Superannuation again

This is my second column in a row on superannuation as super choice looms. Super has been an area that Australia’s politicians have not excelled themselves. The ALP deserves considerable credit for moving on super and extending it to the hoi polloi. Focusing on the long term is also laudable in itself – especially in the light of what we’ve seen lately. Its pretty unclear what the coalition really think of super.

But the ALP didn’t show any real attention to detail. There was lots of pressure from early on I recall Barrie Unsworth stacking on a huge blue to ‘grandfather’ various entitlements that were, no doubt, none too fair.

So there may have been political difficulties that made it hard for them. But the ALP (particularly those who fancied themselves as a ‘big picture’ duo – Paul Keating and his ‘mate’ Bill Kelty) showed a lack of attention to detail which created all sorts of iniquities.

I don’t know this stuff well enough to be sure of my ground here, but it seemed to me very odd that the ALP went for a ‘flat tax’ within superannuation. This meant that it offered little in the way of tax concessions for those on lower incomes whom they claimed (indeed some face substantial tax penalties) to represent and major tax concessions for the wealthy.

I’ve never understood what would be wrong with running the super system through the normal tax system. If you’re on a marginal tax rate of 48.5% then that’s where your tax on super should start and if we feel like handing out tax concessions to encourage savings (not something that appeals to me because, particularly where one only targets a subset of saving, so much of it simply occassions the wealthy rearranging their affairs to capture the incentive) we could provide people with some systematic concession against their marginal tax rate (eg 10% off the marginal rate on their income). I’d be happy to be put straight by readers below, but I find it implausible that it would be much more administratively intensive than the flat tax on super earnings we have now. You might have had to do something smart involving the ATO in the administration of it, but we’ve done that more than once before.

Then there was the way in which fees became quite massive shares of total funds under management for those who made small payments into super, and the way they became fragmented between funds, particularly for itinerant workers. Just a detail for the pollies but I don’t suppose it felt like that if you were a fruit picker and in effect you simply handed over part of your wage to a private bureaucracy. It took until Dawkins’ Treasurership for a fund to be developed which addressed this problem.

In any event, this week’s column argues that, in the context of reform of superannuation towards two goals that are worthy in principle – full funding and greater provision of choice – we’ve nevertheless managed to lose some of the intergenerational risk sharing that went on when we had pay as you go, defined benefit schemes.

As usual the 820 words I got weren’t enough to cross the ‘i’s and dot the ‘t’s. (I stuck an extra para in the version of the op ed appearing below to speculate about more than one kind of instrument for sharing intergenerational risk. I also threw in the Woody Allen quote for fun.) Also there was not all that much intergenerational risk sharing in defined benefit schemes. But the goal of providing more seems worthy of some thought.

I’d be interested in Troppodillians’ views on what would be the best instrument to allow people to take out some intergenerational insurance within their super portfolios.

Are you feeling lucky?

More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness. The other, to total extinction. Let us pray we have the wisdom to choose correctly.

Woody Allen

In October 1987 my father’s retirement superannuation pay-out was sitting in the trustee’s bank account pending payment to him. He wanted to invest it in the stock market. Those with a keen eye for dates might already have guessed that while he waited to extract his money like teeth from the red tape encrusted super system, global share prices fell by almost a quarter!

This final stroke of luck was symbolic of how financially lucky his generation was to enjoy the long boom of the 50s and 60s. Dad’s own father’s generation cobbled together their retirement savings between two world wars and the great depression!

Will your generation be lucky or unlucky? Who knows? Shouldn’t we be thinking about that as we move further towards the goal of putting you in charge of your superannuation with ‘super choice’?

Super schemes have typically operated to guarantee contributors a ‘defined benefit’ (in the way that the old age pension is a ‘defined benefit’ and independent of the tax you’ve paid when younger). We’ve been unpicking this system in a way deregulating it and instead moving towards ‘accumulation’ funding of superannuation (where your ultimate benefits are a simple function of how much you’ve accumulated).

This produces some of the classic benefits of deregulation. Defined benefit schemes create arbitrary unfairness like unexpected benefit changes and/or unexpected increases or reductions in contributions. Accumulation funding is transparent, and ‘choice of fund’ puts you in control.

But there are two problems big problems. Both arise from applying a deregulatory formula rather than optimising the complementary roles of government and markets in a mixed economy.

First, as I argued last week, ‘investment advice’ is riddled with poor skills, poor information about investment performance, and conflicts of interest. We should regulate to improve performance rather than just encrust it in yet more red tape.

Second, full funding exacerbates intergenerational risk. Someone in a ‘lucky’ generation earning a 6% real rate of return on super would retire with nearly twice as much as someone in an ‘unlucky generation’ earning a 3% return.

Many people would buy insurance against that kind of bad luck like they do against having their house damaged. But no-one’s selling it. Even with burgeoning derivatives markets assisting firms manage risk, markets won’t ever do much more than scratch the surface of insuring against ‘intergenerational risk’.

Now pooling risks that markets can’t pool is one of the core functions of government. Could governments help us manage intergenerational risk?

One possibility among several would be to create what I’ll call ‘retirement bonds’ and offer them to superannuation funds. The bonds would pay a yield that was higher than the yield from a diversified share portfolio for an unlucky generation, but lower than the yield for the same portfolio for a normally lucky generation.

A variation on this would be for these bonds to ‘smooth’ returns over long periods of time with excess returns being ‘banked’ and returned to people in poorer years – as occurs within the Commonwealth super scheme, and in a way that is loosely analogous with some of the instruments the government has made available to farmers to average and otherwise smooth their after tax incomes.

Your super portfolio could then purchase some of this ‘insurance’ against your being in an unlucky generation. It’s a trade between two parties each with very different capacity to bear risk. On one side of the trade are individuals like you and me many of whom will prefer greater security of a good return rather than higher returns with much greater risk of bad returns. On the other side is the state, which can pool risks, and so bear them much more effectively.

And because it can be done within the existing ‘super choice’ structure, it’s not ‘one size fits all’ as government action often is and as ‘defined benefit’ funds often are. Each person’s preferences are taken into account by themselves as they make choices and they only take up the offer of ‘retirement bonds’ to the extent they wish.

And, as is the way with trades, both parties win. Not only do you and I get a very important choice we’d otherwise miss out on, but the government could expect to make a profit over time. That’s because retirement bonds pay a yield that’s lower than the return the government would expect from investing the money in a diversified portfolio of high yielding assets like the ‘Future Fund’. The expected government profit would be the premium for insurance that only it could provide.

If retirement bonds came to comprise say 15% of super assets, they’d make a nice little earner. If, for instance, there was a two percentage point margin between payment on the bonds and the expected return on the government’s fund, this would generate over 1 billion per annum which would approximately double with rising super assets by 2015.

The catch?

Government as an entity would bear more risk. However that’s only because its citizens were bearing less or rather lightening its burden by spreading it around.

Its another variation on economic reform, but rather than simple deregulation it would use both arms of the mixed economy government and the market to help us grow richer not by working harder, but by working smarter.