Pension Reform: What Can the U.S. and Australia Learn from Each Other?

by Jon Forman Alfred P. Murrah Professor of Law University of Oklahoma

Faculty Exchange Lecture Texas Tech University College of Law Lubbock, Texas November 11, 2011

Outline

    Life Cycle Model Social Security/ Age Pension Private Pension/ Superannuation Supplemental Savings 2

Year 1960 2000 2040 2080

People are Living Longer: Americans

Life expectancy at birth Life expectancy at age 65 Men

66.7

74.0

79.0

82.4

Women

73.2

79.4

82.6

85.6

Men

12.9

15.9

18.8

20.8

Women

15.9

19.0

20.9

22.8

3

But People Are Retiring Earlier: Percentage of Workers Electing Social Security Benefits at Various Ages

Year 1965 1975 1985 1995 2004 Age 62

23.0

35.7

57.2

58.3

57.5

Ages 63-64

17.7

24.5

21.1

19.5

19.0

Age 65

23.4

31.1

17.7

16.3

18.6

Ages 66+

35.9

8.7

4.0

6.0

4.8

Average age

65.9

63.9

63.6

63.6

63.7

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U.S. Life Expectancies at Birth versus Social Security Full Retirement Age 90 85 80 75 70 65 60 55 50 45 40 1900 1940 Life expectancy at birth, females Life expectancy at birth, males Full retirement age for people born that year 1980 Year of birth 2020 2060 5

Stages of the Simple Economic Life Cycle

Consumption Birth Age 20-25 Income Age 60-65 Death 6

U.S. Social Security

     Social Security taxes Workers pay   6.2% of their earnings for Social Security, and 1.45% of their earnings for Hospital Insurance under Medicare (Part A) Employers pay an equal amount The total is 12.4% for Social Security and 2.9% for HI 2011 tax base is $106,800 in 2011 Social Security Administration, 2009 Social Security Changes, http://www.socialsecurity.gov/OACT/COLA/cbb.html

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Worker Benefits

  Workers over 62 are eligible  If they have worked 10 years Benefits are based on a workers earnings history  Career-average earnings  Average Indexed Monthly Earnings (AIME) 8

Replacement Rates for Retired Worker Age 65, 2011 $120 000 $100 000 $80 000 $60 000 $40 000 $20 000 $0 Board of Trustees, 2011: Table VI.F10.

Past Wages Benefits $70,000 $18,800 55% $10,400 "Low" $41,800 41% $17,100 34% $22,700 "Medium" "High" Earnings Level $106 800 25% $27,000 "Maximum taxable"

 90% of people 65 and older get Social Security.

 Nearly 2 in 3 (64%) get

half or more

of their income from Social Security.

 About 1 in 3 get

almost all (90% or more)

of their income from Social Security.

SSA, 2010a: Table 9.A1.

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Medium Earner’s Replacement Rate at 65 After Medicare Parts B and D Premiums 45 40 35 30 25 20 15 10 5 0 39% 37% 32% Ruffing and Van de Water, 2011.

2005 2010 2030 11

The Australian Age Pension

    funded from general revenues 2011, a maximum of $670.90 every fortnight for singles and $1,011.40 for couples The single benefit is designed to provide about 25% of average male earnings Benefits are reduced by both an asset test and an income test 12

Two Basic Types of Pensions

  Defined benefit plans Defined contribution plans 13

What is a Defined Benefit Plan?

   Employer promises employees a specific benefit at retirement To provide that benefit, the employer makes payments into a trust fund and makes withdrawals from the trust fund Employer contributions are based on actuarial valuations 14

Defined Benefit Plan

  Employer bears all of the investment risks and responsibilities Typical plan provides each worker with a specific annual retirement benefit that is tied to the worker’s final average pay and number of years of service 15

Defined Benefit Plan

   For example, a plan might provide that a worker’s annual retirement benefit is equal to 2% times years of service, times final average pay B = 2% × yos × fap Final-average-pay formula 16

Defined Benefit Plan

  Worker with 30 years of service would receive 60 percent of her pre retirement earnings Worker earning $50,000 would get $30,000-a-year pension  B = $30,000   = 60% × $50,000 = 60% × fap  = 2 percent × 30 yos × $50,000 fap 17

What is a Defined Contribution Plan?

