03/02/2025
Firstlinks published an article by Bruce Bennett on 8 January 2025 that highlighted some of the problems with the Commonwealth Super Scheme (CSS):
This article drew comparisons between account-based pensions available from industry super funds and SMSFs. I think those comparisons are misplaced. A more interesting exercise would be to compare the CSS with the age pension because both are income streams that are paid for life and indexed to inflation.
In both cases, the provider is the Commonwealth Government and benefits are paid out of general taxation revenue. That means that neither are affected by investment returns or market volatility. Secondly, because the Government has the legislated power to raise taxes or borrow money, there is no risk that the provider’s commitment to the retiree will not be honoured. There is no counter-party risk.
From the retiree’s viewpoint, these income streams are risk-free, allowing the recipient to plan their retirement spending program with absolute confidence and certainty.
On the other hand, retirees whose retirement income depends on the accumulated wealth of invested super contributions and who then depend on an account-based pension in retirement need to manage a range of risks that retired Commonwealth public servants and age pensioners do not. These risks include:
Longevity risk
We are all living longer as life expectancies increase. Longevity risk refers to the risk that we will outlive our retirement savings. Nobody knows how long the money must last. Managing one’s own retirement funds over a lifetime has many pitfalls, even with expert help.
Life expectancy is a median figure, not an average, with half of retirees living longer and a few people living past 100. Planning to live to the life expectancy is risky and will be inadequate for half of retirees. The challenge is to ensure their money will last a retirement of uncertain duration while also dealing with life’s vicissitudes.
Inflation risk
Inflation risk refers to the way the purchasing value of our money declines due to rising prices. Even low rates of inflation can seriously erode the financial well-being of retirees who live many years and is an ongoing concern for anyone living on a fixed income. Increased life expectancy increases inflation risk.
Retirees can manage this risk by investing in more growth assets so that the asset values grow at least as fast as inflation. This, however, exposes retirees to increased volatility of market risk.
Market risk
The price of assets traded on the market often does not just reflect the intrinsic value of the asset, but also market sentiment, which in turn is affected by political and economic events beyond anyone’s control. Retirees who sell assets to generate their income need to manage the volatility of market prices.
Because shares are the easiest to sell, their inherent liquidity makes the stock market the most volatile, and price declines of over 20% are not uncommon. Such losses can seriously erode retirement savings. However, shares have substantially outperformed other investments over time and are often recommended for retirees’ long-term investments as part of a balanced investment allocation strategy.
Retirees can manage market risk by holding a diversified portfolio because the prices of different asset classes usually do not move in the same direction at the same time. A diversified portfolio reduces the risk of volatility at the cost of slightly lower returns.
Many retirees manage market risk by reducing or eliminating their exposure to growth assets altogether. Investments in bonds or term deposits certainly have no price volatility, but also provide the lowest return on their savings. Such a conservative portfolio increases both inflation risk and longevity risk.
Sequencing risk
Several consecutive years of falling prices, especially early in retirement, can mean that progressively more assets need to be sold to generate sufficient retirement income. That can have a profound effect on the life of the remaining assets and their capacity to generate income for a long retirement.
Legislative risk
All retirees are exposed to legislative changes which may alter the types and rates of taxes as well as changes to entitlement to benefits such age pension or the health cards. All citizens are exposed to adverse legislative changes, but retirees are generally not in position to return to work to rebuild their savings when unexpected legislative changes seriously disrupt their retirement plans. In recent years, there have been several major proposed and legislated changes to super that dramatically impact the retirement plans of many retirees.
The gold standard of retirement income is the defined benefit pension such as the CSS. It is an indexed pension set at percentage of pre-retirement salary, paid until death, with a lower percentage paid to the surviving spouse until their death. These pensions are paid to retired judges, academics, military personnel and federal politicians who entered parliament prior to 2004. Such a pension may not have any residual capital value, but all the financial risks outlined above are managed by the provider. The beneficiaries of these pensions can plan their retirement with absolute certainty.
The reason these defined benefit pensions are being phased out is precisely to transfer those risks from the provider to the beneficiary.
In most countries, retirees have access to a risk-free pension similar to our CSS that is provided by either their previous employer or the government. Australia is unusual in that retirees enter retirement with a lump sum which is often the largest amount they have ever managed, often with very limited financial literacy, to support themselves for a retirement of uncertain duration and complexity. They also face that challenge largely alone. Financial advice is costly and scarce. The focus of super funds is on accumulating a healthy super balance in preparation for retirement, but there is precious little guidance, from any source, on how to navigate these retirement risks.
The traditional method of managing risk is to pool that risk through insurance. All insurance seems a waste of money until those risks present themselves and we are glad to have access to the pool of money that we contributed to, to help us manage an unfortunate event. But there is no insurance against retirement risk.
