Australia's superannuation – doomed by its origins

I have presented evidence that Australia's super was created to save the unions from financial oblivion ("Australia's superannuation - DNA and transparency", On Line Opinion, 15 April 2013). As Treasurer, Paul Keating was stiffed by the union leadership when adopting the type of super system now inflicted on Australians, unaware of the self-interest which lay behind this diversion of people's pay into a crude, amateur structure of myriad funds amenable to union influence. How damaging is that? Good question. Trustees of public super funds have resisted transparency into their financial dealings, rendering impossible a proper assessment of the effect of this contrivance. However, two important conclusions can be drawn from the macro information which is available publicly.

First, super is flawed at the policy level because the promised tax advantage is eaten away by the system selected. The costs of public super funds are revealed in aggregate figures supplied to the Australian Prudential Regulatory Authority. Australians in public super funds generally can count on losing an average of around 11 per cent of their compulsory super deduction every year to funds' expenses, on top of the 15 per cent tax they pay on it. Most people have a marginal tax rate of 32 per cent or less, so little is gained by having super in these public funds, by individuals or by government. This practice has been going on at least since records started in 1997. Because Australia's universal super grew out of desperate manipulation by the unions, and funds' commercial structures have increasingly become incestuous, it is not surprising that the expenses born by Australians are inexplicably high.

Second, super will fail because it cannot deliver on its promise. The Australians on whom it was inflicted will be let down badly - because, as American Nobel Laureate William Sharpe observed fifteen years ago, the risk in defined contribution super has been ignored, in both the United States and here. Individuals caught up in the system are unaware of the risk they bear, the funds' trustees have displayed not the slightest interest in it, nor has the government which is heavily exposed to it. This risk is driven by markets of many types – equity, debt, currency, property, commodities. The impact of this market risk has been amply on display for the last five years. To most readers my claim that this risk is ignored probably lacks credibility. After all, what about that vast body of finance and portfolio theory which underpins legions of experts and advisers? The short answer is, yes, material does exist which addresses single-period risk (e.g. annual), but no, it cannot address the risk in defined contribution super because the influence of time is assumed away.

However, it is not just in super that market risk is ignored. Increasingly government revenue is dependent on markets, yet no account of it is taken in fiscal planning. In practice, super outcomes and Federal budgets are each planned around averages. In future periods when financial markets are returning less than average, retirees will be asking the government for greater-than-budgeted amounts of age pension. The risk of this extra demand can be estimated. Our simulations show that for a lot of retirees the variability of demand for the age pension is substantial. Age pension supplements can rise by two to five times the amount which governments' long term planning is based upon. This elevated demand can go on for years.

Future generations will be unable to foot the fiscal bill for these humps in pension demand. The government's Intergenerational Report (2010) shows that age pension is the largest component of budget spending. It will grow by 45 per cent as a proportion of government spending within forty years. The personal cost of the age pension will grow by 250 per cent in that time, from $1,570 per person now to $3,890 per person in 2050, in real terms. Again, those numbers are averages, saying nothing about risk. Just as the stochasticity of markets (chance unfolding over time) drives this age pension burden to much higher levels, government revenue can be expected, with a sound probability, to be in shortfall elsewhere (less capital gains, investment income, commodities etc).

To understand how this calamitous prospect could have escaped notice from the beginning, despite abundant policy makers, actuaries and regulators, amidst the cacophony of market economists, let's reflect on Treasury's role and its customs. Almost two decades after the inception of super, Treasury released that third intergenerational report, projecting government outlays forward three to four decades. It contained no hint of the inbuilt market risk. Why? Because Treasury has always relied on what is termed "central case modelling". That is, it assumes averages will win through. Treasury routinely does rough checks on uncertainty using "sensitivity analysis" - an intellectually frugal technique whereby assumptions are changed arbitrarily on either side of the central value to test the effect of being wrong. Not altogether useless. And indeed that checking was done. And I believe Treasury discovered the uncomfortable truth at that point.

The evidence that Treasury tumbled to super's the inbuilt time bomb, is contained in a Treasury paper released in 2007 (1). Risk was assessed using jolly old sensitivity analysis. The Treasury paper shows the effect of higher investment returns, and offers commentary. But no mention is made of lesser return assumptions. Eh? This is the bit that matters. Astonishingly, this critical result is omitted from the Treasury paper. Even a test this simple would have made Treasury aware of the dice which super has loaded within it. No doubt Treasury did the analysis. Was horror and confusion the reason for omitting the result? What else makes sense?

