Fiscal Implications of Population Ageing

Fiscal Implications of Population Ageing

In setting fiscal policy, we need to recognise that New Zealand's population, like that of many developed nations, is ageing. The ratio of those aged 65 and over to those in the working age population is projected to more than double by 2051. This means that government spending on NZS and Health are likely to grow faster than GDP.

Projections show that the cost of NZS (net of tax) rises from 4% of GDP now to 9% of GDP over the next 50 years. These long-term projections require us to make assumptions about such uncertainties as future net migration, fertility and mortality rates. Notwithstanding these issues, the number of retirees over the next 50 years can be reasonably well projected (they are already born).

NZS is indexed to average wages, which means there is a link to GDP. This means that economic growth is unlikely to generate the extra 5% of GDP needed to cover the higher cost of NZS.

The Government is determined to preserve a universal publicly funded pension and the link between that pension and the average wage, without having to resort in future to a significant increase in the average tax rate. We have the opportunity now to set aside contributions in a fund to meet some of the future costs associated with the provision of retirement income.

Currently, the annual cost of NZS is met by taxes of those in the workforce. Partially prefunding NZS requires the Government to "pay in advance" a part of the future costs, rather than solely relying on "pay as you go".

The Government has not yet finalised the policy approach towards partial prefunding. However, we have made a number of working assumptions, as outlined in Annex 4, based on development work since the Budget Policy Statement.

Figure 1 - Partially prefunding NZS

Source: The Treasury

Figure 1 is a stylised representation illustrating how the "pay in advance" approach operates. During the period to around 2025, the excess of the contribution rate over each year's NZS costs will be retained in a fund. In the short-term, contributions to the NZS Fund are somewhat lower than the required contribution rate, because the Government is re-building operating surpluses¹. As shown in Figure 1, after the transition period the amount of "retained" contribution declines. In later years, when the costs of NZS exceed the contribution rate, the balance is generated from the Fund.

The effect of the approach is to smooth the costs of NZS so that they are paid at a more even rate over time. The contribution rate is initially higher than the current "pay as you go" cost of NZS alone. Given demographic projections beyond the next 40 years (the working assumption time horizon), the rate is likely to rise through time (see Annex 4). However, the smoothing effect means that the "pay as you go" element further out is lower than it would otherwise have been. The degree of smoothing actually achieved will be influenced by demographic trends and the rate of return on Fund assets.

Over the next 50 years, population ageing is likely to affect other areas of the budget, especially Health spending. Compared to NZS, projections for future Health spending are more problematic. Increasing per capita incomes may lead to higher demand for services. New technologies may reduce the cost of some services, but create a demand for new services that we cannot even imagine today. The effect of population ageing on future Health costs will also depend on the degree to which longer life shifts health care costs to later ages, rather than extending the period of care.

On the other hand, the structural change in our population may reduce cost pressures in areas such as education that are primarily used by young people. Other areas of government expenditure such as administration and defence are less sensitive to changes in the population structure.

Overall, the share of government expenses in GDP is likely to rise as a result of population ageing. Because it seems probable that NZS expenses will increase, it is responsible to put in place now measures to help deal with them. This has motivated the Government's approach to NZS. The approach to partially prefunding NZS is a major step forward in dealing with the projected rise in expenses.

However, the Government has not decided how to respond to the increased future costs beyond the partial prefunding of NZS. Rather, we will respond to them progressively as they become more certain over time. As the demographic pressures approach, we will continue to evaluate and adjust our fiscal policy approach. We recognise that, depending on how they develop, we may need to revise our approach to meeting them. In the interim, we will adopt a cautious approach to ensure that we meet our long-term fiscal objectives as the demographic pressures impact.

Prefunding Working Assumptions

The following are the working assumptions used to calculate the impact of the proposed NZS Fund in this Report.

• Until around 2025, NZS payments are funded solely on a "pay as you go" basis. During this period, the excess of the rate of contribution over each year's NZS costs is retained in the Fund. In later years, when the costs of NZS exceed the contribution rate, the balance comes from accumulated assets.
• The contributions to the Fund in the first three years are $600 million in 2001/02, $1.2 billion in 2002/03, and $1.8 billion in 2003/04.
• After this three-year transition, the contribution rate is a percentage of GDP sufficient to finance NZS over a 40-year time frame. At this stage, projections show that the initial required contribution to the Fund immediately after the transition is likely to be around 6% of GDP under the assumptions in this Annex. This includes both the "pay as you go" cost of current NZS, plus the "retained" contribution for future NZS costs. The "retained" contribution for future NZS costs is likely to be around 2% initially, and would decline to zero by around 2025.
• Over time, the contribution rate needs to be revised because of two different effects: forecasts will change in the light of new information; and the 40 year period to be covered by the calculation shifts out by an extra year. Given current projections of demographics beyond the next 40 years, the required contribution rate is likely to rise through time.
• The contribution rate calculation is based on a number of other assumptions, for example the rate of return on the Fund's assets and the tax rate on the Fund's returns. The assumptions used for the purposes of the projections are as follows:

The rate of return on the assets in the Fund is assumed to be equivalent to the long-term Government stock rate. This is assumed to be 7.0%, as in the Long-term Fiscal Model. The expected rate of return will depend on the investment strategy adopted by an independent Board, yet to be established. In practice, the Board is likely to pursue an investment strategy that would earn a rate of return above that of a portfolio invested solely in government stock.

The return on the Fund is taxed at the rate of 33%.