The book on savings is not closed: Cullen

This morning I want to talk about the interface between private and public pensions.

Many government officials and private sector economists argue that the two compete – both financially and in terms of motivation.

In financial terms, the argument is that if the government maintains a robust tax funded pension regime, it has, all other things being equal, to maintain a higher tax rate. This higher tax rate limits the capacity of private individuals to save.

The motivational argument is that if the government maintains an adequate public pension, individuals will be less inclined to save for themselves.

Again, public pensions crowd out private pensions in theory. But in New Zealand we have tested the theory – and found it does not work. We have introduced and maintained a high level of uncertainty and instability around the public pension, and we have given large and regular dollops of tax cuts. And through all of this, private savings have maintained a downward track.

One of the first actions of this Government was to boost the level of New Zealand Superannuation. Since then, we have introduced the New Zealand Superannuation Bill.

I see this as one of the Coalition's most significant initiatives. The Bill is designed to provide for the long life of a realistic, universal, flat rate, non-means tested New Zealand Superannuation entitlement.

The post-war baby boomers will start to retire in about 10 to 15 years time, and because the birth rate has fallen, they will not be replaced in the workforce in the same proportion. This is not a temporary cost bubble. We, like the rest of the developed world, face the prospect of a permanently older population structure.

Unlike the rest of the developed world, we have some breathing space to prepare for that shift in the population structure.

We will protect the future of New Zealand Superannuation:

1. by defining the (married rate) entitlement as being no less than 65 percent of the after-tax average wage;
2. by providing for other parties to "sign on" to the set of entitlements, and for a process of consultation before any aspect of the entitlement regime can be changed;
3. by establishing a fund that partially "pre-funds" NZS and makes it easier for future governments to meet its cost even as the proportion of those in the 65 plus age bracket increases.

Security in retirement is the least that citizens should expect from their government in a civilised, developed country. It is also the most they should expect. It is not the function of the government to maintain in retirement the incomes that people earned during working life. That is the responsibility of the individual.

This is one reason to reject compulsory individualised, earnings based savings: the government is intruding too far into what ought to be personal decisions about how to spread consumption over the life cycle.

Having said that, while NZS will provide enough to enable participation in life, it is not designed to do more than that. NZS is not meant to replace personal savings. It is designed to encourage personal savings.

Under earlier policies, where the level of public provision abated in proportion to the level of private retirement savings, private savings were discouraged. The effect was that people were saving for the government rather than for themselves.

The question for the government is whether a secure NZS is enough. If people have confidence that NZS will provide the basic bread and butter, will they be sufficiently motivated to save to provide the jam?

I have restated this because from the point of view of government policy, it is important to recognise that we see public and private pension regimes as complementary, not competitive. If we can generate an acceptable degree of public confidence in the base level retirement income, I firmly believe that we will have produced a more stable platform on which to build a private pension structure.

The National Party has given an undertaking that it will engage in the debate on the Super Bill on the basis of substance, not politics, and I welcome and applaud that.

They have raised three concerns about the substance of the scheme, and I think it is useful to comment briefly on each of them.

Firstly, they raise the issue of affordability. The argument is that in only three of the last twenty five years have governments generated the surpluses needed for the annual contributions that will have to be made into the fund in each of the next twenty five.

That is true but not relevant. In order to understand why it is not relevant we need to revisit those last twenty five years. They were the years of the Muldoon pension, SMPs and Think Big. Government policies created large structural deficits in the public finances, and large structural deficits led to large public debts. It took the best part of a decade to bring the public finances back into balance. After that, surpluses had to be run in order to reduce debt, and reduce the interest burden of that debt.

By the mid 1990s, we were in a position to anticipate structural surpluses of a level that would have in fact enabled the necessary contibutions to be made into a superannuation pre-fund. But then National dissipated the surpluses as they emerged through rounds of tax cuts. We are now in a position where the structural surpluses are re-emerging. The reason that we are able to afford contibutions over the next twenty five years is precisely because we have learnt from the mistakes of the last twenty five. We will only not be able to afford the payments if we repeat those mistakes.

The second concern National has is that the pre-fund will only contribute 14 percent of the future cost of New Zealand Superannuation. That is only partly true. The broader tax base created by the existence of the fund will generate roughly another ten percent of the cost, compared with what we would have got if we did not have a fund. So a quarter of the cost is the relevant figure.

