Case Study - The Retirement Trap
Two recurring themes that frequently arise when discussing retirement policy are whether people have sufficient incentive to save for their own retirement and even if they do, will retirees subsequently splurge all their savings on holidays, home, a new car etc and then live off the age pension. Indeed, the latter seems to be almost taken as a given by some commentators although at around $35,000pa for a couple, the age pension only provides for a Modest lifestyle according to ASFA’s definition (see later).
Writing in The Australian, 30 June 2017, Glenda Korporaal reports on a paper by Jack Hammond and Terrence O’Brien* which argues that the combination of the changes to super and age pension eligibility coming into effect in 2017 produces a “retirement and income savings trap”. Trish Power of the SuperGuide website has labelled this “Retirementgate”.
As summarised in The Australian:
“The Hammond-O’Brien paper shows that a home-owning couple with $400,000 in super, when combined with the age pension, can earn more than a couple with $800,000 to $1 million in super whose assets mean they don’t qualify for the pension. The retirement savings “sweet spot” is now $400,000 for a home-owning couple who would be eligible to receive 94% of the age pension, delivering them a total income of $52,395 a year (assuming they draw down the minimum 5% of their super).”
The paper further argues that “you cannot secure more (in income) than what you secure with $400,000, until you have at least $1,050,000 in super.”
Note that the analysis is based on essentially maintaining the initial super capital although it recognises that this may not be possible if returns are less than the minimum required drawdown.
Perhaps predictably, most of the comments on the article express anger and outrage at the superannuation changes in particular and Government tax grabs in general, but some are more circumspect such as John who writes:
“The purpose of the system is not so we can pass on a bigger estate to the kids. The exact point of the system is to draw down on your super retirement savings, for at least a few years, and therefore reduce the nation’s total spend on the aged pension.”
Continuing with the theme, Allen and Corporaal writing in The Australian (4/7/2017) under the headline “Cruise ships rise on retiree tide” found “Luxury cruise bookings have doubled for the local arm of one American operator in just over 12 months, fed by cashed-up retirees looking to reduce their assets to qualify for the pension. The stricter assets tests are encouraging retirees to reduce their cash to make sure they still qualify for the pension. The combination is encouraging more retirees to spend up on holidays rather than put their surplus cash into savings or superannuation”. In the same article, Tourism Australia managing director, John O’Sullivan, was not so sure; he said “it was no surprise Australians had embraced cruising. You only have to look at how strong it is in other markets; it has grown aggressively. I don’t know if Australians are using their super”.
Since the analysis, at least as presented, is static in nature, we have used Optimo Financial’s PathFinder model to investigate the issue in a more dynamic setting over 20 years; and especially to see how the financial situation evolves over that time. We look at the hypothetical case of David and Alice who are retired and who are both eligible for the age pension. They have a family home but no other assets apart from their super (to be consistent with the Hammond/O’Brien analysis we have not included personal assets). They have no debt.
The Association of Superannuation Funds of Australia (ASFA) has calculated that in the March quarter 2017, a couple around 65 would require $35,000pa for a Modest lifestyle and $60,000pa for a Comfortable lifestyle. The corresponding amounts for a couple aged around 85 are $35,000pa and $55,000pa respectively.
According to the ASFA Retirement Standard, a comfortable lifestyle enables “an older, healthy retiree to be involved in a broad range of leisure and recreational activities and to have a good standard of living through the purchase of such things as household goods, private health insurance, a reasonable car, good clothes, a range of electronic equipment, and domestic and occasionally international holiday travel.”
We will initially assume that David and Alice require $52,395pa (indexed at CPI) for annual expenses consistent with the “sweet spot” as identified by Hammond and O’Brien. But note that this is $8,000pa less than what is required for ASFA’s Comfortable lifestyle.
We consider three levels of initial super balances:
We have assumed in the analysis:
- Pension fund returns 4.4%pa;
- CPI 2.5%p.a;
Base annual living expenses $52,395 indexed at CPI.
1.2 Question 1: How much will remain?
Since the assumed return on the super fund is less than the minimum required drawdown (5% initially) and therefore the pension fund will be depleted over time, we investigate the projected balance remaining after 20 years for the three cases.
The results are shown in Figure 1. A starting balance of $400,000 is projected to be reduced to around $307,000 while for $700,000 and $1,050,000, the final balances are projected to be $620,000 and $830,000 respectively. Note that these amounts are in current dollar terms. In constant today’s dollars, the amounts are $191,000, $386,000 and $519,000 respectively.
1.3 Question 2: How much extra income?
We have noted that the assumed annual expenditure would be less than ASFA’s Comfortable retirement standard, so the second question investigated is suppose that in each case, David and Alice run down their super over 20 years by increasing their annual expenditure by an equal amount in real terms each year, what is the maximum increase?
Figure 2 shows that with a $400,000 initial super balance, David and Alice could increase their annual expenditure by $8,000 while for $700,000 and $1,050,000 the increases would be $20,500 and $33,000 respectively.
1.4 Question 3: How much if retain some
In the third scenario, we investigate a slight variant of Scenario 2. We saw in Scenario 1, that with an initial super fund balance of $400,000 and an annual expenditure of $52,395 that David and Alice would be left with $307,000 ($191,000 in today’s money) in their account after 20 years. So in this third scenario, we ask how much extra could they spend each year and be left with that amount.
The results are shown in Figure 3. With an initial balance of $700,000, David and Alice could increase their annual expenditure by $11,500 while for a balance of $1,050,000 the corresponding amount is $23,000. Both these amounts would put David and Alice above the Comfortable standard while relying on a balance of $400,000 would not allow them to attain that level.
For this final scenario, we also show in Figure 4 the age pension payments over the 20 years. By around 2029, the annual age pension payments differ by less than $2,000pa for the 400k and 700k cases, while all three cases converge to within that amount by 2032.
Are people likely to forgo saving for retirement or alternatively live-it-up for a few years on their super savings and then rely on the age pension? Maybe, if they are prepared to be satisfied with a Modest lifestyle that won’t afford them many cruises as found desirable by Allen and Corporaal. Nonetheless, Hammond and O’Brien have identified a “sweet spot” of savings around $400,000 and suggest there is little incentive to accumulate retirement funds above that level unless you can get above $1,050,000. Pathfinder is an ideal tool for investigating how the age pension interacts with other savings and to put numerical values to scenarios so that you can properly assess various strategies.
* Jack Hammond and Terence O’Brien “A retirement income and savings trap caused by the Coalition’s 2017 superannuation and Age Pension changes”, Saveoursuper.org.au.