1 Sydney Level 15, 255 Pitt Street Sydney NSW 2000 Australia GPO Box 3698 Sydney NSW November 2013 Telephone Facsimile Mr Tony Shepherd AO Chairman National Commission of Audit Dear Mr Shepherd Challenger Limited is an ASX listed life office and funds manager, and is Australia s largest provider of annuities specialising in post-retirement solutions. Since 2006 Challenger has been an active participant in major public policy processes dealing with Australia s ageing population: Simpler Super 2006 Australia s Future Tax System Review 2008 Review into the Governance, Efficiency, Structure and Operation of Australia s Superannuation System 2010 Productivity Commission Inquiry into Caring for Older Australians 2011 Tax Forum 2011 Challenger s contribution to these processes has been evidence based. The Company commissioned a number of reports by independent actuaries Towers Watson, and its predecessors Watson Wyatt and Towers Perrin, and consultants Deloitte Access Economics. These reports include modelling and analysis of a number of public finance issues arising from Australia s ageing population. Some of the parts of those reports that are relevant to the work of the National Commission of Audit are summarised in this submission. The pricing and costings have not been amended since the reports were prepared but the conclusions that can be drawn from them nevertheless continue to be relevant. This submission deals with 3 sets of issues that impact the Australian Government s budget and balance sheet: 1. The opportunity to reduce the amount of longevity risk borne by the Australian Government; 2. The undesirability of the Australian Government being a provider of retail financial products other than Commonwealth Government Securities; and 3. The unnecessarily high contingent liabilities borne by the Australian Government as a result of the Financial Claims Scheme, in particular the government guarantee of ADI deposits. The first two of these issues deal with the major age related drivers of budgetary pressure over the next 50 years. These are set out in the Productivity Commission research paper, An Ageing Australia: Preparing for the Future, which was released this month. Melbourne Level 19, 31 Queen Street PO Box 297, Flinders Lane, Melbourne VIC 3000 Telephone Facsimile Brisbane Level 9, 241 Adelaide Street GPO Box 3234, Brisbane QLD 4001 Telephone Facsimile Perth Level 5, 50 Georges Terrace, Perth WA 6000 Telephone Facsimile Adelaide Level 7, Suite 714, 147 Pirie Street Adelaide SA 5000 Telephone Facsimile Challenger Limited ABN Challenger Group Services Pty Limited ABN Challenger Life Company Limited ABN AFSL Howard Commercial Lending Limited ABN Challenger Listed Investments Limited ABN AFSL Challenger Diversified Property Trust 1 ARSN Challenger Diversified Property Trust 2 ARSN Challenger Management Services Limited ABN AFSL Challenger Retirement and Investment Services Limited ABN AFSL RSE Licence No. L Challenger Mortgage Management Pty Ltd ABN Challenger Securitisation Management Pty Ltd ABN AFSL
3 meet their particular needs. The products discussed below are in areas where there is real commercial interest with major companies prepared to commit capital to building businesses to meet these needs. Superannuation, aged care and health insurance are highly regulated and the current arrangements do not contemplate these types of solutions, so the government needs to engage with potential providers and develop appropriate regulatory and tax treatments. 1. Reducing the Australian Government s Exposure to Longevity Risk Superannuation and the Aged Pension Longevity risk is carried by individuals, corporate super funds, life offices, by state and federal governments through superannuation arrangements for current and former employees, by state and federal governments through rising health expenditures for Australia s ageing population, and by the Australian Government through the means tests for the Age Pension and aged care. In Australia, the shift away from DB (defined benefit) to DC (defined contribution) superannuation, has resulted in a system where private retirement savings are overwhelmingly and increasingly being held at the individual retiree s risk. Only a small proportion of retirees receive defined benefit pensions or convert part of their retirement savings into a lifetime annuity. Retirees can be divided into 3 categories: 1. Those who are totally dependent on the government Age Pension for all or most of their retirement. 2. Those who are likely to be partially or totally dependent on the government Age Pension for some part or all of their retirement. 3. Those who are unlikely to be eligible for an Age Pension at any time during their retirement. The longevity risk borne by retirees on their private retirement savings is transferred to the Australian Government through the mechanism of the means test. The potential availability of the Age Pension can be assumed to encourage, either or both, higher consumption or riskier investment of retirement savings than would be expected in its absence. In 2009 Challenger commissioned Towers Perrin to undertake stochastic modelling of the expected duration before ruin of allocated pensions with different starting balances, when providing a constant real income including any Age Pension entitlements. The drawdowns used were the ASFA Modest but Adequate and Comfortable benchmarks for an individual. Table 2 demonstrates three things for the individual. First, the absolute financial folly of early retirement. Second, that even with a small starting balance, if a retiree is prepared to live modestly, they can expect to enjoy a material improvement above full Age Pension entitlement in their living standard for the whole of or a large part of their retirement. Third, that if a retiree wishes to live comfortably, they can expect to be totally dependent on the Age Pension quite early in retirement and even if they have a relatively high starting balance of $500,000 that will occur before they reach the age cohort life expectancy of a 65 year old male.
