May 27, 1998 | Lecture on Social Security
I would like to thank the Heritage Foundation for holding what I consider a necessary event in discussions and debate surrounding social security. We have seen this week many issues raised in Kansas City by the President's discussions on social security which go to the fundamental core of proposed social security reforms. Such issues include risk, long-term viability of pay-as-you-go systems, and the realities of individual retirement accounts.
Today I want to place the social security spotlight on an international social security model which has received comparatively little attention concerning possible parallels with reform of the United States Social Security system. Australia today has a strong and effective retirement system, providing detailed and comprehensive retirement accounts for individuals who wish to retire with dignity and economic security.
Unlike some of the more "outspoken" international systems, Australia has quietly pursued the goals of lifting the retirement standards of all Australians and solving the long-term problems associated with social security reform. While I believe no one international model is ideally suited to reforms in the United States, the Australian superannuation model does provide comparative advantages in design, regulation, and investment strategies which match or complement existing retirement components found in the United States.
Moreover, it is also a powerful influence that Australia and the United States have common characteristics with regard to the cultural, political, and social fabric of each nation. Notwithstanding the differences in language and beverages preferred by each nation, a common understanding of Australia and the warmth which this culture generates among Americans is certainly a powerful basis for eliminating the scaremongering which unfortunately seems to be associated with those groups and individuals who are against individual retirement accounts.
Australia constitutionally is a federation of six states and two territories. Tax-raising and revenue powers are largely under the control of the Commonwealth government. This fact is important for the way a unified savings and retirement incomes policy has been adopted in Australia.
In 1983, a Labor Party (social democratic) government led by Mr. Bob Hawke, MHR, came to power with a later Prime Minister, Paul Keating, as Treasurer. After eight years in Opposition, the newly elected Labor Party government was keen to exploit its sizeable majority with wide, sweeping reforms of labor relations, financial services, and microeconomic reform. Both men were determined to deregulate the economy and create an Australian economy which was able to compete more effectively on world terms. A vital ingredient in achieving this goal was significant reductions in wages growth.
Significant dissatisfaction in the labor movement over the extent of coverage among blue-collar workers. For instance, the commission paid to life agents meant that the withdrawal benefits paid to short-serving employees was often negligible.
A strong belief among senior union officials that the future of unions must lie in being able to deliver more than wage increases to their members (especially given their recognition of the need to modify wage demands if Australia was to stay competitive) and recognition that financial services was one service that, for a variety of reasons, would be attractive to deliver.
The need for the government to satisfy pay demands, especially among militant unions such as the building unions, without creating inflationary pressures.
The competitiveness of the financial services sector, which meant that some major institutions were prepared to support the initiative.
Increasing involvement by the union movement in superannuation matters challenged the traditional ideological biases against union involvement by existing industry participants. Yet some companies adopted a more lateral approach with the establishment of institutionally owned but independent nontraditional providers of superannuation services. Larger Australian life insurers such as AMP, National Mutual, and Colonial Mutual all embarked on establishing such a structure with the support of the government and union movement.
In Australia, a centralized wage-fixing system has existed whereby wages are determined for some or all workers through a process of conciliation and arbitration. Although this centralized approach is changing through enterprise bargaining, unions remain solidly in support of award-based superannuation.
Although the union movement has played a pivotal role in the development of the Australian superannuation model, trade union membership, as in many other developed nations, has continued to decline steadily. Between August 1986 and August 1996, the level of trade union membership reported by employees declined by around one-third, from 46 percent in 1986 to 31 percent in 1996. Possible reasons associated with this statistical pattern center on the development of collective bargaining and the growth in information industries and the corresponding decline in heavy manufacturing industry.
First Tier: The Age Pension
A major concern for Australia and many other developed nations is the rapid aging of their populations. This concern was summarized by the Executive Director of the Association of Superannuation Funds of Australia (ASFA), Ms. Susan Ryan, when she commented that:
For Australia the percentage of the population aged over 65 is expected to rise from 15% of the population, 2.9 million, to 23% by 2030, that is, 5 million people. The percentage aged over 85 is expected to more than double, from around 2% to more than 5% amounting to 650,000 Australians over 85.1
|Income Test||Maximum Payment if Your Fortnightly Income is Equal to or Less Than||No Payment if Your Fortnightly Income is Equal to or More Than|
|For Each child||$24.00||add $24.00|
It is important to note that, in the context of the Australian system, social security means benefits provided by the Federal Government in the form of a means-tested old-age pension and superannuation, provided through a working relationship with an employer and/or through a private policy conducted with life insurance companies or bank/life subsidiaries.
