Super fund's impact on markets a secondary consideration: Cullen
The Government explains the benefits, pitfalls and market impact of the multi-billion dollar New Zealand Superannuation Fund.
Friday, March 7th 2003, 4:00PM
Clearly the New Zealand Superannuation Fund is prompting a great deal of debate; some of it informed, some not. It is important to begin any discussion of the fund by reminding ourselves of its primary objective and its structure and governance.
The fund is first and foremost an instrument of long-term fiscal policy. Its objective, let me remind you, is to smooth the impact of our ageing population on the Crown's finances, and hence ensure fiscal and policy stability. We cannot ignore the fact that, over the next 50 years or so, a permanently higher proportion of the population will become eligible to receive payments of New Zealand Superannuation. This change arises primarily from increasing longevity and declining fertility in the population, and is exacerbated slightly by the passage of the 'baby boom' generation.
The effect of the policy is to build up a portfolio of Crown-owned financial assets over the next few decades while the annual cost of New Zealand Superannuation remains relatively low. Those assets will then progressively be drawn on to supplement the annual Budget as the Crown's finances adjust to a much higher level of ongoing expense for New Zealand Superannuation. It is a smoothing mechanism for what remains fundamentally as a "pay as you go" universal benefit.
Contrary to the impression some people have, the primary beneficiaries of the fund will not be future retired people. They, after all, will not receive any larger entitlement to New Zealand Superannuation because of the fund. Instead, the beneficiaries will be the taxpayers of the future, who will not have to face the steep rises in tax rates that would be otherwise needed to maintain New Zealand Superannuation. Given that the cost of New Zealand Superannuation is forecast to rise from the current 4% of GDP to around 9%, these tax increases would, in the absence of the fund, be very significant.
In this sense, the fund can be seen as an extension of the regime of responsible long-term financial management, which has been put in place in New Zealand over the past couple of decades. It is about fiscal responsibility, managing long-term fiscal risk, properly balancing assets and liabilities, and avoiding volatility in tax rates.
The fund is managed by a Crown-entity, known as The Guardians of New Zealand Superannuation. The Crown owns all assets of the fund. The key principles that apply to the governance of the fund are autonomy and accountability.
First, autonomy. The Guardians has full powers over the investment of the fund's assets. The Minister of Finance can give directions regarding the Government's expectations as to the fund's performance. However, a direction cannot be inconsistent with the Guardians' duty to invest the fund on a prudent and commercial basis, and the Guardians must "have regard" to any direction, rather than being required by law to follow it.
The only major constraint on the fund is that it cannot take a controlling interest in any entity. The Guardians can appoint external investment managers for the fund or can manage all or part of it in-house. The fund operates subject to income tax.
Second, accountability. The Guardians are required under the Act to publish an annual Statement of Intent, which sets out the Board's expectations about the performance of the fund and the key risks to the performance of the fund. In addition, an annual report must be presented containing an analysis and explanation of the fund's performance, a statement of investment policies, and a schedule of investment managers and custodians used by the Guardians and the asset classes for which they were responsible.
The performance of the Guardians is independently reviewed at least every five years. All of these documents will be tabled in Parliament and available for public scrutiny.
This governance framework is not unique to the fund. It is essentially the framework that the government is applying to all significant Crown-owned funds.
In the past few years, the government has recognised the need for a consistent approach to the governance policies under which large holdings of Crown financial assets are managed. The total financial asset holdings of the Crown (excluding cross holdings of NZ Government stock) is around $20 billion, with major asset portfolios being held by the Government Superannuation Fund, ACC, the Earthquake Commission and the Superannuation Fund itself (with $1.3b and growing).
These holdings are projected to grow, largely due to the New Zealand Superannuation Fund. By 2007, the Crown's financial assets are projected to be $34.3b (or 23% of GDP). By that year, the NZ Superannuation Fund's financial assets are projected to be over a third of this figure, at $12.4b (or 8% of GDP).
