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Tuesday, 3 November 2015

Making Super work

In 'Not so Super' we learnt that our superannuation system is not meeting its design objectives. Even when projected to 2050 there is no increase in the number of retirees who will be fully self funded. This is despite paying greater proportions of their income into Super for an increasing number of years. At the same time the welfare burden of pensions on our national budget will increase, in real terms.

Why is it so?

What is wrong with our Super settings that results in this undesirable scenario? Lets look under the covers.

In the following calculations I have used ASIC Moneysmart Superannuation calculator. It takes into account current tax rates and super contribution rules. It uses a range of assumptions, see Table 1 below, that can be tweaked to meet an individual's specific conditions. For our current purposes, however, I have stayed with all the defaults, including the rate of return of 5.7% for a balanced fund, except I have not built in any rise in the standard of living increase. The figures do account for inflation but the results are shown in today's dollars.

Assumptions (see note 4) Value
Contribution Fee (%) 0.00%
Management Cost 0.50%
Management cost ($/yr) $50
Advisor Service Fee $0
Insurance premium /yr $100
Salary sacrificed 9.50%
Return on investment 5.70%
Inflation rate 2.50%
Allowance for rise in living std 0

Minimum wage (note 1) $34,159
Average Earnings (note 2) $77,195
Single person pension $pa (note 5) $20,498
Single person part pension cutoff (note 3) $49,296


1. National Minimum Wage order effective from 1 July 2015 https://www.fwc.gov.au/documents/sites/wagereview2015/decisions/c20151_order.pdf
2. ABS Average Weekly Earnings Australia, May 2015 http://www.abs.gov.au/ausstats/abs@.nsf/mf/6302.0/
3. Human Services - Income test for pensions http://www.humanservices.gov.au/customer/enablers/income-test-pensions%20Aus%20gov%20Human%20Services
4. Calculations using ASIC Moneysmart Superannuation calculator with all default value except std of living increase https://www.moneysmart.gov.au/tools-and-resources/calculators-and-apps/superannuation-calculator
5. Current Pension rates - single person no supplements annualised http://www.humanservices.gov.au/customer/services/centrelink/age-pension

Table 1 Assumptions and Sources

I have used the calculator to project the value of a worker's Super Fund Balance for different income levels and investment periods. The income levels range from the minimum wage ($34,159) to $200,000 pa and the investment periods from 10 years to a maximum of 45 years of working life. This latter would be rare requiring a person to start working at age 20 and retiring at age 65.

Table 2 summarizes how Superannuation Grows over time for workers on various annual incomes and for various periods.

Annual income Super Fund Balance ($'000)
After 10 yrs After 20 yrs After 30 yrs After 45 years
34159 (note 1) 34 71 112 179
50,000 48 104 164 264
77,195 (note 2) 75 162 256 411
100,000 98 211 320 534
150,000 148 317 501 805
200,000 197 424 669 1,047

Table 2:  Super Fund accumulation over time

In rough terms, every decade adds the equivalent of one's annual income to the accumulated Super. A worker on $77,195, the average wage today, will grow their Super to the equivalent of roughly 4 x their annual income in 4 decades, approx $320,000. Of course different rates of investment return, inflation and contribution costs will affect these figures significantly.

The figures themselves do not tell us much. The question is how well these accumulated funds can cater for our retirement. 

This is illustrated in Table 3, which shows the annual pension that results from the accumulated funds shown in Table 2. The rate of return used in the table is the same as was used for the accumulation phase, ie 5.7% pa.

Annual income Pension income ($'000 /pa)
After 10 yrs After 20 yrs After 30 yrs After 45 years
34159 (note 1) 2 4 6 10
50,000 3 6 9 15
77,195 (note 2) 4 9 15 23
100,000 6 12 18 30
150,000 8 18 29 46
200,000 11 24 38 60

Table 3: Annual Pensions resulting from various incomes and investment periods

A person on minimum wage, after sacrificing 9.5% of their salary forr 30 years, will have a pension return of a mere $6,000 pa. This is not nearly enough to meet their living costs and well below the Single Person Aged Pension rate of  $20,498 pa. Similarly a person on average earnings will earn $15,000 pa from their super after 30 years, still below the aged pension. You have to be earning above $150,000 pa to have a Super pension be self reliant on your pension on retirement.

