Policymakers and commentators would do well to keep in mind that superannuation is only one of a wide range of investment options open to retirees. Indeed, for retirees with SMSFs in particular, their superannuation is often only a part of their investment portfolio.

The tax exemption on earnings on assets supporting pensions is often put forward as a compelling reason to keep money invested in superannuation in retirement. However, tax concessions currently offered to older Australians mean that many retirees would not pay income tax even if they held their savings outside the superannuation environment. Any changes to the taxation of superannuation should be mindful of this.

Proposals for a tax on pensions

In light of the deterioration in government finances, a number of commentators have suggested introducing a tax on earnings in pension phase. Often these proposals come with the sweetener of a reduction in the tax on earnings in the accumulation phase to make the change more palatable to the electorate.

One such proposal floated in the media estimated that setting a tax on all superannuation earnings at 10.5 per cent would raise the same revenue as the current 15 per cent tax on accumulation earnings. With our ageing population leading to a higher proportion of assets in pension phase, it was predicted that this policy would increase the overall tax take in the longer term.

Unintended consequences

However, our analysis suggests that such a measure alone would most likely have completely the opposite effect; it would drastically reduce the total amount of superannuation savings in Australia and the tax accrued from those savings.

Simply put, if retirees behave rationally in response to such a policy, then most would remove much or all of their superannuation in favour of better tax-sheltered investments. In fact, if the tax rate in the accumulation phase is reduced as part of the same policy, the ATO should expect to see a significant reduction in the total tax take from superannuation and at the same time we may see a reduction in Australians’ retirement incomes.

Let’s look at how such a policy might impact a fairly typical couple retiring at age 65, who own their own home and have $400,000 in superannuation savings between them as well as limited other savings.

Under the current regime, if they choose to keep their savings in the superannuation environment and commence account-based pensions, then earnings on those assets are exempt from tax. Whether they look to take advantage of the flexibility of an SMSF or the relative simplicity of an APRA-regulated fund, they have a wide range of tax-efficient investments to choose from within super.

Introduce a tax on earnings in the pension phase and our couple must think twice about leaving their savings in superannuation. If they withdraw their savings and invest them outside superannuation then the income earned would form part of their assessable income for tax purposes.

A reasonably balanced investment strategy in retirement might yield around 5 per cent per annum on average over the long term – say $20,000 in income on their current $400,000 in savings. When we allow for the Seniors and Pensioners Tax Offset this is below the threshold at which they would start paying income tax, even taking into account their age pension entitlements. From a tax perspective, they would be better off investing their money outside of superannuation.

In fact, if a tax of 10.5% per cent on pension earnings was introduced, we estimate that our couple would need retirement savings of over $1.5 million between them in order for it to be tax-efficient to leave their savings in super compared to outside. This is again based on achieving a 5 per cent per annum return both inside and outside superannuation.

Clearly, this is going to impact on the amount of money retirees choose to keep invested in super. These proposals assume retirees keep pumping their retirement savings into superannuation pensions at the current rates, despite the fact they will be worse off tax-wise. We don’t believe that this is likely, particularly for well advised SMSF trustees, and therefore the expected levels of tax will not materialise. Policies that also reduce the tax rate on accumulation assets are more likely to reduce the overall tax take.

We would go further and suggest that incentivising people to take their savings out of the superannuation environment may also be detrimental to their retirement outcomes. For the less financially literate, choosing your own investments outside the regulated superannuation environment may lead to less appropriate investment, perhaps resulting in lower returns. Removing the self-imposed discipline of setting up a pension to provide a regular income could also lead to retirees spending their savings faster and falling back on the age pension sooner.

Doug McBirnie, consulting actuary, Bendzulla Actuarial