Closing the Savings Gap: The Role of Retirement Saving

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Address to the 5th Annual Super Funds Summit by Hon David Cunliffe

Wednesday, April 7th 2004, 12:08PM

Savings matters

It matters to individuals - for the proverbial rainy day and for retirement.

It matters for the economy to provide needed funds for investment and to reduce our reliance on foreign capital.

And it matters for the Government, which seeks to encourage good saving behaviour, and provides a baseline of income in retirement.

There are three areas I am going to look at today. The first is the link between savings and economic performance. The second covers superannuation policy and savings. The third focus is the new State Sector superannuation scheme.

Saving and economic performance

The first very important point here is that savings and investment underpin economic growth. One of the sources of economic growth is what economists call increasing capital intensity. To put it in non-economic terms it is about having more and better, equipment to work with whether it is computers, telecommunications equipment, factories, assembly lines, trucks, or the roads to drive them on.

But we can't have our cake and eat it too. Committing resources to these things for use in producing income in the future, that is, investing means withholding resources from every-day consumption, that is, saving. Of course, we can borrow from abroad, but, as I will explain in a moment, that is not a “free lunch”.

New Zealand's savings performance is poor. The OECD in its most recent review of the New Zealand economy identified New Zealand as having a below average level of business investment compared with other OECD economies. The IMF and the Treasury have raised similar issues about the level of business investment in New Zealand.

At the same time as our investment has been low, the proportion of New Zealand’s investment financed from overseas, net of New Zealand investments abroad, has risen to amongst the highest of any OECD country.

Taken together, these two points tell us that we have saved less than other OECD economies. This is mainly, if not entirely, due to the household sector.

Fortunately, over the same period, the Government has moved from being a net spender by running fiscal deficits, to a saver by running fiscal surpluses.

There appears to be two key drivers behind the household savings gap. First, there is no doubt that there has been a lower level of participation in long-term, employment-based, saving for retirement plans. As I will outline later, this is something the Government is keen to see improved.

Second, there has been a significant shift in the composition of bank lending from business lending to personal lending, mainly for housing. Some of this reflects changes in the ways in which funding for small business is provided, but it seems clear that personal borrowing to fund consumption also has increased. A fair amount of housing lending will also have funded “equity withdrawal” and indirectly contributed to an increase in consumption spending.

This suggests that the borrowing behaviours of New Zealand households may have been as much a factor in the overall level of saving in New Zealand, as has any lack of participation in retirement saving plans. This is well recognised in the work of the Office of the Retirement Commissioner which in its promotional and awareness work is emphasising sensible management of borrowing as well as the more traditional means of saving.

So New Zealanders have a poor private savings record, with inadequate private provisions for retirement and a worrying skew towards housing lending and equity based consumption spending.

What does all this mean for our economy's external balances?

Our current account is now running at around 4.5 percent of GDP. Typically, the Merchandise trade balance varies significantly over the cycle, reaching a surplus of $1 bn in the year to December 2001 and $3.5 bn in the year to December 2003. There are signs of an improving medium term trend, thanks in part to improved export performance in the services sector.

The real problem is the net investment flows, which are outbound to the tune of 5.5-6 percent of GDP. At 6 percent of GDP, this gap is roughly equivalent to the total annual output of the New Zealand dairy industry. Seen in this light, 6 percent of GDP is not small.

These investment flows reflect outflows of profits on foreign investments in New Zealand. Some would see this as a hangover from the asset sales of the 1990s, although, in fact, the trend is more broadly based.

They also reflect the relatively poor rate of return on New Zealand investments. You can think of the list yourselves, from Air New Zealand's Ansett adventure to the prices paid for other "strategic" investments in Australia and further a field. Can anyone name a highly successful New Zealand in Australia? Can you name half a dozen? This is a major issue for which corporate New Zealand must accept some responsibility. Perhaps this would be more worthwhile than obsessing with compliance costs when: · the US Heritage Foundation lists us as the third freest economy in the developed world. · the OECD has stated that compliance costs in New Zealand are not high by international standards; and · the World Bank found we're one of the least regulated countries in the world and one of the easiest places to start a business.

