Many retired Australians are covered by defined benefit schemes funded by their superannuation savings. These schemes were supposed to be very beneficial to retirees as are the unfunded defined benefit schemes provided by all governments to groups such as politicians, public servants and the military. Were they?
First, a little background
Superannuation deductions from your wage or salary are compulsory; and these make a sizeable and growing share of your total employee receipts.
These superannuation contributions are taxed at what is described as a concessional rate of 15 per cent. But as pointed out by economist Jonathan Pincus, they are not actually.
Jonathan Pincus points out that Treasury’s preferred benchmark is nominal comprehensive income, which lacks both effective protection against inflation and generates exceedingly high effective tax rates based on the consumption/cash-flow benefits of the superannuation scheme.
For long-term savings plans such as superannuation, the appropriate benchmark is the consumption yielded on retirement. This is essentially a consumption or expenditure benchmark. He finds that Australia’s tax regime imposes unjustifiably heavy burdens on low-income earners, and effective rates of over 50 per cent on middle- and upper-income earners. Thus, contrary to the view of Treasury, superannuation is not lightly taxed. Treasury claims a loss of nearly $50 billion in annual tax revenue.
When the Organisation for Economic Co-operation and Development (OECD) reported on the rate of tax subsidy provided by 41 countries’ main private superannuation scheme on a lifetime basis, Australia came in with a tax subsidy rate of about 24 per cent, which is at about the medium value. Hence, the so-called concessions included in Australia’s superannuation scheme seem quite reasonable based on international standards.
Despite this, the Turnbull government introduced a lifetime transfer balance cap which greatly limits access to so called concessional contributions and plays a critical role in my story. In the belief that superannuants are not sufficiently taxed, in 2025 the Albanese Labor government proposes to introduce a new tax set at the rate of 30 percent on unrealised capital gains in superannuation accounts. Such a tax has already been applied in Norway with an unprecedented exodus of the country’s ultra-wealthy. The tax attempted to raise only $146 million but $54 billion in wealth left the country with the departure of hundreds of wealthy people.
While this will be initially limited to supposed high-dollar value accounts (on the amount over $3 million), the base will not be indexed. Hence, eventually, most superannuants will be subject to it. The Grattan Institute disputes this, claiming that only the top 10 percent will be affected in 30 years. But this makes no sense. Inflation could be exceedingly high, or the government could lower the threshold substantially and potentially to zero. The Grattan Institute already recommends that the threshold be lowered by one-third.
There are untaxed alternatives to superannuation investment such as one’s principal residence, as well as the presence of tax havens offering shelter to wealthy investors. If the government forces savers to take as much money as they can out of their superannuation accounts, there could be a net loss of revenue, as occurred in Norway. Moreover, if this happens, more will end up receiving the Age Pension which is exceedingly costly to taxpayers. It does not seem good policy to largely discourage our system of superannuation by falsely claiming that our compulsory superannuation system is excessively generous.
With this background, I now turn to defined benefit pensions.
Defined benefit schemes in Australia
Defined benefit pensions are what are called “annuities”. An annuity is a fixed amount, which is paid annually, hence the name “annuity”.
A conventional annuity has a specified life, such as 20 years. But, for the one million or so Australians on a defined benefit indexed pension (DBIP) annuity, it has an uncertain life as it ends when you die. If you have a spouse who outlives you, then the annuity will generally continue until the death of the spouse at a diminished rate.
These defined benefit pensions are peculiar, and the rules are convoluted. Some schemes depend on the retiree’s final salary, others on the lifetime contributions made.
Some schemes are unfunded. For example, for public servants and politicians their defined benefit plans are paid directly out of Consolidated Revenue. Hence, there are no contributions and no earnings.
There are arbitrary-seeming limits on how much tax-free annual income an individual can receive from any retirement scheme. This is known as the lifetime transfer balance cap. Each superannuation fund member will have their own personal transfer balance cap, which depends on the general balance cap at the time the pensioner enters the scheme.