A Commonwealth government-funded age pension has been a reality since 1909. This is the first tier of the Australian retirement incomes model. The basis of the entitlement for this pension has centered on the concept of need, after being established by a means test. This test has progressively limited the availability of the benefit.
For the government, this commitment in providing the first tier of a social security system is significant, with Australia dedicating $19.6 billion per year, or 15 percent of its annual government outlays, toward this provision. Some 80 percent of retired Australians receive all or part of a pension. The full pension represents approximately 25 percent of average weekly earnings.
|Assets Test||Maximum Payment if Your Assets are Equal to or Less Than||No Payment if Your Assets are Equal to or More Than|
| Couple, non-homeowner
The maximum payment per fortnight is $347.80 ($US273.62) for a single pensioner and $290.10 ($US228.23) each for a pensioner couple. Other associated allowances exist in the form of telephone, mobility allowance, remote area, and education entry payments. To determine whether full or partial payment is received, an income and assets tests is applied. The details of this income and assets test are summarized in the above two tables.
In Australia, the details of this test are administered by the Department of Social Security on a regular basis. Based on the details contained in the assessment relating to the levels of income and assets, payments may be affected in three ways:
Assets which are over the maximum payment settings will cause payments to be reduced by $3 per fortnight for every $1,000 (single or couple combined).
Hardship provisions apply.
Income over the amounts for maximum payment reduces the payment by 50 cents on the dollar (single pensioner) or 25 cents on the dollar (each member of a couple).
For the purposes of this imposed test, income is any money, valuable consideration, or profits you may have earned, derived, or received. Income for the assessment of the age pension includes deemed income on certain investments as well as income from overseas.
Unlike the United States or United Kingdom, where the pay-as-you-go system for receiving a first-tier retirement benefit is linked with contributions, the Australian system is simply funded from consolidated revenue sources. Current government policy provides age pensions to people who have reached the age of 65 for men and 61 for women, subject to residency and income and assets tests. By 2013, the qualification age for the age pension will be gender-neutral, being set at 65 years.
Background to a Compulsory
With this as a backdrop, the need for change in the retirement policy of Australia was sharply defined by the Labor government in 1983. The newly elected government had strong links with the trade union movement, whose peak body, the Australian Council of Trade Unions (ACTU), urged greater superannuation coverage for workers.
Moreover, unions could see their position and relevance strengthened if they were identified in assisting or providing this service to their members. Superannuation during this time was provided through traditional employer-sponsored plans. Career employees were usually covered by defined benefit schemes, while blue-collar employees were commonly covered by defined contribution plans. It is important to note that coverage rates during 1983 were only around 2 million people (40 percent of the workforce), with the entire superannuation asset pool amounting to $32 billion. Members were generally concentrated in government-related positions and the financial services industry.
By 1986, circumstances were ideal for the introduction of a widespread employment-based retirement incomes policy. Continuing wages pressure and demands by the union movement on the government for a comprehensive superannuation policy to be initiated led to the introduction of award superannuation, set at up to 3 percent of an individual's yearly income. This amount was paid by the employer in the form of a wage increase granted by the Conciliation and Arbitration Commission.
Industry funds were effectively given a tremendous boost with this industrial and political decision. They are sponsored by employer and employee organizations in one or more industries and were established initially to receive the 3 percent award contributions. As of June 1996, there were 159 industry funds with 5.8 million accounts (35 percent) and $17.6 billion in assets (6 percent). A heavy concentration exists within this type of superannuation fund. Ten of the largest funds account for some 66 percent of assets in this sector.
Ongoing debate about the aging population and growth in superannuation funds continued into the late 1980s. Partly to ensure that appropriate prudential safeguards were implemented and developed toward superannuation, the Insurance and Superannuation Commission (ISC) was established as the agency responsible for the regulation of superannuation on a Federal level.
As indicated in my Churchill fellowship report, public confidence in the pensions industries of many countries, including the United States, is partly a product of how efficiently the retirement incomes industry (life insurance and pensions) is regulated. Responsible Australian government ministers, along with bureaucrats, in the late 1980s and today remain determined to avoid any breaches of legislation which will erode public confidence in the retirement incomes model. In contrast, the United Kingdom is seeing the government eager to reform the regulation of pensions to restore public confidence in the pensions industry after widespread mis-selling of personal pensions.
