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Australia’s retirees are winning big.

Australia’s pension plan has the right idea—if only retirees stopped trying to game it

By Allison Schrager

Increasing the retirement age from 60 to 62 caused rioting in France. Mere mention of entitlement reform in America contributes to political deadlock.  Aging populations in Europe and America have begun to strain the financing of state-sponsored. On average in developed economies, more than 60% of elderly peoples’ income comes from public sources. Social Security, in America, is projected to run out of money in 2033 and poses an even greater burden on taxpayers. In France, Spain, Italy and Germany state pensions are also funded by current taxpayers. Pension benefits in Germany already take a large share of GDP and are expected to increase well above 10% by 2050. Thoughtful reform is necessary for the sake of long-run fiscal health and retirement security.  What’s the best way?

One idea that both the left and right, in America, can agree on is to give richer people less benefits for their tax-dollar, through means-testing benefits. Means testing, when the government considers your income and/or wealth to determine if you are eligible for benefits, sounds like the most efficient way to reform pensions. It ensures that people who need the most help get it and that the government does not waste money paying for people who don’t need state support. But how means testing will work is not exactly clear. Would it be based on current or lifetime income? Some high earners don’t save. Will we leave them destitute? It seems that both wealth and income should be part of the equation.

Australia has already attempted to answer some of these questions with its means-tested state pension, called the Age Pension. It co-exists with mandatory, tax-advantaged, private savings accounts, the Superannuation Guaranteed Scheme, nicknamed Super, to which Australian employers must contribute. When the program started 20 years ago, they put in 3% of their employees’ salary. Today, the mandatory contribution rate has increased to 9%  and will begin increasing toward 12% later this year. Employees can contribute extra if they choose but the hope is that these accounts will make retirees less dependent on the state.

Super accounts aren’t sufficient to fund everyone’s retirement, especially low earners and people who spend time out of the labor force. People who don’t save enough are eligible for the Age Pension.  In order to receive it you must pass a means test, demonstrating sufficiently meager wealth and income. Income in retirement includes returns on your investments. If your annual income is smaller than $7,200 and your assets are less than $281,000 (if you’re a homeowner) you get the full state pension, $28,745.  The value of your primary home does not count toward your assets, but some durable goods such as cars, boats and antiques do. Your pension benefit is reduced by $13 for every $27 of income above $7,200 or by $40 for every $1000 in wealth above $281,000. Both the asset and income test are applied. Whichever test yields the smaller benefit is what you get. Qualifying for the Age Pension, at any level, entitles you to subsidized drug prescriptions and other benefits.

Australia has an enviable savings rate and the state plan is in decent financial health. By 2040, government spending on the elderly is projected to take up 4% of GDP. That seems cheap compared to what’s projected in Europe.  It seems Australia has it figured out and in many ways it is a well-designed program. But there are some peculiarities that countries considering means testing can learn from.

Economists usually don’t like means testing because it can create queer incentives by imposing high marginal tax rates.  In Australia, an extra $1,000 in the bank can cost you the state pension, prescription drugs and other state benefits. The Australian Treasury estimates the means test on the Age Pension levies a 78% marginal tax rate on investment income.

That gives Australians an incentive to put their money in less productive assets that don’t bear interest, like vacation homes, art and jewelry. What’s even more surprising is once you reach retirement age, you can take your entire Super account as a tax-free, lump sum and spend it however you like or give it your children (though there exists an annual gifting limit). If you’re on the margin of receiving state benefits, it makes sense to do just that, and then claim the Age Pension.

Excluding housing wealth from the asset test creates an incentive to put money into your home. That may explain why Australians in their fifties are taking on more housing debt than ever before. According to a report written by economist Simon Kelly, Australian baby boomers increased their debt levels over the last 10 years. Their property debt increased 45% between 2002 and 2010. That’s remarkable because these are the years boomers should be paying down debt and preparing for retirement.  But taking on more debt has become more common in other developed markets too. According to the American 2010 Survey of Consumer finances, the average baby-boomer’s property debt also increased since 2002 in the US, but only by about 20%. The new generation of Australian retirees has more debt than generations before: property debt among 55 to 64 year-olds increased 123% (compared to about a 70% increase in America) in the last 10 years.

The run up of debt in Australia is probably also due to higher property values which increased 60%, and a looser credit environment. Though taking on debt can be a clever way to retain your wealth and still get a pension. According to Kelly’s report,many Australians load up on property debt and then it pay off with their Super, rather than using it for its intended purpose retirement.  Taking out a home equity loan before retiring, paying it off with the Super once they are of age, and then claiming the Age Pension enables Australians to spend their Super before they retire.

If you’re wealthy or even upper middle class, you probably won’t blow your savings to get the Age Pension. But considering 76% of retirees receive some Age Pension, the means test determines the income of many elderly Australians today. Though the Superannuation scheme is still relatively new, so many current retirees didn’t have enough years to build up savings. The hope is that the future retirees, with more years of saving in Super, won’t be as dependent on the Age Pension.

The means tests used to be worse in terms of discouraging saving. It was reformed in 2007 when the rate at which you lost benefits, for each dollar of income of wealth, was lowered so more Australians could save and still qualify for the Age Pension. The income and asset tests were also simplified.  But these reforms didn’t go far enough. It would be better if Australia required some form of at least annuitization or taxed lump sum withdrawls so it would be more difficult to game the system. There seems to be little interest to try that any time soon. Current reform discussion in Australia mirrors America and Europe. Rather than focusing on the strange incentives that the Age Pension poses to low and middle earners, which encourages dependency on state benefits, the concern in Australia lately has been centered on the tax benefit Super gives to higher earners. Future reform aims to adjust Super’s tax structure in order to extract more revenue from richer Australians.

The Australia experience shows that that means testing is no panacea but it makes sense because it ensures the most needy get help. Yet it is very hard to design a system that does not create perverse incentives. The means tests have to bite somewhere. It’s worse when different types of assets get disparate tax treatment. A clean, sensible plan can quickly become arcane and rife with unintended consequences. Throw political interests into the mix and it gets ugly fast.

In some ways America and Europe are moving to the private savings and smaller-state-benefits-for-the-wealthy model.  Private, tax-advantaged, employer-sponsored retirement savings accounts are already popular in America and the UK. Meanwhile, a generous state pension for all won’t be sustainable much longer. Richer people can probably expect less in exchange for their taxes. But explicit means testing is probably not the best path forward. Europe and America already have means testing when it comes to state benefits for the poor (food stamps, rent subsidies, etc.) and adding more and extending it to the middle class will make an already complicated, flawed system even worse.