Super fund faces four risks: Brash

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National Party finance spokesman Don Brash outlines what he sees as the risks to the New Zealand Superannuation Fund.

Friday, March 7th 2003, 4:37PM

There are many things which are uncertain about the future but, short of some cataclysmic outbreak of disease or war, it seems inevitable that over the next few decades we will see a major ageing of the New Zealand population. At the moment, only 12% of the population is over 65 years of age. By 2040, the proportion over 65 years is expected to have doubled to 25%. Perhaps even more dramatic is the proportion of the population who will exceed 85 years of age. That proportion currently is only 1%; by 2040, the proportion is expected to be around 5%

Moreover, those projections assume a steady net inwards migration of 5,000 per annum over the period to 2040. That seems a pretty safe assumption, indeed even a conservative assumption, given that net inwards migration last year was over 38,000, and over the last 10 years net inwards migration has averaged nearly 12,000 per annum. But if we fail to narrow the gap in living standards between New Zealand and the rest of the world - which seems very probable given the present Government’s primary focus on wealth redistribution rather than wealth creation - the assumed net inflow of 5,000 annually could turn to a significant net outflow. That would further increase the ratio of those over 65 to the total population.

But assuming for the moment we get the net inwards migration of 5,000 annually, the implication of the projected ageing is that the cost of New Zealand Superannuation, if it continues to be provided on the present basis, will rise from about 4½% of GDP to nearly 10% of GDP by 2040. And while that may seem like an eternity into the future, it is not much further away in the future than Britain’s entry into the European Common Market (as it was then called) in the past.

At least as sobering is the fact that on present policies the government’s cost of providing healthcare will also rise strongly over this period, from little over 6% of GDP to nearly 11%.

The increased cost of both New Zealand Super and government-funded healthcare would thus be some 10% of GDP by 2040 - or nearly 21% in total.

There would, of course, probably be some reduction in government spending on education because there would be fewer children to be educated. But Treasury estimates suggest that, on current policies, total core government spending would rise from not much above 30% of GDP currently to nearly 42% in 2040. And that would have to raise serious questions about the sustainability of present policies or, put another way, about the willingness of those who will then be in the workforce to pay the taxes required to pay for all those over 65.

Faced with this situation, the present Government has established the Big Cullen Fund to achieve what is known in the jargon as "tax-smoothing" - in other words, the scheme is designed to build up assets during the next 20 years or so when demographic trends are favourable and then run them down as population ageing becomes a major factor. It does not change the overall fiscal cost of providing New Zealand Super, and does not pretend to do so.

But there are some very big risks in this approach.

Investment risks
First, and most obviously, there are investment risks. When the creation of the Big Cullen Fund was proposed to the country, it was based on the assumption that the funds in the scheme could be invested in equities to return over 11 per cent annually over the long-term, and in bonds to return over 6 per cent annually over the long-term. It was assumed that the total pre-tax return on Fund assets would be 9.4 per cent annually.

Well, it is certainly too early to be sure that those figures are wildly optimistic, but they certainly look too optimistic to me. And experience with the Government Superannuation Fund (quite unconnected to the Big Cullen Fund of course) - which lost $202 million in the first 14 months after it diversified out of New Zealand government bonds into a range of assets in November 2001 - only serves to remind us that there is a big potential downside in investing in international shares, especially when world equity markets are expensive and the New Zealand dollar well below its long-term "equilibrium".

Fortunately, at present the funds allocated to the Big Cullen Fund are safely on deposit with the Reserve Bank, in New Zealand dollars, earning 5.75% - lower than the assumed long-term return on the Fund but hugely better than would have been the case had the funds been invested abroad, especially if they had been invested in overseas equities.

Anybody who has read Robert Shiller’s book Irrational Exuberance will know that it is possible to invest in equity markets for decades at a time and not show a return on equities of over 11 per cent annually. And, as somebody who chaired the Reserve Bank’s superannuation scheme for nearly 14 years, I know that that scheme did not come close to averaging a 9.4 per cent pre-tax return - and that was managed by some of the best professional fund managers in the business.

So the first risk is that the Fund may generate a long-term rate of return not much better than, or possibly even less than, the cost of the government’s borrowing. Since for at least a number of years to come the Government could have reduced public sector debt rather than create a large pool of assets (as the Australian Government has chosen to do), building up the Fund involves an unnecessary investment risk. And that is true, of course, whether the Fund is invested in equities or in bonds, overseas or in New Zealand: all investment markets have some degree of risk, and any prudent investment manager will wish to ensure that the assets of the Fund are well diversified.