In 1989, there was a further major government initiative in the development of a retirement incomes policy to address the medium and long-term needs of an aging population. The Better Incomes: Retirement into the Next Century Statement was released:
The Better Incomes Statement expressed a commitment to "maintain the age pension as an adequate base level of income for older people" but went on to state that persons retiring in the future would require a standard of living consistent with that experienced whilst in the workforce.2
Birth and Development of a
Compulsory Pensions Model
With a delay in the 1990-1991 wage case occurring, where the ACTU and the government supported a further 3 percent round of award superannuation, the government saw its opportunity to act in a decisive manner toward retirement saving.
In August 1991, the Treasurer foreshadowed the government's intention of introducing a Superannuation Guarantee Levy, which commenced on July 1, 1992. In issuing a paper on the levy, the Treasurer indicated that such a scheme would facilitate:
A major extension of superannuation coverage to employees not currently covered by award superannuation;
An efficient method of encouraging employers to comply with their obligation to provide superannuation to employees; and
An orderly mechanism by which the level of employer superannuation support can be increased over time, consistent with retirement income policy objectives and the economy's capacity to pay.3
Additionally, in a statement on Security in Retirement, Planning for Tomorrow Today, given on June 30, 1992, the Treasurer at the time, the Hon. John Dawkins, MP, reaffirmed the government's position and direction on the aging of Australia's population and the need for compulsory savings for retirement:
Australia--unlike most other developed countries--meets its age pension from current revenues. Taxation paid by today's workers is thus not contributing to workers' future retirement security; the revenue is fully used to meet the annual cost borne by governments.
And, like most other people, Australians generally undervalue savings for their own future retirement. Private voluntary savings cannot be relied upon to provide an adequate retirement security for most Australians. This is so even with the very generous taxation concessions which are available for private superannuation savings.
...In the face of these factors, changes are required to the current reliance on the pay-as-you-go approach to funding widely available retirement incomes. This means that we need now to start saving more for our future retirement. It also means that saving for retirement will have to be compulsory. It means that these savings will increasingly have to be "preserved" for retirement purposes. Lastly, the rate of saving will have to ensure retirement incomes which are higher than that provided today through the age pension system.
There seems to be a general awareness in the community that something has to be done now to meet our future retirement needs.4
The Superannuation Guarantee Charge Act 1992 requires all employees to contribute to a complying superannuation fund at a level which increased from 3 percent per annum in 1992 to 9 percent per annum. It should be noted that some discrimination was made for small business in how the levy was introduced and increases, based on the size of the annual payroll. If the employer chooses not to pay the levy, he or she will have a superannuation guarantee charge (SGC) imposed on their business operations by the Australian Taxation Office (ATO). By deciding to neglect their obligations under Act, employers will not receive favorable taxation treatment in regard to contributions made by them on their employees' behalf.
At the present time, the levy is currently at 6 percent, which will increase progressively to 9 percent by 2002. The threshold for paying this levy was based initially on the individual earning a minimum of $450 per month.
Determining What Levels of
Superannuation Are Needed in Retirement
Clearly, the Federal Government in Australia has insisted that superannuation contributions today should match the expectations of all Australians in retirement. The distinction with other overseas retirement systems is that compulsion in other countries provides a minimum level of retirement income, with the individual voluntarily making contributions to generate the necessary income levels to maintain lifestyle in retirement.
the previous Labor Government published estimates indicating that a contribution rate of 12% of yearly income saved by a male over 40 years of full-time work would provide a 49% replacement rate in retirement. This figure assumes that the individual has no dependents. The replacement rate was estimated to be 40% when a dependent was assumed by the then Hon John Dawkins, Treasurer.
Dr Vince FitzGerald, an economic consultant commissioned by the Labor Government to inquire into Australia's savings behavior, suggested that if most people are eventually to depend on private saving for income in retirement, then a replacement rate of well over 60% should be a goal. This would clearly require a contribution rate higher than 12%. FitzGerald also suggested that the ultimate target for retirement saving might require a contribution rate of 18% of annual income, based on an international norm for replacement rates.
On this evidence, one can argue that contributions of 9% of yearly income (the compulsory SG) saved over 40 years will provide a relatively low replacement rate. The replacement rate would be even lower for 9% contributions made over a period of less than 40 years. Certainly, many people currently in the workforce will not have 40 years of saving to generate an adequate retirement income. Therefore, an individual relying on 9% contributions could experience a fall in living standards, even though eligible for a partial aged pension.
With compulsory superannuation saving in Australia set at 9% for the foreseeable future, voluntary saving will be necessary if people want to increase their overall retirement income to a level that allows them to maintain their standard of living when they leave the workforce.