Perhaps if New Zealand Businesses focussed more on their investment returns abroad they wouldn't spend so much time being depressed about the New Zealand economy. Business confidence has been negative for 21 of the past 24 months when: · our GDP growth over the year to September 2003 was 3.9 percent, faster than the US, the UK, Europe or Japan · gross domestic expenditure rose 6 percent over the year ended September 2003; and · unemployment is 4.6 percent down from 7.7 percent in 1998

In short, while the Government has run healthy fiscal surpluses to offset this investment imbalance, the investment performance of New Zealand industry has not matched that of its foreign counterparts.

It is worth noting that in future, investment returns for the New Zealand Superannuation Fund will account for a great portion of New Zealand's assets abroad. As a diversified portfolio this will earn close to international average returns for investments with similar risk.

Does this mean that foreign direct investment in New Zealand is a bad thing? By no means. FDI bridges the savings gap and brings important benefits.

Appropriate foreign direct investment benefits New Zealand firms, for example, when a firm replaces a piece of mechanical equipment with a new electronic technology, operators generally also need to be retrained and up-skilled. New Zealand firms also benefit from access to international sales channels, management expertise and R&D alliances.

Without foreign capital inflows we would have to cramp local investment to maintain consumption or vice versa. If investment in New Zealand were constrained to our level of savings we would miss out on some of those indirect benefits. We are clearly better off to sustain investment at the higher level, albeit with the share of income it generates accruing to non-resident savers, provided that it contributes to the productivity of the real economy.

FDI is not a complete solution to the savings gap. We would be better off still if we financed more investment ourselves. In that case, we would pick up both the direct returns as well as the indirect benefits.

We need to be cautious about assuming that foreign saving can be a complete substitute for a low level of domestic saving. There is evidence that despite the openness of global capital markets, savers have a tendency to invest in their home economy because they know it better.

It is also possible that foreign saving invested in this economy goes mostly to well-established sectors and firms, which are easier to understand from a distance and less to the innovative start-ups that are important for the growth of this economy. Foreign saving may therefore not entirely fill the gap left by low domestic saving.

Neither should we view New Zealanders' investment options as being New Zealand based only. Just as we rely on overseas investment, our domestic savings can also be invested abroad and the scope for that is vast. Indeed, in a truly open economy you would expect to see two way flow of capital as savers seek to diversify their investments.

An example is the NZSF which, is investing a substantial proportion of its portfolio abroad for this very reason and because the sheer size of the fund would crowd out suitable opportunity if limited to investing in New Zealand.

Clearly then, savings matters to our economy because: · We need to provide capital for investment · Our low savings rate is matched with a high reliance on foreign capital · Combined with the relatively poor performance of New Zealand investments abroad this adds to a significant component of our current account deficit. · This in turn underlines the importance of the prudent and responsible fiscal stance the Government has adopted.

If this is the situation, what is the Government doing about it?

The Government has run consistent and large surpluses across the business cycle. Among other things, these surpluses support the Government’s investment in the Superannuation Fund, which in turn assists our national savings rate.

We have also taken a proactive approach to attracting high quality foreign investment. The formation of New Zealand Trade and Enterprise and a boost in the funding it receives is part of that. This year NZ Trade and Enterprise will get a total of $246 million, an increase of 25 percent over what its predecessors, Industry New Zealand and Trade New Zealand, received.

Part of that effort is about attracting FDI, and part is also about improving the performance of New Zealand based exporters through initiatives like the Beachhead and Mentoring programmes. Global connections are also a key part of the Growth and Innovation Framework and this will be emphasised in the 2004 GIF package which, will provide further support for New Zealand business seeking to break into offshore markets. There will be more good news for New Zealand exporters in the year's Budget.

Tax is another area where there are gains to be made in improving our savings performance. In many ways the tax system may be compounding the issue by adding disincentives to save. Current tax rules penalise participants in actively managed funds, potentially making New Zealanders hesitant about saving through these vehicles for fear of tax disadvantage, or based on an aversion to complexities in the tax system. Does our tax system support investment that will lift economic productivity? Or does it reinforce existing trends towards 'passive' investment in real estate and other non-productive assets? Recent moves announced by the Minister of Finance to re-examine depreciation regimes, pick up on this theme.

