financing of pensions in the transition phase involves intragenerational redistribution.

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  1. And how is this any different to many generational inequalities that have always existed, and always will if we are to progress? For the War Generations, many of them never got to reap the rewards of any form of superannuation, having already paid their social debt with their lives, and yet they provided for us the society we have about us today. Given a choice between double-contribution and life, I’ll choose waking up each day, any day!
    As Paul Keating noted, “Life wasn’t meant to be easy…”

  2. Janet, forgive me the pedantry, but Malcolm Fraser is noted for (mis)quoting/paraphrasing George Bernard Shaw with “Life was not meant to be easy …”

    • I’m sure many people have noted the same or similar expression. That’s why I didn’t indicate Paul was the originator, merely one who made the comment.

      • Oh, and I used Keating as if I’m not mistaken, his Government put in place the current scheme of things over in Australia.

        • Janet, I already regret the pedantry. My point was that in the annals of Australian politics Fraser is noted for this quote, not Keating.

          • You are absolutely correct MarktheGraph.
            He was roundly criticised for it. That’s what happens when politicians tell the truth that voters don’t want to hear – amusing really.

  3. Cameron, I’m not sure that I like your “buy the parents house twice’ analogy, but I have heard others comment that compulsory superannuation is just another type of austerity that deprives choices and spending power that would otherwise drive more economic growth.

    When I then look at what can happen when a retiree draws their super as a lump sum and then still qualifies for the aged pension I can see that it could be argued that younger generations are being robbed of that extra economic prosperity as well as having to pay the extra tax to fund welfare on a pay as you go basis. Is that your point?

    If so it’s a difficult problem. Most believe that a little austerity is a good thing as long as it isn’t too heavy.

    There is no doubt that if we gave compulsory superannuation away and we all received that extra as income, then that would create some genuine winners and probably a larger number of losers who wouldn’t save any of that extra money.

    It seems intuitive that all that money in super schemes being invested into shopping centres and shares etc must push up asset values. Given that an exact calculation of all of the effects of unwinding all of that would be difficult if not impossible, how can you say with any surety what the effect of unwinding this will be. Of course that can only be hypothetical anyway as voters are now used to having superannuation, which is why the savings rate fell away when super was introduced.

    A very interesting thought and worth investigating, best of luck on the political front with this. Politicians don’t like radical changes that affect hip pockets of voters that could be perceived as being detrimental to the voters.

  4. Just a couple of points, Douglas Macarthur introduced compulsory savings to the japanese as means of funding their rebuilding of their economy as the capital wasn’t able to be found given what was happening re the marshall plan etc.
    Paul’s Keatings vision was that the pool of savings would offset our CAD and make us less reliant on overseas borrwings. I would make the argument that the 2 Billion per month that flows into our financial system via compulsory super helped us during the GFC.
    The unfortunate issue is however the politicisation of super, that started with the Fightback, which would have increased the penalties re taking the lump sum versus pension income streams.
    The dismantling of RBL systems whilst streamlining the tax recording further excabarated the situation and simple super with no tax after 60 has worsen this.
    As Paul Keating once said, you can incentivise 60% of the population with a carrot , the rest of them you need a stick.

  5. I can’t stand old people, they make me sick, the have super, then go buy up property to enslave the next gen’s even more, so we pay taxes to them, and they take even more. I could not care less if there was a mass extermination of old people, many of them never saved and now they want us,, the next gens’ to fun their retirements.

    • It’s not the generational issue that is the problem. It’s productive people vs non-productive. The older generation have many people who have worked hard and saved and have been disadvantaged by the FIRE economy ponzi. Similarly there are many younger people who do nothing productive yet are paid fortunes for their production inhibiting activities. Our whole govt system is now designed to reward such people the highest.
      Not allocating blame to younger generations either. I’m just pointing out that looking at it as a generational issue is totally wrong and will gain nothing.

  6. Great article. There are other dynamics which make the system even more pernicious.

    It concentrates power in the hands of the financial industry who have shown every decade since the ’80s (in case we forgot the Great Depression) that they are incapable of risk management let alone a sustained, sustainable strategic vision for society.

    These second rate bankers have shoved money into housing/shares and the managed to convince people that drastic house price increases are not inflation. This in no small part has driven the decline in fertility as it becomes impossible to buy a dwelling on a single income, and drastically delays file formation (And then the BB have the audacity to complain about kids staying at home longer.)

