Investment strategy and the PSS

May 17th, 2007

As a Commonwealth Public Servant I’m lucky enough to be in the Public Service Superannuation defined benefit scheme. Back when I joined the Public Service this was a really nice scheme. You get a (generous) defined benefit linked to your final salary in the public service, and you get a big contribution from your employer. On the downside, it’s not very flexible and it’s really only for pension (rather than lump sum) benefits. You can get a lump sum, but it’s a bad deal compared to the pension. And the big deal is there’s a maximum benefit limit.

In the past I would have liked to put a lot of money into the PSS, but the maximum benefit limit meant (assuming I have a full career in the APS) that I would reach the maximum benefit while putting in close to the minimum contribution.

Then, last Budget, the Government announced some changes to the way that private superannuation is taxed. In short, while earnings still get taxed at a 15% rate, contributions and payments do not. So now other superannuation (especially Self-Managed Super Funds) look more attractive. How much more attractive than the PSS? Well, I never really worked it out because I any increase in super would have to go into another fund.

Which brings us to this Budget, and the announcement that the Maximum Benefit Limit for the PSS would be raised. Not massively, but enough that I can make some additional contributions now. Which brings me to today’s question – if I have some money to contribute, should I put it into the PSS or a self-mananged fund?

To start with, let’s suppose that I’m going to contribute an amount equal to 2% of my salary extra to the PSS. Under the rules, this means that the Government will match that, increasing my benefits by 4% of my salary. Why am I talking in terms of a percentage of my salary? Because that’s how PSS benefits are set, based on a percentage of your final salary. And ‘buying’ one per cent of my final salary costs one per cent of your current salary. This contribution comes out of my after-tax salary, so I need to gross this up for the before-tax cost.

To work out what this is worth in 35 years when I retire, I need to assume a rate of wages growth, we’ll say 4%. And inflation of 2.5%. Put this all together, and the real average annual return is 1.9 per cent per annum. But the PSS also lets you buy an actuarially “cheap” pension, so this needs to be grossed up by 15% to get a fair value, to give you a real average annual return of 2.3%.

So what about putting the money into a self-managed fund?

Firstly, you can salary-package your contribution, allowing you to contribute out of before-tax income. We’ll assume the contribution is the same amount as the PSS in terms of before-tax cost. This contribution then gets taxed at 15% as income of the Super fund. From then on, the earnings of the super fund are taxed at 15%, and you’ll also pay some management cost (let’s assume 1% of funds under management). If you assume that the return on funds invested is 7%, then you’ll get a real average annual return of 1.9%.

So it looks like the PSS is the better bet. BUT – you’ll pay tax on the pension from the PSS, but not on the payment from the self-managed fund. There’s a rebate of 10%, but you’ll still pay income tax. Put all this together, and what do you get? Well, I think the self-managed fund gives you about a 20% higher return than the PSS. But if the stock market had returned 6 per cent rather than 7 per cent, then the PSS would be about 5% better. And if your wages grew at 5% rather than 4% (say you expected a few promotions between now and then), then the PSS would be 10% better with a 7% stock market return, and 32% better with a 6% stock market return. Here’s a summary table, showing the self-managed fund return compared to the PSS:

Stock market 7%Stock market 6%
Wages 4%+20%-5%
Wages 5%-10%-32%

So the conclusion is that I’m going to need a more sophisticated model, because it sounds like this is a decision that depends pretty dramatically on the assumptions that you make.

(Disclaimer: This does not constitute financial advice. Individual circumstances vary. Consult a financial advisor. If you believe me without getting this checked you’re on your own!)