In this post we measure the fairness of the Australian Retirement Funding system using a common-sense metric. One of the challenges in working out if any retirement funding system is fair or not is coming up with a measure of “fairness”. However, there is an immediately obvious choice.
We look at the lifetime amount of tax paid as a percentage of the overall lifetime income received. We do this with and without consideration to benefits (we consider the Age Pension a negative tax when considering benefits). A fair system might be one in which the ratio of the percentage of tax paid over a lifetime to the percentage of tax paid as part of your annual salary while working is similar across income levels.
The Australian system is often criticized for favoring the well-off and we intend to see if this is the case. Prior to commencing this post, I suspected that the Australian system does indeed favour the rich, mainly because contributions are pre-tax with a flat rate contributions tax of 15%.
Assumptions
We will make certain assumptions during this analysis. We will assume that the person under analysis is single, works from the age of 22 until 66, makes 100% of their income from the age of 32 until 66, 50% at 22 increasing to 55% at 23, 60% at 24 etc. We assume a pre-tax contribution rate of 9.5%. We assume that the person plans to live to 90 and in retirement spends a fixed amount each year which results in Super running out at 90. We assume a standard real Super return rate of 6%. We assume no inflation and no wage growth/Standard of living increases. We assume tax rates as of May 2019 remain the same. We assume that there are no additional contributions to Super beyond the statutory requirements and there are no additional income producing accumulated assets. We assume accumulation mode earnings tax of 8%.
We also assume that Super is not drawn down until retirement age (66) and if the Super accumulation account exceeds $1.6M at any time prior to retirement concessional contributions continue to be made to Super until 66. At 66 a maximum of $1.6M is transferred to the Pension mode account. At this stage when we draw a retirement income the minimum amount is removed from the pension account (as per Super rules) and the maximum from the accumulation account. When the accumulation account reaches an amount where it is more sensible to invest in a vehicle outside super (i.e. when it can be expected that total tax is less than 15%), we move funds from it into an investment account with the same earnings profile as Super. We have not made use of SAPTO for this analysis.
We assume there are no tax minimization schemes to reduce taxable income both when working and in retirement. That is no negative gearing, family trusts, company tax rates etc. Maybe these will be shutdown soon. These schemes may introduce unfairness, but they are not part of the retirement funding system and their unfairness should be assessed as a separate exercise.
These assumptions could be made more realistic at the expense of more complexity. However, the purpose of this exercise is to get a rough understanding of the fairness of the system and further refinements are not expected to make a great deal of difference.
Amount of Tax Paid as percentage of overall income
In this section, we will look at the ratio of the percentage of tax you pay over your lifetime to the percentage of tax you pay when employed over the course of a year. We might consider a system fair if this ratio is independent of income.
The diagram below shows the amount of tax paid by a Tax payer as a percentage of their wage (exclusive of Super). As you can see, the system is progressive; the more you earn the higher tax percentage you pay.
Now let’s work out this statistic for each income level:
Lifetime Tax Paid / (Lifetime Tax Paid + Lifetime spendable income received).
This is a measure of the amount of Tax you have paid in your lifetime as a percentage of your total lifetime income.
We’ll also work out this statistic:
(Lifetime Tax Paid – Age Pension Received) / (Lifetime Tax Paid + Lifetime spendable income received)
This is a measure of the amount of lifetime Tax you have paid less any subsidies (in this case the Age Pension) as a percentage of total lifetime income.
You can see that the lifetime rate of tax is lower that the rate incurred by the tax payer during their working life. We might have expected this as very little tax is paid in retirement (although some is under our assumptions, as not all funds can be moved to the tax free Pension account when the total super balance exceeds 1.6M).
Let’s now look at the ratio of the percentage of tax paid during your lifetime versus the percentage of tax paid when working.
We have done this below for tax and also tax less benefits.
That is we we look at these ratios:
(Lifetime Tax Paid / (Lifetime Tax Paid + Lifetime spendable income )) / (Annual Tax Paid when working/ Annual income when working exclusive of Super)
and
((Lifetime Tax Paid – Lifetime Benefits) / (Lifetime Tax Paid + Lifetime spendable income )) / (Annual Tax Paid when working/ Annual income when working exclusive of Super)
You can see that once we take into account Age Pension benefits, the higher your salary, the higher the ratio of your lifetime tax percentage to Salary Tax percentage.
Using the metric that we described at the beginning of this section, we can again consider the Australian retirement funding system to be fair.
Yearly Spend After Retirement Versus Prior to Retirement
We can also compare an individual’s post-tax pre-retirement income with their income in retirement. If the multiple is independent of income, this sounds like it might be a reasonable measure of fairness. However, it’s not quite as good as the original measure. Just because a person had a high income during their working life doesn’t mean they are entitled to a high income in their retirement. The sums need to add up.
We can see what this multiple actually is though.
It turns out that, if you contribute the 9.5% each year and work between 22 and 66, your retirement income will be about 50% higher than your working life income (even more for low income retirees due to the pension)!
Here is the diagram showing the multiple of income in retirement versus peak working life income (after tax and after super) with and without the 1.6M transfer-to-pension-mode limit.
You can see that that:
- If you have a low income, your retirement income multiple is quite a bit higher than other income multiples. This is due to the Age Pension.
- If you have a pre-tax super inclusive income of above about $100K, your retirement income multiple is between 1.5 and 1.6 for all incomes up to the maximum ($250K). High income earners appear to start being advantaged towards the higher end of the multiple at around $200K.