Another disincentive arises through the over taxation of low to middle income savers participating in superannuation funds. The Government has tackled the issue of taxing employer contributions at the employee’s marginal rate, but the issue of over taxation on accumulated earnings remains. One potential solution to both of these problems is the use of the risk-free return method. It has not yet been determined if RFRM is a viable method of taxing the returns to savings domestically and I am not offering a view on it today, but work on this approach and on other solutions to over taxation of savings is underway.

To sum up then: · Saving matters to both individuals and to the economy as a whole · New Zealanders do not save enough · We are therefore heavily reliant on foreign savings to finance investment and consumption · New Zealanders' investments abroad provide, on average, significantly lower returns than foreign investment in New Zealand. · We therefore have a persistent current account deficit driven by net outbound investment income. · FDI is nonetheless essential both to full the savings gap and for the indirect benefits of skill and technology transfer. · Although the structural issues are imbedded in the private and household sectors the Government is working to improve the savings rate and to support the performance of New Zealand investors and exporters and attract high quality foreign direct investment to New Zealand.

Of course a key element in lifting savings performance is the contribution of retirement savings and it is that I which to focus on for the balance of my remarks today.

Saving for retirement

Adequate retirement savings are essential for individuals and for the economy as a whole.

The future standards of living of the retired will depend on the future income of the New Zealand economy. Indeed, once people stop working they become more dependent on other sources of income.

One of those other sources of income is New Zealand Superannuation. Up until recently NZ Super has been set up entirely as a pay-as-you-go arrangement, with each cohort of the working aged population paying a basic level of superannuation to the retired population. The implicit “social contract“ has been that each cohort will take its turn, first as taxpayers, and subsequently as NZ Super recipients.

But population aging has the potential to upset this simple dynamic. We know that by about 2050 the proportion of the population aged over 65 years will have increased from about 12 percent in 1999 to 26 per cent. This raises concerns about how reasonable it is to expect future taxpayers to pay the taxes arising from population aging, and indeed their ability to pay. It is this that led the Government to establish the New Zealand Superannuation Fund.

The key features of the NZSF will be familiar to most in this audience, so let me recap just briefly. The Government will be contributing the equivalent of approximately 1 ½ percent of GDP for about the next two decades. From that point on, it is anticipated that the Fund, including accumulated earnings, will be drawn on to part finance the future mounting cost of NZ Super. The Fund will be invested on a commercial basis, under governance arrangements that place the Guardians of the Fund at arms length from the Government.

The Fund can be seen as a burden sharing arrangement, under which current taxpayers contribute about 1 ½ percent of GDP per annum to partially pre-fund the future cost of NZ Super. To some extent it can be seen as a tax smoothing arrangement, but more than that, it represents savings that will generate a future source of additional income. More will come from investment returns to the NZSF than from direct contributions.

Hence the Government is growing its own future income by saving and investing now, just as the economy as a whole needs to save and invest now to grow its future income to meet future aspirations.

The NZSF will help to provide certainty for New Zealanders, something that people have been crying out for in superannuation. It appears that under National anyone who is 49 years old or younger would have the goal posts moved again. This creates a great deal of uncertainty for those 49 years and under attempting to plan and save for their retirement. This uncertainty is only exacerbated by National's very poor record on Superannuation in the 1990s where they came into government with a promise to abolish the surcharge but in fact extended it, froze the payment and increased the age of entitlement.

In addition, on 1 April the rate of New Zealand Superannuation for a married couple will rise to $383.22. Had National stayed in office that figure would be only $361.40.

Now my National colleagues might argue that increasing life expectancy means people might choose to retire later in order to accumulate more savings for their eventual retirement.

That approach is questionable in theory and doomed to failure in practice. Questionable because choice is one thing and compulsion is another. National's real agenda is about raising the qualifying age to above 65 years old, which means working on will not be a choice at all.

Doomed to failure because it ignores the low savings rates and greater health care needs of older New Zealanders. Older New Zealanders have sent a clear message to both the Government and the opposition: don't even think about doing to us what Muldoon did in the 1970s. They want the super fund protected at the current reasonable level of benefits.

It is worth restating, however, that the Government sees NZ Super as a base level of retirement income, available to all, but it will not meet the aspirations of all. We expect and encourage most to aspire for something better but will not condemn them to accept less.

