Cullen refines ethical investments

The Budget is being presented on Thursday. The Select Committee is due to report back on its consideration of the New Zealand Superannuation Bill on 12 June.

Under these circumstances it is very difficult for me to offer you a detailed report on progress under way.

What I intend to do today is to restate the high level policy objectives of the government with regard to superannuation, and to respond to some of the issues that have emerged in the public debate since the Super Bill was introduced.

There are two very powerful drivers of our approach to superannuation: macroeconomic stability and personal security. They rank right up there with the core responsibilities of the modern state, and underscore why I see superannuation as a key strategic issue rather than a political tactic.

The economy faces a number of structural problems, not the least of which is the problem of substantially upgrading our collective human capital. A less visible, but similarly important problem is our low rate of national savings.

The free market purists would say that the savings rate does not matter. They point to countries with high savings rates, like Japan, experiencing protracted stagnation, and countries with low savings rates, like the USA, having a strong currency and have experienced protracted growth. They also argue that in purely rationalist terms, we benefit by borrowing from foreigners. The theory is that rational individuals would not borrow if they could not get a better return than the rate of interest they are paying on the borrowings, so there is a net gain in economic wellbeing by leveraging returns off foreign borrowing.

I do not buy these arguments for two reasons. The first is that borrowers do not have perfect knowledge – particularly about the future! In the last few decades we have seen evidence from widely different economies that what seems rational for the individual is not necessarily rational for the collective. If there are capital gains to be made, it makes sense to borrow.

But if everybody chases the same capital gain there is eventually an oversupply of investment funds relative to potential investment returns.

Assets are inflated above values that would be justified by underlying earnings potential and the bubble bursts. Investors herd in and stampede out.

Secondly, even if we could enhance economic growth and production by using the savings of foreigners to do so, the benefit to New Zealanders is reduced to the extent that we have to divert a part of that production to pay the foreigners for the use of their capital.

The last work done by Bryan Philpott stressed this point. He calculates that between 1984 and 1999, GDP – the total value of output from within our national boundaries – increased by 1.8 percent a year in real terms.

However, because of our very poor savings record and our reliance on the savings of others, the net income paid overseas – to the overseas owners of capital used in production here – rose from $1.6 billion a year in 1984 to $7.4 billion in comparable dollars in 1999.

The result is that national income – the total value of output accruing to New Zealand nationals – only grew by 1.4 percent a year.

When population growth is taken into account, national income per head grew by 0.2 percent a year. And this, ultimately, is what drives living standards – the amount of output per person that New Zealanders can lay claim to.

The latest Monetary Policy Review put out by the Reserve Bank last week projects a government operating balance 2 percent of GDP in the 2002 March year, and 2.5% percent in the year after that. By contrast, the household savings rate is a negative 3% of houshold disposable income in those years.

Superannuation policy has to be seen as a part of the solution to raising the savings rate. By transferring a good part of the emerging structural surplus into the Superannuation Fund, the government translates short term fiscal surplus into long term national savings.

Equally, there is little point in lifting the public sector savings rate if that is immediately offset by a fall in the private savings rate. In my view this is not happening. It would only happen if people increased borrowings in a way that they would not have if the money put into the fund was paid out as tax cuts instead.

Our experince with tax cuts in the 1990s was that they seemed to have an almost invisible effect on private savings.

This does, though, raise the issue of improving private savings.

I have said it time and time again, but it still bears repeating, that the government does not see the New Zealand Superannuation Fund as the solution to the problem of promoting national saving and improving income in retirement.

It is a vital part of the solution but it is still only part of the solution.

The second core justification of the Super Scheme is that contributes to enhanced social security. The need to restore confidence among people that a decent pension will be there for them has increased in direct proportion to both the level of interference and instability in the provision of public pensions in recent decades, and the scaremongering that has gone on that the pension cannot be sustained when the baby-boomers retire.

I have a strong philosophical commitment to the view that security in retirement is the least that citizens should expect from their governments 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 what leads me at the personal level 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.

Just as there is need to increase public savings from a social security and economic stability perspective, the imperatives of security in retirement coincide with the imperatives of raising private savings from a economic stabilisation point of view.

I have given two speeches in recent months on this topic: one to the annual meeting of Grey Power, and one to the annual meeting of the Association of Superannuation Funds of New Zealand, and there is not a lot more that I can add to this topic at this stage.

