What's wrong with Labour's New Zealand Superannuation Fund proposal?

Full text of a paper criticising Labour's Superannuation proposal

Wednesday, November 17th 1999, 12:00AM

What's wrong with Labour's New Zealand Superannuation Fund proposal?

Reason for this paper

We are a group of people with an interest in public policy on retirement incomes. We are concerned that Labour's proposal to set up a "New Zealand Superannuation Fund" has attracted little attention. It's a logically flawed proposal that Labour proposes to implement without proper debate or rigorous analysis. Dr Cullen wants to start the Fund with legislation that will take effect from 1 April 2001.

We want voters to understand that the proposed Fund is more likely to increase the cost of New Zealand Superannuation over the next 30 years, taking all things into account. The Fund is more likely to detract from, rather than improve, New Zealand's economic health and increase future governments' exposure to risk.

We hope this paper starts a proper discussion on this flawed addition to the many twists and turns in superannuation policy that New Zealand has suffered from over the last 25 years.

The underlying premise

The underlying premise of Labour's superannuation proposals is that a partially or fully funded superannuation scheme can guarantee the security of New Zealand Superannuation over the long run. This view is wrong. The problem of the sustainability of New Zealand Superannuation does not disappear as Labour claims; in fact, Labour's proposals make New Zealand Superannuation less sustainable because they are likely to increase its cost. Labour's funding proposals are economic window dressing. They will rob Peter to pay Paul.

Summary of problems

Here, in summary, is what we think is wrong with Labour's proposal:

Our ability and capacity to create wealth – not the level of savings –is the key to the living standards of present and future retirees.

An increasing elderly population can continue to be supported at current income levels only by boosting future output, constraining current consumption and investing overseas to fund future imports, and/or by constraining the consumption of the working-age population in future.

Labour's proposals do not address the problem of the sustainability of New Zealand Superannuation with an ageing population and do not guarantee the future level of New Zealand Superannuation.

The transfer to the Fund of a dollar of personal tax revenue to pay a dollar of New Zealand Superannuation to an existing superannuitant involves no change of substance. Similarly, the transfer to the Fund of a dollar of personal tax revenue in excess of that required to fund current New Zealand Superannuation, assuming no change in tax or spending, leaves the government's overall operating surplus unchanged. Peter is robbed to pay Paul.

A surplus in the Fund cannot be built up without being matched by an equal reduction in the surplus on other government activities unless tax is increased and/or existing spending is reduced.

A change from the present "pay as you go" (PAYG) approach to a fully funded basis requires workers during the transition to pay twice. It is impossible to change to a fully or partly funded superannuation scheme without increasing taxes and/or reducing spending on New Zealand Superannuation or other goods and services.

Labour proposes to increase the generosity of New Zealand Superannuation by raising its level relative to wages and it is committed not to increase taxes to finance the Fund or introduce any form of income or asset testing. Without the required tax increase and/or cuts in other spending, Labour's funding proposal is essentially the present PAYG scheme with higher superannuation payments, additional administration costs and a lower surplus than otherwise. There are no compelling grounds for fully or partly funding New Zealand Superannuation or similar non-contributory public programmes that are presently funded on a PAYG basis.

There is no provision in New Zealand's constitutional arrangements that would enable Labour to prevent a future government from reducing or abolishing the New Zealand superannuation tax or using the Fund for purposes other than the payment of New Zealand Superannuation. It would also be inconsistent with New Zealand's democratic principles to attempt to bind a future government as proposed by Labour.

Most, if not all of the money will need to be invested overseas and that will raise the government's (and the country's) risk profile in both the short and the long term.

The investment risk remains with the government – it is also very difficult to see how such a large pool of money will be free from political interference.

The proposed Fund is another kind of compulsory retirement savings scheme.

Labour's proposal is therefore fundamentally flawed. The rest of this paper looks at these problems in more detail.

What's wrong with the idea?

There are many things wrong with Labour's proposals – from the economic to the political.

Economic strength matters: The material living standards of people in retirement are largely determined by their ability to consume goods and services. Retirees cannot consume the money represented by public or private savings directly. Those savings must be used to buy goods and services that are produced by New Zealand's working-age population or by workers of other countries (imports). The British economist, Nicholas Barr, expressed this point in these terms:

Pensioners do not eat pound note 'butties' – they use the pound notes to purchase consumption, and it is consumption that matters.

It is our capacity to create wealth that matters. The ability to produce goods and services and to buy imports is the key to the living standards of present and future retirees. That doesn't mean that we should not save for retirement; only that savings by themselves won't help. It's what's done with those savings that matters. We want Labour to explain how the proposed Fund will help increase the capacity of tomorrow's New Zealand workers to produce more.

How do we support the growing elderly population? An increasing elderly population can continue to be supported at current real income levels only by:

boosting future output by increasing the working-age population relative to the dependent population (for instance through immigration and by lowering the impact on the retirement/work decisions of New Zealand Superannuation) and by raising productivity;

constraining current consumption and investing overseas with a view to financing imports in the future; and/or

constraining the consumption of the working-age population in future, for example through higher taxes, to make more goods and services available to retirees.

Labour's proposals do not address the problem identified in its policy of the sustainability of New Zealand Superannuation with an ageing population. We want Labour to explain how the proposed Fund boosts output, raises productivity, constrains current consumption or might constrain the consumption of future workers.

Where will the Fund come from? Labour's proposed Fund is to be built up by a 'tax' to be known as the New Zealand "Superannuation Tax". It will transfer a proportion of each year's personal income tax to the Fund. The new tax is a funding formula rather than a genuine tax. