Why the Cullen Fund should be invested overseas

By BILL FOSTER*

There has been much comment about where the Government should invest its National Superannuation Fund ("the Cullen Fund").

The Government is taking money from current taxation to build up the fund. It justifies this on the grounds that demographics show there will be fewer taxpayers and more retired people in future, so that tax should be set aside now to provide retirement benefits for today's taxpayers when they become elderly.

Also, perhaps more significantly, establishing the Cullen Fund helps resist political pressures to increase Government spending of surpluses.

Whether the Government's approach to superannuation is pay as you go (payments come out of taxes received at the time the payments are made) or a funded strategy (taxes are put into a fund from which future payments are made), payments in the future must be made from the assets or income available in the future.

The different schemes are just different ways of determining how to allocate future assets and income of the Government.

The real challenge is to find ways to increase national economic wealth and income - from which the future payments will be made.

Now we know that higher taxation reduces national income available for private spending and investment. So, at the national economic level, the Government has to believe that it can get a better return on the Cullen Fund than the economy generally, otherwise it would have been better to leave the money in the economy and extract it as taxation later, when more would be available.

The Government also has to believe it can get a higher return on Cullen Fund investments than individuals could get if they invested for themselves, otherwise it would just make the saving compulsory and let individuals choose their investments (as in Australia).

Can the Government get higher returns from the Cullen Fund?

There is no empirical way to test this question, because we cannot experience the alternatives. If there was certainty the Government's choice would be clear.

First, there is no convincing evidence that compulsory savings of any form increases national savings rates (which are important to increased investment and growth), although it may be helpful in promoting awareness and changing attitudes to saving. This may be more likely if individual accounts are maintained and individuals are aware that the Government will not promise they will be looked after in retirement.

It is also possible that the Government (or its agents managing the Cullen Fund) will want to minimise potential losses and be more risk averse than if individuals invested the money for themselves, so that lower average (long-term) returns might be expected.

So where should the Government invest the Cullen Fund?

Investing overseas If the money is invested overseas (as prudent diversification for an individual investor would suggest):

That means the Government believes overseas investment will achieve a higher return than local investment (if not, then why invest overseas?). This implies that overseas countries will grow at a higher rate than New Zealand, acknowledging that New Zealand has no prospect of achieving above OECD average growth. That appears to contradict the Government's stated aim for our economic growth rate, but it provides a good justification for the investment, particularly if taxpayers would not have invested as much overseas themselves.

Even if overseas returns are no greater than local returns, the diversification away from dependence on the local economy can be beneficial by reducing exchange rate risk for a small country increasingly dependent on overseas purchases.

Investing locally If the money is invested in New Zealand:

Under a passive investment strategy, it will earn the same return as the economy - less costs - so why do it?

Under an active investment strategy, it is virtually impossible for large managed funds to "beat the market" over time (when investments become a significant proportion of the market, their returns very closely reflect market returns).

If the Government buys securities which have already been issued (which will mostly be the case), it is not actually spending on new investment for growth. In the main it will be transferring the money from taxpayers to current holders and hoping someone will buy the securities back at a good price when the cash is needed - then transferring that money to superannuitants.

Significant investments in marketable securities such as shares or bonds will have a noticeable price impact at the time of purchases and sales but will not affect the underlying sustainable values of the companies that issued the securities (and hence not affect their returns).

Appointing independent advisers to invest the Cullen Fund does not remove these concerns. It is still a pool of tax funds being invested by the Government.

The Government could direct the Cullen Fund into national projects that are expected to offer high rates of return. If successful that would increase national income and wealth. But this is just what the Government tries to do anyway with some of its tax moneys or borrowing. Experience shows governments have a poor record of "picking winners" and project funding choices are subject to strong political, social and environmental concerns, which cut returns.

Again, there can be no expectation that Cullen Fund money would get better than national economic growth rates if invested this way.

Paying off the mortgage The first piece of advice that advisers usually give people looking to save for their future is this: pay off your mortgage first. Issuing debt at the same time as investing taxpayers' money is borrowing to invest - a risky strategy not usually recommended to ordinary investors.

The level of Government internal public debt stands at around $35 billion, or more than 25 per cent of GDP. So why not use the surplus taxes to pay off public debt, directly reducing future interest costs?

Superficially, when interest rates are higher than the economic growth rate, repaying debt looks a good investment, if there are no better choices.

However, it is also worth noting the well-established Government policy of having no overseas debt. For the same reasons (higher overseas rates and reducing foreign currency risks) that policy is consistent with a policy of overseas, rather than local, investment of any surplus money.

Conclusion Most of the comments about the Cullen Fund have been special-interest pleading by groups seeking to benefit from the allocation decision.

What the Government does with all tax money is important (including whether to tax and how much) and it does influence national growth and wealth.

If the Government sets policies and creates an environment (including the tax structure) to encourage growth, we will all be better off in our old age. To the extent it does not, we will all be worse off.

Government investment domestically is just another transfer payment - taking money from one group and giving it to another. If the transfers are wise, they will lead to increased national growth and wealth. If not, they will not. For any local investments, the best expectation must be that, on average, they will do no better than the economy.

Unless the Government invests the funds overseas (believing in higher returns and the protection of diversification) or directly in national projects which clearly improve economic growth or wealth, there is no strong argument for taxing to create the Cullen Fund in the first place. Those who want the Cullen Fund invested locally do not have a good case.

* Bill Foster is a former managing director of the stock exchange and is now a Wellington-based independent consultant.