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Questions & Answers on Pre-Funding New Zealand Superannuation

Wednesday, October 11th 2000, 12:00AM

by Philip Macalister

What is pre-funding?
Pre-funding NZS involves establishing a Fund now to invest money to meet part of the future cost of NZS payments. While the baby boomers are still in the workforce, we have a window of opportunity to prepare for the increase in NZS costs that will come after they retire.

Why do we need to pre-fund?
Like other developed countries, New Zealand faces an ageing population. In the future there will be fewer working age people for each retired person. A higher proportion of the population will be receiving NZS, which will lead to a significant increase in the costs associated with NZS.

If nothing is done, future governments will face four equally unpalatable options:


  • Cut retirement income entitlements dramatically.

  • Impose a large increase in the tax rate.

  • Introduce a harsh asset and income test on eligibility for NZS.

  • Cut other spending programmes like health and education.

How will pre-funding NZS help us to deal with an ageing population?
Pre-funding will allow us to maintain current NZS entitlement levels into the future and bring stability to retirement income policy. We will not have to increase the age of entitlement, change the indexation to average wages or introduce income or asset tests. Pre-funding means that we can smooth the costs of superannuation over time, so we will not see the sharp increases in taxes that we would otherwise have to face in the future.

Why is pre-funding preferable to a compulsory saving system?
Compulsory systems determine retirement income on the basis of the taxes a person paid during his/her working life. These systems do not adequately provide for people who spend time out of the workforce and people who earn low incomes and the government would need to continue making provision for these people. Such systems are also more complex than NZS, requiring records to be kept of each individual’s income and tax payments to determine that individual’s entitlement in retirement. A system like this could not be fully in place by the time the baby boomers retired.

How does pre-funding differ from compulsory superannuation schemes?
With pre-funding, retired people will continue to receive NZS in the future. The government will establish an investment fund to manage funds being set aside to meet future NZS payments. Working age people will not have individual retirement accounts or be required to pay specific retirement related levies or taxes. The contribution to the Fund will be made from general taxation.

What are the benefits of setting up a fund versus paying off debt?
We are balancing two fiscal priorities in paying down debt and pre-funding superannuation. It is important to keep government debt low and we have set out long-term objectives for debt that will ensure that it remains low. However, we believe we can achieve these debt objectives and smooth the costs of superannuation at the same time.

Making explicit annual provision for funding of future NZS obligations brings home to the present the cost of these obligations. Without this discipline, the demands of current expenditure would dominate and continuing to pay down Crown debt much below the objectives we have set would not receive the same priority once it reaches even lower levels.

Won’t the government get a better return by paying off debt?
No. Generally, diversified funds earn more than the rate of interest payable on government bonds, which is effectively what the government "earns" when it pays off debt. Besides, the true cost to the government of maintaining debt is less than the face value of interest paid because it recovers some interest paid in the form of tax.

Can’t the government borrow when the future cost of NZS rises?
The future higher cost of NZS is not a temporary peak, but a permanent higher plateau. If the government tried to borrow to cover the rising cost, it would have to look at permanently-escalating debt, which is clearly unsustainable.

Isn’t it wiser to cut taxes and let us save for ourselves?
The Fund is to pay for the universal, government-financed New Zealand Superannuation. Private savings are additional to the common basic entitlement. The government is saving to meet its own future obligations to citizens. It is not saving on behalf of individual citizens.

Surely the only way to pay for NZS is to ensure a growing economy?
It is important to encourage economic growth, but economic growth will not make the NZS more affordable. As the economy, wages grow. Because NZS is linked to wages, the level of NZS grows. It is the slice of the cake, not the size of the cake, that remains constant. We need to make sure that we can meet the costs of maintaining the slice of the cake.

How can the government make intelligent estimates of what things will be be like in forty years’ time?
It doesn’t try to. The government makes best guesses about what it will need to pay out over the next 40 years, and what it needs to put aside to meet that cost. Then each year it adjusts calculations in the light of what happened in the previous year, and adjusts to changing circumstances year by year as the horizon rolls out into the future.

What’s to stop the government raiding the Fund?
The law will require governments to gather enough in tax to meet the annual costs of NZS for at least the next 20 years. The Fund will gradually build up during this time, and its size will be the best indicator of the security of future NZS. Any government that tried to raid the pensions of the next generation would suffer at the court of public opinion.

How does pre-funding differ from what we currently have?
We currently have what is called a "pay as you go" system, where NZS is paid out of the Government’s current tax receipts. The form of pre-funding we are considering is "smoothed pay as you go". This will involve creating an investment fund that will accumulate and invest funds. These funds will be drawn on to augment the "pay as you go" system to pay NZS as costs increase in the future

What impact will pre-funding NZS have on government spending?
If pre-funding were not introduced, some other approach to addressing the increase in NZS costs would need to be taken, so the impact on government spending will depend on what would be done in the absence of pre-funding. Compared to what would be the case if the current system were continued, spending on retirement income policy will become a larger proportion of government spending in the short term and a lower proportion in the longer term.