Instead, I am going to comment on three of the core criticisms that have been made of the super fund scheme.

The first is that it is not necessary: that the increase in the proportion of the elderly in the population will be offset by a reduction of those of younger age, so that the overall dependency ratio will not change much.

Secondly, that it is unfair as between the generations.

Thirdly that we should wait until there is a concensus in Parliament before introducing the scheme.

On the matter of the dependency ratio, the question for me, as Minister of Finance, is not what share of total economic production goes to each age group within the population.

It is what share of the consumption needs of each group has to be paid for by the government.

In this respect, young people (generally), need much less by way of payments from the government than do the retired. Basic costs of support (housing, clothes, food, phone, power, insurance, transport) are essentially "private" for the young (parents support them), and "public" for the retired (the government pays NZS which is the primary income out of which those things are paid for).

One less young person does not equal one more retired person as far as the government’s financial obligations are concerned.

A rough calculation done by Treasury concludes that each person under 16 costs the government $4,603 each year, and each over 65 year old costs it $16,866.

The older age cohorts in the dependent population are nearly four times as expensive, per head, fiscally, as the younger cohorts.

I do not buy the argument that less will be spent on education. It is sensible to plan on the basis that in the future, we will need to spend much more per pupil than we do now in order to remain competitive in the modern world (smaller class sizes, more computer and technical supports and so on).

Even if we do spend less at that point, I imagine that we will spend more on health treatments if the proportion of the elderly in the population increases.

If demographic change "frees up" tax money I am sure there are many other good uses that people can see it being put to.

The dollar freed up cannot fund both NZS and health costs. By partially pre-funding NZS I am creating more capacity for future governments to respond to pressures for more health and other spending.

I have a great deal of difficulty understanding the National Party’s argument on intergenerational fairness.

As I understand the sort of compromise they are floating, they would guarantee New Zealand Superannuation to those who are already retired or near retirement – say those over 45 or 50 – but make no such commitment to the next generation.

Later generations would have to rely on a fairly vague promise of tax cuts and possibly tax incentives to save for a much larger share of their retirement income.

I cannot think of a scheme that is less fair to the coming generations. They will have paid to keep their parents and grandparents up to current NZS formula levels only to see it evaporating before their very eyes as they move into their sixties.

On present plans, we will pay net into the fund for the next 20 or 25 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.

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.

Finally, I want to talk a bit about the consensus argument. This is a sham.

It is an excuse for ducking the hard decision on the fund. Those who say that we must wait for consensus are in effecting rejecting the super fund but do not have the courage to front and say that.

I have been Labour’s spokesperson on superannuation for nearly 15 years now, and in all that time consensus has been the catch-cry, and the more it has been talked up the more likely it was that people calling for it were trying to avoid consensus.

There was too much political advantage in having a different position on super.

My view is that the great and enduring consensuses on superannuation policy, like those in the USA and in Australia, have followed rather than led new schemes.

They have followed by the law of political gravity. As the funds have grown, and as they have been seen by the population as a whole to be a clear indication of where their pensions are going to come from, they have become too strong a force to try and deny.

So it will be with this fund.

I am going to end this presentation by reflecting on one area that is perhaps more of concern to the fund managers that would seek to do business with the Guardians of the Fund.

This is the question of ethical investment, sustainable investment, socially responsible investment or other variations on that general theme.

The debate on this starts at one level of disagreement.

Any attempt to fetter fund managers with non-commercial – such as ethical – constraints is seen to lower the long-run returns achievable.

You can have ethical investment, but at a cost because it limits the full range of choices a fund manger has. The subsidiary argument is that giving fund managers dual objectives always gives them an excuse: if returns are low it was because they were pursuing ethical investments; if they invest in controversial companies it was because they were seeking better returns.

The jury is out on this.

There is certainly a lot of evidence around that socially responsible funds do not produce weaker financial results than conventional ones, but the counter-claim is that there has not been the time horizon or the scale of funds under management to make valid comparisons.

At the next level, the argument is that investment that is not sustainable would not be selected by fund managers. Sustainable investment is best practice.

Also, socially irresponsible investment will eventually attract sanctions in one form or another: government regulation, consumer boycotts and the like. Hence prudent fund managers would build into their calcuations the risks of reducing returns from socially irresponsible entities. This is a bit too simple.

