Age Pension debate makes clear: adequate super is pivotal

Older workers are already working longer; but the debate around paying for the Age Pension has only just begun. Eric Yen/Flickr, CC BY-NC

Talk about increasing the Age Pension eligibility age to 70 has generated a lot of anxiety and indignation. What seems to be going unnoticed in all the hype is that we have just experienced a round of pension age increases, and are soon to begin another.

Between 1995 and now, the eligibility age for women has gradually increased from 60 to 65. What’s more, from July 2017, the pension age for men and women will increase again, rising to 67 by 2023. That makes a total increase of seven years over less than three decades for women and a two year increase for men.

What happens when the pension age increases? Kadir Atalay and Garry Barrett from the University of Sydney studied the effects of the five year increase in women’s eligibility. They found that as the pension age increased, some women did indeed work longer. Others drew on alternative sources of income, including accessing other government payments, such as the Disability Support Pension.

Will - and can - people work longer?

Whether raising the pension age to 70 would induce most people to work longer is unclear. It depends on people’s capacity and opportunity to keep working, and on the availability of alternative sources of income.

Can people keep working to age 70? Clearly some do already, but for the majority, it would mean a real shift. The current average age at retirement is around 62 and nearly two thirds of 65-69 year olds are retired. The large majority of mid-life workers still intend to retire in their mid-to-late 60s, and only 17% plan to wait until 70 or older.

Moreover, a large minority leave work more or less involuntarily due to health or other conditions. Stints of unemployment also tend to be longer for older workers. It is not clear that a longer work life would be readily achieved at older ages. If you can’t work and the pension is years away, what can you do for money?

The need for adequate super

An obvious and increasingly important answer is superannuation. Contribution rates and average balances are rising. The preservation age – the age at which you can start drawing out from your superannuation account - is much lower than the pension age but also rising. People born before 1 July 1960 can start spending their super at 55, and this rises to 60 for those born after 30 June 1964.

So under current rules, a person born in 1964 will have seven years between getting access to their super at 60 and being eligible for the Age Pension at 67. Seven years is a long time in self-funded retirement - enough to use up $200,000 in super if you withdraw annual income roughly equal to the full pension.

The advantage to the fiscal position from older eligibility is clear: raising the pension age may induce some to stay at work; for some, disability support is an option; for others, it will mean using up their super before taking a part or full pension. Spending super becomes a one-for-one substitute for the pension as the eligibility age goes up.

This is much less expensive to the budget than supporting the part payments due under the means-test tapers. But it casts the debate about higher contribution rates and “adequacy” in a whole new light. Higher contributions are generating a cushion that could fill the gap between leaving work and getting the pension without enhancing retirement lifestyle.

Indexed to earnings - or prices?

The Age Pension is hugely valuable to older Australians, and worth much more than the net present value of the expected payments. What makes the pension so valuable? First, the full annual payment of nearly $21,900 (for a single person who owns a home) covers the bare necessities - most of the $23,200 cost of the ASFA “modest” retired lifestyle standard.

Second, payments don’t stop until you die, insuring retirees against running out of money before the end of an unexpectedly long and lengthening life. Life expectancy for a 65 year old is now about twice as long as it was 100 years ago, and continues to rise by about two months each year.

Third, purchasing power and relative welfare is protected by indexation. Pension payments keep up with both prices and average earnings. Every six months, the pension is compared with the CPI, the Pensioner and Beneficiary Living Cost Index and changes in Male Total Average Weekly Earnings, and increased to cover whichever change is the highest.

Indexing against prices looks after purchasing power, but indexing against wages maintains the relative welfare of pensioners with other groups in the economy. This turns out to matter a lot. Over the past ten years, the difference between earnings and price growth has been substantial, at about 1.9% pa, amounting to a 20% higher pension payment than would exist under price indexing alone.

Fourth, because of means-testing, part-pensioners have their payments adjusted as their income and assets change. In effect, the pension partly hedges investment risk – going up in bad years and down in good years. Then there are various concessions and allowances.

To get an idea of just how valuable these insurances are, consider how much money you would need for a DIY Age Pension. If you wanted to use a typical income stream product like an allocated pension to match the pension payment, cover inflation, wage increases, longevity and investment risk, and be 99% sure you won’t run out of money before you die, a 65 year old male needs to invest about $740K. That’s nearly four times as much as the average superannuation account balance at retirement. Women need even more.

The Age Pension provides important forms of insurance against longevity, prices, relative welfare declines and investment shocks. The government can provide this type of insurance for less than it costs individuals to insure themselves by (partly) pooling longevity risk, and hedging inflation and wage growth via income and consumption taxes. As the tax base shrinks and retirees live longer, this becomes harder.