RDP 9603: Australia's Retirement Income System: Implications for Saving and Capital Markets Appendix A: Further Details

This Appendix gives additional details on some specific points relating to the operation of the previous and the new system in Australia.

A.1 The Previous System

Australia's previous system of official retirement income support consisted of two separate elements: the age pension which provided a basic level of benefits for most people, and tax-advantaged voluntary savings for retirement.

The Age Pension

Benefits

Australia has an age pension that provides a flat-rate income for retirees. The level of the pension has varied between 20 and 25 per cent of Average Weekly Earnings (AWE) over the past 40 years, and is currently around 25 per cent. The pension is indexed to the CPI and the government has committed to making irregular ad hoc adjustments to maintain the level at around 25 per cent of AWE. There are also various supplementary benefits available to age pensioners such as cheap public transport, telephone services and pharmaceutical benefits.

Eligibility

The age pension is available to men over 65 and women over 60 (although the eligibility age for women is being raised to 65 by 2014). The benefit is asset tested and income tested. Over time the stringency of the means testing has varied. Currently the assets test reduces the value of the pension by $3 for every $1,000 of assets above a threshold level ($118,000 for single people and $167,500 for married couples). The family home is excluded from the assets test although higher asset limits apply to non-owner occupiers (owner occupiers with homes worth more than $70,000 are better off under the test; the average house price is around $150,000). Income testing reduces the value of the pension by 50 cents for every dollar earnt above a fairly low threshold ($94 per fortnight for singles and $164 per fortnight for couples). When this interacts with the income tax system it can lead to quite high effective rates of marginal taxation.

Funding

The age pension is funded out of government consolidated revenue; there is no explicit tax for the provision of the pension. In 1994/95 the cost of the pension was $12.7 billion or 2.8 per cent of GDP. This proportion has been relatively stable over time, varying between 2 and 3 per cent of GDP.

Voluntary Superannuation

The other form of officially sanctioned retirement provision was voluntary superannuation: that is, savings for retirement that are concessionally taxed and inaccessible until retirement. These schemes could be either accumulation funds, with the final payment related to contributions plus earnings, or defined benefit schemes, where the final payment is related to final income. These funds invested in assets in much the same way as unit trusts and other professionally managed funds. Many of the funds were employer-sponsored and structured as an employment incentive. Defined benefit schemes tended to be weighted towards longer term service with the one employer, thus encouraging loyalty. The private sector schemes were all fully funded.

Public sector schemes, in contrast to private sector schemes, were predominantly unfunded. Voluntary employee contributions were paid into a fund and invested to earn income following a normal accumulation scheme. The government, however, did not pay anything into the schemes and met liabilities out of consolidated revenue as they arose. Current estimates of the net present value of these liabilities are around $100 billion for State and Federal schemes, or around 20 per cent of GDP.

Taxation Changes

Within this institutional framework the taxation arrangements were the main area that changed prior to the introduction of the SGC legislation. New taxation arrangements introduced mainly in 1983 and 1988 continue to apply under the SGC. In the early 1980s employer contributions to superannuation funds, employee contributions (up to a limit of $1,200, equivalent to around 9 per cent of AWE), and income on superannuation assets were tax free. Pension payouts were taxed as normal income, while lump-sum payouts had the first 5 per cent added to income for taxation in the year of payout with the remainder tax free.

In 1983 the status of employee contributions was changed to be no longer tax-deductible, and they thus had to be paid out of after-tax income. Other changes at that time primarily involved the taxation of lump-sum payments related to employer contributions and fund earnings. These were now taxed at 30 per cent. If the recipient was over 55 the first $55,000 were taxed at the concessional rate of 15 per cent. While tougher, these changes still involved a concessional treatment as earnings remained tax free. There were also grandfathering provisions that exempted pre-1983 contributions.

In 1988 the arrangements changed again. Employer contributions were now taxed at 15 per cent on entry to super funds (although they remained fully tax deductible to the employer). Employee contributions were still paid out of after-tax income. Fund earnings were subject to 15 per cent tax. Pension payouts were subject to normal income tax with a 15 per cent rebate, while lump sum payouts were subject to 20 per cent taxation or, for recipients over 55, $60,000 tax free and 15 per cent on the remainder. The lump sum component attributable to employee contributions was tax free. These provisions remain broadly in place subject to adjustment of the tax-free threshold.

Another change introduced in 1988 (and fully effective from 1994 after some transitional arrangements) was to revamp the Reasonable Benefit Limits (RBLs). This was aimed at encouraging people to take benefits in the form of annuities and thereby provide for their retirement rather than relying on the government pension. The RBL rules stipulate a maximum amount of superannuation that can benefit from concessional taxation (initially $400,000, to be indexed by AWE). Beyond this limit normal taxation (currently 48.5 per cent) is applied; this limit doubles if more than half of the payout is taken as an annuity. The limit is considered to be sufficiently high that it will only affect high income earners, at least until the new SGC scheme matures in around 40 years time.