The Fund may discourage private sector savings and encourage early retirement

Second, there is the risk that setting up the Fund may create the illusion that payment of New Zealand Super on the present basis - "65 per cent at 65" for a married couple, without means test - is somehow guaranteed by the Fund for the indefinite future. But while the Fund may ease the fiscal cost of meeting New Zealand Super payments to some extent, that extent is very modest. At the point where withdrawals from the Fund peak in 2065, those withdrawals will cover just 17 per cent of the fiscal cost of New Zealand Super, and on average the Fund will cover just 14 per cent of the fiscal cost during the years when it is being drawn down. And that is on the basis that the Fund earns at the rate assumed. So there is nothing approaching a "guarantee" provided by the Fund.

A Treasury report in August 2000 observed that:

If pre-funding contributed to providing a more certain and stable environment for people to make their savings decisions in, it could be argued that it would lead to an increase in private saving. However, the evidence is much stronger that pre-funding would lead people to think that retirement income provision was secure and that they did not need to save for themselves so much.

Further on, the same report noted that:

A pre-funding system that created a greater sense of certainty that an individual would receive a specified entitlement may well influence decisions about labour force participation, potentially reducing the productive capacity of the economy. Such an effect might not just occur at the eligibility age, but also earlier for younger people who have sufficient savings to tide them over until they are eligible.

At this stage, it is probably too early to see evidence that the establishment of the Big Cullen Fund is leading people to retire early, although if this were to occur it would be serious given that the last thing we should be encouraging, given the ageing of the population, is early retirement.

But there is some evidence emerging that people have been persuaded that the Fund does "guarantee" the government’s ability to pay New Zealand Super on the current basis indefinitely and may be a bit less inclined to save as a result. Certainly, a recent survey commissioned by financial services group Sovereign found that the proportion of people believing that the Government would provide an adequate retirement income has doubled in the last three years to 18 per cent. If additional saving by the government were to lead to reduced saving in the private sector, that would be an important offset to any benefit which the additional government saving might have.

The Fund may lead to increased government spending

The third risk involved in the establishment of the Big Cullen Fund involves the risk that it might lead to increased government spending. The Treasury report by Nick Davis and Richard Fabling cited earlier found that pre-funding had "significant welfare benefits" on the "assumption that the assets accumulated under tax smoothing earn an average return over the government’s cost of borrowing". But they acknowledge that when what they call "practical political economy considerations" are taken into account - which is another way of saying "when real world political pressures are taken into account" - "expenditure creep (where additional government spending is triggered by an improving balance sheet position) tips the balance in favour of a balanced budget approach." They suggest that to control "expenditure creep" "strong fiscal institutions are a prerequisite for achieving the welfare gains of tax smoothing".

Well, how confident are you that, in an MMP Parliament, we will see a tight rein over "expenditure creep"? The present Government quite early on in its first term announced that they would abandon the previous National Government’s target of getting core government spending below 30% of GDP in favour of getting core government spending plus contributions to the Big Cullen Fund below the higher figure of 35%. And during that first term we saw quite a substantial increase in government spending. Indeed, Dr Cullen broke his own self-imposed spending cap and then promptly abandoned the cap entirely! At this stage, this looks likely to be a recurring pattern. And what the Treasury argued was that, if the existence of the Big Cullen Fund makes Ministers feel more willing to increase government spending in the years ahead, we would have been better not to have it at all!

The Fund may get hi-jacked to invest in low-return but politically popular projects

The fourth risk is that the Big Cullen Fund will get hi-jacked to fund every low-return project wanted by some minor political party important to the Government’s political survival. If this were to happen, the risk of the rate of return on the Fund being depressed below the government’s borrowing cost would clearly rise and the subsidy provided to the low-return project would be conveniently hidden from public view. We have already seen calls by smaller political parties for the money in the Fund to be used to fund road projects which don’t meet Transit New Zealand’s criteria, and to support the New Zealand equity market.

To be fair, the Big Cullen Fund has been set up with strong safeguards in that respect. The Guardians of the Fund have clear instructions to ensure that the funds for which they are responsible are invested in a prudent and fully commercial way consistent with best practice portfolio management, subject to "avoiding prejudice to New Zealand’s reputation as a responsible member of the world community". (I presume that means that investment in brothels is off the agenda, but what about investment in the shares of companies making cigarettes, or armaments, or beer? What about companies that mine coal, or produce electricity by burning hydrocarbons? What about companies involved in research on genetic modification?) The Minister of Finance can give directions regarding the Government’s expectations as to the Fund’s performance, but a direction cannot be inconsistent with the Guardians’ duty to invest the Fund on a prudent and commercial basis.

So in that respect, the Fund is off to a good start, and the Minister is to be commended for appointing people as Guardians without regard to political affiliation.

But of course there remains the risk that at some future date, when the political pressures change, the Government will change the legislation under which the Big Cullen Fund operates so that funds can be diverted to satisfy non-commercial objectives. The very existence of this large pot of money would make it too easy to justify all kinds of uneconomic projects on the grounds that they might have some unquantifiable social benefit. We have seen the same sort of behaviour on the part of the trustees of several of the community trusts, where thinly-disguised grants are described as investments.