The table highlights in red those super returns that fall below the aged pension rate, in yellow where the super returns are above the full aged pension cut-off but still qualifying for a part pension and in green where the super returns are enough to fully sustain the worker without qualifying for any aged pension.

The sea of red tells the story. Most people will qualify for a full aged pension, a few high income earners will qualify for a part pension and only the very highest earners with longest investment periods will be totally self reliant.

Of course these figures a broad generalisations. Many factors will alter the results. Workers don't maintain the same wage throughout their life, rates of return vary and often, especially as they approach retirement age, workers make salary sacrifice contributions to top up their funds. Also these figures apply for single earners, married couples have different pension cut-offs , etc.
Nevertheless the figures do tell a story. Under current prevailing conditions of inflation, contribution rates, rates of return, most workers will have to rely on an aged pension in their retirement.
This exercise has been another way of demonstrating, under the covers so to speak, what the projections discussed in 'Not so Super' already told us. Superannuation is not working as intended.

What is the core objective of Super? 

It is obvious that we do need to make changes, but what should we change?

Before we can make suggestions in this regard we need to be clear about what we want our Super to achieve. 

We really have only a single straightforward objective; - 

The superfund balance at retirement age has to be sufficient to generate an annual pension income which is greater than the Aged Part-Pension cut-off

Let's call this target Super balance the Self-Funded Retirement Threshold, SFRT. In today's terms based on a nominal return on investment of 5.7% pa and given the Aged Part -pension cut-off at $49,296 the SFRT is $864,842. Naturally this will vary as the Aged Part-pension cut-off increases with inflation and as average investment returns change.

Nevertheless the core objective of our Super system is for employees to reach and exceed the SFRT balance in their Super Funds.

5 Changes to Improve our Super

Given this clear objective it follows that all rules governing superannuation should be focused on achieving it.

This insight allows us to consider a range of changes that can lower the burden on our welfare budget and yet increase the number of workers achieving self funded retirement.

Here are 5 suggestions; - 
  1. Taxation discounts on super contributions should apply only while the projected balance at retirement is lower than the SFRT. There should be NO discounts on super contributions if projected balance is greater than the SFRT.
  2. Super fund annual contribution limits should increase as the employee approaches retirement , without affecting the tax benefits pertaining to these contributions
  3. Retirees should not be allowed to withdraw a 'lump sum' from their Super if by doing so its remaining balance would fall below the SFRT
  4. Government could issue a government guaranteed Superannuation Bond (SAB) with a fixed rate of return above inflation eg 5%. Any SAB investment cannot be withdrawn till retirement and its value at retirement is the inflation adjusted value of the sum invested, ie no capital gain. The maximum value of investment for any individual would be limited to the SFRT. The government could manage the SAB to reduce debt and to fund infrastructure projects. 
  5. It could be mandatory for Super funds to purchase SAB as part of their annual contributions. This 'compulsory' contribution could be equivalent to the value of the tax discount provided on Super contributions. eg if a worker contributes $10,000  in any year to his super and has saved $1500 in tax in making this contribution he would have a mandatory contribution of $1500 to the SAB. Their are two benefits to this approach.  The government receives a ready source of funds in return for the tax 'discount' on super contributions. Funds that can be used for long-term infrastructure projects. At the same time the individual receive a guaranteed inflation adjusted return on at least part of their super contributions.

These are only some potential rules that could help improve our Super system. Many other options are of course possible. However they illustrate that with a clearly defined objective we can better identify the changes that enable self-funded retirement to become a reality for a majority of our workforce. And that would indeed be super!

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