I believe most New Zealanders would aspire to more than the support provided by NZ Super. NZ Super is sufficient for the basic retirement living costs but will not provide the financial buffer and the luxuries that many New Zealanders would like.

This is why the Government has put an emphasis on private saving for retirement, and on our concern that there should be an environment conducive to that. The Government considers a combination of NZ Super and enhanced private savings that will provide the comfort New Zealanders deserve in retirement.

Previous governments have taken the view their role was to ensure that there was a level playing field, with the Office of the Retirement Commission playing an awareness and educative role. I should say that the ORC has been doing a good job, and the Government supports its efforts.

But is raising awareness, by itself, sufficient? I doubt it.

In recent years, economic thinking has introduced some of psychology’s understanding of how people make choices that involve up-front costs and distant benefits. They help to explain why people often procrastinate in making decisions that involve such choices, and why there can be a tendency for people’s short-term preferences to win out over their long-term preferences.

Out of these developments in thinking has emerged a renewed interest in the institutional environment that best enables people to make saving-consumption choices that are consistent with their own underlying preferences. The theory points to a need for mechanisms that address procrastination and short-term biases.

To be sure the market provides some such mechanisms, though only to a limited extent. For example, some banks have provided saving accounts that pay bonuses if contributions are maintained for more than a prescribed period. But on the whole, mechanisms such as these are not at all prominent in the savings market, and may be less prominent today than previously. We know, for example, that participation in workplace-based long-term saving plans is significantly lower than it used to be.

Workplace-based saving is perhaps the area where the new lines of thinking have most obvious application. Appropriately structured, workplace-based saving plans can help people initiate, and remain committed to, a long term saving plan.

This thinking was reflected in the Periodic Report Group report on saving for retirement, issued late last year. The PRG has recommended that steps be taken to reinvigorate workplace-based savings plans. It recommended that the Government establish a work-based savings group to develop an agreed approach to promote work-based savings.

We have acted on it and given a lead in our own capacity as an employer, with the establishment of the new State Sector Retirement Scheme. I would like to say a bit more about the background to and structure of that scheme. The Government is currently in the process of developing terms of reference for a group to be established to look at the design of a work-based savings product. Dr Cullen intends to announce the membership of the group and its terms of reference before this year's budget.

State Sector Retirement Savings Scheme

The new State Sector Retirement Scheme will contribute to closing the savings gap.

For over one hundred years, state sector superannuation was provided through the various schemes administered by the Government Superannuation Fund (GSF) and its predecessors. When the GSF closed in 1992, responsibility for the provision of superannuation savings schemes or retirement income schemes for state sector employees was devolved to the separate employing agencies, although some departments sponsored the establishment of the umbrella, the Global Retirement Trust.

Use of the Trust has been uneven and generally there has not been anything that has replaced the GSF in terms of comprehensive coverage or level of employer or employee contribution.

The State Sector Retirement Savings Scheme is the first such government wide initiative to be created since closing the GSF.

The new scheme starts in July this year, with the options for employees to backdate matching contributions to 1 April 2004.

Scheme Structure Employees are able to choose their level of contributions above a minimum of 1.5 percent of gross salary, paid direct from their salary. Employers will match this up to1.5 percent of gross salary in year one, and 3 percent in year two.

The employer contribution cannot be “cashed up” as remuneration, and the employer and employee’s contributions are both locked in until the member reaches retirement age (subject to some provisions such as hardship) early retirement and transfers to an alternative scheme.

The point is to make it clear that the scheme is a retirement saving scheme, not just another form of remuneration.

The funding for these two years comes from a central pool of “new money”, rather than individual agencies’ current budget. Year three and on details have not been decided but the intention is that the merits of the scheme will be sufficient to encourage employees to continue their contribution.

The scheme is an umbrella defined contribution retirement savings scheme under which individuals have the capacity to choose between the products offered through four Master Trusts, which have been selected from the New Zealand superannuation industry via a competitive tendering process.

Employees participating in the scheme will choose one of: · AMP Financial Services Ltd (AMP); · ASB Group Investments Limited (ASB); · AXA New Zealand (AXA); or · Global Retirement Trust (GRT).

They will then choose from amongst the managed investment funds offered by their chosen provider.