Further changes announced in the 1996/97 Budget increase the tax on employer contributions to 30 per cent for employees earning more than $85,000. This higher tax rate is phased in for incomes between $70,000 and $85,000 and applies only to new contributions made after the announcement date.

A.2 Rules for the New System

The new system really begins with introduction of SGC legislation in 1991. However, the introduction of award superannuation in 1986 was an important precursor to this.

Award Superannuation

In 1985 the union movement argued for, and received, a commitment to establish a 3 per cent employer-funded superannuation benefit, in lieu of a similar general wage rise. This was implemented by inserting a requirement into employment awards that employers pay 3 per cent of wages into a nominated industry superannuation fund. Many different union-organised industry superannuation funds were created to receive the contributions, which are beginning to attain a significant size. As awards were renegotiated, the coverage of superannuation was increased to many more members of the workforce than had previously been the case. Nonetheless, the coverage of this scheme was not universal and, due to negotiation delays in some areas, not all union members received the benefits immediately.

SGC Legislation

In 1991 the government extended the coverage of superannuation to all employees by introducing the SGC legislation. The legislation mandated minimum levels of superannuation contributions by all employers on behalf of their employees. The levels were to start at 5 per cent (or 3 per cent for employers with a payroll of less than $500,000) and were scheduled to rise until they reached 9 per cent in the 2000/01 financial year. The government also flagged the possibility of raising contributions to 12 per cent through employee contributions at some later date. The structure of the legislation was that employers were not technically mandated to contribute to employee superannuation, but if they did not the government would impose a Superannuation Guarantee Charge of an equal amount through the tax system and then redistribute this to the employee. The SGC payments would not be tax deductible and would have an additional administration charge included. Thus, it would be cheaper for employers to make the superannuation contributions themselves.

Participation

Participation is mandatory in that employers are required to make contributions for all their employees, subject to some exemptions for part-time and casual workers who do not generate sufficient balances. These exemptions are made in order to reduce administrative problems associated with contributions of very small amounts. In all cases where people do not accumulate sufficient balances to fund their retirement, the age pension will continue to act as a safety net.

Contribution Rates

The required contributions are detailed in the table below.

Are Some Industries Subject to Different Rules?

Those industries which were subject to award superannuation continue to be bound by those rules. However, the levels of contributions required under the award are less than under the SGC legislation and, to that extent, subsumed. Nonetheless, the award provisions continue to govern the fund into which contributions have to be paid.

Voluntary Contributions

Individuals may make additional voluntary contributions. These are typically in the range 2 per cent to 10 per cent of salary. However, the taxation treatment of additional contributions is different to employer-provided superannuation as they have to be paid out of post-tax income. Contributions by the self-employed are essentially voluntary. Up to a threshold amount they can benefit from employer-treatment of their contributions for tax purposes. They can also qualify for the government co-contribution on any contributions as employees in line with the schedule.

Funds Management

The funds are generally managed by professional managers who are chosen by a board of trustees for each superannuation fund. The superannuation funds themselves are chosen by the employer, or negotiated with the employer as part of the award process. This led to the establishment of union-created ‘industry funds’ which cover many workplaces. It is also possible to appoint external trustees for a more ‘off the shelf’ type of superannuation fund.

Investment Restrictions

There are practically no restrictions on where the funds can be invested. The only significant one is that no more than 10 per cent of funds (at cost) can be invested in the business of the sponsoring employer. There are moves to reduce this to 5 per cent (of market value). In the 1960s and 1970s rules existed which required superannuation funds to invest a minimum of 30 per cent of their assets in government securities, but these rules are no longer in place.

Payouts

Benefits must be ‘preserved’, that is, made unavailable to the beneficiary, until age 55, subject to exemption in cases of hardship and some voluntary contributions which can be withdrawn on change of employment. Legislation is proposed to raise this to 60 years by 2025. Traditionally the most common form of benefit has been a lump sum. The more recent RBL provisions are aimed at encouraging people to take an annuity. The type of annuity purchased can be either a traditional annuity (which provides a given income for the rest of the person's life) or an allocated pension. An allocated pension pays an annual income based on investment earnings. The allocated pension is not guaranteed to last for the retiree's lifetime. The difference between these two products is that with an annuity the life assurance company bears the investment and mortality risk while with the allocated pension the retiree does. Thus, if a person with an allocated pension dies relatively early there may be a lump sum to be distributed to their estate. If a superannuation fund member dies before payout the accumulated contributions are paid to the estate and are tax free, regardless of the age of the beneficiary.

Life Insurance

Mandated life insurance or disability provisions do not exist. However, many funds offer these facilities, taking advantage of the fact they can obtain cheaper life insurance without the necessity of everyone having a medical (ie pooled life insurance cover). Disability insurance is also offered by some on a similar basis. This usually involves the employer paying an extra contribution to cover the cost of the insurance. These policies can pay benefits as either lump sums or annuities and the choice made will depend upon individual circumstances. Some schemes also provide annuities on retirement that will revert to surviving spouses if the retiree dies relatively early, but this is not a mandated requirement.