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Measures of Living Standards in Retirement

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The adequacy of retirement incomes is usually assessed using either an absolute (or budget) framework or a relative framework using replacement rates. Comparison with a poverty benchmark is another relative measure. The level of the single full-rate Age Pension is also assessed relative to an objective benchmark (currently 25 per cent of Male Total Average Weekly Earnings). Total retirement income, including superannuation, is most often assessed using a version of a replacement rates framework.

The absolute or budget framework seeks to estimate the actual income required to live at a certain (budget) standard or lifestyle in retirement. A prominent example is research commissioned by Westpac Banking Corporation and ASFA (Saunders et al 2004), which has estimated how much it costs for Australians to have certain specified lifestyles in retirement. Such analysis was considered in detail in an earlier joint paper by the author (Rothman and Bingham, 2004) and will not be discussed further here2.

Replacement rates are defined as ratios of a person’s income or spending power after retirement to that before retirement. The proposition underlying the replacement rate concept is that a person’s standard of living in retirement should be a reasonable proportion of his or her standard of living during working life.

Treasury, as well as a number of key groups (including the Institute of Actuaries3), consider that a replacement rate measure based on a comparison of potential (net) expenditure before and after retirement is strongly preferable to a comparison of gross incomes before and after retirement. Some important groups (including IFSA (see later)), however, have based their replacement rates on gross measures. Gross measures may be misleading because of substantial differences in taxation and saving before and after retirement.

An expenditure replacement rate is an after tax measure which takes account of the drawdown of capital during retirement. Replacement rates based on income alone do not take account of draw-downs of capital. Consequently, such measures understate the contribution of retirement savings to the maintenance of living standards in retirement. This paper uses expenditure as the most useful and practical guide to standards of living. It is worth noting that expenditure or spending is not quite the same as consumption, because it is does not include the provision of (free) government services nor imputed rent on owner occupied housing.

Two replacement rate measures which have been commonly used and advocated are the ratio of average expenditure in retirement to the expenditure in the last year of full-time working life, and the ratio of first year retirement expenditure to the expenditure in the last year of full-time working life. A comparison of expenditure levels in the first year of retirement and the last year of working life can often be unrepresentative of standards of living across the whole of retirement, particularly where superannuation benefits are taken as a lump sum4. Chart 1 (reproduced from Rothman and Bingham, 2004) shows clearly the importance of the periods of retirement and working life over which averages are taken; neither working life expenditure nor retirement expenditure is constant in real terms.

Chart 1: Hypothetical expenditure projections for working life and retirement in real terms for a single male, benefits taken as a life expectancy pension

Chart 1: Hypothetical expenditure projections for working life and retirement in real terms for a single male, benefits taken as a life expectancy pension

Alternative measures are the ratios of average expenditure in the first 5 (or 10) years of retirement to the average expenditure in the last 5 (or 10) years of working life. Such measures may be particularly useful for evaluating scenarios where a member phases down to retirement by working part-time for a period before fully retiring. These measures also have the additional benefit of symmetry when comparing pre and post-retirement expenditure levels.

The differences that can arise because of different measures are illustrated in Table 1 below. This table parallels a similar table in Rothman and Bingham, 2004, but has been revised to include the impact of Better Super and changes to personal tax scales. The replacement rates are consistently higher than in the earlier Table. The emphasis is on allocated pensions as these, while previously important, are likely to become even more prevalent after the introduction of Better Super. The drawdowns assumed leave minimal estate at average life expectancy as potential replacement rates are being estimated. Similarly when a lump sum is taken and kept outside superannuation it is drawn down evenly to leave a minimal estate.

Table 1: Various replacement measures for a single male with a working life of 35 years5
Salary (multiple of AWOTE) Private benefit taken as: Average over retirement / last year work* First 10 years retired / last 10 years work First 5 years retired / last 5 years work First year retired / last year work
0.75 Allocated pension 80% 80% 75% 71%
Lump Sum 78% 72% 67% 63%
1.00 Allocated pension 70% 69% 64% 60%
Lump Sum 67% 61% 56% 52%
1.50 Allocated pension 60% 57% 53% 49%
Lump Sum 56% 49% 44% 40%
2.50 Allocated pension 52% 49% 45% 44%
Lump Sum 46% 38% 34% 32%

* Published analyses by Treasury have mostly used this measure.

It is important to note that Table 1 assumes Superannuation Guarantee (SG) contributions only are made and that there are no savings outside superannuation. With these assumptions, clearly replacement rates fall as income rises, because at higher incomes age pension payments are lower (or nil), and some tax in retirement may be payable6.

Whether or not any particular expenditure replacement rate is optimal is a matter for judgement. It seems generally accepted, however, that a replacement rate of less than 100 per cent will generally be appropriate. This is because (most) retirees do not face some major expenses, (eg home mortgage costs, the cost of raising children and the cost of commuting to and from work) which are more likely to be faced by people of working age. Services and products may also be available to retirees from government or private sources at a reduced cost. Different replacement rates will be appropriate for different individuals. The Government has not set an explicit benchmark replacement rate but has over recent years put in place numerous policies that improve replacement rates.


2 Rothman and Bingham (2004) concluded that most baby boomers were likely to have retirement spending power equivalent to the ‘modest but adequate’ (MBA) budget from a combination of SG contributions and the age pension. More specifically, single baby boomers retiring from 2010 on were projected to do so.

3 Superannuation and Standards of Living in Retirement – Modelling Assumptions’, Institute Of Actuaries Report to the Senate Sele
ct Committee Inquiry into Superannuation and Standards of Living in Retirement, September 2002

4 A significant part of the controversy concerning adequacy arises from differing approaches to such measures, rather than from the parameters used or calculations done within an agreed framework.

5 Only compulsory SG contributions are made for all hypothetical cases presented. Further assumptions include a 7% per annum nominal rate of earnings (after fees but before tax), wages growth of 4% per annum and inflation of 2.5% per annum. Retirement is at age 65 in 2042. Here, as elsewhere in the paper, 2042 represents 2042-43.

6 No tax in retirement is payable after the Better Super reforms where an allocated pension is taken and retirement is at age 60 or higher.