Eligibility The scheme applies to employees of government departments and entities for which the State Service Commissioner has statutory responsibility for negotiating collective agreements. These include: · The 35 public service departments · The six non public service departments such as the Police and Defence Force · The state school sector · Registered teachers employed by free kindergarten associations.

About 100,000 employees may be eligible, depending the specific eligibility criteria. As an indication, the current take up rate for the teachers’ scheme is 35%.

In general, the overall impact of the scheme on the government budget is not expected to be large but the potential benefit as the scheme matures could potentially be significant.

Design considerations

In designing the scheme the government came up against the inherent problem that people often a limited ability to save. There are a number of reasons for this such as the potential for earnings from registered superannuation schemes to be taxed at a higher rate than an employee’s marginal tax rate. As I’ve outlined, there may also be psychological resistance to long term saving.

Finally, changes in work habits with more frequent employment “churn” and the increased use of total remuneration packages have worked against traditional work based superannuation.

So the design of the scheme had to address these constraints. The key features of the scheme that aim to overcome these are:

Firstly, employer contributions must go into the scheme and cannot be “cashed up”.

Secondly, the size of the scheme means that joining gives members the benefits of economies of scale in areas such as fees.

Being a workplace scheme with deductions at source, the contributions are “out of sight”.

Finally, the scheme is a retirement scheme so there are limits on access to fund balances.

We faced a dilemma in setting the level of employer contributions at 1.5% in the first year and 3% in year two. On balance, the rates were chosen to be motivational and also affordable.

Scheme Details

The key aspects of the scheme design involve portability, transferability of the scheme benefits and the provision of “new money” to kick start the scheme. Funds will vest immediately but will be locked in until retirement.

The scheme has been designed to assist State sector employees in saving for their retirement. The principal design features are: · It’s voluntary for employees. · It’s portable. Individuals may continue membership of the scheme if they move to an employer that does not offer a subsidy or is in the private sector or they can transfer their benefits to another approved scheme · Members can only access their money when they reach the age of entitlement to NZ Superannuation, or up to 10 years prior, if they actually retire. If they are 50 or older they can also access their money in cash when they leave the State sector. · Members can apply for all or part of their benefits to be paid for reasons of significant financial hardship. · Payments will not be payable upon termination of employment with the State sector but can be transferred to another approved retirement scheme. · Employees will be able to suspend their contributions. · Individual employers will also be able to vary aspects of the scheme in line with future collective or other bargaining. · Employees will be able to divert any amount of their remuneration to this retirement saving schemes. The scheme's success will depend on factors such as its investment performance and the aspirations of employees. It represents a substantial attempt by this Government to encourage employees to plan for their future.

Through Government leadership and significant private sector cooperation, the scheme will also have the desirable side effect of focusing attention on individual provision for retirement and the role of workplace schemes in both the public and the private sectors.

Concluding Remarks

In summary then I’d like to reiterate these key points.

Saving has a role to play in lifting the future incomes of all New Zealanders. Saving enables us to grow the stock of income generating capital we own, and to capture the income return from that capital. Our past savings performance as a nation however has been poor.

We have an over-reliance on foreign saving which, combined with the relatively poor returns on New Zealand investments abroad, have fed a substantial deficit in net investment income on the current account.

The Government recognises this and is addressing it in a number of ways. These solutions look at both parts of the national savings equation, ie State and private savings.

The Government is improving its own superannuation savings performance to help smooth the burden of the State providing a basic standard of living for future retirees. However, this does not address the issue that most New Zealanders will aspire to something more than that and therefore need to address their individual savings questions.

Here the Government is active on a number of fronts such as the work of the Office of the Retirement Commission, reviewing the tax regime and by providing leadership by example with the new State Sector Superannuation Scheme. There is, of course, more to do.

We must lift the domestic savings rate, including looking at options private and employment-based schemes.

We will continue to grow the value of our exports, and the performance level of New Zealand investments abroad to reduce over time the net investment outflows on the current account.

And we will continue to seek high quality inward investment through an active programme of engagement with investors and a domestic economy where the fundamentals remain strong.

Saving matters.

Your work matters.

I wish you well for your conference and thank you for your contribution to lifting New Zealand's savings performance.

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