5 up of DLAs of $10,000 per retiree the government's overall budget position was projected to improve by 0.03% of GDP by 2020 and 0.18% of GDP by The Deloitte Access Economics modelling shows two other desirable outcomes of introducing DLAs: 1. The result of the policy change would be a redistribution of income (1) from early in retirement to later in retirement and (2) towards those who live longer. Not surprisingly, that better accounts for longevity risk. Indeed, the realignment of retirement incomes towards the later years of retirement should be a key priority for government, both because it serves to reduce age pension expenditures, and because it increases the welfare of future retirees by countering the key market failures in the provision of longevity risk insurance in the Australian retirement income system. 2. The benefits of DLAs are skewed toward retirees in the lower income deciles who are largely below the key thresholds in the age pension means test and who would not therefore experience any reduction in their Age Pension entitlements. Accordingly, their income from their DLA represents an absolute enhancement to their welfare. This will reduce future pressures for increases in the rate of the Age Pension. The Deloitte Access Economics modelling highlights an important opportunity for Australia ' s retirement income system - that it is possible to (1) increase retirement incomes, (2) reduce reliance on the Age Pension, and (3) improve the targeting of government assistance by improving the way retirement savings are used to fund retirement incomes. Removing the regulatory impediments to post-retirement products that allow the principal retirement risks to be transferred to private providers will reduce the Australian Government's already considerable exposure to longevity, inflation and market risk through the means test for the Age Pension and Aged Care. Reducing the quantum of those contingent liabilities on government will reduce future pressure on Australia's sovereign rating. The Final Report of AFTS supported both DLAs and the removal of restrictions on the purchase of lifetime annuities: "The Review has also identified the role that deferred annuities can play in an ageing society. These products commence from a specified age and are a type of insurance against running out of income in retirement. " (page 543) "an allocated pension cannot ensure security of retirement on its own " (page 118) "Products are not available in the market to cover the broad range of preferences of retirees in achieving security of income. This is a structural weakness in the Australian retirement income system. The main product on the market that does achieve this security of income is a guaranteed income for life...given the diverse preferences of retirees, a single product is unlikely to satisfy all people who wish to manage their longevity risk. This suggests a need for product innovation within the Australian market." (page 118) "The increasing life expectancies of Australians will require a greater choice of retirement income products that can cater for the different needs of individuals in retirement. There are not enough products that guarantee an income for the whole of a person's retirement." (page 120) "Deferred annuities (overseas), which provide an income from a certain age, are also becoming more prevalent. These annuities allow a person to lock in part of their retirement savings to generate an income when they are entering the latter stages of their retirement. This provides a person with more certainty in how they manage the rest of their assets before the commencement of the deferred annuity." (page 123) "many people prefer to have the security of knowing they will always have an income above the Age Pension " (page 118). "given the unique nature of deferred annuities, there is a case that they should only be means tested when they start to pay an income, unless a person can access the capital before this time." (page 126) "the rule requiring a minimum payment to be made from a pension every year does not cater for deferred annuities." (page 119) "The government should also consider removing other legislation constraints that may inhibit the development of longevity products. However, this should not be at the cost of necessary prudential or
6 consumer protection. Given the nature of these products, they should only be provided by prudentially regulated entities. Products that provide a guaranteed income should follow consistent prudential requirements to reduce the risk that a provider is unable to meet their obligations as they fall due." (page 124) "There should be no restrictions on people wanting to purchase longevity insurance from a prudentially regulated entity. This would be an important element in making it easier for people to purchase these products. " (page 116) "People should be able to purchase these products with superannuation as well as non-superannuation money." (page 126) "The restriction on people aged 75 and over making contributions should be removed. However, a work test should still apply for people aged 65 and over. There should be no restrictions on people wanting to purchase longevity insurance products from a prudentially regulated entity. (AFTS recommendation 20) "In many cases, people may choose not to purchase longevity insurance at their retirement age. As they grow older they may be in a better position to judge their potential longevity. However, after a person retires they may be unable to make further contributions into a superannuation fund due to the work test rules. These restrictions should not apply to contributions made to a prudentially regulated superannuation fund or life insurance company for the purposes of purchasing a longevity product. " (page 126) There is a current measure of the 2013 Budget to remove