The Fund will result in markedly higher government debt than otherwise

It is important to note that the Big Cullen Fund will lead to significantly higher government debt than otherwise. At the moment, the Government projects strong operating surpluses for the years ahead, with these surpluses being sufficient to finance both contributions into the Fund and the Government’s investment programme. In other words, the gross government debt outstanding is projected to remain broadly stable over the years ahead, rather than reduce fairly strongly as would be the case in the absence of the Fund.

But, as the National Bank of New Zealand argued in October 2001, financial markets care about gross debt and not about net worth. The National Bank estimated that the increase in the government borrowing programme as compared with the situation without the Big Cullen Fund would add about 0.25 per cent to the interest rate on 10 year bonds and, by thus increasing the cost of capital throughout the economy, would result in a reduction in the economy’s potential growth rate of about 0.2 per cent per annum. That estimate seems a bit high to me, but even if the estimate is wrong by a factor of two, it implies a very substantial cost imposed on the economy by the creation of the Big Cullen Fund.

It is also worth noting that the Government’s projection of a stable level of gross public sector debt is, of course, premised on the assumption of continued large operating surpluses. If those surpluses diminish, either because of increased government spending or slower growth in the economy, the implications for the size of the public sector borrowing programme could be alarming unless the Government sharply curtailed contributions to the Fund.

The biggest risk: the Fund may enable the Government to avoid talking about the parameters of New Zealand Super

Perhaps the biggest single risk created by the Big Cullen Fund is that it gives the Government the ability to pretend that the "New Zealand Super problem" has been "solved" and that there will never be a need to even discuss the design parameters of the scheme. Alas, that is not true. No society can lightly contemplate spending an additional 10 per cent of GDP on government-funded superannuation and government-funded healthcare in a world where working-age people have the easy option of avoiding that implied increase in the tax burden by moving to countries where the tax burden is lighter. (In this connection it is interesting to note that the cost of taxpayer-funded retirement income in Australia is markedly lower than in New Zealand, and is projected to reach only about 4½ per cent of GDP in 2040 - roughly where the cost of New Zealand Super is now.)

How might the New Zealand scheme be changed? I don’t believe that any political party, and certainly not the National Party, would support reducing the pension for those who are already over 65 years of age, or indeed for those who are old enough to have a reasonable expectation that the present scheme will remain unchanged. That would be totally unfair, and would leave people who have very limited opportunity to build up a larger nest egg in potentially serious financial difficulty.

But for those in their 30s and 40s, with 20 or 30 years to go to retirement? I’m not sure. Certainly people of that age have much more scope to save a little more for their retirement. And since there is evidence that many younger people doubt that New Zealand Super will be available to them when they retire, the Big Cullen Fund notwithstanding, it is possible that they might support some reduction in the level of the benefit in exchange for a much higher probability that the benefit will in fact be paid. Having said that, it is important to stress that the National Party is not advocating any change in the level of the benefit, whether for those aged 65 or those aged 25.

And what about means testing? Again, given the experience which first Labour and then National had with means testing, I very much doubt that any political party will suggest that, at least not for many years to come, and I am certainly not advocating that here either. But it is, to put it mildly, somewhat odd to have the average wage earner paying tax so that those with very substantial incomes and/or very substantial assets, in some cases millionaires, can get an additional $19,000 per annum. In Australia, the taxpayer-funded pension is subject to both an income and an asset test, with apparently quite vigorous steps taken to catch those who try to shelter income and assets in trusts.

I suspect that eventually - if not in five years then almost certainly in 10 or 15 - we will have to look at the age of eligibility again, as indeed even Dr Cullen has acknowledged. When "universal" was first introduced at age 65 in 1898, the average life expectancy was just 59, and those lucky enough to reach 65 lived for an average of 13 years. Today, the average life expectancy at birth is 78, and those who live to 65 live an average of another 18 years. By 2040, average life expectancy is expected to be 84, with those reaching 65 living for a further 22 years. With a steady decline in the proportion of the workforce who are engaged in heavy manual labour and a steady improvement in the health of older New Zealanders, it seems inevitable that at some stage we will need to increase the age of eligibility. Of course, people will still be free to retire whenever they wish, but it is not clear why the diminishing band of working-age adults should be expected to fund retirement when people have a large number of healthy years ahead of them.

Last year, the Retirement Commissioner noted that "there will inevitably come a day when the age of eligibility for New Zealand Superannuation will need to be reviewed" and went on to suggest that political parties should together review that issue from time to time, perhaps every 12 years. In several countries, the age of eligibility for the taxpayer-funded retirement scheme is already above 65 - notably Ireland, Iceland, Denmark and Norway - while the United States is very gradually raising the age of eligibility to 67. In the United Kingdom, there has been recent discussion about the possibility of enticing people to remain in the workforce until 70 in exchange for a higher pension at that point.

