Audit commission must cut retiree entitlements

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By Leith van Onselen

The Australian’s David Uren has published an article today imploring the newly established Audit Commission to tackle Australia’s ballooning pension payments, which are projected to skyrocket as the baby boomers enter retirement, as well as to address the sustainability of the superannuation system:

At the top of the list [for reform] is the $40bn annual cost of the age pension…

The last intergenerational report said pension costs would rise from 2.7 per cent of GDP now to 3.3 per cent within about 15 years and to almost 4 per cent by 2050…

There is a paucity of research on what people actually do with their superannuation. Anecdotally, the story is that a portion of lump sums gets spent on renovating the house, consumer durables and travel. This spending lifts living standards for retirees while improving their eligibility for the age pension. No one really knows how much disappears this way.

A new research paper drawing on work of actuaries Towers Watson and the Melbourne Institute shows that 95.8 per cent of singles and 88.1 per cent of couples will wind up drawing the age pension, either in full or in part…

The faster the superannuation lump sums are run down, the greater the burden on the age pension becomes…

The 1996 audit commission suggested that the way to constrain the burden of an ageing population was to reduce the generosity of the indexation of the age pension and make it dependent on budget conditions. Instead, the Howard government legislated the link to male total weekly earnings earnings, deftly exploiting the political potency of the retired population. Kevin Rudd sought to follow suit by awarding a big one-off increase to pensions in his first budget.

This is the terrain that the new audit commission must navigate if it is to confront the impact that ageing is having on the budget, as required by its terms of reference.

Earlier this year, Australian National University’s Alan Tapper, Alan Fenna and John Phillimore released a fantastic research paper examining the extent to which welfare policies across the period 1984 to 2010 have favoured the elderly at the expense of the young. Their three main findings were that:

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  1. there has been a substantial shift over this period in favour of the elderly;
  2. this trend has accelerated rapidly in recent years under both the Howard and Rudd Governments; and
  3. as a result of this accelerated trend, elderly households today are on average well off by comparison with younger households.
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What stands out is the recent surge in net benefits, which took place mostly under Coalition government. Critics might argue that in this period the long Australian tradition of relative restraint on expenditure on the elderly, under both Labor and Coalition, was here abandoned…

Perhaps most alarmingly, the study found that the bulk of assistance provided to the elderly is not based on need, but purely aged-based, with elderly Australians tending to be quite well-off when compared against younger Australians:

We might suppose that increasing support for the elderly is an expression of increased recognition of need. To test this claim we need to be able to rank ‘neediness’. This can be partly done in terms of ‘equivalent final incomes’… Table 6 shows the equivalent final incomes of the elderly and all households. Note that this table exaggerates the increase in EFI between the two surveys, because here the EFI for 2003–04 has not been adjusted by the CPI. The point of the comparison is not the relative change between 2003–04 and 2009–10 within each group, but the gains and losses of the different groups relative to each other in this period.

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…the most interesting comparison is that with all households. Rapid gains to the elderly in this period have brought them close to the EFI for all households. The gap in 2003–04 stood at about 21 per cent (based on an estimate that the EFI for all elderly households was about 505). In 2009–10 it had fallen to only about five or six per cent (estimating that the elderly EFI was about 960)…

As Table 7 shows, wealthier households are older households. Net worth peaks at around age 60. A sharper picture is obtained if we take household size into account using equivalence scales. Here we have used the square root of household size (a method that approximates quite closely to the ‘OECD modified’ scale used by the ABS to calculate equivalent final incomes). The resulting ‘equivalent net worth’ indicates that even households aged 75 and over are one-third better off than the mean for all households, while households in the 65–74 age group are 60 per cent better off than the mean…

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Given that equivalent final incomes for the elderly are now close to the average for all households, and that the net-worth distribution is skewed in favour of older households, we can reasonably infer that an integrated measure would show that households headed by persons 65 and over are better off than the average for all households under that age.

If all this is right, the Australian system of social transfers to the elderly is much more than a safety net. Viewed in ‘lifecycle’ terms, it shifts resources from the income-rich but asset-poor stages of life to the asset-rich but income-poor stage. Viewed in terms of the ‘vertical’ dimension, it is a system of upwards redistribution from the less well off to the better off…

Clearly, Australia’s system of transfers and entitlements is unsustainable – given the shrinking pool of workers that will be called upon to fund non-workers (see next chart) – but also inequitable – given that too much assistance is provided to those that are not in need.

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So what, then, could the Commission of Audit recommend to put Australia’s system of tranfers, and the Federal Budget, back on track?

First, Australia’s superannuation system needs to be overhauled to ensure that tax concessions are more evenly spread and balances are not exhausted too quickly, so that fewer retirees fall back on the aged pension.

Currently, super tax concessions cost the taxpayer about $32 billion a year, according to Treasury, with the bulk of those going to middle and upper income earners. At the heart of the issue is the 15% flat tax on superannuation contributions, where the amount of super concessions rises as one moves up the income tax scale, resulting in a system whereby higher income earners receive the most super tax benefit, despite being the very people that are the least likely to rely on the aged pension in retirement. Replacing the 15% flat tax with a flat 15% concession, for example, would greatly improve the equity and sustainability of the system by: 1) providing all taxpayers with the same taxation concession; 2) boosting lower income earners’ super savings and thus reducing reliance on the aged pension; and 3) reducing overall costs to the budget.

In a similar vein, incentives should be changed to discourage an individual from retiring at 60, withdrawing their super tax free as a lump sum, blowing the money on consumption, and then going on the aged pension from 65 years of age. Taxing superannuation lump sums, whilst at the same time encouraging retirees to withdraw their savings as a annuity (instead of the pension), are essential reforms that would improve the system’s equity and longevity.

Finally, means testing of the aged pension must be tightened to ensure that it only goes to those retirees most in need. Under current arrangements, fore example, an individual living in a $2 million home but with little in the way of financial assets is entitled to the full pension, despite being “wealthy”. The situation is both unsustainable and inequitable, requiring the owner-occupied home to be included in means testing of the pension.

Ultimately, with Australia’s population ageing as the large baby boomer cohort shifts into retirement, and Australia facing a falling proportion of workers supporting retirees, root-and-branch reform of both superannuation and the pension will have to be pursued. Let’s hope the Audit Commission is up to the task.

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About the author
Leith van Onselen is Chief Economist at the MB Fund and MB Super. He is also a co-founder of MacroBusiness. Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.