the impediments to the provision of DLAs, specifically to give the assets supporting them the same tax treatment as the assets supporting other superannuation pensions and to remove the requirement for a minimum draw down during the deferral period. This is a simple form of longevity insurance, to be offered on retirement with no provision for commutation to the retiree or their estate. The measure has no net cost to revenue in the forward estimates. Such products with no capacity for commutation are risk products. They should be afforded the same tax and social security treatment as other insurance products. That is, the insurer should be taxed at the corporate rate on changes to the net value of assets and liabilities. The products should not be assessed for social security purposes as an asset of the policy holder unless and until the event occurs which causes them to pay a benefit. This treatment would allow individuals to buy insurance against longevity risk before age 60. It would also provide a basis for consistent and appropriate treatment for a DLA type structure to support LTCI (long term care insurance) for aged care and lifetime private health insurance products. Aged Care Long Term Care Insurance Challenger s submission to the Productivity Commission Inquiry into Caring for Older Australians proposed the government allow provision of risk products, with either single or periodic premiums to provide payments to cover aged care costs as a form of LTCI (long term care insurance). The products would be in the form of a non-commutable deferred lifetime annuity with known real return priced on the risk of needing care (survivorship and age of needing care), and longevity (the expected length of time in care). Such products would be more affordable for retirees because of the lifetime cap on aged care fees under the new aged care regime. Single premium longevity risked product to fund accommodation bonds By making it easier and providing more flexible solutions for an individual to pay for their aged care accommodation, efficient private financing solutions would assist government in reforming the aged care system. Challenger modelled a potential product to assist retirees with nursing home accommodation bonds and included it in its submission to the Productivity Commission Inquiry into Caring for Older Australians.
7 Rather than liquidating their house and other assets to fund an accommodation bond, or not being able to find a place in suitable care, a proportion of frail aged do seek appropriate financial products, in the form of either conventional loans or reverse mortgages. Life offices could offer a single premium loan product to pay the nursing home accommodation bond at a fraction of the upfront cost of the bond to the resident. The product; This would be a pooled lifetime product priced on the time a nursing home resident could expect to remain in care, in sequence: The resident or their family negotiate the accommodation bond with the nursing home provider. The resident pays an age-based premium to the life office to cover the bond. The life office pays the accommodation bond to the aged care provider. The aged care provider deals with the bond in the normal way, deducting a maximum of $299 per month in retention amounts for the first 5 years and has use of the bond for capital purposes. When the resident dies or leaves the home, the nursing home provider returns the full residual value of the bond (bond minus monthly retention amounts) to the life office. Pricing The baseline pricing below shows the proportion of the bond paid by the life office. The pricing methodology uses projected cash flows and targets a return on capital. Policy cash flows are projected corresponding with the cash flows to the life office. The life expectancy at each age has been derived from a summary table provided by the Productivity Commission with that table informing the assumptions governing the behaviour of the policy cash flows. These assumptions include exit probabilities and a fee of $299 per month for the first 60 months. The exit probabilities are the single most important reliance placed on the pricing results. It is noted that the assumption was made that people purchasing this product will have the same exit profiles as the people already in aged care. In other words, there was no allowance for anti-selection factored into the pricing. The assumptions governing the cash flows to the life office include distribution and administrative expenses along with a capital structure consisting of AAA credit capital and longevity capital. Given the government guarantee on the repayment of the bond, a AAA credit capital structure is appropriate. Challenger modelled the pricing of the product assuming two different structures for the repayment of the bond upon the resident exiting care. The no bequest pricing assumes that no premium is returned to the resident no matter how short the length of time they spend as a resident. The 12 month reducing bequest pricing assumes that if the resident dies or leaves the home in the first year there is a proportionate return of the premium, 364/365 on the first day and 1/365 on the second last day of the first year. This is only an indicative example for the model based on the limited data available, as actual pricing would have to consider a number of complexities, such as rollovers if a resident moved between nursing home providers. The differences in pricing between a $200,000 bond and a $1 million bond reflect distribution and administration costs, and the regular deduction from the bond by the aged care provider. The percentages represent the proportion of the bond paid by the life office. The numbers in brackets are the life expectancy (period of residential care) of a person of that age and gender entering residential care at that age.