    Heavy reliance on “assets” which fluctuate wildly in “value” means that life cycle financial planning becomes very difficult (and still from what I understand Challenger can’t sell easy to understand annuities??).
    This means the older generation delays retirement after an asset price crash which means jobs – the great socializing force – are not available for those young who need to be socialized. Look at the number of 55+ who have started working in the states after the big kablooie. (And the concomitant fall of the working young)

    I would like to see a proportion of GDP which is linked to the proportion of the population which is above retirement age. Clearly if a small percentage of the population gets a large percentage of final demand it is unfair, as is the converse.

    Debt is the promises of the past, and the present never matches past projections. This is true of defined benefit (one kind of debt) and defined contribution (another kind of debt).

  7. Super – lurk for the rich, pointless for the poor and patronising to the middle class.

    This is unfortunately not news for those caught in the intergenerational squeeze.

  8. Rumples

    I agree with much and disagree with much of what you said.
    Firstly a question, you say here “Since almost all investments to fund pension schemes are transfers of ownership of existing assets – shares, bonds and property.”
    If there is only a transfer of ownership going on then the proceeds would end up back in the consuming pool. In the great circle of things you would not have savings at all?

    I’d suggest that this is, largely, the case for Australia as the saving inherent in the Super scheme has not resulted in the elimination of the CAD. In fact we have produced a rapidly growing CAD through most of the period since Compulsory Super was introduced.
    This would suggest that, in the absence of other policies, the scenario you outline holds.

    I believe the rest of your analysis is a bit simplistic. I guess that is necessarily so in a short paper. However brevity seems to lead to a fundamental error. I’m having trouble with brevity myself here for such a complex subject.

    Other than the logical problem I’ve raised above re transfers and savings you claim benefit to the economy for the extra money that is spent if there is no Super saving. In fact you are arguing the simplistic notion that all saving is bad for the economy.
    If we had no compulsory super, together with our perpetual negative RAT rates (so no savings outside Super), anti-productive industrial and Govt development policy and low taxation, then much of increased spending would have ended up in the external account meaning more debt and asset sales.

    You seem to have made the assumption that debt, domestic or foreign, is perpetual and free.

    • Personally I’d like to believe that Super is patient capital which provides the financial bed rock from which new businesses can be developed. Unfortunately it does seem that Super is really more about existing asset transfer as opposed to new asset development. If developing new productive (meaning export) industries were the focus of super than I could see the point of having super. Without this focus we have an increasingly difficult to manage CAD problem. On the surface it seems that the external asset transfer, implied by our CAD, is really what funds current retirement. I’m not sure you can repeat the process, for the next generation, without raising the likelihood or large scale personal defaults and even sovereign defaults (visa vie Argentina).
      It remains to be seen how much long term positive cash-flow will result from the latest round of mining infrastructure capital deployment, so maybe I’ll need to eat my words.

      I suspect that Tinkler might be showing us the future whereby bond/hedge funds (many Asian based) gain ownership of key Aussie mineral assets through the liquidation process (along the same lines as the Channel9 TV deal).

      WRT to this last point I really wonder what point there is in making Aussie directors liable for insolvent trading. Many US companies trade while technically insolvent, it is not at all unusual, however the prospect of technical insolvency seems to really hamper new business / startup formation in Oz by requiring additional satrtup capital stock AND creating this on-going need to recapitalize (to avoid technical insolvency). This recapitalization often occurs at the worst possible time. I’ve personally been involved in one business where we basically told investors that we were repurchasing our debt at 20c/$. The company got over the hard period and went on to prosper, some impatient investors lost out, but so what, they at least had the option of insuring against default, this option is not available to the startup manager, employee or seed capital investor.

  9. ” The children in the household not only pay for their parents during the transition period, they must also buy the house from them. ”

    why? what if the parents leave the house to them?

  10. sydboy007MEMBER

    Current superannuation tax concessions are enormous. There are $30 billion worth of superannuation tax concessions per year. Almost half those tax breaks go to the wealthiest 12% and almost a fifth go to the wealthiest 2% of Australians.

    Dr Richard Denniss, from the Australia Institute, says his analysis shows that tax concessions to self-funded retirees will cost the Federal Government $45 billion in 2015, almost twice as much as the aged pension.

    Some questions raised by Dr Dennis (from his report Can the taxpayer afford ‘self-funded retirement’ 2012?)

    * If the objective of the subsidies for superannuation is to reduce the cost of the age pension why can people access their super at 55 when they cannot access the age pension until they are 65?

    * If the objective of the subsidies for superannuation is to reduce the cost of the age pension why can people who already hold more assets than the amount prescribed in the assets test continue to make concessional contributions?

    * If the cost of providing tax concessions for superannuation are greater than the cost of providing the age pension how could substituting the former for the latter save the government money?

