Policy options for consultation
Perspectives on retirement income policy options
A number of reviews, and other countries, have found that a retirement income system should provide a guide to retirees for managing longevity risk and achieving outcomes that suit their individual circumstances, regardless of their level of financial literacy, engagement or superannuation balance.
As a general principle, major changes to the retirement income system need to consider the policy settings in the tax and transfer system. These settings are outside the scope of the Inquiry’s Terms of Reference.
The Super System Review
The Super System Review Panel’s ten ‘Super policy principles’ included the following:
Financial literacy is an important long term goal, but a compulsory superannuation system cannot depend on all its participants having the skills necessary to comprehend complex financial information or being investment experts.39
The OECD roadmap
- Encourage annuitisation as a protection against longevity risk
- Promote the supply of annuities and cost-efficient competition in that market
- Develop appropriate information and risk-hedging instruments to facilitate dealing with longevity risk
- Ensure effective communication and address financial illiteracy and lack of awareness
These recommendations provide a guide only. For example, as discussed later in this chapter, there are products other than annuities that provide longevity protection. The elements of the roadmap mentioned above have not been implemented in Australia.
Australia is unusual in neither mandating nor encouraging the use of income streams with longevity protection in retirement (Table 8.2). Information provided to the Inquiry by Centre of Excellence in Population Ageing Research (CEPAR) notes that Australia “is the only developed economy with mandatory retirement saving to have no decumulation structure”.42
|Country||What are the requirements, if any, where a retirement benefit from a defined contribution (DC) plan is to be taken as an income stream?|
|Australia||There is no requirement to take an annuity but for those who convert their benefit into a tax-advantaged drawdown product, there is a minimum drawdown each year based on the member’s age.|
|Canada||In most circumstances, the benefit from a registered DC plan must be transferred to a locked-in retirement account, a Life Income Fund (LIF) or an annuity. There are minimum and maximum withdrawal amounts from the LIF, which take into consideration the member’s balance and age.
There is no requirement for Registered Retirement Savings Plans but for those who convert their benefit into a tax-advantaged Registered Retirement Income Fund, there is a minimum withdrawal percentage based on age.
|Chile||All benefits must be converted into a life annuity or a programmed withdrawal product, except for any portion of the benefit that is above the specified maximum.|
|Denmark||The tax rules provide no limit on the contributions paid into a DC plan if the benefit is taken as an annuity. However, there is a limit on the contributions if the benefit is paid out as instalments for a period of between 10 and 25 years. Contributions for other forms of benefits cannot be claimed as a tax deduction.|
|Netherlands||All retirement benefits must be converted into an annuity. Annuity payments are fixed but may be increased if profit sharing results allow for it. Several annuity options are available at retirement.|
|Singapore||The retirement benefit is converted into a life annuity if it is above a prescribed minimum. Amounts above the prescribed maximum do not need to be converted.|
|Sweden||All retirement benefits from a DC plan must be converted into an annuity, which could be a life annuity or a fixed term annuity, depending on the options available from the insurance company. However, the individual bears some risks as the insurance company can vary its assumptions and payments, even after the payments have commenced. Some policies guarantee a return of premiums.|
|United Kingdom||Following recently announced changes, from April 2015 up to 25 per cent of the accumulated retirement benefit may be taken as a tax-free lump sum. The remainder can be withdrawn as a lump sum (taxed at the individual’s marginal tax rate), or taken as an annuity or other drawdown product.|
|United States||There are no requirements for DC plans (such as 401(k) plans) to provide annuities or income stream products.|
A spectrum of policy options
Policy settings should ensure that retirees can manage their accumulated balances in a way that improves retirement income and risk management, without transferring an excessive amount of longevity risk to the Government.
A spectrum of policy options is available to achieve the objectives of the retirement income system and position Australia to manage its demographic challenges better (Table 8.3). There are policy trade-offs along the spectrum between the degree of individual flexibility and freedom, and the benefits of effective pooling of risks.
This spectrum does not consider alternative approaches that involve more fundamental changes to the retirement income system, such as to the Age Pension.