9 A critical factor is the design of the bequest model. To sell most lifetime annuities it is necessary to have features that provide a return of capital if the policy holder dies early. Nursing home accommodation bonds are a particularly complex area for product design because of the range of circumstances that may pertain to people leaving a facility. There are some regulatory risks associated with providing a single upfront premium lifetime loan to assist retirees to pay nursing home accommodation bonds, principal amongst these are: Government changes to the size of bond required or residual amounts; Government changes to retention amounts; and Removal of the government guarantee on return of the bond. There would be no policy justification for making any of these changes retrospectively. Prospective regulatory changes could change the size and shape of the market, but there would be sufficient lead time to adapt a product offering or for a provider to wind down their business and leave the market. There are a number of regulatory conditions precedent for provision of a single premium lifetime loan product: Government guarantee on return of the bond to the life office should apply in the same way as it applies to a resident (this is to avoid the expense of the provider doing credit assessments on individual nursing homes); Product needs to be assets test exempt in the same way as a bond paid by the resident; Resident must be legally capable of assigning to the life office any right to return of the bond so that it can be dealt with outside their estate; and Alterations to the ACAT assessment standards must be capable of being monitored so that life offices can understand changes in the risks they are underwriting. Challenger s submission to the Productivity Commission inquiry noted that a commercially provided reverse mortgage could be used to pay for any of these products or to provide for other living expenses. Lifetime Private Health Insurance Cover A DLA or immediate lifetime annuity structure could also be used to fund lifetime health insurance cover for retirees. An additional premium could be attached to regular PHI payments over a lengthy period or a large single premium could be used to provide lifetime health cover commencing from a date on or after retirement. 2. Financial Claims Scheme - government guarantee of ADI deposits In 2004 when Prof Kevin Davis wrote his report canvassing options for a scheme, he said: A criteria-based approach has been used to explore the possible coverage of a guarantee scheme and allow cost estimates for any scheme to be modelled. The criteria proposed for determining coverage involve restriction to: products that are supplied by prudentially regulated institutions; `capital certain' and `critical' financial products issued by financial institutions; and consumers who are least able to assess product risk. Applying these criteria leads to specific classes of institutions and products that might be covered by a guarantee. These include, primarily, deposits of ADIs, policy liabilities under general and life insurance, and some income products offered by prudentially related institutions. Maximum coverage limits aim to focus protection on retail consumers and preserve incentives for well-informed stakeholders to exert market discipline.