Why should retirement income be given this status above other government spending?
Pre-funding NZS will give the public certainty about the retirement income that the government will provide. Publicly provided retirement income should be certain because, more than in other policy areas, people in retirement are not easily able to respond to changes in NZS parameters.

Will pre-funding require tax rates to be higher than they would be in the absence of pre-funding?
This would depend on what changes were made in the absence of pre-funding. Compared to what would be the case if the current system were continued, taxes would remain at their current level in the short to medium term, but would be lower in the longer term than they would otherwise have been.

How will contributions to the Fund be treated in the government’s accounts?
The forecast and actual contributions to the Fund will be disclosed in the Statement of Cash Flows. The contributions and the Fund’s balance will also be disclosed in the Notes to the Crown’s financial statements.

Contributions to the Fund cannot be recognised as an expense of the Crown because the Crown ultimately controls the Fund. Recognition of a liability on the Crown’s balance sheet is also unlikely to be acceptable under generally accepted accounting practice.

How will the Fund be established?
The Fund will be established through a new Act, the New Zealand Superannuation Act. This Act will bring together the funding and entitlement aspects of superannuation. It will be introduced later this year and enacted in April 2001. The Fund will begin operations on 1 July 2001.

What are the costs of operating the Fund?
This is yet to be determined. The main costs involved will be fund management fees, remuneration of Board members and fund administration.

Entitlements
What payments will the Fund cover?
The aim of the Fund is to ensure that NZS is sustainable into the future. Therefore, the Fund will not be available to the government of the day to use for any other purpose than the payment of New Zealand Superannuation. The Fund will cover the standard NZS allowances (married couple, single living alone, single sharing and non-qualified spouse married couple rates) and non-standard allowances (married couple with NQS included before 1991, partners in rest homes (with NQS included) and hospital rates). It will also cover NZS payments made under international social security agreements. It will not cover Veterans’ Pensions, Transitional Retirement Benefits, nor supplementary assistance that retired people may be eligible for. It will not cover health costs associated with the retired.

NZS will continue to be paid by the Department of Work and Income (DWI).

How will pre-funding affect NZS entitlements?
Pre-funding relates to how NZS is funded overall. It will not have any direct impact on NZS entitlements.

However, with pre-funding, New Zealand Superannuation can remain a universal entitlement for those over the age of entitlement (65 from 1 April 2001) who meet residency criteria (10 years working life in New Zealand, 5 after age 50). The wage floor for the married couple rate will be 65% of average earnings and NZS will not be subject to income or asset tests.

Governance
What will the vehicle for the pre-funding of superannuation costs be?
A Fund will be established that will receive payments from the government. A Crown entity Board called the Guardians of New Zealand Superannuation will be set up to invest the assets of the Fund.

The Fund will be an asset of the Crown managed by the Board, which will be a Crown entity. The Board will be subject to the standard Crown entity accountability requirements. It will be required to prepare a Statement of Intent and report against this in its annual report and quarterly reports.

The Board will be responsible for determining the investment strategy of the Fund, allocating portfolios to fund managers to invest, monitoring the performance of these portfolios and amending allocations if necessary. They will do all this independently of the government.

The Board would invest the Fund on a sound commercial basis. While this means that the Fund will have investments that have risks associated with them, it is expected that it would invest in a manner that is prudent.

If the Board makes investments that are not in the best interests of the Fund, or if members behave inappropriately with the Fund’s assets, the Governor-General will be able to dismiss the members of the Board.

Who will appoint the Board?
The Board will be appointed by the Governor-General on the recommendation of the Minister. The government will call for Board nominations from organisations representing the elderly, employees, employers and the savings industry. Those nominated will need to have appropriate commercial experience for managing an investment fund.

What will be the liabilities and responsibilities of fund managers contracted to run the Fund?
The Board of the Fund will determine the responsibilities of fund managers. These responsibilities must be consistent with the overriding objective that will be set out in the Fund’s legislation – that the Fund must be invested on a sound commercial basis.

How will fees be set for fund managers for the Fund?
The Board of the Fund will determine this. Industry practice is to set fees on a commission basis. If this approach were adopted, the amount paid would depend on the return the managers earned for the Fund, ensuring fund managers strive to deliver the best returns on the Fund.

Will the Fund’s investment returns be subject to tax?
Yes. If the Fund were tax exempt, the government could lose a significant part of its tax base. Tax exemption would also create tax avoidance opportunities. Given these opportunities the Fund would have an incentive to avoid tax in order to maximise the return to the Fund in preference to maximising the returns to New Zealand as a whole.

