Written by Partner Geoff Sanders and Senior Associate Simun Soljo
Introduction
The interim report of the Financial System Inquiry has identified the retirement phase of superannuation as a priority issue which requires change. The report has supported the view held by many in the industry that the superannuation system is too focused on the wealth creation phase (and the resultant tendency for retirees to take a lump sum on retirement) and is failing to meet the risk management needs of retirees. Various policy options to encourage the development of more suitable products are considered, and if the Federal Government decides to implement some of them, it could result in significant changes to the retirement phase of superannuation.
The issue
The Financial System Inquiry (the FSI) interim report makes a number of important observations about the drawdown phase of superannuation, with the key observation being that the system provides limited choice to retirees in managing risks at retirement.
In particular, the system currently provides limited products which manage both longevity risk – the risk of retirement savings running out during a retiree's lifetime, and investment risk – the risk associated with income payments in retirement being adversely affected by investment performance. Perhaps as a result of this, the report finds that the vast majority of payments from the superannuation system are taken as lump sums or as account-based pensions, neither of which address either of these risks.
The report notes that an ideal retirement income system would provide retirees suitable product options which allow them to appropriately manage longevity, investment and inflation risks, while maintaining appropriate flexibility to make lump sum withdrawals where necessary. However, while lump sum payments and account-based pensions (which make up 94 per cent of all current pension assets) which allow ongoing access to lump sums provide that flexibility, they fail to address any of the other design requirements, not least the longevity risk of retirees whose life expectancy is likely to continue to increase.
This failing is particularly important at a design level given that longevity risk is currently substantially borne by the Australian taxpayers through the age pension. Therefore, shifting some of this risk onto retirees and private sector financial product providers may be attractive for Government policy makers.
The possible solutions
Key options considered by the report to address these policy failings of the current system settings in retirement include:
- facilitating development of new products that allow retirees to combine a flexible income product with protection against longevity risk; and
- mechanisms to encourage (or compel) a greater take-up of appropriate retirement income products, including the possible introduction of a product default or mandated take up of retirement products with longevity protection.
Development of longevity products
The report notes that few Australians use income stream products that include longevity risk protection, and that Australia is unusual in not encouraging the use of such products.
Indeed, the report identifies a range of impediments to the development of new longevity products under the current regulatory regime, including the following largely tax-driven settings which may be encouraging (or at least do not discourage) retirees to select lump sum or account based pension options on retirement rather than more suitable retirement product options.
- To be eligible for tax concessions as superannuation income streams, products must comply with the design requirements in the superannuation legislation. While annuity products which meet these requirements and provide an income for life are currently available, they generally allow commutation only in very limited circumstances, and so a major drawback of these products is loss of access to any form of superannuation lump sum. A desire to retain access to the lump sum, along with other behavioural biases of retirees, may be major reasons for the preference for accumulation and account-based pension products in retirement.
- There are also current impediments to the introduction of products which would allow retirees both to retain control and to manage longevity, such as deferred lifetime annuities. Deferred annuities provide for payments to commence only at some time after the product is bought. This could be, for example, at a fixed time in the future or when the annuitant's account-based pension runs out. However, the main impediment to the development of these products is that they do not attract income stream tax concessions as they do not pay income from commencement. The Federal Government is currently consulting on proposals to extend concessional treatment to deferred annuities (see our Client Update on the discussion paper.)
- Another product discussed in the report, which currently does not qualify for superannuation income stream tax concessions is group self-annuitisation in which participants pool their superannuation savings in exchange for the right to receive a lifetime income stream payable from the pool. The income payments are not guaranteed, and reflect the investment return of the pool and mortality experience of the group, but they are expected to provide a higher income than guaranteed annuities because of the absence of capital requirements.
There is hope that the final report will address at least some of the above issues and lead to a greater variety of suitable, tax-efficient retirement products on offer to retirees.
Encouraging take up
However, the report does recognise that, even if the appropriate array of products were made available to retirees, it is possible (indeed perhaps likely) that some further form of government intervention may be required to ensure a move away from Australia's 'lump sum culture'.
Accordingly, there are various further policy options flagged in the report that the Government could pursue to encourage take-up of longevity products in retirement:
- Defaults: Unlike the accumulation phase of superannuation, which now provides for MySuper as a default product, there is no retirement income default product which applies upon retirement. The Cooper Super System Review recommended extending the MySuper product into retirement by incorporating a retirement stream product, but this was not taken up by the Government at the time and the report suggests that this might need to be revisited.
- Compulsion: The report notes that, while the Government currently mandates contributions into superannuation during the accumulation phase, there is no requirement that retirees take some or all of their superannuation benefits as guaranteed income streams providing protection from longevity and inflation risk. Compulsion would, of course, be very politically difficult to implement, but it may be that some form of compulsion (even if for only part of retirees' account balances) may be necessary if a meaningful take up of suitable retirement products is to be achieved.
- Financial advice: The report notes that retirees are required to make 'critical, once-in-a-lifetime decisions regarding when and how to draw down their savings over the remainder of theirs lives'. Many are unprepared for such decisions and so good quality financial advice becomes important. Various policy proposals aimed at improving the quality of advice have been raised in the report and in ASIC's submission to the FSI.
- Other policies: Other policies which could be considered include other means of discouraging the take up of lump sums (such as by making those options less attractive from a tax perspective), but again these could be politically difficult to implement.
Other issues
Other issues touched on in the report include the practical difficulties in providing retirement incomes, which changes to the tax concessional treatment of deferred or pooled annuities will not address.
These include the capital requirements applying to guaranteed products, the lack of availability of long-dated Government bonds which allow annuity providers to manage interest rate risk, and the uncertainty around longevity risk, especially as medical advances could continue to significantly increase life expectancies. All of these factors make it difficult for product issuers to manage risk and offer compelling rates of return on such products, and so make these products difficult to offer and sell.
There is also the fact that most retirees enter retirement with insufficient superannuation balances to provide an adequate income for life. However, this may become less of an issue as the superannuation system matures.