The Retirement Income Review regards the age pension as the mainstay of our retirement system, so the Final Report offers no incentives to decrease dependence on the age pension by encouraging personal savings. Indeed, it could be argued that with the harsh means tests, saving for retirement is actively discouraged. Greater savings result in the age pension entitlement being reduced or eliminated.

Enjoy a higher living standard in retirement

Retired Australians have a long history of dependence on government support. As at June 2019, 71 per cent of people aged 65 and over received some form of pension payment, and over 60 per cent of these were on the maximum age pension rate. As the age pension is regarded by many as adequate, especially for home owners, there is a reluctance to save without compulsion.

Therefore, the only way to improve retirement incomes generally is either to increase the Superannuation Guarantee (SG) or to encourage retirees to consume more of their own savings. A more efficient use of retirement savings implies that people consume some of the equity in the family home and spend more of their superannuation savings during retirement rather than leaving it as a bequest to their beneficiaries.

The Review notes many retirees die with a substantial part of their retirement savings intact. That seems irrational when they could SKI (spend kids' inheritance) and have a higher standard of living. Encouraging this would also mean a higher standard of living during their working life as well, as more of their income would be available for consumption rather than for retirement saving.

The counterproductive behaviour of conserving capital in retirement is explained in the Final Report in a number of ways:

  • Complexity of government systems in age pension, super and age care
  • Ignorance of the benefits of the age pension
  • Ignorance of the government support provided for health and age care
  • Focus on super balances rather than the income produced
  • Poor financial literacy
  • Poor access to financial advice.

Aspiration is not ending up on the age pension

As they are unable to return to work to rebuild their savings, self-funded retirees face many risks. These include market risk, inflation risk and longevity risk. Age pensioners, however, do not need to manage these risks. In addition, they face minimal costs for health and age care.

If retirees behaved rationally, according to the Review, they would use their assets (super and family home) more effectively to increase their standard of living. As the age pension is seen as the best way of managing those retirement risks, they could plan to end their lives as age pensioners because it provides adequate income and their retirement will be risk-free.

The flaw in this analysis is that while the age pension provides certainty, for many people it means certain poverty. It is a living standard to which not many independent retirees aspire. The reason should be clear. Wealth, and the income it produces, provides more choice in every aspect of life. The age pension may provide a basic retirement income, but it severely limits available choices.

In other countries, retirees have a pension paid for life by their previous employer or the government in defined benefit schemes. They can plan their expenditure in retirement with certainty. They seldom have access to lump sums and need never consider such far-reaching consequences.

In Australia, there is also a group of retirees, apart from age pensioners, who enjoy a risk-free retirement. They receive a guaranteed income for life, but frequently that pension has no residual value. Therefore, it cannot be included in a bequest. This group includes retired politicians and government officials, judicial officers, military and police officers, as well as university academics. The guaranteed retirement income removes almost all retirement risks and there is no impediment to spending.

Perhaps this influenced the members of the Review panel, all of whom belong in the above category, where spending all the available resources must seem obvious.

Holding capital in reserve is a rational choice

For Australian independent retirees, however, the retirement challenge is much more complicated. If they wish to achieve a higher income, they not only need to manage the above risks, but they also need to manage legislative risk. This is the risk that the government changes the rules as concessions are withdrawn or new taxes imposed.

Advisers often use life expectancy figures as a proxy for longevity risk. Life expectancy figures represent the median, not the average. By the time a cohort reaches its life expectancy, 50 per cent of the cohort is still alive! Planning to consume all one’s resources by one’s life expectancy is inherently risky for half of the population! Longevity risk receives little attention because the age pension assumes the role of ultimate safety net.

The Final Report also overlooks fundamental human behaviour. We spend our lives trying to grow our wealth and our income to have greater choice. And yet, the Report suggests that people should voluntarily impoverish themselves as they age. Few people do this willingly unless they seek to qualify for that government funded annuity, the age pension.

It is not avarice driving this behaviour. In order to manage these retirement risks, retirees require an abundance of caution to navigate a retirement of uncertain duration and complexity. Therefore, the rational and prudent thing to do is to hold capital in reserve to meet unexpected liabilities.

The covid-19 pandemic provides an excellent example of rational behaviour in response to uncertainty. This event generated great uncertainty about future income, particularly as the duration of the lockdown was unknown. The June quarter GDP figures showed a drop of 7 per cent, the largest on record, but 95 per cent of that fall was accounted for by a reduction in consumer spending.

Although there were reduced spending opportunities, most of that is explained by a determination to hoard cash as insurance against an uncertain future. The domestic saving ratio grew from 4 per cent normally, to 20 per cent, again showing that hoarding cash is a rational response to uncertainty. People were given early access to their superannuation savings of up to $20,000. Much of these superannuation savings went straight into bank accounts at a time when banks are paying almost nothing in interest. Indeed, banks report that savings accounts now stand at a record $100 billion. Economists expect this money to be consumed when confidence returns.

Company response was also prudent and rational

Due to the extreme uncertainty, many dividend distributions were withheld. In some cases, extra capital was also raised at low prices thereby diluting shareholdings. The rational response to uncertainty is to hold capital in reserve. For everyone, our confidence in the future determines our willingness to spend resources today.

During the pandemic, the assets and incomes of many businesses and employees were protected with a range of government initiatives, but independent retirees were left to manage this crisis alone. Market values of their assets were smashed by March 2020. The income they had relied on evaporated. Rental income stopped and bank interest rates were lowered. Arguably this was legislative risk writ large.

By contrast, age pensioners and retired government officials were completely unaffected. According to the Governor of the Reserve Bank, retirees just need to “suck it up”.

Life as a self-funded retiree

The rational response then, is to self-insure against a very uncertain future. Indeed, a long-term psychological effect we should expect from this pandemic is that future independent retirees will hold even more capital as insurance against unexpected calamities.

Given the risks faced by independent retirees, it is not clear how more financial advice, knowledge of government services or increased financial literacy will change this behaviour. The Report demonstrates limited understanding of the risks faced by independent retirees, or indeed rational human behaviour in response to high risk and uncertainty. Wishful thinking will not change this behaviour.

To give retirees confidence to use more of their resources, we need to reduce risk in retirement so that they can plan with greater certainty. A SKI strategy is more akin to a slippery slope.

Jon Kalkman is a former director of the Australian Investors Association. This article is for general information purposes only and does not consider the circumstances of any investor.

This article first appeared on Firstlinks, a Morningstar company.