Funding arrangements
P>Where will contributions to the Fund come from?
The contribution will be paid from general taxes. No dedicated tax will be set up.

What amount would need to be set aside each year to address the NZS costs associated with the ageing population?
Any projections about the contribution rate for meeting NZS costs are based on assumptions used in the modelling. These projections will change if different assumptions are used, on issues such as future NZS costs, investment strategies and rates of return.

The amount put aside each year will vary – but will be sufficient to meet current NZS payments and make provision for future increases in NZS costs. Current modelling estimates that in 2004/05 (the first year after the transition period), that the total contribution will be 5.54% of GDP, of which 1.75% will be put aside for the future. The amount put aside will then decrease over time as current payments increase and represent a larger amount of the total contribution.

What level of surpluses will the government need to run to pre-fund future NZS costs?
The actual contribution will be determined by the size of available surpluses. Future governments may, however, decide to make contributions at the required rate even when surpluses are less than this rate. While the Treasury will determine the required contribution rate, the government of the day will determine the actual contribution rate.

Between 2004/05 and 2009/10, it is estimated that the portion of the required contribution rate associated with pre-funding future costs will be 1.7 – 1.8% of GDP and surpluses are estimated to be greater than this.

How will the government pre-fund future New Zealand Superannuation costs if there are insufficient surpluses?
The government will make contributions to the Fund from available surpluses. Where these are insufficient for making the required contribution a reduced contribution would be made. If this were the case, the government would need to specify how it would make up for the reduced contribution in future.

What will the assets of the Fund accumulate to at its peak?
The Fund’s assets are projected to peak at roughly 50% of GDP, although the actual size will depend on factors such as NZS costs, interest rates and the investment strategy pursued by the Board of the Fund. It is projected to peak sometime between 2023 and 2029. The Fund balance would then fall gradually and approach zero sometime late in the 21st Century.

How will the contribution rate be calculated?
The contribution rate will be calculated annually. The contribution rate used in the modelling assumes a forty-year rolling horizon - roughly equivalent to the length of a person’s working life. This means that the annual rate is 1/40th of the amount needed to fund 40 years of NZS. Each year that the rate is calculated, the period that it covers moves out one year (e.g., in 2004 the period covered would be 2004-2044 and in 2005 the period covered would be 2005 – 2045).

The contribution rate in the modelling assumes the transition path specified in the Budget Policy Statement is followed ($600 million in 2001/02, $1,200 million in 2002/03 and $1,800 million in 2003/04). The contribution rate in the modelling also assumes that the Fund will be invested 50% in risk-free world government securities and 50% in world equity with an expected portfolio return (after tax) of 6.1%.

Why will the rate be set annually?
Each time the contribution rate is calculated, the period covered incorporates more of the future high-NZS-cost years and fewer of the current lower-NZS-cost years. Setting the rate annually means that the amounts by which the contribution rate is adjusted with each new rate setting will be lower than would be the case if the contribution rate was set less frequently.

An annual rate setting process also allows the government of the day to take other influences into account when setting the rate, such as the likely size of the operating balance, and the earnings on contributions made in previous years.

When will payments from the Fund be made?
Payments will be made to DWI for NZS as soon as the Fund is established. The Board will also receive additional funds to invest for the future. These will be drawn on when the amount payable for NZS exceeds the required contribution rate, or after a minimum period of twenty years, whichever occurs latest. The year in which NZS payments exceed the contribution rate will depend on factors such as returns earned on the Fund and the actual amount payable for NZS. This is projected to occur in the late 2020s.

Investment objectives
How will the Fund’s investment strategy be determined?
The Fund will be invested at arm’s length by professional fund managers appointed by an independent Board.

The Board of the Fund will determine the investment strategy. This will need to be consistent with the investment objective that the Government will specify in the governing legislation, which is that the funds must be invested on a sound commercial basis to ensure that there are strong long-term returns. The investment strategy will also need to be consistent with any directions the government of the day gives the Fund.

Will the Fund invest internationally as well as domestically?
Yes. The Fund’s aim is to achieve strong long-term returns. Given the size that the Fund will reach relative to the number of high-return investment opportunities that will be available in New Zealand, it is likely that the Fund will need to look offshore for investments that will achieve its aim.

Shouldn’t the Fund just invest in government stock?
Solely investing in government stock would imply that the Fund was a nominal Fund only. We want to establish a real Fund that will assist us in ensuring that NZS remains affordable into the future. The Fund may choose to invest some of its assets in government stock, but the extent to which it does will be determined by the role government stock can play in the Fund’s objective of achieving strong long-term returns.

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