Recent figures indicate that Australians are voluntarily contributing to their retirement savings. It is estimated that in 1995-96, 31% of total contributions to superannuation were voluntary by employees.5
Taxation of Superannuation and
General Taxation Policy
With the advent of compulsion, it is also important to discuss the relatively unique approach by Australia toward the taxation of contributions, income generated from the superannuation fund, and the eventual benefits paid in the form of an annuity or lump sum.
This taxation approach on investment income is mostly offset by credits under the imputation arrangements. Under this system credit is received for tax paid by companies in which the fund's assets are invested. For employers the contributions to complying funds are tax deductible as are contributions by the self employed. There is limited tax on benefits paid. The rules are extremely complicated with the level of tax depending on whether benefits were accrued before or after 1983. 6
In May 1995, the Treasurer announced that associated personal income tax cuts would be delivered in the 1999 financial year and would be redirected to employees and the self-employed through means-tested government superannuation contributions, to be implemented as part of the superannuation package announced in the 1995-1996 Budget. Essentially, a co-contribution system was planned with 3 percent of salary funded by tax cuts and the other 3 percent by employee contributions. It was the intention of the government to collect these amounts through the SG system. These actions would eventually see Australian workers contribute 15 percent of their salaries into superannuation accounts.
During August 1996, the government introduced for higher income earners a Superannuation Surcharge, based on a combined total taxable income and superannuation contributions above $70,000. There is a 1 percent surcharge for every $1,000 above the $70,000 limit, up to a maximum of a 15 percent Superannuation Surcharge.
In the design of any retirement incomes system, the political sensitivities of preservation were considered in Australia. This is the minimum legal requirement for how long superannuation amounts must be held in a fund for a member's retirement. Currently, superannuation benefits must be preserved until age 55. Special funds--Rollover funds--operate in Australia to "park" benefits until they can be paid or transferred to another complying fund.
|Assessable Income||Maximum Rebate|
|Up to $27,000||10% on up to $1,000 of personal contributions (maximum rebate $100)|
|$27,000 - $31,000||Rebate reduced by 2.5 cents for each dollar of assessable income over $27,000|
In dealing with the problems associated with women not making sufficient contributions for their retirement, the Federal Government has proposed the spouse contribution. Where a spouse earns less than $10,800, they may be able to claim a rebate of 18 percent for funds contributed to their superannuation fund (to a maximum of $3,000 per annum, providing a maximum rebate of $540). This was due to take effect on July 1, 1997.
|Member's Age at Financial Year End||Deduction Limit*|
|Under 35 years||$10,232|
|35 years to 49 years||$28,420|
|50 years and over||$70,482|
|Note: *Indexed annually to Adult Weekly Ordinary Time Earnings|
For the self-employed, the associated deductions for superannuation are more generous. To receive this deduction status, they must receive less than 10 percent of their assessable income from employment. They essentially can claim a deduction for the lesser of up to $3,000, plus 75 percent of contributions over $3,000, or the age-based MDC limit.
A comprehensive Pay As You Earn (PAYE) system of taxation exists in Australia, with no well-developed forms of indirect taxation being utilized by the Federal Government. In Australia at the moment, much debate centers on whether this taxation mix will continue through the current government's efforts to reform the existing framework.
|Member's Age at Financial Year End||Deduction Limit for 1997/1998*||Contributions for Subtantially Self-Employed|
|Under 35 years||$10,232||$12,643|
|35 years to 49 years||$28,420||$36,893|
|50 years and over||$70,482||$92,976|
|Note: *Indexed annually to Adult Weekly Ordinary Time Earnings|
Table 1 below allows a comparison to be made between personal income tax rates and the tax which is currently levied on the superannuation industry.
Currently, the taxation rate for companies is set at 36 percent. Over the past decade, industry has lobbied successfully to have company taxation reduced--it was argued--to stimulate investment from domestic and overseas sources.
It is important to note that the Australian superannuation and taxation system has Reasonable Benefit Limits (RBLs) built in to restrict the amount of benefit that can be received at concessional tax rates. There are two limits, one for lump sums (the traditional benefit form in Australia) and one for pensions. The pension limit is higher (twice as high) in an attempt to prevent Australians from consuming all their savings quickly and then relying on government assistance in the future. In the past, these limits had been based on earnings; but they are now set using dollar limits.
Methods of Superannuation
Most of the existing and new superannuation accounts which have been established in Australia since 1992 have been associated with the industrial awards system through existing industry funds. Effectively, this means that, as part of your terms and conditions of employment, you are required to join a superannuation scheme prescribed by your employer. Recently, the Federal Government has introduced legislation which requires that choice be provided to employees by their employers. This policy change will see employees provided with five choices of retirement products.