The experience both within New Zealand and overseas is that the best governance framework for government-owned financial assets involves arms length management of asset portfolios, by autonomous, accountable agencies. This enables funds to be managed on a prudent and commercial basis in a manner consistent with best practice, maximising return without undue risk.
In this way, the investment decisions made by the Guardians of the Superannuation Fund will be protected from political interference, although there is a clearly stated expectation that fund managers will avoid prejudice to New Zealand's reputation as a responsible member of the world community.
The New Zealand Superannuation Fund has its critics, of course. Those on the right would prefer that the surpluses paid into the fund be diverted to tax cuts in the short term. But they are strangely mute on the question of how New Zealand Superannuation will be funded once the inevitable demographic shift takes place. Will they contemplate the significant tax hikes needed to provide basic security to older New Zealanders? Or will they opt for cutting the value of the state pension? Or introducing some kind of means test? There is a lack of transparency there, which is glaringly obvious to most voters.
The other criticisms are expressions of concern about how the fund will be managed, and focussed on two issues:
1. What degree of exposure the fund should have to overseas equity markets; and
2. Whether the fund represents an opportunity for the government to deepen the New Zealand capital markets, and thereby - it is argued - improve access to financial capital for New Zealand businesses.
The first of these issues was aired at the Parliamentary Finance and Expenditure Committee last week when it heard a presentation from David May, the Chair of the Fund Guardians. The Greens co-leader Rod Donald put forward a view that, in light of the loss of value experienced by the Government Superannuation Fund after its recent programme of selling New Zealand Government Bonds and buying into the global equity markets, the New Zealand Superannuation Fund should be required to invest most or all of its capital in the New Zealand capital markets.
In reality, Mr Donald's proposal would most likely endanger the objective of the fund. He is possessed by the rather bizarre notion that exposure to the New Zealand markets is somehow an act of patriotism. However, requiring the fund to be weighted towards the New Zealand capital markets would subject it to significant small market risk, and hence compromise the ability of the Guardians to deliver on the fund's long-term objective. If, as seems clear, he would further require the fund to minimise risk by limiting its investments to government bonds and other domestic securities, the chances of it generating any significant real returns seem slim.
The overwhelming evidence of history is that over an extended period of time a better return, with very limited risk, comes from a diversified fund, with a mix of bonds and equities, foreign and domestic. We have to remember that the fund is a long-term mechanism. It is calibrated towards smoothing costs over a 40 year rolling horizon. Current projections are that no draw down from the fund will be required for at least 25 years. There is no reason to fear that a significant rate of return cannot be achieved over that period.
Let me turn to the question of whether the fund could kill two birds with one stone and supply much needed capital to New Zealand businesses in addition to its primary role of managing future fiscal pressure. This is an apparently attractive idea, based one imagines on the perceived success of Singapore's National Provident Fund in providing capital to that country's markets.
However, the availability of capital itself is a necessary, but not a sufficient, condition. One should not confuse volume with depth. Requiring the fund to direct a significant portion of its assets towards the New Zealand markets would not guarantee a deepening of those markets. You cannot turn a shallow, braided river like the Rakaia into deep, fast flowing one like the Clutha simply by increasing the flow of water. What we mean by "deepening" capital markets relates to the strength and sophistication of the institutions which comprise the market, as well as to the availability and liquidity of capital in both primary and secondary submarkets.
I can assure you that deeper capital markets are very much on the government's agenda. For example:
- A fundamental review of the law of insider trading;
- Market manipulation law (recognising the potential for small market issues in the New Zealand context);
- Penalties, remedies and the application of securities trading law; and
- Substantial security holder disclosure;
These initiatives are designed to deepen capital markets. However, this is not a primary purpose of the Superannuation Fund.
It is an important design principle that government policies avoid multiple or potentially conflicting objectives. While - as I will argue later - there are some factors that would point to a New Zealand based fund investing disproportionately in local equities, we cannot afford to ask the Guardians to play a role which, even at the margins, may conflict with their primary objective as set out in statute.