It could still be argued that it is still only a quarter. The point to note is that a quarter of the cost is vital, at the margin. In the future, NZS will cost nine or ten percent of GDP. A quarter of that is something like 2.5 percent of GDP, or $2,750 million in today’s money. As a Minister of Finance in the future, I would most decidedly not turn my nose up at the prospect of having "only" $2,750 million more to juggle around meeting competing demands for funds.

Finally, National raises the issue of inter-generational equity. This surprises me because I think it is the one argument that has almost no legitimate basis at all.

On present plans, we will pay net into the fund for the next twenty or twenty five years and draw net out of the fund after that. That means that people who are now between 40 or 45 and 65 will pay extra, but never have their taxes subsidised by fund earnings. Those under 40 or 45 will at least benefit from some of the tax modification that the fund allows.

The sandwich generation is in fact the baby boom generation, but I would argue that they are best placed to absorb the cost. They have come through the era of free education, near full employment and affordable home ownership, and many came through the era of more extensive employment-based superannuation.

The next generation has the student debt, is more likely to experience at least intermittent periods of unemployment or low earnings, and has a harder job getting a start with owning a home.

A regime that guaranteed state pensions for those over 45 but reduced them for the next generation would be the most unfair from an inter-generational perspective. The young generation would pay taxes to fund their parent’s pensions but get a much reduced pension themselves.

We must be clear. Unless we can restart history, we cannot have a state pension regime that is absolutely fair as between the generations. The task is to allocate any inter-generational burdens to the generation that is most able to shoulder them. My super scheme does that.

Let me now turn to the private pension regime and how that interfaces with the public scheme I have been talking about.

In comparison with other developed countries, New Zealand has very few incentives available to individuals who save for retirement. Saving through a structured, retirement focussed vehicle like a superannuation scheme or pension fund is taxed in exactly the same way as money in a savings account in a bank.

In these circumstances, people tend to save in ways that leave them ready access to their money or more options for using it: term deposits rather than pension schemes. They also seek out avenues where returns are not taxed – like buying second houses where the capital gain is not taxed.

The net result is that savings rates are low, and the form that savings take is not very efficient from the point of view of the wider economy.

This has led the government to review the basis on which private savings are taxed or otherwise encouraged.

While the government can’t compel people to save, it can encourage them to do so.

In this regard it would be useful if we had a clearer idea of what leads individuals to save. There is some evidence emerging about the factors that drive savings.

The level of income is an obvious one. Roughly seventy percent of the savings that are made are made by the top thirty percent of the income range. Because contributions to reductions in the level of a home mortgage are regarded as savings, the percentage of savings into formal private pension schemes made by the top income group is likely to be much higher.

Secondly, education does seem to make a difference. Studies in the USA suggest that when workplace based information programmes are run, there is an increase in commitments to savings plans. This is the case even when there is no employer subsidised scheme operating. I note that the industry here has been reducing its financial contribution to education about the benefits of savings, tending to argue that this is a public interest matter and therefore the responsibility of the government.

There are industry benefits as well, so we do need to talk about this some more. Whether industry contributions would be forthcoming if there was a different type of education campaign, or whether a boost to contributions would be linked to a new tax regime for savings are the sorts of issues that could be explored.

Finally, early evidence in New Zealand implies that there is a detectable difference between the savings behaviours of different age cohorts. This means that adjusting for income, age and the like, one generation will have a better savings record than another. Specifically, the generation born before the war – between roughly 1925 and 1939 – shows up has having saved less than the post-war generations.

It is not clear why this is the case, and we need to do more work on explaining the research findings. These were periods of radically different social and economic circumstances, and when different policy settings were operating. We are contrasting, for example, a major economic depression and a war, with a period of prolonged economic expansion and full employment, and that long boom with the huge economic restructuring that followed it.

We do not know at what stage in the life cycle savings habits form. Were the savings intentions of the pre-war generation formed during the period of personal insecurity, or during the good years that followed?

It would also be interesting to find out why both the post-war baby boomers and generation x that followed have relatively stronger savings records, despite entering very different employment and policy environments at the start of their working lives.

The point to take from this is that savings habits arise out of the environment in which they are formed. We must try to construct a savings-friendly environment relevant to the circumstances of the present.

My thinking is that three elements need to go into constructing this environment: education, opportunity and incentive. Education is the responsibility of the government and the industry. Opportunity is the responsibility of the industry; the product they offer has to be relevant. Incentive is the responsibility of the government.