- The people with the worst outcome are earning about $100K – $140K.
- The 1.6M limit change disadvantages high income earners, but not significantly.
This is a strange result as we would expect high income earners to be significantly advantaged due to the fact that their Super contributions come from pre-tax income, and therefore not subject to progressive taxation. We would expect them to have a significantly higher multiple of their post tax income.
Let’s look at what happens if we remove the Age Pension and the 1.6M limit.
You can now see the effect of the pre-tax contributions by the people with higher incomes. Without the Age Pension, using our metric the system is definitely unfair with retirement income increasing as a percentage of pre tax income prior to retirement. The Age Pension (and to a smaller degree the 1.6M limit) helps to make the Australian Super system considerably fairer.
Now, if we add in the Div293 tax change mooted by the Labour party (changing the limit for high income earners to pay 30% contribution tax from $250K to $200K), you can see that the system becomes even fairer:
In fact, changing to a value of $185K seems about right in terms of making the system the most fair using this measure:
If we add in the Pension mode Tax originally promoted by Labour (15% earnings tax for earnings over $75K in Pension mode), while being aware of the pitfalls in modelling this with a standard return rate (as described here), we get this diagram:
You can see that once an income of approximately $200K is reached, this measure doesn’t actually have an impact. This is because when Super accounts are high near retirement, a significant proportion is kept in the accumulation account (or other investment account outside super if it is more advantageous to do so). In order to minimize tax, we want to move as much out of this account as possible by using it for spending. The problem is we must withdraw 5% (between 66 and 74) of the Pension mode account. As this is being run down by the new tax, we can’t move this out as quickly resulting in more tax on the accumulation account.
What happens if we vary the return rate
We’ve assumed a 6% real return rate, which although a bit lower than the average Australian Super rate since inception, it’s still quite a bit higher than rates used in modelling exercises. Here are the results for some other rates.
You can see that the system advantages lower income earners more if we assume lower rates.
Challenges
We’ve seen that the Australian retirement funding system appears to be quite fair. However, this is not the way it is often portrayed in the media. Let’s look at some of this commentary and common arguments.
This article makes the following arguments:
MANY people would argue that it is fair enough that they get a tax deduction on their superannuation. After all, if you’re a wage earner then the government is making you put aside 9 per cent of your salary, and a higher percentage in the future – money you cannot get your hands on until you are at least fifty-five.
What that argument ignores, though, is the large-scale redistribution of wealth that is taking place within the superannuation system. In reality, it’s people on lower incomes who have a right to feel cheated. And if you’re young, you have a right to feel doubly dudded. The tax concessions are distorted not only in favour of people on higher incomes but also to advantage older generations.
The tax deduction for super operates like a flat tax, with contributions and interest earnings taxed at 15 per cent from the first to the last dollar of income. That means the deduction is worth much more to those on higher incomes, who pay marginal tax rates of 38.5 per cent and 46.5 per cent.
What this argument ignores is that when the Super system is combined with the Age Pension system (the two major pillars of the retirement system), people on lower wages are disproportionately advantaged. They achieve higher multiples of pre-retirement income in retirement, sometimes considerably so.
And this:
Treasury calculated last year that the top 1 per cent of income earners receive an average of $510,000 in retirement support from the government, all of it through tax concessions, compared to $250,000 for the bottom 10 per cent, almost all of it through the age pension.
What this also ignores is that the tax paid by the top 1% during their working life is enormously higher than the tax paid by the bottom 10%. The ratio of lifetime tax less benefits paid as a ratio of lifetime income again favours people on lower wages, with people on especially low wages paying negative lifetime tax.
And this:
The tax concessions discriminate between generations, too. Because superannuation income is tax-free from age sixty, once again, the higher your income, the more tax you save. As Bank of America Merrill Lynch economist Saul Eslake puts it, “I can’t think of any single policy reason, as distinct from a baser political motive, why people over the age of sixty or sixty-five should pay less tax on the same amount of income than people under the age of sixty-five.” The politics are driven by demographics: the rapidly rising numbers of baby boomers who are retiring. Over the next decade and a half, more than 60 per cent of the total assets of superannuation funds are expected to shift from pre-retirement accumulation accounts to retirement benefit accounts.
There is a good policy reason for not paying tax during the Super drawdown mode. The reason is that the present system (the system in which the Australian Age Pension system is combined with the Australian Super system) is already progressive. If the super drawdowns were taxed on exit, for example at salary earnings rates, while maintaining a flat tax on entry and a flat tax on earnings, the system would be extraordinarily progressive and a poor vehicle for building up wealth for retirement.
Conclusions
In this post we’ve proposed some metrics to assess the fairness of the Australian retirement funding system. We’ve also modeled the likely income available to persons in retirement with various salary levels and then applied the metrics to the resulting spending profiles.
The outcome is very surprising. The Australian retirement funding system, which I expected to unfairly favour high income earners is, when using the proposed metrics, unexpectedly fair. For salaries above about $90k, the regressive nature of Australian Superannuation is countered almost exactly by the progressive nature of the Australian Age Pension system. For salaries less than $90k, salary earners tend to be favoured.
This is good news for pending retirees as it should mean the system will be more stable and less likely to change. Less change makes it easier to plan.
In the next post we will look at some schemes used in different countries and compare these with the Australian system via the metrics described in this post.
Retiring early for Australians 