Approach to retirement income
Australia has an inconsistent approach to its retirement income system. Policy related to the accumulation phase is based on the premise that many people underprovision for their retirement and are prone to behavioural biases, which motivates the use of default and compulsion arrangements. The policy settings for the decumulation (or drawdown) phase generally take a more laissez-faire approach. There is an implicit assumption that individuals have the capacity and options available to them to manage their income and risks in retirement.
A large body of evidence in behavioural economics — much of which has emerged since the Wallis Inquiry — demonstrates that poor outcomes can emerge from complex decision making at critical junctures, such as for retirement. Making decisions to manage income and risks in retirement is complex, even for people with specialised financial training. As stated in the Consumer outcomes chapter, affordable and high-quality financial advice can bring significant benefits for retirees, and the quality of financial advice could be improved.
If superannuation benefits are not transformed into retirement income streams effectively, taxpayers ultimately carry significant risk in the form of higher Age Pension costs.
Australia faces a significant demographic challenge. The number of people aged 75 or older is expected to rise by 4 million between 2012 and 2060; this represents an increase from about 6½ to 14½ per cent of the population.1 The ageing population and higher life expectancy is expected to result in lower workforce participation rates, which will tend to lower the trend rate of growth in the economy and raise costs for governments.
The life expectancy of Australians is among the longest in the world. For the first half of the 20th century, life expectancy for 65-year-olds was broadly constant, but it has increased by one to two years each decade since the 1970s. Life expectancy at age 65 is forecast to increase further (Chart 8.1). In 2014, the most commonly used life expectancy measure for a 65-year-old male is about 20 years.2 However, because of likely future improvements in longevity, 22 years is a more realistic estimate.3
Chart 8.1: Life expectancy of a 65-year-old Australian male
Source: Australian Government Actuary.4
The ageing population presents a major challenge for the financial system. Australia needs a suitable range of financial products and services to enable a greater number of individuals to manage income and risks in retirement and to help manage the transition from work to retirement.
The ageing population also has implications for government finances. This will contribute to higher government costs from the Age Pension, health and aged care.
The growing size of retirement assets
The volume and proportion of superannuation assets held by retirees is forecast to increase substantially (Chart 8.2). This growth is due to the maturing superannuation system and population ageing.5
Chart 8.2: Superannuation assets in the retirement phase
Source: Rice Warner.6
Currently, Australians who wish to convert their superannuation assets into an income stream within the tax-advantaged superannuation environment largely have the choice of two products:
- Account-based pensions account for at least 94 per cent of current pension assets.7 They allow retirees to choose their investment strategy. People can decide how much to draw down (subject to prescribed minimums), and they can make a lump sum withdrawal at any time. Most people draw down the minimum amount.8, 9 Account-based pensions are offered by superannuation funds.
- Annuities provide a guaranteed regular income stream for an upfront lump sum payment or a series of smaller payments. Retirees receive income over a specified time horizon (fixed-term annuities) or for the remainder of their life (lifetime annuities). ‘Indexed annuities’ protect this income from the effects of inflation. Annuities are sold by life insurance companies.
The current dominance of account-based pensions over annuities is due to a range of factors, including the flexibility of account-based pensions, which allow both lump sum withdrawals and residual assets for bequests, the perceived lack of value provided by annuities, and the fact that individuals can rely on the Age Pension to help manage longevity risk.
A striking difference between Australia’s retirement income market and those of other developed countries is the size of its annuity market. According to the OECD, the size of Australia’s annuity market is only around 0.3 per cent of GDP, compared with 28.8 per cent in Japan, 15.4 per cent in the United States, and more than 40 per cent of GDP in some European countries.10, 11 The Government bears much of Australia’s longevity risk by providing the Age Pension, which contributes to the low demand for longevity-protected income products.
Implications for funding the economy
The investment allocations underlying income stream products can affect aggregate demand for different assets and the depth of certain markets. This will become increasingly important as retirement assets increase. Current retirement income products invest in different ways:
- Individuals with account-based pensions typically invest in portfolios that are evenly split between growth and defensive assets.12
- Annuity liabilities are used to fund assets that are predominantly invested in fixed income investments, although a portion of these assets are infrastructure and property investments with appropriate characteristics, such as providing regular cash flows.13
1 Productivity Commission 2013, An Ageing Australia: Preparing for the Future, Productivity Commission, Canberra.
2 Life expectancies are usually reported as ‘period’ life expectancies. Period life expectancies take into account improvements in mortality that have been observed to date but not projected future changes to mortality. They may therefore understate life expectancies.
3 Australian Government Actuary 2014, data provided to Financial System Inquiry, 21 May 2014.
4 Commonwealth of Australia 2009, Australian Life Tables 2005–07, Canberra. ‘Period’ life expectancies using 25-year mortality improvement factors.
5 The superannuation system could be considered mature when retirees have benefited from contributions at the maximum Superannuation Guarantee rate over their entire careers.
6 Rice Warner 2014, Ageing and capital flows, commissioned by the Actuaries Institute for the Financial System Inquiry.
7 Plan for Life 2014, data provided to Financial System Inquiry, 23 June 2014.
8 Rothman, G and Wang, H 2013, ‘Retirement income decisions: Take up and use of Australian lump sums and income streams’, paper presented at the 21st Colloquium of Superannuation Researchers, Sydney, 9–10 July.
9 The minimum drawdown rate to qualify for the tax exemption on earnings currently ranges from 4 per cent for those aged under 65 to 14 per cent for those aged over 95.
10 OECD 2013, ‘Survey of Annuity Products and their Guarantees’, paper presented at the Insurance and Private Pensions Committee meeting, Paris, 5–6 December.
11 The OECD defines size as the amount of assets backing products (where dedicated or separated accounts back the products) or technical provisions or reserves.
12 Rice Warner 2014, Ageing and capital flows, commissioned by the Actuaries Institute for the Financial System Inquiry.
13 Plan for Life 2014, data provided to Financial System Inquiry, 18 March 2014.