A few weeks ago I outlined some options for an incentive regime for private savings in a speech to the annual meeting of Grey Power. I will repeat those options here, but expand on them in the area where the industry might like to consider how it could interface with a tax based incentive regime.

I must stress that incentives alone are not the answer. They will not work if the educational work has not been done and the opportunities to save are unattractive.

If we rule out compulsion – on the philosophical basis that I have outlined earlier – incentives essentially come down to aligning the tax system with private savings programmes.

The two key constraints are:

1. any incentives must not be too expensive fiscally, or else stimulating private savings crowds out other spending on programmes that have wider public benefits;
2. incentives should add to the level and rate of savings, and not merely result in a shift in the form of savings or a transfer of savings from current vehicles in order to seek new tax advantages.

At this stage we are thinking of putting up a new, parallel option to the current TTE regime under which savers could opt for a TEt regime. This means payments into the fund would be out of tax paid income – the same as applies currently.

However, the earnings of the fund would be exempt from tax and at the end of the life of the scheme, that element of pensions that represent the withdrawal of the (tax paid) capital contribution would be exempt, but that portion representing the tax exempt earnings on the fund would be taxed (hence the little "t").

Details would have to be worked out and would depend on the form in which pensions were drawn down, but in general, roughly half of the payments out of a pension fund are a return of capital contributions and the other half the earnings of the fund.

This leaves the issue of containing the (temporary) loss of revenue associated with the new option and limiting the amount of switching of savings.

Here there is a smorgasbord of possibilities, and a package can contain more than one serving.

The options include:

• Limiting qualifying deductions to those made "at source".

• Limiting the annual amount that can be placed in a TEt scheme.
• Limiting the total amount that can accumulate in a TEt scheme.
• Restricting access to TEt to schemes that "lock" savings in, either for a minimum number of years or until some designated retirement age.
• Restricting access to a TET scheme to those who are below some designated age, at or near retirement.
• Requiring schemes to limit the amount of any benefit that can be withdrawn in a lump sum, to reinforce the pension orientation of scheme design.

It is this last option that might both create the most controversy and provide opportunity for the development of new products.

In a pure scheme, the quid pro quo for a tax exemption would be that the whole of any benefit is taken as an annuity.This would align the incentive with its basic purpose, and minimise creative arrangements that simply "farmed" the tax break.

I see three problems with this. Firstly, there is a basic expectation in New Zealand – so strong that it is virtually a part of the savings culture – that some form of a pension entitlement is accessed as a lump sum. Secondly, there is a desire to leave some "unused" part of a stock of savings to children rather than to the insurance company. Finally, the track record with annuities is not that encouraging: people feel, rightly or wrongly, that the industry prices annuities conservatively. Savers get a lower annual income than they would expect from the sums accumulated during the period of contribution.

There is a danger that if the government compelled savers to take benefits in the form of an annuity, all of the incentives to improve the value of the annuity would dissipate. In effect, the tax wedge is the margin the industry enjoys to supply a sub-standard savings product and still attact customers.

Remember that with a TEt regime, annuities already get a tax advantage. The taxable (say half) of the lump sum would probably be taxed at an effective marginal tax rate of 39 cents in the dollar. Because a pension is taken in retirement, the marginal tax rate on the annuity is likely to be nearer 20 cents, or whatever the mid-range marginal tax rate happens to be in the future. The annuity enjoys quite a large tax advantage, and I will take a lot of persuading that it needs major legislative assistance as well.

This does, though, pose a challenge for the industry. The industry needs to design a product that does have enough flexibility to meet customer demand and be consistent with the purpose of granting the tax advantage.

The debate on the provision of private pensions has yet to get underway. However, it should be seen as the logical extension of the first stage initiative to rebuild confidence in New Zealand Superannuation.

The savings and insurance industry also has its role to play. The industry has already developed a generic product that allows employers to offer superannuation without having to customise it for each employer and that allows employees to switch employers and maintain contributions.

There are regulatory issues that need to be addressed, including things like the need for some pension schemes to issue prospectuses. After that, additional steps would be promotional and educational and the government and industry need to work together on these.

The signal I want to send is that the book on savings policies is not closed.

Thank you again for inviting me to talk to you today, and my best wishes to you for a successful annual meeting.