Means-tested pension policies become more important globally, as the general population ages and the life expectancy improves. The policies are country-specific to meet government budgets and are updated regularly. Since the Australian retirement system is relatively young, the long-term effects of this new pension system are not yet known. Changes to policy, means-tests and tax rules are expected to occur frequently due to fiscal reasons and once the effects of policy changes to a retiree’s personal wealth (and the economy in general) become evident. Variables directly related to the means-test such as entitlement age, means-test thresholds, taper rates and pension payments can all be adjusted to meet budget needs by the government. On a larger scale, regulatory changes may include whether the family home is included in the means-tested assets, the elimination of minimum withdrawal1
rules, changes in mandatory savings rates or additional taxes on superannuation savings. From a mathematical modelling perspective, this poses difficulties in terms of future model validity, as regulatory risk and policy changes can quickly make a model obsolete if it is not modified to account for the new rules.
The Australian pension system is based on the compulsory superannuation2
guarantee (paid by employers), private savings, and a government-provided means-tested Age Pension. The superannuation guarantee, supporting both defined-benefit and defined-contribution pension plans, mandates that employers contribute a fixed percentage of the employee’s gross earnings to a superannuation fund, which accumulates and is invested until retirement. The current contribution rate is set to 9.5%, and additional contributions attract certain tax benefits. Private savings are comprised of these additional contributions, but also include savings outside the superannuation fund such as investment accounts, dwelling and other assets. Finally, the Age Pension is a government-managed safety net, which provides the retiree with a means-tested Age Pension. This means-test determines whether the retiree qualifies for full, partial or no Age Pension once the entitlement age is reached. In this means-test, income and assets are evaluated individually, and a certain taper rate reduces the maximum payments once income or assets surpass certain thresholds (which are subject to family status and home-ownership). Income from different sources is also treated differently; financial assets are expected to generate income at the so-called deeming rate, while income streams such as labour and annuity payments that are not from a pension account are assessed based on their nominal value.
The motivation for this paper was the recent changes for Allocated Pension accounts, where assets are now assumed to generate a deemed income and no longer have an income-test deduction. Account-based pensions (such as Allocated Pension accounts) are accounts that have been purchased with superannuation and generate an income stream throughout retirement. Such an account does not have tax on investment earnings and is subject to regulatory minimum withdrawal rates each year, which increase with age. Prior to 2015, these types of accounts allowed for an income-test deduction that was determined upon account opening, and withdrawals were considered to be income in the means-test. The income-test deduction allowed the retiree to withdraw slightly more every year without missing out on Age Pension. However, in 2015, the rules changed. Existing accounts were ‘grandfathered’ and will continue to be assessed under the old rules, while the new rules will be applied to any new accounts. The arguments for the changes were simplicity (people with the same level of assets should be treated the same, regardless of how the assets are invested), to increase incentive to maximise total disposable income rather than maximising Age Pension payments and to simplify how capital growth and interest-paying investments are assessed (Department of Social Services 2017
). From a fiscal point of view, the recommendation to introduce the new rules was based on estimated unchanged costs3
); however, the 2015–2016 budget stated expected savings of $
57 million for 2015–2016 and $
129 million and $
136 million for subsequent years (The Commonwealth of Australia 2015
). The allocation to Age Pension in the 2015–2016 budget includes all changes to the Age Pension in a combined viewpoint, so the specific impact of the deeming rule changes on the government is not known.