Yet many Australians establish individual superannuation policies through intermediaries in the form of financial planners and life insurance intermediaries. Overall, these two groups provide the backbone of distribution for superannuation providers through fee-based and commission remuneration structures.
In recent years, with increased disclosure and regulatory requirements for advice, the margins on each sale by an intermediary have progressively tightened. Additionally, regulatory and industry involvement has seen unfavorable selling practices discouraged through regulatory and company compliance procedures. These processes have been implemented to prevent some examples of mis-selling and inappropriate sales from occurring.
Many companies are now evaluating the British experience of selling pensions directly, using on-line and telephonic methods. Initial data suggest that this industry development may be positive for product innovation and diversity in the market.
Types and Status of Funds in
In Australia, superannuation is provided on the whole by trust-based superannuation funds. The overall classification of superannuation funds can be broken down into six distinctive groups:7
Corporate or enterprise funds, provided by a single or group employer. An overall trend in recent years has seen these funds declining, with members transferring into industry funds or retail master trusts.
Industry funds, sponsored by employer and employee organizations and developed primarily in response to the establishment of the 3 percent award contributions. Although these funds are growing rapidly, they suffer from coming off a low base and having, on average, small account balances. Initially, most of the investment of the funds was handled through life office capital-guaranteed contracts. This reflected a shrewd decision by the industry funds to take advantage of the artificially high interest rates offered (because of averaging and competitive pressures) and to ensure that the capital values of contributions would be protected. From the outset, the industry funds followed a policy of contracting out all services: administration, provision of death and disability coverage, and--most important--investment. Contracting out investment management meant that the funds were able to take advantage of the highly competitive marketplace and also reduce one of the early concerns of their opponents: that the investment decision process would be manipulated for ideological or industrial relations purposes. The asset allocation responsibility was always retained by the funds and usually exercised with advice from an asset consultant. The trusteeship of the industry funds was, from an early stage, shared between equal numbers of employee (union) representatives and employer representatives, with an independent chairman. Legislation today has reaffirmed this industry feature. It is worth making the observation that, from the outset, the industry fund trustees and union "drivers" of the funds have generally been much more diligent and independently professional than most trustees of traditional employer funds. They have generally been hard but fair buyers of services.
Public-sector funds, established for the workers of Federal, State, and local governments and their instrumentalities. Like many similar funds worldwide, these funds are largely unfunded.
Retail funds, offered principally by the large financial institutions and distributed through intermediaries to consumers who meet the necessary conditions of holding such accounts. These accounts can come in the form of master trusts, personal superannuation products, rollover products, and allocated pension and annuity products.
Excluded funds, looking mainly at the funds held by individuals or families with one through four members. In recent times, these funds have witnessed rapid growth through some associated tax advantages derived from their establishment.
Superannuation products offered directly by life offices, involving an increasing segment of business where products are distributed directly to individuals by life offices.
ensure that a fund's administrative functions are properly carried
out, trustees have the choice of having the administration run by
the fund itself (internal administration) or contracting fund
administration to a specialist superannuation organization
(external administration). When considering which option to pursue,
trustees also need to assess associated issues such as cost, fund
expertise, and access to systems infrastructure.
Demographic Characteristics of Australia
Australia's population is aging, with a median age of 34 years in 1996 compared to 32 years in 1991. Just over one-fifth (21.6 percent) of Australia's population (excluding overseas visitors) in 1996 were aged 0-14 years; 14.5 percent were aged 15-24 years; 30.8 percent were aged 25-44 years; 21.0 percent were aged 45-64 years; and 12.1 percent were aged 65 years and over.
majority (73.9 percent) of people counted in Australia were
Australian-born. Of those people born overseas, over one-third
(36.2 percent) were from the United Kingdom, Ireland, or New
Zealand. For the remaining overseas-born people, the highest
numbers were born in Italy, Vietnam, Greece, China, and
Australian Bureau of Statistics (ABS) data indicate that in 1996, Australia had a population of 18,312,000. This estimated population is expected to increase to 26,001,000 by 2050.
For Australia, the level of migration has for many years been a controversial issue in relation to persistently high unemployment and fears that the cultural identity of the nation will be lost. In the 1950s, large levels of immigration commenced, principally from the United Kingdom and Southern Europe. Such a wave of new immigrants would continue through to the 1960s. During this time, it was the government's policy position "to populate or perish," with subsidized passage being provided to new immigrants.
the 1970s, the willingness for Australia to maintain immigrant
levels has declined. This primarily political decision has affected
Australia's demographic profile, with fewer young people being
incorporated into the population from overseas countries,
principally in Asia. Recent ABS data depict the sharp decline in
immigrant levels in recent years.
