With Defined Benefit or Final Salary pension schemes dying out in the UK, the big question now is how we will cope under the new breed of Defined Contribution (DC) schemes, which offer returns based entirely on the investment performance of retirement funds rather than being linked to the recipient’s salary while working.
One country that has long experience of a DC-based system is Australia. Here we look at some key aspects of a pension system that has long been widely admired internationally.
94%
of Australians exercise the freedoms they have on retirement
Australia moved to its current, DC-based system in 1992. The country has a relatively small number of large superannuation funds into which workers are automatically enrolled and to which they make mandatory contributions. These have risen over the years and now stand at 9.25% of salary. They are due to continue climbing in the years ahead, reaching 12% around 2020.
Australians who have been members of the system since the start and are now approaching retirement have often built up significant savings: A$400,000 (just over £200,000) is not unusual for a saver at 65, according to the
Murray Inquiry report, a panel of inquiry into the country’s financial system that reported in November last year. These sums dwarf the amounts that people typically accumulate in the UK, with estimates of the average pot usually said to be between £20,000 and £30,000.
In the UK, we have not forced people to save, but we have obliged most of them to convert what they did save into a lifetime income. In Australia, it is the other way round: individuals are compelled to save but face no restrictions on what they must do with their money when they retire. The advent of auto-enrolment into occupational pension schemes via the National Employment Savings Trust (Nest), coupled with the abolition of near-universal annuitisation, effectively makes the UK look like a less developed version of the Australian system: strong encouragement to save, coupled with freedom of choice when you retire.
"UK retirees can now take a quarter of their fund tax-free and the rest at normal marginal tax rates"
Today, about 94% of Australians exercise the freedoms they have on retirement by putting their pension money into a ‘retirement account’ and drawing it down progressively over the years, with no protection against the risk that it might run out. Part of Australia’s problem, the Murray Inquiry concluded, was that left to themselves people do not buy insurance against longevity risk, which usually means buying an annuity. If this could be changed, savers would on average have higher retirement incomes and could therefore maintain higher levels of consumption in retirement, which would benefit the Australian economy.
Spurred by the fact that annuity rates have fallen by more than half in the past 15 years, the British Chancellor of the Exchequer George Osborne last year decided to do away with “patronising” restrictions on people drawing down from their pension pots. UK retirees can now take a quarter of their fund tax-free and the rest at normal marginal tax rates – 20% for most pensioners. But just as Osborne was making these changes in London, the authorities in Australia were moving in precisely the opposite direction. One of Murray’s recommendations was that citizens be offered a default option that would involve them spending part of their pension fund on a guaranteed income for life – to wit, an annuity.
Such a move should be voluntary rather than obligatory, it said, but would nevertheless mark a significant shift in the direction of travel pensions-wise.
The original version of this article was published in the March 2015 print edition of the Review.