Our superannuation system is highly regarded outside Australia, particularly by foreign governments with high pension costs to support and by fund managers who view the trillion dollar investment pot as a great sales opportunity. Within Australia, however, few people believe the system is stable or satisfactory, and most are confused by the jargon and frequent changes. In fact, superannuation laws have been revised every year since the introduction of taxes on lump sum benefits back in 1983.

In the May 2006 federal budget, the Howard government announced a comprehensive review of superannuation to tidy up many loose ends and remove complexity. This led to the so-called “Simpler Super” changes, later renamed “Better Super” for government advertising purposes.

One of the key changes was to make superannuation pension payments tax-free and remove any limit on the amount that could be withdrawn from a pension account. Consequently, anyone over sixty who converted their superannuation benefit into an allocated pension (renamed “account-based pensions”) now has a flexible investment contract with no taxes paid on fund earnings, capital gains or withdrawals.

As part of its election platform, Labor promised to maintain tax-free pensions. Hence, the scope of the current review of taxation being conducted by Treasury Secretary Ken Henry expressly prohibits looking into the fairness of tax-free pension benefits.

Super and taxes

In a perfect world, there would be no taxation of superannuation while it accumulates – the more money paid into an account, the greater the compounding effect on the benefit. We ought to have a system that encourages people to become self-sufficient in retirement thus leaving social security (the age pension and ancillary benefits) as a safety net to support those who enter retirement with inadequate benefits.

It makes sense to remove or reduce taxes on contributions and investment earnings because they are the biggest deterrent to saving for retirement. But reforming the system must go further, to deal with the inequities that are built into the existing arrangements. Four key areas of the super system are unfair.

• Women are relatively disadvantaged. On average, they have shorter working lives but live for a longer time in retirement, so they have to spread their benefit over a longer period. At the very least, supplementary superannuation support should be provided during periods of child bearing and raising.

• “Concessional contributions” (contributions made by employers) are assessable at a 15 per cent tax rate within a superannuation fund. This means that many low income Australians, who are paying at or near that tax rate, do not regard superannuation as being concessional. It also reduces the mandatory 9 per cent superannuation guarantee contribution to a nett 7.65 per cent, even though most actuaries and industry commentators know that the minimum contribution required for an adequate retirement income is at least 12 per cent of pay.

• The means testing for age pensions is invasive and complex. It needs to be replaced with a system whereby retirees use their own assets (above a threshold) before they are eligible for the age pension. Effectively, people will be self-sufficient to a point and will then fall back on a full Age Pension. We will not need part pensions.

• The investment earnings of workers’ accumulation accounts are taxed whereas the pension accounts are tax-free even if retirees have millions of dollars invested.

Tax-free pensions

The fourth of our key issues is relatively easy to fix. Investment earnings on pension assets need not be tax-free, but could be taxed at the same rate as superannuation investment earnings on assets in the accumulation phase (currently 15 per cent of income and 10 per cent of capital gains).

We estimate that this initiative could bring in additional tax revenue of $90 billion over the next 15 years. We certainly don’t want this to be added to all other taxes on superannuation funds, but it could be used to remove the taxes elsewhere and make the whole system more equitable.

For example, we could lower investment taxes to about 10 per cent over time if superannuation and pension accounts were all taxed at the same rate. Alternately, we could cut this rate to 12 per cent and remove the tax on contributions for those earning less than $50,000 a year. Either of these measures would be fairer – and would not cost the government more.

When the Coalition introduced tax-free pensions, they argued that the majority of pensioners pay little or no tax so a 15 per cent tax on pension earnings would be onerous. But the rate is still relatively low and would claw back significant revenue from those with large pension balances.

Means testing the age pension

It is also desirable to simplify the means-testing of the age pension and to provide more certainty to retirement incomes. People should spend their own money before falling back on social security – much like the unemployed are forced to do. At present, nearly half the people in retirement receive a part pension with complex rules for calculating their entitlement.

People should be allowed to keep a reasonable amount, which we propose should be set at $250,000. If a pension account earned 7 per cent per annum, this would allow withdrawals of $10,000 a year whilst still maintaining the value of the account in real terms, assuming inflation is running at 3 per cent. Together with the age pension, this income would provide a reasonable living in retirement – and there would be sufficient assets to cater for occasional needs for additional expenditure.

The key points of this approach are:

• At retirement age (65 soon to be 67), retirees quarantine a superannuation amount (say) of $250,000 which will be an exempt asset for the purposes of means-testing;

• Retirees can shift non-superannuation assets to this account at retirement age, provided the total quarantined amount does not exceed $250,000;

• Those who retire later can transfer further amounts (say, $15,000 a year) into their quarantined account;

• Retirees with non-exempt assets must utilise these before being eligible for an age pension;

• The value of the family home above (say) $1,000,000 will be a non-exempt asset. We suggest a way of treating this to allow access to the age pension without selling the home. The resulting “debt” would be repaid with interest upon death or selling the property;

• Once a retiree has no assets apart from exempt assets (which will usually consist of the exempt superannuation account up to $250,000 and their family home), they will be entitled to a full age pension;

• There will no longer be a part age pension or any regular means testing, just a straightforward assets declaration on claiming the age pension.

Effectively, people will be self-sufficient to a point in time and then they will then fall back on a full age pension. We will not need part pensions, so the system will be much simpler.