For retirees, the rational response to uncertainty is an abundance of caution and to self-insure against possible calamitous events. In practical terms it means hoarding cash for a rainy day. The result is that, whereas retired public servants and age pensioners can spend every last dollar, safe in the knowledge that the next paycheck is just around the corner, retirees who depend on account-based pensions need to hold significant sums in reserve to cover the range of possible unforeseen events.
With this well entrenched behaviour, many retirees typically preserve capital and significantly underspend their super savings thereby leaving large bequests of concessionally taxed savings to their beneficiaries. Policy advisers seem to have a problem with that. Firstly, retirees could have had a higher standard of living if they had saved less while working and spent more in retirement. Secondly, the tax concessions provided to super are designed to support retirees in retirement, not to be bequeathed to beneficiaries. However, these advisers seem to have no problem with the tax-concessional wealth contained in the family home becoming a bequest.
Annuities as an option
The public policy solution to retiree underspending is almost always to encourage/coerce retirees to use a significant portion of their savings to purchase an annuity which has all the certainty of the CSS or the age pension because annuities are seen as the best insurance against retirement risk.
Annuities have the following features:
The annuity provides indexed income paid for life. There are no worries about longevity or inflation.
The annuity payment is unaffected by investment returns or market volatility. There are no worries about market crashes.
Annuities provide certainty and confidence for retirees to spend their hard-earned savings.
For policy makers, annuities offer other advantages. Retirement risks are pooled within a cohort. The capital provided by people who die young generates the income for people who die much later. That means as a cohort it is self-funding and requires no more injection of capital from the government. For the individual, however, this may not be such a good deal. The family of a retiree who dies young not only loses their loved one, but also loses access to the capital that person accumulated over their working life.
Policy makers understand retirees as a cohort. Within a cohort, it is not difficult to determine the median life expectancy, the median super balance or the average annual expenditure on housing and so on. But life expectancy and other cohort averages are of limited usefulness when planning retirement. Indeed, prudent planning suggests that retirees need to plan for the extreme-case scenario. Given that a couple has a 70% chance that one of them will survive until age 90, cautious retirees need to plan for their savings to last for at least 25 years. A lot can go wrong in that time.
For the individual retiree, their experience may be anything but average and individuals will make plans to meet their individual circumstances.
However, the enthusiasm for annuities, coming from people who are not yet retired, overlooks these limitations. As Bruce Bennett points out, annuities offer no access to capital for unexpected expenses such as health crises or age care. They offer no residual value to support a grieving young family, and they are not transferable between spouses. In addition, annuities offer low returns because they are usually backed by bonds to generate guaranteed income for an indefinite period. Because an annuity is a promise to pay a regular income for life, there is also the counter-party risk that the provider may not be able honour that promise over the long term.
The Australian Government provides an incentive so that a retiree buying an annuity will increase their age pension entitlement, but only if the retiree forfeits access to their capital. The government changed the Age Pension means testing rules in 2019 to support the use of certain lifetime income streams which feature payments for life, regardless of how long a person may live, and reducing access to capital over life expectancy. Only 60% of the purchase price of the annuity is counted in the asset test until their 84th birthday and 30% thereafter.
Note that the UK government removed compulsory annuities in 2011 and the demand for annuities in Australia has been weak even with incentives. This evidence has not stopped the latest Grattan proposal which is for retirees to purchase an annuity from the government with 80% of any amount of super above $250,000, because that would boost retiree’s income by a claimed 25%.
It would mean that after a lifetime of work allocating a part of their salary to accumulate a pot of money for retirement, retirees would hand it back to the government to buy the equivalent of an age pension. This removes counterparty risk but the awkward fact is that there are many other retirees who receive the age pension, complete with the valuable pension card, without any effort on their part.
And if the government is the annuity provider, retirees would need to trust that the government will not experience some national emergency during their retirement that required the redirection of their retirement savings to other national priorities. Politicians have form in finding retirement savings an irresistible honeypot for their favourite projects.
An alternative approach
While encouraging people to draw down on their accumulated wealth in retirement might be good public policy, several million retirees completely disagree because they are deliberately and purposefully conserving that capital. Changing that mindset is extremely difficult, so maybe it’s time for a different approach.
A comprehensive retirement income policy would provide more certainty to Australian retirees by mitigating some of the risks listed above.
If the aim is to encourage retirees to spend more, consideration should be given to the idea of a universal health card provided to everyone after a certain age. After all, medical conditions like cancer or heart disease do not discriminate between rich and poor. Without such financial support, the self-funded retiree is compelled to self-insure against life’s upheavals.
The retirement risk that is completely within the government’s domain is legislative risk. Every time legislation is introduced to make changes to super or tax in retirement, it disrupts careful retirement planning and discourages younger people from making further voluntary contributions because they do not trust the government to honour the promise that super implies. The solution is simple. Any proposed change to super must have a long lead-in time and existing retirees, who made their plans according to existing rules, must be protected from those proposed changes by grandfathering.
Of course, the other suggestion would be to make the age pension universal, but that would require a major restructuring of the taxes and concessions relating to super and is beyond the scope of this article.