Table 8.3: A spectrum of policy options for superannuation in retirement
A major theme of this chapter is how the retirement income system does not meet the risk management needs of many retirees. Potential improvements to the status quo, which do not necessarily involve fundamental changes to the system, include:
- Improving financial advice provided to individuals prior to retirement — as discussed in the Consumer outcomes chapter, affordable and high-quality financial advice can bring significant benefits for retirees.
- Removing barriers to developing new income products — as discussed later in this chapter.
The taxation and social security systems could be used to create strong incentives for retirees to take superannuation benefits as income streams that help manage longevity risk. There are already tax settings in place to encourage superannuation benefits to be taken as income streams, but these streams are not necessarily longevity protected. The Actuaries Institute submission notes:
Given that the taxpayer ultimately bears the risk related to how individuals access and invest their retirement savings, it is reasonable that the Government proposes various incentives and/or restrictions on how superannuation fund assets can be drawn down.44
It may be appropriate to have policies that discourage lump sums. Several submissions recommend restricting or discouraging lump sum benefit payments. For people with very small superannuation balances, lump sums may be the most appropriate way to draw down their benefits.
To be effective, the tax and social security implications of decisions may need to be significant. The fiscal costs of additional incentives would need to be appropriately targeted and offset by savings elsewhere to avoid increasing the overall cost of the retirement income system to Government.
Defaults could be introduced to the retirement phase of the system, potentially in conjunction with policy incentives. The Government could require that part of an individual’s accumulated superannuation benefits be directed into a non-commutable income stream that provides protection against inflation and longevity risk, unless the individual opts-out. Potential products that could be appropriate defaults are discussed later in this chapter. Default arrangements could differ based on the size of the account balance, or other individual circumstances.
Defaults have powerful effects on decisions and can address the issue of low levels of financial literacy among retirees. One Australian experiment, which looked at the effect of default options on individuals allocating savings between account-based pensions and annuities, found that the distribution of allocations to annuities was strongly clustered around the default proportion (Chart 8.5).45 Pension schemes with annuities as the default option tend to have high rates of annuitisation.46 These findings are consistent with the high proportion of Australian employees who are members of their employers’ chosen default superannuation fund.
Chart 8.5: Proportion of assets taken as an annuity with different default arrangements
Source: Bateman et al.47
The World Bank recommends “countries that offer a constrained choice to retiring workers and do not mandate the use of a single retirement product for all should also specify the product that will be used as the default option. This will help workers who are unable or unwilling to make a decision on their own and will protect them from abusive selling practices of brokers and selling agents of providers”.48
The Super System Review recommended that default MySuper products should be ’whole of life‘ by incorporating a retirement income stream product.49 Under the recommended arrangement, trustees would consider longevity, inflation and investment risks in selecting a product. However, the previous Government decided that MySuper products would only cover the accumulation phase initially, so MySuper retirement benefits can only be paid as lump sums.
Default arrangements have other drawbacks. Since individuals can opt out, there remain incentives for retirees with small- and medium-sized balances to deplete assets early in their retirement and fall back on the Age Pension.
Then there is the difficulty of choosing default arrangements. No single product, or suite of products, meets all the needs of all retirees. ASFA’s submission notes the difficulty of setting up a system that suits all individuals due to the “complex maze of tax, social securities and savings interactions”, which differ depending on personal circumstances.50
The Government currently mandates contributions into superannuation for a significant majority of Australian workers. At retirement, it could also require that all or part of superannuation benefits be moved into a non-commutable income stream that provides protection against inflation and longevity risk.
If annuities were selected for mandatory take-up, this would address adverse selection problems and should reduce their price. Research into annuity prices in the United Kingdom found that the effects of adverse selection in compulsory annuity markets are substantially lower than in voluntary annuity markets.51
If longevity protection were to be mandated, deferred products (discussed later in this chapter) may be appropriate. CEPAR notes some of the benefits of mandatory purchase of deferred lifetime annuities.52 They include:
- The low amount of information asymmetry between retirees and providers regarding individual circumstances projected 20 or 25 years into the future
- A definite time horizon in which to use other assets to fund retirement
- Reduced problems associated with cognitive ability at older ages
A strong argument against compulsion is that it restricts the ability of individuals to tailor their retirement plan to suit their specific needs. This could result in worse outcomes for some retirees. Rocha and Vittas advise against mandating a high level of annuitisation, noting the benefits of a portfolio of retirement income products.53 CEPAR notes that “[i]ndividual circumstances are far more heterogeneous in later life than they at earlier life stages, and mandate design can therefore be challenging”.54 Indeed, the United Kingdom has announced reforms that, once implemented, will remove the effective compulsory annuitisation of privately accumulated retirement balances.