The former head of Treasury, Ken Henry has admitted, in effect, that super is a failure. At the first sign of real market volatility, Henry publicly doubted the wisdom of holding risky assets in super portfolios. But sadly he misses the point. More conservative portfolios will deliver a bigger drain on revenue from the age pension. Adopting them will simply make the failure of super more predictable. Even nongs know that markets are risky. Australia's economy has been termed a market economy for decades. Professionals know that market risks can be powerful, measured, modelled and managed. But not our Treasury, bless its central-case culture.

And They Keep Dancing

I'm not able to judge whether Keating has awoken to the disaster he has inflicted upon this nation. He has pointed to his ability to implement policy. That's the beginning of the problem. Remember that universal super was cunningly implemented, enticing not a whimper from citizens. People didn't notice being charged for super at the outset because, instead of their pay being reduced, a pay rise was diverted into super. Then they had tax cuts diverted into super. For most Australians there was no noticeable income effect.

In more recent times, Keating presents as an authority on why people should have even more deducted from their pay. He campaigned for upping the super charge to 12%, which he says "will enable fund members on an average salary to retire on 70% of their income, up from 40% under a 9% guarantee." Theatrically, twenty years on, the same parroting without a care for risk. He knows that this incantation depends on the roulette wheels within an almighty casino, over which not even Keating has control. But, before that, Keating advised in 2010 that his system was doomed, by John Howard:

To suit the self-funded retirees and the grey heads who Howard thought were voting for him, what he did he extended the income test right out (relaxing the taper rates for their homes and cash assets). Thanks to Howard we've got an unaffordable retirement income system.

Undaunted, Keating now wants more (15% of pay packets) diverted into that unaffordable system, arguing that greater longevity demands it. This is the politician who labelled another as a nong, a donkey, an intellectual rust bucket, a clod hopper, and poor silly so and so. Still he struts, having inflicted a profound error of policy upon this nation. If we construct an index of policy stuff-ups, taking the pink batt fiasco as unity, then Keating's super is of magnitude tens of thousands of PBEs (pink batt equivalents). At least he warned us:

If the day comes to throw the switch to vaudeville, I'll do it, understand? I mean if one has to be all-singing, all-dancing, that's what we'll be. But in due time.

Greatly more productive super systems are practical. Having dragged Australians to the point of facing responsibility for retirement - while thwarting them with misinformation - it is a modest step to creating adequate, independent self- managers. The essence of a concessional scheme could be retained, offering people the choice of taking all or part of their savings now held by public funds; the remainder would be rolled into a rethought self-managed structure, with scant overhead. Contributions could be made or not, with modest tax advantage. Design would minimise avenues for intervention by cant and cunning.

If it was a worthy policy to assist Australians to be self-reliant in retirement, it was an error to conflate its implementation with unions preoccupied with survival. The evidence points to a breathtaking, self-interested manipulation of citizens' incomes as the result. It was an error to dismiss other ways of safeguarding citizens' forced savings. And to ignore the risks for individuals and the nation. It is no surprise that commerce saw the possibilities, leading to a paradigm now in which funds' competitive success matters more than individuals' needs. I can find no parallels for long, plodding, implacable policy aberrations on the scale of our super which so directly affect citizens pay-packets. The eminent American public servant John Kenneth Galbraith has pondered public policy failures. He would say that Australia's super has arisen:

Out of the pecuniary and political pressures and fashions of the time. Economics and larger economic and political systems cultivate their own version of the truth…There is no serious sense of guilt; more likely there is self-approval.

Thus, while Australia's super is said to be the best, the envy of the world, it is, when disrobed, an exquisite token of a Galbraithian "long and large departure from reality of approved and conditioned belief."

Galbraith would say also that it is too late for Australia to rearrange retirement policy sensibly. The super behemoth has entrenched itself, with aggressive defences. Group effort has been applied to command these new financial fiefdoms establishing barricades of managerial, political lobbying and specialist marketing skills. The public super funds, controlling a trillion dollars of assets, have prepared for challenge. Guess who is paying?