There are profitable investment outlets, particularly short term outlets, that do generate good returns from bad labour and environmental practices.

I said earlier that the terms socially responsible, ethical and sustainable tend to be used interchangeably, when there are some subtle but important differences between them. There are also differences in approach to this type of investment.

Since the Superannuation Bill was introduced, a number of investment organisations have been making presentations - not just to the government - about how the ethical dimension might be incorporated into fund management decisions.

There are a number of models.

The first is the prohibitionist model.

Certain types of investment are simply declared to be off limits: arms manufacturers and tobacco companies are two examples. There are two problems with this model.

Firstly, it only narrows the range of potential investments marginally, and can be seen to be tokenist.

Secondly, the prohibited product groups can be produced by corporates with other legitimate products, and companies that profit from the products need not be the companies themselves. Banks, for example, make money from tobacco when they lend money to tobacco companies. It is very hard to fully screen a prohibition list.

The second model is the investor values model. Here the investor decides what sorts of values it wants reflected in its portfolio and the fund manager selects accordingly.

That seems to be viable when the value system of the investor is tightly defined: say a religious organisation with funds to invest.

It is harder to define the values of the investor when the ultimate investor is the people of New Zealand, or even the government of New Zealand. Values are diverse and at times conflicting within the body politic.

Thirdly, there is what is known as the best of sector approach. The best of sector recognises that there are sectors that will have an inherent disadvantage when it comes to some aspects of social or environmental performance.

A computer software company will always generate less environmental damage that a mining or chemical company. However, a modern economy does need minerals, fuels and chemicals, so screening some sectors is simply hypocritcal.

The best of sector ranks companies within sectors against standards of (say) social, labour and environmental performance. It then limits investment to companies in the (again, say) top 30% in the sector.

It chooses from among those that make the grade according to conventional financial performance indicators.

The approach does limit choice to the companies that have gone through the ranking process. It is also of limited use when investments in intermediary organisations like banks are being considered.

The final model I want to talk about is the active partner model. Under this model, there are some prohibitions, but apart from that organisations that the fund invests in are encouraged to work with agents of the fund manager to improve ethical performance.

That involves a mix of improving reporting on the triple bottom line: financial, social and environmental, and improving performance in each of these categories, but especially the last two.

The incentive for companies to engage with the agents is that if they do not, the fund manager will not invest in them.

I am not sure that this intimate level of active engagement can be maintained with a fund of the size that the NZSF is expected to grow to, but that will be something that the Guardians will have to look at.

I don’t think that the best way forward is to select a model in advance and prescribe it in legislation. The whole field is evolving too rapidly for that.

My preference is to stay with the emphasis on process that is outlined in the Bill. That process might be fine-tuned, but it operates through a number of re-inforcing procedures.

It starts with a high level value statement. The Guardians must invest the fund on a prudent commercial basis, but must also "avoid prejudice to New Zealand’s reputation as a responsible member of the world community".

That could imply a prohibition screen, but the Guardians do have scope to develop other methods to avoid irresponsible investing prejudicing New Zealand’s reputation.

The Guardians must then establish investment policies, standards and procedures and review them annually. These are published in a statement, and the statement has to cover a wider range of factors that include ethical investment.

This is important. There has to be an annual statement that covers all three dimensions of ethical investment: policies on ethical investment, standards on ethical investment and procedures relating to ethical investment.

Each year, the Guardians must publish a report that includes a statement certifying whether or not the investment policies, standards and procedures have been complied with.

There is adequate scope for Parliamentary and public scrutiny of whether the policies on ethical – and of course other dimensions of – investment are appropriate, whether standards are adequate, and whether standards have been met.

To round things out, at least every five years there has to be an independent review of how efficiently and effectively the Guardians are performing their functions. That includes whether the policies et al on ethical investment are appropriate and whether they have been complied with.

This package is sufficiently specific, sufficiently flexible, sufficiently transparent yet sufficiently accountable to allow us to move forward with some confidence on this new investment frontier without compromising the financial imperatives of the fund.

There are other key issues that the Guardians will need to grapple with about the investment performance of the fund, but there is no time for these today.

The programme you have in front of you is varied, and allows for a very stimulating discussion of all aspects of superannuation policy.

I noted that I saw superannuation as crucial from the point of view of macroeconomic performance and personal security.

I am sure your deliberations will allow further insights to be gained into how superannuation policy can contribute to both.

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