Problems with decisions that span over multiple time periods are typically modelled with life cycle models and solved with backwards recursion (Cocco et al. 2005
; Cocco and Gomes 2012
; Blake et al. 2014
, to name a few). Life cycle modelling based on utility theory originates from Fisher
) and was later updated by Modigliani and Brumberg
), who observed that individuals make consumption decisions based on resources available at the current time, as well as over the course of their lifetimes. The key work for early models was laid out by Yaari
), who extended the model with uncertain lifetime and studied the optimal choice of life insurance and annuities, while Samuelson
) and Merton
) studied the problem in relation to optimal portfolio allocation. Nowadays, there are extended theories available such as prospect theory (Kahneman and Tversky 1979
) or stochastic dominance theory (Kopa et al. 2016
; Levy 2006
). While prospect theory is based on the findings that individuals often violate expected utility maximization, the stochastic dominance is developed on the foundation of the expected utility paradigm. There is a plethora of research on retirement modelling internationally (Boender et al. 1997
; Dupačová and Polívka 2009
; Hilli et al. 2007
; Vitali et al. 2017
, to name a few), but there is still rather limited research modelling the Australian Age Pension, and even less that enforces the minimum withdrawal rules. The model in Ding
) does not constrain drawdown with minimum withdrawal, which would limit the author from finding a semi-closed form solution. Similarly, other authors that focus on means-tested pension also do not enforce minimum withdrawal rates, such as Hulley et al.
), who use Constant Relative Risk Aversion (CRRA) utility to understand consumption and investment behaviour, or Iskhakov et al.
), who investigate how annuity purchases change in relation to Age Pension. It should be noted that their assumptions do not include Allocated Pension accounts; thus, minimum withdrawal rates may not apply. However, as the majority of Australian retirees own an Allocated Pension account (or similar phased withdrawal products), there is surprisingly limited research conducted on the implications of the regulatory minimum withdrawal rates (Andreasson et al. 2017
). The exception is Bateman et al.
), who compare the welfare of retirees when the current minimum withdrawal rates were introduced in 2007 against the previous rules and alternative drawdown strategies. The authors use a rather simple CRRA model to examine the effect of different risk aversion and investment strategies, but find that the minimum withdrawal rules increase the welfare for retirees, though slightly less than optimal drawdown does. In Andreasson et al.
), the minimum withdrawal rules are included in part of the model outcome, but are by no means exhaustive and only provide a brief introduction to the effects. These rules are designed to exhaust the retiree’s account around Year 100; however, it is empirically observed that after Year 85 (subject to investment returns), the withdrawn dollar amount starts decreasing quickly. In a recent report from Plan For Life
), it is identified that only 5% of retirees exhaust their accounts completely, though this number is expected to increase as life expectancy increases and the population ages. They find that retirees tend to follow the minimum withdrawal rules as guidelines for their own withdrawal, as few withdraw more than the minimum amount. This is further confirmed in Shevchenko
). However, Rice Warner
) argues that the minimum withdrawal rates should be cut by 25–50% to prevent retirees from exhausting their superannuation prematurely due to increased longevity. They suggest that the current rates are simply too high for many retirees, thus not sustainable for people living longer than the average life expectancy, and are significantly higher than what is optimal in Andreasson et al.
). In addition, it has been discussed in the media whether deeming rates are set too high, and as retirees tend to have a low proportion of risky assets while in retirement (Spicer et al. 2016
), this often results in lower returns on assets than what is assumed in the income-test. The Australian term rates4
are below the upper deeming rate; hence, the effective return on the portfolio is generally lower than the deeming rate. This, in turn, will affect the Age Pension payments for the retiree.
In this paper, we demonstrate how the assessment of policy changes can be done via an expected utility model in the Australian pension system. We adapt the model previously developed in Andreasson et al.
) to examine the impact of this policy change on an individual retiree. This model captures retirement behaviour in the decumulation phase of Australian retirees subject to consumption, housing, investment, bequest and government-provided means-tested Age Pension and is an extension with stochastic factors (mortality, risky investments and sequential family status) to what was originally presented in Ding
); Ding et al.
). The contribution of this paper is to improve the understanding of the effect deeming rate-based policies have on a typical retiree’s optimal decisions, both in terms of how the optimal behaviour changes and whether the retiree is better or worse off. We also examine the impact high and low risky returns have on the retiree in relation to deeming rates. We then examine the differences in optimal decisions between an Allocated Pension account opened prior to 2015 with the one opened after 2015, as well as compare the results with the recent 2017 asset-test adjustments. The paper is structured as follows: In Section 2
, we summarise the model and present the Age Pension function, as well as explain the parameterization and policies. Section 3
contains a discussion of the results. Finally, in Section 4
, we present our concluding remarks.