Funding pensions by saving through the Superannuation Fund lowers risk for future generations, says study.
On Monday, even as the Prime Minister John Key was reiterating his pig-headed refusal to address the long-term affordability of the state pension, the New Zealand Superannuation Fund reported on its performance.
In the 10 years since Sir Michael Cullen set it up it has achieved an average annual return of 9.35 per cent. That is after costs but before New Zealand tax, which it considers a return to the Crown.
The Government stopped contributing to the fund in 2009 arguing that as fiscal surpluses turned to deficits it made no sense for it to borrow to save.
Key 'comfortable' with superannuation costs:
But the fund's returns have exceeded the Government's cost of borrowing, as proxied by the Treasury bill rate, by an average 13.6 percentage points per annum over the past five years.
Against that background a paper by economist Andrew Coleman released by the Treasury last week makes fascinating reading.
It explores the relative merits of funding the inevitable increase in the cost of New Zealand superannuation out of the tax take of the day (pay-as-you-go or PAYGO) or by way of saving through the New Zealand Superannuation Fund (save-as-you-go or SAYGO).
He makes a strong case that SAYGO is the way to go.
But first, why is any change necessary?
Increasing longevity. If the age of entitlement is not raised the average length of time recipients will receive superannuation will increase, possibly by two years a decade, Coleman says.
"[Age] cohorts who may have paid for their elders to receive 17 years of retirement income might obtain 22 years in turn."
"Why then does Finance Minister Bill English baulk at the riskiness of investing taxpayers' money in capital markets, if the long-term benefits are as Coleman describes?"
Relying on SAYGO to fund the increased cost of super would mean tax rates rose sooner, but in the long run taxes are likely to increase by significantly less than under PAYGO.
"If the return to capital is 2.5 percentage points higher than the [economy's] growth rate - a gap similar to that experienced in the last two decades - in the long run the taxes needed to fund New Zealand Superannuation payments on a PAYGO basis are over twice as large as the taxes needed to fund it on a SAYGO basis," Coleman found.
"If the return to capital is only 1.25 percentage points higher than the growth rate, the long-term taxes needed to fund New Zealand superannuation payments on a PAYGO basis are still 50 per cent higher than the taxes needed to fund it on a SAYGO basis."
Depending on how they are invested, the fund's additional assets either increase the size of the New Zealand economy, reduce foreign claims on domestic production, or increase claims on foreign production.
"In each case resources can be transferred to retired people without requiring the high long-run taxes needed in a PAYGO-funded system."
In the 2012/13 financial year the $10.2 billion paid out in New Zealand superannuation represented just under 17c in every $1 of tax paid, and was equivalent to 4.8 per cent of gross domestic product.
The increase in taxation as the PAYGO route would require, assuming no changes to entitlements, represents a large opportunity cost to future generations, that is, it pre-empts other uses of that money. In particular an increasing share of their incomes will be unavailable to save and invest for their retirements.
It begs the question of whether future taxpayers will stand - or stay - for that.
"A PAYGO-funded expansion provides a transfer to the first generation of recipients at the expense of a large opportunity cost on future generations. Not only would many consider this unfair, but it raises the risk that future generations will suddenly reduce entitlements to New Zealand superannuation, or that significant outward migration will occur."
By contrast Coleman argues that a SAYGO-funded expansion of New Zealand superannuation is intergenerationally neutral as each age cohort pays for its additional entitlement. The cohorts who will receive a longer period of retirement incomes than their predecessors are the ones who get to pay the higher taxes required to contribute to the fund.
Increased reliance on SAYGO would change the risks faced both by individual superannuitants and by the Government.
The volatility of investment returns can make people wary of being too reliant on capital incomes during their retirement, Coleman says.
On the other hand under the status quo the level of the pension is pegged to wage growth.
"Although SAYGO-funded retirement incomes schemes increase exposure to capital income risk, they reduce it to labour income risk. Countries like New Zealand that have experienced long periods of low real wage growth suggest this risk can be considerable."
In the long run the biggest economic risk is weak productivity growth.
"This will generate low retirement incomes in both SAYGO-and PAYGO- funded retirement income schemes, either because of poor investment returns or because pensions amounts are linked to low wages."
But the New Zealand Superannuation Fund can mitigate that risk by investing offshore. And it does. Right now only 14 per cent of its $25 billion is invested in New Zealand.
By its very nature it spreads risk over a lot more people and a longer time horizon than an individual's savings scheme can.
The present Government has rightly used the strength of the balance sheet it inherited to take the strain of two major shocks: the worst recession since the 1970s and earthquakes that laid waste much of our second largest city.
Why then does Finance Minister Bill English baulk at the riskiness of investing taxpayers' money in capital markets, if the long-term benefits are as Coleman describes?
Coleman's paper is a useful reminder that the options for addressing the long-term sustainability of New Zealand superannuation are not limited to raising the age of eligibility, means testing or tinkering with the indexation.
Revitalising the New Zealand Superannuation Fund, which at its current size can only nibble at the problem, is an option too.
But the longer the Government persists in its craven pretence that there really isn't a problem, the less attractive all the options become.