Thanks to a quirk of fate, the IMF Staff Association included me in the early 1970s in their negotiations with management to restructure the IMF Staff Pension Plan. That experience opened my eyes and broadened my horizon about the costs and benefits of offering employee benefits in the form of indexed pensions with open-ended commitments.
The fact that the ultimate decision makers were also direct beneficiaries of the negotiated agreement ensured a big spending final product covering the needs of both short- and longer-term employees. The IMF could afford such largesse because achieving financial discipline was not a high-priority issue.
Several years later, reassigned from tax policy to work for Dr. Sax on social welfare policy for the Fraser government, our attention was at once drawn to the lack of any fiscal discipline in the federal government’s spending on superannuation benefits. A Cabinet Decision set up a multi-department Occupational Superannuation Task Force to consider the costs and benefits of superannuation arrangements.
What became at once obvious was a total neglect of the costs and benefits of the superannuation benefits available to both private and public sector employees. Chapter 5 has already detailed how past governments advised by an asleep at the wheel Treasury have run up an unfunded liability on future taxpayers of at least $500 billion. The comparison with the much earlier decisive action by NSW to limit the costs of their employee superannuation benefits highlights the huge costs of the Commonwealth’s use of unrealistic, outdated mortality factors in offering indexed pension payouts.
Just as important were the provisions providing private sector and government accumulation scheme super funds with tax-free income accrual and tax on only 5% of lump sum withdrawals until the first 1983 tax changes (which split benefits into pre and more heavily taxed post 1983 benefits). The introduction of the imputation credit system of company tax in 1987 forced a further change in 1988 introducing a 15% tax on superannuation deductible contributions and fund earnings to offset the cost of extending the benefits of imputation to super funds.
At that stage, the legislation tried to limit total costs initially by strict limits on deductible contributions and tight maximum benefit limits. At one stage there was strict maximum benefit limits set at 7 times the highest Final Average Salary over 3 consecutive tax years. Fortunately for ordinary taxpayers many of the very high-income taxpayers in that period were adopting strategies such as negative gearing and using tax schemes to reduce their taxable income.
In many cases taxpayers ignored the much larger tax savings were available to those who maximized their taxable income over the three-year period, giving them much larger tax benefits via access to a vastly increased maximum benefit limit. Of even more importance to higher income taxpayers was a fundamental problem in the concept of maximum benefit limits and the current changes of no upper limit on super account balances since 2007.
This, of course, is the huge attraction of investing in appreciating assets and receiving fully franked dividends in superannuation (15% tax) and pension (0% tax) funds. The latest budget capital gains tax changes will encourage even further the use of superannuation to minimize capital gains tax bills and maximize the benefit of franking credits.
Switched on taxpayers use several strategies to reduce taxation bills in pension and superannuation funds. For example, taxing all interest income in full making no allowance for inflation increases the attractions of investing superannuation in fixed interest assets when attractive yields are on offer. In the mid-1980s when 10-year government bonds yielded as high as 15% p.a. and the yield on CPI indexed bonds was 4% p.a. plus inflation (unfortunately all Australian Indexed bonds matured in 2020), superannuation and pension funds feasted on these ideal highly rewarding safe investments.
More recently increasing capital gains tax liabilities on investments held outside superannuation has focused attention on concentrating super and pension fund investments on appreciating assets especially those also paying franking credits.
Even after the latest Sec 296 increases in the tax rates applicable to superannuation balances more than an indexed $3 million and $10 million, current taxation arrangements do little to discourage the accumulation of large superannuation and pension fund balances. The tax rules provides limits annual non-concessional personal contributions of to $130,000 until either age 75 or the account balance reaches the current cap of $2.1 million. By making non-concessional contributions for children and grandchildren early in life, wealthy individuals have an easy and workable option to save tax and keep assets within the family structure.