10 The claims scheme was subsequently restricted to two classes of product providers, ADIs and general insurance. The advent of a financial claims scheme applying to investments in ADIs introduced a distortion into the market with advisers recommending term deposits, not on the basis of superior rates or the characteristics of the counterparty, but because of the government guarantee. During the GFC when the per person per institution limit on the FCS was set at $1 million there was a flight of investments to ADIs, with catastrophic consequences for funds and their investors. Banks and financial advisers continue to promote bank accounts and term deposits on the basis of the "government guarantee." There is a strong case for restoring competitive neutrality to investment markets and to return the FCS to its original purpose, providing deposit insurance to retail investors so that they have liquidity for transactional banking in the immediate period after a bank failure. This was intended to enhance financial stability by reducing the likelihood of a run on deposits. The result of too high a limit on deposits eligible for the FCS has been to give bank deposits a preferred status as investments. This is an inappropriate use of the Australian Government s balance sheet. When the FCS was reviewed after 3 years of operation the cap was reduced from $1 million to $250,000. Statement 8: Statement of Risks in Budget Paper No , shows that even after that reduction in the cap, total deposits eligible for the government guarantee were estimated at $696.9 billion as at 28 February While some might argue that the risk of multiple bank failures is low and that in the event of a bank failure it is unlikely that payments made under the FCS would not be recovered by bank liquidation or the levy on surviving banks, those assessments of improbability in relation to the aggregate contingent liability do not remove the need to target the measure at supporting households transactional banking needs in the interim while a bank failure is worked out. Ideally the cap should be limited to the original level preferred by the banks of $20,000 and applied on a per person, rather than a per person per institution, basis. To reduce the distortions that the FCS is creating in both investment and lending markets, only at call accounts should be eligible. 3. Governments should not be financial product providers Except for raising debt for their own purposes governments should not be financial product providers. There are a number of recommendations which the NCOA could make that if implemented would reduce the level of financial, operational, market, inflation, and longevity risk carried by the government in relation to its current or potential role as a provider of financial products. First, endorse the Government s policy of privatising Medibank Private. There are both commercial and mutual competitors and no sound policy justification for the government maintaining ownership of an operator in that market. Second, the NCOA should recommend that the Government reject proposals by the Productivity Commission that government establish an Australian Pensioner Bond Scheme which would allow pensioners to place the proceeds from the sale of their home into a government guaranteed account to draw on flexibly for living expenses and aged care. According to the Final Report of the Inquiry into Caring for Older Australians, this facility should be exempt from the age pension means test, free from all fees and the capital should be indexed by the CPI. The social security concession would only be available to the publicly provided product. At the 2012 Australian-Melbourne Institute Economic and Social Outlook Conference, Challenger publicly sought clarification from the then Productivity Commission Chairman for the reason behind this rather curious recommendation for government to become a provider of retail financial products. The question was referred to the Commissioner responsible for the particular Inquiry. His response was an infant industry argument that the government could make its exit when a private market had been established. The point is
11 that with the key social security benefit only being available to the publicly provided product no private market could ever be established. It should first be noted that life offices already provide capital guaranteed fixed term CPI indexed annuities at rates which are more favourable than a CPI indexation of capital, and generally compare favourably relative to bank term deposits and indexed Commonwealth bonds. These products do not involve fees. If the government believes such products should be age pension means test exempt then it can provide that treatment without also having to provide the financial product. If the government decided to become a product provider this could be done either on budget or funded. If it were done on budget the return to retirees would reflect the risk free rate for issuing new government bonds that the purchase price of the pensioner bond would replace. Without a subsidy, which would have to be borne by other taxpayers, this would be lower than the rate a private life office could offer the pensioner, reflecting the higher yielding assets in which the life office would invest. If the government decided to invest the funds to provide a market competitive rate of return it would have to accept the same market risks as the shareholders of a private provider. The government would also carry the implementation risk of establishing the new product and integrating it with its existing delivery of aged care as well as the ongoing operational risk. To provide guaranteed products life offices have to meet APRA s prudential standards to hold significant amounts of capital against liquidity, market, inflation and operational risks. In the case of retirees purchasing from the government, this capital would have to be provided by taxpayers or the costs associated with these risks would be additional budget expenses. Unfair pricing, which does not recognise the actual capital requirements, would eventually result in losses being borne by taxpayers. An obvious example is the South Australian Government s SGIC (State Government Insurance Commission) which was established with insufficient capital, relied on a government guarantee, and eventually failed resulting in very heavy losses. That was not fair to taxpayers. A similar issue arose in the course of the Henry Review of the taxation system when it was suggested that the government enter the superannuation annuity market as a provider. The proponents of this concept argued that public provision has a number of benefits over private provision: The Government has greater capacity to invest assets in a risky portfolio against long term liabilities of this kind, and it has the lowest possible default risk and cost of capital. By utilizing the existing social security administration, the product would also benefit significantly from economies of scale and scope for extremely cost effective delivery. The question of relative efficiency of administration is a highly contestable point. Modern life offices already have low costs and their operations are highly scaleable. Challenger commissioned Access Economics to examine the implications of using the government s AAA rating and therefore low cost of capital to provide an advantage in pricing a publicly provided annuity. Access Economics concluded that the government could use its capacity to borrow at the risk free rate in the short term to benefit buyers of publicly provided annuities but that would not benefit Australians as a whole and the funding advantage would be eroded over time. The central issue is that labelling borrowing as public or private does not change the inherent risk in a transaction, but only who bears that risk. The cost of the marginal transaction paying upfront now for an income stream to follow is the same regardless of whether done publicly or privately. Over time, public provision would either draw directly on the Budget or tend to dilute the cost of capital advantage to public sector borrowing as a whole.