For anyone joining from 2023, the cap is set at $1.9 million and for someone joining from July 1, 2025, it will be $2 million. Approximately 17 per cent of superfund members have a balance that is at or exceeds the cap.
Your entering transfer balance cap itself is indexed for inflation, but, sadly, your personalised cap is not indexed if it was ever fully utilised, even temporarily. This means that only the unused portion of your cap can be indexed for inflation. This is arbitrarily discriminatory. It is designed to prevent any further access to tax-free benefits over your lifetime even when inflation has made you a great deal worse off.
This deemed special value of your annuity is directly related to your annual pension. The value is 16 times your annual entitlement (and conversely, your annual entitlement is the value divided by 16). Thus, if your DBIP cap is set at $1.9 million and your annuity amount (annual pension) is set at the current permitted maximum of $118,750, then this special value equals your cap of $1.9 million as 16 times $118,750 is $1.9 million.
According to the Australian Bureau of Statistics, the pensioner/spouse combination entered the scheme at the age of 65 in 2022 and the age at death is 83 with an expected retirement phase of 18 years. I allow for a rising life expectation such that the last surviving person in the combination is expected to die after 20 years in the scheme.
Government policy reduces the benefits by 33 per cent
With a universal multiplication factor of 16 and a generous expected 20-year life, the implied real (in excess of the Consumer Price Index) return for the pensioner is only 2.2 percent per annum. The government, in conjunction with the funds, chose the factor of 16 to impose a severe cap on the value of funded defined benefit pensions.
Over the last 32 years superfunds have earned a nominal rate of return of 8 percent per annum and with an average CPI inflation rate of 2.6 percent per annum, the real return was 5.4 percent per annum which is far more than the 2.2 percent rate stemming from the factor of 16.
This understatement of fund returns lowers the multiplicative factor for funded schemes from 16 to 12 and means that pensions would need to be raised by a massive 33 percent to reflect the expected returns on the funds provided by the pensioner over his lifetime. That is, the government set return on funded defined benefit plans is exceedingly low.
Thus, a risk neutral investor would prefer an accumulation account to a funded defined benefit plan as the expected returns are 33 per cent higher. Sufficiently risk adverse investors may prefer the certainty of funded defined benefit plans over more risky accumulation funds.
Within the $1.9 million cap, a 5.4 percent return increases the annual pension by over $39,000 for someone at the cap limit to $157,674.
Doubling the expected time in retirement to 38 years with expected death at age 103 would also be consistent with a 5.4 percent return.
Whether the multiplicative factor is 16 or the more justifiable 12, the deemed value of the pension remains constant over the expected 20 years of the pension life. This makes no sense other than to arbitrarily restrict access to super. The older and closer to death (termination) the smaller is the remaining value of the pension. One day prior to death, the deemed pension value is identical to when the person first entered the scheme.
Naturally, there are penalties for exceeding the cap. For example, if you have additional assets or contribute to an accumulation fund such that the value of your transfer balance exceeds the value of your personalised DBIP cap, then the excess balance is taxed at 15% for the first time you have an excess transfer balance and 30% the second.
Funds placed into an accumulation account are taxed at your marginal rate. This inability of the pensioner to replenish the value of his capped pension by taking on additional work could discourage socially beneficial participation in the labour market at a critical time in which the elderly are encouraged to continue to contribute by working longer.
Millions of prospective retirees commiserated, and super funds celebrated when funded defined benefit plans were withdrawn by universities and private employees as they were supposedly not commercially viable. But this is not necessarily true.
In conclusion, any retiree who at one time reaches his caped amount is no longer eligible for inflation indexation.
Moreover, funded defined benefit pensions terms set by the government can be severely discriminatory against recipients who have personally contributed to their fund and appear designed to subsidise superfunds and accumulation accounts at the expense of pensioned retirees.
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