There are also concerns that a compulsory system would disadvantage groups in the community with lower-than-average life expectancies. However, this issue could be managed through product design. For example, in the United Kingdom, ‘enhanced’ or ‘impaired’ annuities, which pay higher incomes for the same purchase price, are available to people with certain medical conditions that lower their life expectancies.
There are trade-offs between individuals having more freedom and flexibility to decide how to draw down their benefits, and ensuring that the system facilitates effective risk management through pooling, which would more effectively deal with:
- Low levels of financial literacy and awareness
- Behavioural biases preventing retirees from purchasing longevity protection
- The Government’s exposure to longevity risk
Ideally, the retirement income system should facilitate individuals achieving the mix of income, risk management and flexibility appropriate to their circumstances, given their level of accumulated assets.
The Inquiry would value views on the costs, benefits and trade-offs of the following policy options or other alternatives:
A spectrum of options to achieve the objectives of the retirement income system and position Australia to manage the challenges of having an ageing population:
- Maintain the status quo with improved provision of financial advice and removal of impediments to product development.
- Provide policy incentives to encourage retirees to purchase retirement income products that help manage longevity and other risks.
- Introduce a default option for how individuals take their retirement benefits.
- Mandate the use of particular retirement income products (in full or in part, or for later stages of retirement).
39 Commonwealth of Australia 2010, Super System Review Final Report, Part One, Overview and Recommendations, Canberra.
40 OECD 2012, The OECD roadmap for the good design of defined contribution pension plans, OECD, viewed 12 June 2014.
41 Financial literacy and disclosure are discussed in the Consumer outcomes chapter.
42 Centre of Excellence in Population Ageing Research 2014, data provided to Financial System Inquiry, 10 June 2014.
43 Mercer 2013, Melbourne Mercer Global Pension Index, Australian Centre for Financial Studies, Melbourne (with the information for the United Kingdom updated following a change to arrangements there).
44 Actuaries Institute 2014, First round submission to the Financial System Inquiry, page 8.
45 Bateman, H, Eckert, C, Iskhakov, F, Louviere, J, Satchell, S and Thorp, S 2013, ‘Default and 1/N Heuristics in Annuity Choice’, School of Risk and Actuarial Studies Working Paper 2014/1.
46 Benartzi, S, Previtero, A and Thaler, R 2011, ‘Annuitization puzzles’, The Journal of Economic Perspectives, issue 25, vol 4, AEA Publications, Pittsburgh, pages 143–164.
47 Bateman, H, Eckert, C, Iskhakov, F, Louviere, J, Satchell, S and Thorp, S 2013, ‘Default and 1/N Heuristics in Annuity Choice’, School of Risk and Actuarial Studies Working Paper 2014/1.
48 Rocha, R and Vittas, D 2010, ‘Designing The Payout Phase Of Pension Systems: Policy Issues, Constraints And Options’, World Bank Policy Research Working Paper 5289, The World Bank, Washington.
49 Commonwealth of Australia 2010, Super System Review Final Report, Part One, Overview and Recommendations, Canberra.
50 Association of Superannuation Funds of Australia 2014, First round submission to the Financial System Inquiry, page 32.
51 Finkelstein, A and Poterba, J 2002, ‘Selection Effects in the United Kingdom Individual Annuities Market’, The Economic Journal, issue 112, Wiley, Oxford, pages 28–50.
52 Centre of Excellence in Population Ageing Research 2014, data provided to Financial System Inquiry, 10 June 2014.
53 Rocha, R and Vittas, D 2010, ‘Designing The Payout Phase Of Pension Systems: Policy Issues, Constraints And Options’, World Bank Policy Research Working Paper 5289, The World Bank, Washington.
54 Centre of Excellence in Population Ageing Research2014, data provided to Financial System Inquiry, 10 June 2014.