    * Of all the ways to boost retirement incomes, are tax concessions the most effective?

    Treasury’s forecast suggests that there will be a slow but steady rise in the number of people receiving a part pension and a very small (around 3 per cent) increase in the number of people receiving no pension. As the following calculations show, it follows that a very small increase in the number of people who do not receive the age pension and a small increase in the proportion of the population who receive a part pension can only save the Commonwealth a relatively small amount of money.

    If we assume that the population in 2047 is 32 million and that 24 per cent of that population is aged over 65 then the population of retirees will be 7.6 million. Taking the Treasury estimate of a three per cent increase in the proportion of retirees receiving no age pension (230,000 people) and a 15 per cent increase in the proportion of retirees receiving a part pension (1,152,000 people) it can be estimated that the reduction in the age pension bill, compared to today, would be equivalent to 10.5 per cent of the retiree population (15/2+ 3) multiplied by the age pension.

    That is, the projected reduction in the age pension bill in 2047 can be estimated as 806,000 people multiplied by the current single age pension rate of $695.30 per fortnight equates to a saving of around $14 billion per year in 35 years’ time. Given that this year’s tax concessions cost more than twice that amount, and that the future benefits need to be discounted to today’s dollars, the Treasury projections included in the figure above make clear that the impact of the large, and rapidly growing, cost of tax concessions for superannuation do not provide a net benefit to the Commonwealth budget.

    • Great Analysis Syd! Be interested to see if anyone can refute this?

      I cannot understand why there is such endless political praise for a current system that provides little to no benefit, is patronising to the extreme and supports a veritable swarm of rent-seekers.

  11. Our current system of funding retirement has many problems, and our superannuation system is one of them.

    As we know, many people aren’t sensible. Specifically those who are 10 or more years from retirement are, by majority, not sensible. Ten years seems like a long time. Apparently.

    The tax concessions available on both contributions and earnings within superannuation, and even more so once superannuation assets are moved to the tax-free Account Based Pension environment, do little to stimulate or strengthen our economy. Yet it has a meaningful impact (reduction) on tax revenues.

    It would be incredibly unpopular, but I have said for a long time that an ideal “superannuation” system would be a government-underwritten Defined Benefit Scheme, including some of the key features:

    *Earnings at a guaranteed, nominal CPI+ rate (say, CPI+2%). This money could then be used to invest in the nation’s infrastructure, reduce any unnecessary debts etc.

    *At retirement the lump sum in your Defined Benefit account is then paid back as an annuity (not be taken as a lump sum), paid until death, maybe with a small reversionary benefit to your spouse.

    *At death a small portion of the starting value of your annuity (at date or retirement) can be paid to your estate (say, {opening sum x (1 – (age/120) }.

    Managed correctly, this would improve confidence in our pension funding system, encourage more sensible spending and investment, and provide greater stability and certainty of commonwealth pension funding obligations.

  12. I think the value of retirees is much underestimated by economists. They are often primary carers for their grandchildren allowing both parents to work without the substantial cost of day care.

    • I think the value of retirees is much underestimated by economists. They are often primary carers for their grandchildren allowing both parents to work without the substantial cost of day care.

      30-odd years ago, sure (it certainly was true for me).

      Today, I question whether many are in a position to do this when most people have to relocate from where they grew up to find work.

      • Or when the grandparents choose to relocate to another state for lifestyle reasons…and then complain we don’t spend our own hard earned to fly the kids up to see them!

    • This is the tip of the iceberg in terms of a general ignorance of the economic profession to ‘home production’ or informal production.

      If only grandparents billed their children for child-minding, and these same children billed their parents for programming their VCR (or teaching them iPad, mobile phone etc), then we would all be better off because measured GDP would be higher.

      My kids grandparents are worth a mint.

    • Most boomers want to Spend the Kids Inheritance and I suspect are too busy living their Grey Nomad dream to care about child care.

  13. Another serious inter-generational inequity has occurred; the introduction of strict urban growth containment and levying of charges upfront for infrastructure for development instead of pay-as-you-go. This translates into capital gains for all incumbent property owners, at the expense of everyone who buys their first one.

    Robert Bruegmann called this “the greatest inter-generational wealth transfer in history” and I think he was right. The transition in superannuation funding is the second-greatest.

    • Would agree with this. The problem is that there were a multitude of these transitions all occuring at the same time:
      1) Introduction of infrastructure levies started around 1990 and expanded in early 2000s;
      2) Compulsory Superannuation started in 1992 and was expanded through Howard’s years in power;
      3) HECS was introduced in 1989 and raised during Howard’s years.

