A fundamental flaw in the Australian retirement system?

It comes as shock to retire with less superannuation than someone on a similar income. Image sourced from www.shutterstock.com

Most Australians accept that during their working life, some earn more than others. But will they accept that the compulsory Superannuation Guarantee Levy system could deliver very different post retirement incomes to those who had similar pre-retirement incomes?

The Australian retirement system, consisting of the Age Pension, the SGL system and personal savings has one serious flaw that will only start to emerge once the system has matured in 2020.

Almost all analysis done on the retirement system uses “on average” assumptions in relation to periods of contribution, investment returns, costs and period of retirement and usually concludes the system is “adequate”. But this analysis fails to consider that over a typical working life of 40 years, a lot can vary. In particular, all SGL contributions go into some type of investment vehicle where the member’s accumulated retirement benefit is a function of investment markets. Naturally, these include significant “shocks” from time to time, such as the recent global financial crisis.

The consequence of investing SGL contributions in market-linked securities, regardless of the capabilities of the fund managers, is that workers are going to have very different retirement incomes depending on how “lucky” they were in not being subjected to market shocks during their working life. My own research, conducted with colleagues, shows that even without any market shocks, the typical worker could end up with a replacement ratio (the ratio of post retirement income to pre-retirement net income) ranging from around 45% to almost 300%. With even a modest number of market shocks, this range could extend down to almost 35%, and that includes the Age Pension.

This range in post retirement standards of living is highly likely to be viewed as unacceptable by retirees who have been forced to defer part of their income to retirement savings. This will not only create unanticipated demands for the Age Pension, but possibly social unrest.

The solution to this issue already exists and was a fundamental part of the industry fund philosophy when first established. The solution is to go back to the concept of the SGL contributions being invested in a common pool, but to credit the member account with an interest rate, much the same as occurs with bank deposits on a regular basis. The interest rates would reflect the underlying earnings of investments in the pool, but would be smoothed by creating reserves to balance the poor times with the good times.

This is not a new concept and has been practised in investment-related insurance contracts for many years. It is, of course, not perfect and if mismanaged can create problems and failures as it did with Equitable Life in the UK. But if properly managed, it can create much smoother returns to members of retirement funds and reduce the effect of market shocks and the impact of market volatility.

One of the reasons that industry funds abandoned this concept was that they were expanding very rapidly, and $100 worth of reserves at the beginning of a year had considerably less impact in smoothing returns during the year when assets doubled to $200. But industry funds are now much more mature and this issue can be managed.

The interest rate concept would create more significant financial risk for the Boards of superannuation funds, and greater financial skills would be required than are currently needed. But the result would be less volatile retirement benefits for members who are already pooling their contributions and are expecting some level of retirement income evaporation close to retirement. The regulation of superannuation funds would also need greater attention, but the regulator already has similar issues with the few remaining defined benefit funds.

A return to a more stable distribution of investment returns is socially desirable and will help to avoid the negative results of the current system. Without it, many people will find they reach retirement without much of the money that they thought they would have.

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