By gifting annual donations at the maximum allowed annual level of $130,000, the current rules help build an account balance of at least $1million at age 30. By the minimum age of 60 when access to the account begins, without any further contributions a low annual after-tax and fees earnings rate of inflation plus 3% would generate an age 60 account balance of $2.4million in today’s dollars. A higher real rate of return of 5% p.a. would generate a balance of $4.3 million again without any further contributions after age 30.
With the average superannuation account balance now less than $500,000, this raises a fundamental equity question: why does the legislation no longer set a maximum benefit limit especially for non-concessional contributions at younger age limits? And once fund members have passed the $2.1 million cap on concessional contributions, why does the legislation allow further compulsory or concessional contributions even at younger age groups.
Quite frankly the current legislation lacks any fundamental rational basis. The continuing efforts of bureaucrats and politicians to ignore the extreme generosity of their unfunded defined benefit pension schemes could be one explanation. So far successive governments have not even focused on ensuring that the large and growing superannuation tax expenditures generate budgetary savings in age pension and related social security and aged care outlays.
Superannuation as it now runs gives a very tax-effective way for people to build wealth with no limits on the potential gain (the best I have seen is $100,000 to $17 million in six years) with no tax on withdrawals of funded superannuation benefits. The 2007 changes effectively removed the taxation of funded benefit withdrawals leaving only funded bequests to non-dependents taxed at a 17% rate. Before then, above the maximum benefit limits excessive benefits faced varying tax rates subject up to the top personal marginal tax rate.
Compared with the pre-2007 legislation, the new Sec 296 penalty tax rates are wimps and a gift to the already wealthy. In no case is there any penalty for exceeding the $3 or $10 million thresholds. Up to $10 million (individual) or $20 million for a couple with superannuation equally split, the tax regime is more generous than the 30% company tax rate given the concessional treatment of the first $3 or $6 million of assets.
Without more tax payable on withdrawals, superannuation up to unlimited amounts is an extremely attractive investment choice. Assume a low annual return (including franking credits) of say a low 6%, even a $3 million cap would generate an annual income of $180,000 would attract tax at say 10% (after franking credits) of $18,000. The same income in personal names would attract around $50,000 in tax with the difference of $32,000 equaling the annual value of the age pension. The higher the return, the larger the tax saving.
Focusing on tax-free pension funds (with a set-up limit currently of $2.1 million), the tax rules allow an annual tax-free pension payment of $125,000 and cash refunds of franking credits to the fund. Thereafter 50% of an added payment is subject to personal income tax but only after the standard tax-free area of at least $22,000 is reached.
Compared with the tax burdens on workers and ordinary Australians, these tax arrangements border are extremely generous. It is time for a future government to reintroduce maximum benefit limits and taxes on withdrawals. One final comment is essential. In past years, governments have relied on the inability of individuals to split their superannuation with their partners to reduce the costs to revenue. With the introduction of super splitting in divorce situations and more super splitting options, there is now greater scope for superannuation splitting between partners.
Nevertheless, any legislation restoring maximum benefit limits and penalty tax rates on withdrawals needs to allow for differences in individual circumstances. Take for example, the case of the $2.1 million cap on funded pension balances. That is extremely generous for a single person owning a house and not paying rent. It is much tighter for a couple where only one partner has superannuation assets with or without a home.
In reinstating maximum benefit limits, any future legislation needs to consider more realistic options than have applied previously: for example,
$3 million (single homeowner); $4 million single non-homeowner: $6million (married couple combined) homeowner: $7.0 million (couple combined non-homeowner). In applying these limits, the legislation will require valuations of tax-subsidized, and taxpayer financed defined benefit pensions. Given that these schemes except for Judges will be less common over the next fifty years, using conservative actuarial factors such as 15 at age 65, 10 at 70 and 5 at age 75 or later calls for consideration to simplify administration.
Allowing retirees already receiving generous, indexed lifetime indexed pensions to double dip using the funded superannuation tax benefits is long overdue for detailed review.