Statistical Analysis of the Australian Superannuation System. Although compulsion in the Australian superannuation model is seen as the major reason for asset and contribution growth in the past four years, voluntary contributions have also increased significantly as the general public becomes more aware of the advantages of the current system. This assessment is reinforced by the ISC in their media release dated July 6, 1997:
Superannuation contributions for the first nine months of the 1996/97 financial year were approximately 14% higher than the same period of the previous financial year. This result indicates that contributions are now growing at around two and a half times the rate attributed to the increase in the SG levy alone.8
Total assets in superannuation accounted for $316.7 billion, which represents an annual growth rate in asset value of 20 percent, or 4 percent during the quarter.
As of the end of the September 1997 quarter, there were 16.8 million member accounts for the estimated 6.7 million workers who have superannuation.
Revising the Australian Model
Recent developments since the election of a new Liberal Coalition government in 1996 have meant that the planned commitments detailed for compulsory contributions have been altered.
In May 1997, the government announced that the planned government co-contribution would be abandoned in favor of a savings rebate. The rebate will apply to member (undeducted) contributions, all net personal income from savings and investments, or a combination of both up to an annual cap of $3,000. This will be effective from July 1, 1998, at a rate of 7.5 percent, increasing to 15 percent from July 1, 1999. Thus, the government is not ploughing money into individual superannuation accounts but is providing a taxation rebate as an incentive to promote individuals making superannuation contributions or savings.
The government considers the savings rebate represents an important enhancement of Australia's retirement income system in providing significant encouragement to people to save for their retirement through superannuation or other saving. The government also sees that it is offering choice and incentive, allowing individuals to choose the form most suited to their needs.
Other recent developments have included the introduction of the Retirement Savings Account legislation. This legislation provides for banks and other prudentially regulated institutions to directly offer accounts which can accept superannuation contributions. Tax treatment and preservation requirements will be the same as those for other superannuation products.
Unlike previous superannuation products, RSA providers will not be required to have the trustee structure. As well, RSAs are to be "capital guaranteed" and, as such, will be "low risk/low return" products. Arguments supporting these products include their ability to be portable for consumers and their general low fee/charges structure. Criticisms of the products have centered on whether they will be able to generate sufficient returns to provide for the member in retirement.
indicated, the original threshold for compulsory contributions
under the SGL was $450 per month. Through budgetary measures
announced this year, "the provision for employees earning from $450
to $900 per month (or $1800 over two months where the employee is
under 18 years of age) to opt out of the SG system will now take
effect from 1 July 1998."9
One of the more controversial issues also arising out of the last Federal Budget was the issue of choice of fund. Under proposed legislation which was expected to become law by July 1, 1998, employers will now be required to offer their staff a choice of superannuation funds. The employer, under the proposed legislation, will have to provide choice in the form of one of four options:
Limited choice: The employer will be required to provide a choice of at least four funds to employees.
Unlimited choice: The employee may choose from any complying superannuation fund or retirement savings account.
Australian Workplace Agreement or a certified agreement: The superannuation fund or RSA which is offered to the employee is agreed to in a formal agreement between employer and employee.
Informal written agreement: The employee may request that his superannuation be invested in a fund without the employer making an offer.
An obvious question that has to be asked is whether consumers have the ability to make often complex and highly technical choices when dealing with what may well be the largest financial purchase they will ever make in their lifetimes. Also, recent surveys have indicated that fund managers, on average, anticipate that administrative costs will increase by 10 percent.
Once again, my Churchill fellowship report indicates a clear link between public confidence, the ability to shape or mold an individual's retirement, and the amount of disclosure information provided to an intended recipient of a retirement product. Many countries which are considering reforms in their pension systems in Europe and Asia are grappling with this issue of "empowering" the individual to make more active decisions in retirement planning. Consider the cases of the United Kingdom and Chile.
The introduction of the Social Security Act 1986 provided a new avenue for employers to pursue in offering benefits to their employees in occupational pension schemes, this being in the form of contracted-out defined contribution schemes. Since 1988, the number in contracted-in defined contribution schemes has remained at about 500,000, but 430,000 are now in the new contracted-out schemes.