12 Access considered two theoretical economies the first with no net government debt, and all private borrowing subject to the full risk inherent in its underlying economic activities. The second economy is identical in structure to the first, except for a government guarantee on all debt transactions, funded through an efficient income taxation system. The first economy faces credit defaults on occasion, which are absorbed as costs by creditors, resulting in a higher pre-tax private cost of capital to cover those risks. The second economy has no defaults because they are covered by the government guarantee, so it has a lower pre-tax private cost of capital, but higher taxation which constrains the level of economic activity. With this simple comparison Access demonstrates that; Some of the costs of default risk can be covered by governments, but only at the cost of externalising the risks toward other parts of the economy the initial apparent savings on interest payments are in fact matched by costs elsewhere in the economy over time it is just that the savings are more obvious and the costs more diffuse. Debt markets prefer government debt over private borrowing because governments are less likely to default than corporations. Governments enjoy superior credit ratings in part because they have the ability to pass on the cost of debt to taxpayers. Access noted; Such a transfer of costs is a key benefit for debt investors, who are only interested in recovering their money. It does, however, come at a price lower living standards for taxpayers and collateral damage to the economy as higher taxes discourage investment and workforce participation. If markets are well informed, the cost of capital advantage enjoyed by governments is likely to be eroded as more borrowing increases the risk attaching to government debt. Even if markets do not fully adjust, the actual resulting risks are passed to taxpayers. While markets hold the view that government activities are better risks than business activities, Access says; when governments borrow in order to fund the purchase of business assets (as would be the case for a public annuity offering), then that view is diluted. Sophisticated markets are able to look through the public sector label placed on borrowing to the assets underneath, attaching similar levels of risk to those for private borrowers. Access points out that there are serious implications in adding to the government s debt exposures; Increased borrowing costs on all Government debt would offset the borrowing cost advantage on new debt effectively negating the cost of capital advantage of public provision. That means debt sustainability matters and that governments cannot borrow in a manner which steadily increases overall leverage in perpetuity. Doing so would threaten fiscal sustainability, and hence external stability, the government s credit rating and the cost of credit. An iron rule of economies is that somebody pays. Access summarised the government s current exposures from official sources, as follows; On official forecasts, the total stock of CGS on issue (which is a proxy for gross government debt) is expected to peak at $301 billion by (over 20% of GDP). It is likely that this elevated level of debt will be with Australia for some years to come. Contingent liabilities represent possible costs to the government arising from past events or decisions which will be confirmed or otherwise by the outcome of future events that are not within the Government s ability to control. They include loan guarantees, non loan guarantees, warranties, indemnities, uncalled capital and letters of comfort. These possible costs are in addition to those recognised as liabilities in the consolidated financial statements of the Australian Government general government sector. Current quantified contingent liabilities are $930 billion. This is around 78% of GDP in When outstanding gross debt is taken into account together with the contingent liabilities, this takes the total government potential exposure to over 90% of GDP in In the light of current debate these estimates appear to be somewhat understated. Access found that there is no sustainable funding advantage from government provision of annuities;
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