It is essential that the Guardians be allowed to follow a careful, best practice approach to their prudential responsibilities. They have made steady progress so far, and are emphasizing quality and depth of process, rather than speed.
After a global search process, with extensive interviews and reference checking they have appointed Paul Costello as chief executive. Mr Costello is a New Zealander, and is currently ceo of the Super Trust of Australia. After a similar search global process, Mercer Management Consulting has been appointed as lead asset allocation and portfolio construction advisor. The Board of the Guardians is currently seeking an advisor to assist with investment manager selection.
The board will pursue a policy of regular and open communication with the financial media including:
- Press releases to announce significant events;
- A spokesperson readily available to the financial media; and
- Development of a website as a comprehensive source of information.
What then is the likely market impact of the fund? That depends upon a raft of decisions that the Guardians of the Fund will need to determine before they begin to invest the Fund. These decisions relate to:
- Risk tolerance;
- The distribution of assets to equities and to other classes of assets;
- Hedging policy;
- Issues of geographical spread;
- The market entry strategy;
- The mix of in-house and external management; and
- The ethical policy of the Fund.
The question of how much of the Fund to invest in New Zealand will also be part of this equation. As I hope I have made clear, the Guardians will approach this question in the same manner as any New Zealand based investor.
Clearly, New Zealand equities are a small proportion of total global equities, and hence diversification means placement of a significant proportion offshore. Nevertheless, there are other factors to be considered which imply that a prudent investor operating within best practice guidleines would allocate significant funds to the New Zealand markets:
- First, there are tax issues. New Zealand investors benefit from imputation credits issued by New Zealand companies. Conversely offshore investments may incur tax in those overseas countries, which cannot be offset against the NZ tax liability on income from those investments;
- Second, any investments made by a New Zealand fund in New Zealand do not carry any currency risk, and therefore are exempt from any costs associated with attempting to hedge or mitigate such risk;
- Third, there is the advantage of local knowledge in considering investment in New Zealand equities;
- And finally, at the present point in time, the New Zealand economy is performing well vis-à-vis our major trading partners, and is attracting attention from overseas funds with a mandate similar to that of the New Zealand Superannuation Fund.
These factors are prompting New Zealand fund managers - including those who manage the other major Crown-owned funds - to invest disproportionately in the New Zealand markets. For example, the GSF has a target of placing 14% of its assets in New Zealand bonds and one eighth of its portfolio in New Zealand equities. That target - which is currently under review and likely to be increased - will result in over $400 million of new equity being injected into our stock market.
As I said at the outset, there is nothing to suggest that the Guardians of New Zealand Superannuation will follow the same strategy as the GSF. However, for illustrative purposes, if the Guardians make a comparable allocation, the result will be an additional $250 million per annum directed into the stock market. If this occurs, then the resulting opportunity for a deepening of the New Zealand capital market will be a welcome by-product of the operation of the fund.
To sum up, the New Zealand Superannuation Fund is an important policy instrument whose purpose is to address a specific issue in the long-term financing of New Zealand Superannuation entitlements. It is set up with a best practice governance structure, which will ensure that investment decisions are focussed on the task at hand, and are not influenced by political priorities of the day.
Ultimately, the test will be whether it achieves its primary objectives. Its impact on the New Zealand capital markets is a secondary consideration. While it is likely that it will make a positive contribution to the depth of our capital markets, and in so doing supplement the other measures that the markets themselves and the government has in train; it is important that we keep our eyes on the prize: fiscal and policy stability, and strengthening incentives on successive governments to avoid short-termism in fiscal policy.
In this particular long-term - 50 years or more - all of us in this room will be either dead or well into a financially secure dotage. However, our children and grandchildren will not thank us if we fail to prepare the country's finances for pressures that are clearly foreseeable and quantifiable, nor will they thank any political party which seeks to compromise a long-term financing strategy for the sake of short-term political gain.
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