There is little support for the assertion that the shift to defined contribution schemes among employers reflects companies' changing views toward defined benefit schemes. Most recent data on the issue from the Government Actuary's Department suggest that 50,000 members had seen their scheme change from defined benefit to defined contribution between 1987 and 1991, accounting for just 10 percent of the total increase in numbers.10
Another significant change resulting from the introduction of the Social Security Act 1986 was that choice for the first time was provided to individuals on whether to join employer-provided pension schemes. Before 1988, most firms providing occupational schemes made membership compulsory for eligible employees. Just 8.5 percent of scheme members were in voluntary plans. This accounted for 17 percent of private-sector members, with none in the public sector.
Overall since 1987, the total percentage not joining has increased from 18 to 23 percent, with a slightly more rapid increase among women employed full-time. More recent data from the National Association of Pension Funds 1994 annual survey suggest that the take-up among new employees for pension products was about 80 percent and has remained around this level since 1990.
The Third Tier: Private
Through allowing people to contract out of their State Earnings Related Pensions Scheme (SERPS--a government-sponsored substitute for an occupational scheme) entitlements and transfer from occupational schemes, personal pensions in 1988 received a significant boost in sales growth and long-term product development. The popularity of these products was quickly established, and by 1992, 23 percent of male and 19 percent of female employees had contracted out and were in personal pensions.
Concern in Treasury and other areas of government was that these new retirement vehicles were only being used to receive the rebate provided through transferring out of SERPS. In 1991, 24 percent of employees had contracted out into personal pensions, yet about three-fifths of these personal pensions had been established simply to receive the associated rebate and incentives provided by the government. Such a situation partly led or induced the mis-selling of pensions--which has continued to erode recovery in public confidence--within the industry.
Overall, personal pensions today are "manufactured" by a number of providers. These companies are mainly life insurance companies, although building societies, unit trusts, and other financial organizations are permitted to administer pensions (at least up to retirement). Restrictions on investments are relatively few, and it is important to note that even supermarkets in the United Kingdom are offering such financial services products on an execution-only basis.
In general, the deposits from personal pension funds must be used to purchase annuities. Recent legislative amendments have increased the individual's freedom of choice between annuity suppliers. The government has ensured that the tax privileges extended to personal pensions are the same as those which exist for occupational schemes.
A concise summary or assessment of personal pensions and the future role that they are likely to play in the British market is provided by Mr. C. D. Daykin, the United Kingdom's Government Actuary, in his report to the European Commission:
Personal pensions at the minimum level for contracting-out are unlikely to provide a very inadequate income in retirement. A major challenge for education (and marketing) is, therefore, to persuade people that they must make additional voluntary contributions and that the responsibility for ensuring an adequate retirement is theirs. The State will not provide more than the basic flat-rate pension. Of course, there will still be the possibility of means-tested income support, but the whole thrust of encouraging private provision for pensions is to lessen the dependence on State Benefits.
Views differ as to the likely success of these objectives. Trade unions and staff associations in general remain very suspicious of personal pensions, which they see as putting too much of the risk (particularly of investment performance relative to inflation) on the individual and too much money (commission, profit, etc) into the hands of financial intermediaries, insurance companies and other financial institutions. The preferred option of organized labor is the final salary occupational pension scheme, if possible with full price indexation of pensions, both in payment and in deferment. 11
Distribution Issues and
With rapid transfers out of an existing government pension tier and membership movements out of occupational schemes, principally through industrial and economic restructuring, the demands placed on existing distribution networks have been extreme.
Coupled with an increased volume of business, commission restrictions were lifted in the late 1980s, which allowed intermediaries to dramatically increase the up-front commissions. Poor disclosure of product design and general information on pension policies was provided to the consumer under existing mandatory provisions. Minimum competency standards for intermediaries was also a major concern; with no minimum set standards of advice and training, intermediaries often provided inaccurate and, in the most extreme cases, misleading advice. Based on these features of the British life insurance and pensions industry, the seeds were clearly sown for problems to occur in the future.
Currently, the British government is implementing a "name and shame" strategy which it hopes will force those pension providers to resolve the associated cases identified under Securities Investment Board and Personal Investment Authority reviews. Recent media attention associated with the launch of the Office of Fair Trading's pensions report in July has further emphasized the need to resolve the cases associated with 2,500,000 consumers. The suspected compensation costs will amount to £11 billion.