    Individual account plan Employer typically contributes a specified percentage of the worker’s pay to an individual investment account for the worker Owned by employee Benefits based on contributions and investment earnings 18

Defined Contribution Plans: How Individual Retirement Savings Accounts Work

CONTRIBUTIONS FUND EARNINGS BENEFITS 19

Defined Contribution Plan

   For example, employer might contribute 10% of annual pay Under such a plan, a worker who earned $30,000 in a given year would have $3,000 contributed to her account  $3,000 = 10% × $30,000 Benefit at retirement based on contributions, plus earnings 20

Australia: A Universal Pension

  1986—industrial agreements for 3 percent of payroll contributions 1992/1993—superannuation guarantee legislation, eventually mandating 3 percent contributions to individual retirement accounts  Higher levels phased in, reaching 9 percent in 2002/2003 21

Tax Treatment of a Typical Individual Account in Australia – tte

15% TAX (payable by the fund) 15% TAX ZERO TAX (from age 60)

CONTRIBUTIONS FUND BENEFITS EARNINGS 22

IMPROVING NATIONAL SAVINGS AND SUPERANNUATION ADEQUACY

 The Government will increase the superannuation guarantee (SG) rate from 9 to 12 per cent over time.

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Superannuation

 

GOVERNMENT CONTRIBUTIONS FOR LOW INCOME EARNERS

 A new superannuation contribution of up to $500 will be provided by the Government for workers with income up to $37,000.

CATCH-UP CONTRIBUTIONS FOR OLDER WORKERS

 The Government will allow individuals aged 50 and over with total superannuation balances below $500,000 to make up to $50,000 in concessional superannuation contributions. 24

Most elderly don’t receive pensions in the U.S.

Percent with Employer-Sponsored Pensions All age 65+ Couples Unmarried men Unmarried women 41% 51% 42% 34% Social Security Finances: A Primer , at 10.

25

Tax Treatment of a Typical Individual Account in the U.S. – eet

ZERO TAX ZERO TAX TAX

CONTRIBUTIONS FUND EARNINGS BENEFITS 26

Tax Treatment of a Roth Individual Account in the U.S. – tee

TAX ZERO TAX ZERO TAX

CONTRIBUTIONS FUND EARNINGS BENEFITS 27

Goals for a Pension Plan

   First, ensure that every employee earns a meaningful retirement benefit  and that long-time employees are guaranteed an adequate income throughout their retirement years Second, have a minimum of work disincentives for employees coming in and out of service Third, be affordable and well-financed 28

Optimal Policies for Maximizing Retirement Income

   Contributions Accumulation Pay-out (Decumulation) 29

Contributions

   Voluntary v. Mandatory Encourage Saving More  Tax incentives?

 Limits?

Defaults 30

Accumulation

   Investment Rules Fiduciary Duties Distribution 31

Accumulation: Investment Rules

  Improve Investment Choices Minimize Fees 32

Accumulation: Fiduciary Rules

 Fiduciaries should:  Act solely in the interest of plan participants and their beneficiaries and with the exclusive purpose of providing benefits to them;     Carry out their duties prudently; Follow the plan documents (unless inconsistent with ERISA); Diversify plan investments; and Pay only reasonable plan expenses 33

Accumulation: Fiduciary Rules, continued

  Impose fiduciary duties on more brokers and financial advisers Toughen the standards 34

Accumulation: Distribution Rules

  Preserve benefits until retirement Raise the retirement age 35

Pay-out (decumulation)

  Improve Individuals’ Understanding about Retirement Income Encourage life-time income options  Targeted Withdrawals   Require Sponsors to Provide an Estimate of Lifetime Annuity Income on Benefit Statements Encourage sponsors to offer a default annuity 36

Preretirement Earnings Replacement Rates, 2011

Source of replacement rate income Low earners’ replacement rate

Social Security Replacement rate needed from other sources to achieve 75 percent replacement rate 55.2

19.8

High earners’ replacement rate

33.9

41.1

37

Source:

http://www.gao.gov/new.items/d11400.pdf

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https://guidance.fidelity.com/living-in-retirement/annual-portfolio-withdrawals?ref_ls=lr3007 . 39

Source:

http://www.gao.gov/new.items/d11400.pdf

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About the Author

  Jonathan Barry Forman (“Jon”) is the Alfred P. Murrah Professor of Law at the University of Oklahoma College of Law, teaching tax and pension law and the author of Making America Work (Washington, DC: Urban Institute Press, 2006). He was the Professor in Residence at the Internal Revenue Service Office of Chief Counsel for the 2009-2010 academic year.

Jon can be reached at [email protected]

; www.law.ou.edu/faculty/forman.shtml

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