Over the past 20 years, I have been managing a variety of government and industry superannuation and pension funds in Australia, Singapore and the UK. Returning to Australia last year after a seven year contract in the UK, I have noted some shortcomings in the way information about superannuation is reported to individuals.
The Australian superannuation system has an excellent reputation as one of the most successful for ensuring the majority of the workforce automatically makes some provision for their retirement. Many countries have subsequently adopted some of these features into their own systems including the UK which implemented its form of Defined Contribution (DC) pensions, known as ‘Auto-Enrolment’ in 2012.
The early adoption by Australia of a DC system more than 20 years ago was a masterstroke of strategic vision and demographic awareness. In implementing DC, it allowed the private sector, the Federal Government and the individual states and territories to largely eliminate any link of retirement incomes with workers’ final salary defined benefits (DB). According to APRA, the DB-only component of the super industry was only $70 billion as at June 2013 – a mere 4% of the asset base.
But one of the unfortunate consequences of moving to a DC system is that superannuation has become detached from any link to an income that the individual can expect in retirement.
Losing the link to salary
The original idea of a ‘final salary’ or DB pension scheme was simple for an individual to understand: the level of income in retirement would be linked to the salary they were earning whilst contributing to the scheme. There were technicalities about contribution rates, which salary (final or career average) would be paid and how overtime and other variable uplifts would be treated, but the basic notion had clarity and was easy to communicate.
In Australia, only a limited number of employers ever offered DB income streams. The market here generally had a ‘lump sum at retirement’ model which I believe is far inferior to an income stream. Contrast this with the benefit in the UK where a worker who had contributed to their pension beyond 20 years could expect to receive roughly two-thirds of their salary by way of a pension income after retirement. This income would typically be indexed to the cost of living and would last for the entire life of the worker. Whilst the provision of income in retirement was the responsibility of the employer, the individual always had a guideline for the level of income in retirement.
Under the current DC system in Australia there is no link with the projected income that a worker can expect to receive in retirement. All of the risks of achieving an adequate retirement income have been successfully passed onto the worker. These risks include, but are not limited to:
- longevity risk – how long will the individual live and need the income
- adequacy risk – building an adequate pool of savings to cover the income needed
- investment risk – the investment strategy adopted for the rest of their life
- drawdown risk – how much to draw on the pool of savings once the individual retires
- inflation risk – how to keep pace with any rise in the cost of living in retirement
- healthcare risk – what health care needs the individual may have in retirement
- provision for after-death – how much to leave and how to manage this.
The responsibilities of the individual under a DC system are daunting.
The need to report projected income from superannuation
At present there is limited free advice available to individual workers to assist them with these DC risks. Some employers provide independent financial advice, and most super funds provide some level of free advice but this often focuses solely on their own funds. Most individuals are not equipped with the right information from their super funds to make the best informed decision.
Super funds should provide improved reporting to aid members to make decisions about retirement. Each individual receives an annual statement showing their current superannuation accumulation balance. What is missing is the projected retirement income (in real terms, adjusted for inflation) compared to their current salary. In the DC world, inflation risk rests with the employee, and they need to know the value of their savings in current dollars.
Behavioural finance concludes that people feel content with a much smaller accumulated total than they actually need. As soon as an accumulated balance gets close to a multiple of salary (say three times average salary at $150,000) or close to the cost of the average property in Australia (say ten times average salary at $500,000) then individuals ‘feel’ wealthy and no longer focus on saving more.
This is inappropriate because these sums will not provide – even for a worker on average salary – sufficient income in retirement to live at the same level of comfort as when they were earning their salary. The salary-linked reporting provides the right information, despite the fact that it may not be a pleasing message for most workers.
Sound assumptions are required to prevent this being used purely as a marketing exercise. Good practice would be to establish a set of assumptions (i.e. on asset growth rates, retirement age, inflation) for use by every super Fund across the industry so that the projected income number is comparable across funds. In the UK for example, the Pension Regulatorsets the assumptions for these comparisons and each annual pension statement has to show an expected income per annum assuming growth rates of 3%, 5% and 7% of the assets until retirement.
It is very useful for a 40 year old Australian who still has time to save more for retirement to be told that their projected income will be only 15% of their current salary adjusted for inflation. They have time to take corrective action, if financially possible.
Given that contributions are related to salary it seems strange that the accumulation pot size is given so much importance. The objective of the DC saving scheme is to produce an income in retirement for individual workers. A sceptic might suggest that super funds do not want to tell their members this vital piece of information lest they receive poor member feedback, or worse, cause members to switch to another fund. This can be addressed by using agreed industry-wide assumptions which are sanctioned by the regulator, APRA. But not giving this vital piece of information as early on as possible is letting the clients down.
Link to the employer’s remuneration policy
Another hidden corollary of the current compulsory DC system is that employers have now ‘switched off’ from using pensions as a positive tool in their remuneration policy. Before compulsory superannuation, quality employers would use higher superannuation benefits as a method of enticing quality employees to work for them and to retain the loyalty of their existing staff.
Nowadays in Australia the opposite might be true – that superannuation might actually become a negative for remuneration policy. Since it is compulsory, superannuation is not considered a variable component of remuneration policy. And the requirement for incremental increases in superannuation contributions over time may actually ‘backfire’ on employees. A worker may feel they lose out because a potential wage increase may instead be allocated towards a mandated super payment. In this way real wage cuts are likely as superannuation contributions gradually increase.
The Australian super system has set the standard for governments to reduce their reliance on social security pension provision. But the individual worker has assumed significant responsibilities for the total management of their income from retirement to grave. Most individuals are relatively unaided and without the necessary reporting tools to correctly interpret data and make decisions. I find it startling that even today, most super funds do not report to their members a projected income in retirement.
Bev Durston has over 25 years’ experience of implementing investment solutions for pension funds, sovereign wealth funds and fund managers. She recently relocated to Sydney and founded an advisory business for institutional clients, Edgehaven Pty Ltd. Bev has a first class Banking and International Finance degree from CASS in London, and a Masters of Applied Finance from Macquarie University.