  14. Current production always sustains the current population.

    It is as simple as that. Barring some exceedingly wise long term storage of food like the Egyptians did, there is simply no other way of abstracting the process of the current workers sustaining everyone.

    This means that no matter how your super is allocated, someone, somewhere who is currently working is paying for your retirement.

    Want proof? Simple. Here’s a though experiment.
    Imagine a few years of poor harvests. Global food supplies have dwindled. There is widespread famine in poorer nations. Wealthier/luckier nations have all but banned food exports. Food is being rationed in some countries and is increasingly expensive on the black market.
    (Before you state that this scenario is unlikely, remember that Russia banned the export of wheat recently. Other nations barred their staples from being exported. It will only take about 3 bad years before we’re suffering at this level.)

    Ok, so now imagine you’re an asset rich retiree. Your plan is to sell assets to fund your retirement. What happens to the price of your assets in this environment?

    Well, rationally, it would play out like this: The people in the best position to purchase your assets are choosing instead to focus on survival. They’re stocking up on canned food and grains with what little extra income they have. They’re not looking to buy assets. They’re looking to ensure they outlast everyone else. Many of them have given up on housing all together, instead, they are living in vehicles/tents.
    All markets in this scenario will crash.
    Assets are meaningless if you’re starving.

    Thus, superannuation is a complicated abstraction process that assumes the future will be much like the past.

    I’m not saying it’s a trap, but it’s not a panacea either.

    Personally, I like the idea of our race using some massive container ships moored near Antarctica/Arctic for food storage. Free cooling. Extremely long term storage. Retrievable fairly quickly.

    The Egyptians knew the weather was unreliable. We’ve forgotten this due to our ability to ship goods. I think just-in-time manufacturing of food will bite us at some point.

    • You sound like a natural Surivalist, Myne.

      Although I think you use a bit of an extreme example, your point that someone, somewhere is paying for your retirement, is (in nearly all cases) correct.

      It’s an exceedingly basic point that most people (and economists, and asset managers) tend to forget.

      On the matter of food supply; people tend to see the solution to an ageing population (living longer, with less taxpayers to foot the bill) as a population increase. Obviously this perpetuates the problem, while increasing the number of mouths to be fed & reducing available supply of arable land. In the long-run it’s unsustainable.

      It would be much better for us (socially & environmentally) to bring population “growth” to 0%. We could theoretically do without detriment to the greater population by increasing asset transfer taxes at death (there have been numerous studies in the US that show assets transferred through the generations rarely make it past the second hand-down (i.e., third generation)…all it does it breed one or two generations with a sense of entitlement)

  15. Many ignore the demographics that Keating etc. identified in the 80s whereby an inter generational competition for public resources started exemplified by introduction of super and fee paying international students, as more public resources would go to pensions and health care with ageing populations. This also meant less tax payers for each retiree, or in other words a pay as you go system would place an intolerable burden upon younger generations already who are now expected to pay up front for services previously viewed as free. One can see pay as you go pension systems bankrupting public entities, companies and governments in Europe, many would envy Australia and its superannuation system, not perfect but in a generation’s time (I now bit too long term for most in Oz) most will thank the forsight of 80s politicians…..

    • It’s not really the payg nature of the welfare bankrupting Europe really is it? It’s the gross largess of these welfare systems that have evolved to pander to lobby groups and buy votes combined with the epic stupidity of the political classes.

      Australia may still find itself in that spot, and possibly would be there right now if not for the absolutely epic terms of trade.

      Super will just be a another big pile of cash for the idiot politicians to tax when required.

  16. Agreed pre-funding of retirement doesn’t change the fundamentals, it is always the working generation paying an income to the retired generation.

    Pre-funded or not, the key is the working generation needs to be of sufficient size to be able to afford to pay a reasonable income to the retired generation.

    Alas the fundamental problem … Western governments have without exception failed dismally to deal with the changes in life expectancy and falling birth rates.

    So we’ve got a huge cohort moving into retirement and a small cohort moving into working age.

    I personally am very pesmistic that Democracy’s can actually deal with this problem. Grey voting power means no party dares start to tackle the issue until it is too late.

  17. ‘it is always the working generation paying an income to the retired generation.’

    That’s not exactly true. If the savings of the older generation were spent on investment then, in that sense, the retired generation has paid for itself.

    Unfortunately as a boomer i have to say that we inherited good infrastructure; we were left good space in our cities by wiser men who went before us; yet we have spent it all and then some. We have not done the same, as our forefathers did for us, for future generations.

    • flawse
      It is not to late! Reverse mortgages provided exclusively by the state, land tax and raising the gst will all help.