Some 600,000 priority cases have been identified, but the Treasury has said the total number affected could top two million.... Friends Provident, which has 6,433 cases to review, was fined a record £450,000 last month by the Personal Investment Authority for dragging its feet in sorting out its most urgent cases.12
In a speech delivered on November 6th, 1980 Minister of Labor Jose Piñera expressed that the goal of the reform was to create a retirement system based on "freedom, and solidarity; a fair and yet efficient retirement system; a retirement system for everyone." He went on to say that the reform was a "transcendental step that would benefit every Chilean, within the spirit of freedom, progress and justice."13
Under the system, all benefits are provided through the AFPs (pension fund administration companies). These are privately owned and managed companies which are regulated by the Superintendency of Pensions and are required to meet a variety of solvency and consumer protection issues. Although some pressure is mounting to lift the current retirement age in Chile, the existing level remains at 65 for men and 60 for women.
Due to its defined contribution characteristics, the new system relies on the merits of the AFP generating a sufficient rate of return on its investments. The assessment of the likely benefits to be provided by the annuity that is purchased from a life insurance company, via accrued contributions, was estimated by the Instituto Libertad y Desarrollo:
Actuarial calculations indicated that retirement for men at age 65 and for women at age 60, with a pension of approximately 75% of their last active year's income, required a system that could deliver an average annual rate of return of 4 percent. This seemed perfectly compatible with the potential of Chile's economy.14
All covered or "dependent" workers must lodge 10 percent of their monthly earnings in a savings account with an approved, high-regulated intermediary called the AFP. Each AFP manages a single fund, with the complete return on the fund being allocated to the individual accounts.
An additional function of the AFP is to provide survivors and disability insurance according to rules prescribed by the government. Once the worker becomes eligible to receive pension benefits, he or she has one of two options: choose a sequence of phased withdrawals provided by the AFP or purchase a real annuity. This latter option will require the affiliate to purchase the annuity from a life insurance company.
The major drawback associated with the Chilean model is the overall costs associated with administration, distribution, and regulatory restrictions. For example, the administrators face extensive restrictions on investments. They must guarantee a return within a certain band of the average return of the industry, if needed, through their personal resources. The administrators can offer only one fund, and the affiliate can invest with only one AFP. Existing banks, mutual funds, or insurance companies cannot manage mandated savings.
Also, transfers between different pension funds are restricted, based on minimum stay periods and transfer fees. The fund administrators can charge fees as a percentage of salary (which is typical) and of the assets managed, as well as flat transaction fees for deposit, withdrawal, and account statements.
In summary, there is no doubt that the Chilean model has some ambiguous characteristics which are seen to detract from the overall system. The Chilean system's high administrative costs, relative to those of other international systems, pose a large problem for the Superintendency.
On the issue of market efficiency and competition, a similar argument can be mounted that seemingly excessive or ineffective regulation puts an undue cost on AFPs and the market for private annuities. Associated regulations which relate to the requirements for capital to enter the system, investment limitations, annual return requirements, and management fee limitations place an indirect cost on the associated affiliate and have an impact on associated competition among such affiliates.
The new system imposes minimum and maximum restrictions over the funds' rate of return on pension investments, such that no AFP is permitted to earn 2% more or less than the all AFP average. In addition, AFP commissions are subject to regulatory restrictions, including the requirement that commissions be levied only on new contributions (and not on assets or returns). New entrants to the AFP fund group are permitted, with minimum capital requirements for reserves set at approximately US$120,000-$480,000 (in 1991$). Finally, the Chilean government tightly limits AFP investments by specific asset class: the maximum allowable domestic (Chilean) equity holding was 30% of the fund's portfolio, while the foreign equities cap was 10% (later lifted to 20%), and government bonds can constitute no more than 45% of the AFP portfolio.15
As I have indicated in my introduction, the purpose of this paper is to add substance to the debate surrounding viable international comparisons which demonstrate that individual accounts exist and operate successfully in Australia and other countries.
Unfortunately, the tyranny of distance has seen much of the information on the successes of the Australian superannuation model precluded from consideration by major stakeholders involved in the social security debate. Yet, today as tomorrow, Australia will continue to build on its gains as a healthy and innovative retirement model, based on the acceptance by most Australians that empowerment and retirement accounts allow the individual to shape their destiny more successfully in the future.
Furthermore, Australia, unlike Chile and the United Kingdom, is not attracting as much international criticism for the associated marketing and administrative costs which are passed on to the consumer. Through active competition and efficiency, the market has generated comparatively high returns and low administrative costs.
-- David O. Harris is a Research Associate with Watson Wyatt Worldwide in Bethesda, Maryland. A native of Australia, he served as International Liaison Officer and International Pensions Research Manager with the Australian Competition and Consumer Commission and the Office of Fair Trading in the United Kingdom. He is the author of At the Intersection: An International Study of Public Confidence in the Life Insurance and Superannuation Industry.