More private sector savings would not ease the future fiscal problem without means testing

Would it help the situation if individuals saved more for their own retirement? It would clearly help them in their retirement but it wouldn’t ease the fiscal problem because New Zealand Super isn’t means-tested; and, as indicated, it seems very unlikely that there will be a means test in the foreseeable future. (And of course the risk is that, even if means-testing was introduced, the very fact of its introduction might discourage some people from saving.)

I think it is important to emphasise that more private saving doesn’t help to resolve the fiscal issues posed by the ageing of the population. There has been some suggestion lately that government should provide "incentives" to encourage more private sector saving, perhaps in the form of tax concessions of some kind (as if living in reasonable comfort in retirement was not incentive enough!). But although most people suggest that they would save more if offered such tax incentives, all the evidence from New Zealand’s history and from other countries is that, though increased funds certainly flow into the tax-preferred vehicles, often in large amounts, total private sector savings do not increase. To make matters worse, public sector savings go down (because of the tax incentives), so that aggregate national savings also decline. Not an attractive proposition for any Minister of Finance! While there are clearly strong arguments for removing some of the features in the tax system which discourage saving, I am not persuaded that tax incentives have any positive effect on total savings.

Which leaves only compulsion. Having a Singaporean wife, and having some knowledge of the extraordinary growth of Singapore as a result, I am slightly more tempted by the idea of a compulsory scheme than most economists are. It is certainly hard to avoid the conclusion that one of the factors in the growth of that country was the availability of large amounts of domestic savings, although Hong Kong, with no compulsory saving scheme (until now), has achieved similar growth rates.

But there are plenty of reasons to make me cautious about advocating such a scheme. First, the New Zealand people resoundingly rejected a well-designed compulsory savings scheme in a 1997 referendum and, despite some surveys suggesting that opinion may have shifted since that time, I don’t have much doubt that a referendum held today would also be defeated. Second, unless the levels of contribution were high (as they are in Singapore), it is not clear that such a scheme would in fact raise total saving. Certainly in Australia there is ongoing debate about the extent to which total savings have been increased by the compulsory savings scheme in that country, though nobody doubts that the funds under professional management have increased considerably as a result of the scheme. Third, for most households with children, it is almost certainly the case that their best form of saving by far is the repayment of mortgage and other debt. No other form of investment offers such a high risk-free rate of return. For those running small businesses or farms, reinvesting any surpluses in their businesses is similarly almost certainly an investment with a higher rate of return than is likely to be achieved by a diversified portfolio of managed assets, although the risk of the latter is arguably lower. In any case, such a scheme would not ease the prospective fiscal problem unless access to New Zealand Super was means-tested, and even then a scheme of this kind would have little impact on the fiscal problem if Australian experience is anything to go by.

It is also quite unclear how a political party which stands for personal responsibility and freedom of choice could, with a straight face, argue for a further compulsory retirement income scheme on top of New Zealand Super, the compulsory scheme which exists at present.

Mr Chairman, I don’t doubt that the Big Cullen Fund was established with the best of intentions. But the risks are huge, including the biggest danger of all, that it has created the illusion that New Zealand Super can continue on the present basis forever. The most important thing that the Government should be doing with its fiscal surpluses today is ensuring that they are used to maximise the growth of the economy by reducing public sector debt, reducing the tax burden on the economy, and fixing some of the country’s major infrastructure bottlenecks, most obvious in this city of Auckland. While faster economic growth will not, of itself, ease the fiscal problem on the horizon (because the level of New Zealand Super benefits are linked to the average wage, which must be expected to rise with per capita income), it is ultimately the health and vigour of the economy in years to come which is the guarantee of government’s capacity to pay benefits to those in retirement. The stronger the economy, the more confident we can be that the benefits promised by New Zealand Super are secure.

Sadly, the Government seems to have little idea about how to encourage economic growth, and indeed seems to have completely abandoned any attempt to return New Zealand to the top half of the OECD within a finite period.

And while the Government should be doing everything possible to encourage the growth of the economy, all political parties should be encouraging a rational and level-headed debate about the future parameters of the taxpayer-funded retirement income scheme. Contrary to much popular myth, and despite a huge amount of good work by a succession of government-appointed committees, such as the Todd Task Force in the early nineties, there has never been such a public debate about the key parameters. We should surely be mature enough to undertake that debate, while assuring all of those who are already receiving New Zealand Super, or who can expect to receive it within the next 10 or 15 years, that their benefits are assured. Only when we achieve a broad public consensus around parameters which are sustainable for the long term will any change in those parameters be both durable and politically feasible.

This is a speech made by National Party finance spokesman Don Brash to the FundSource conference.

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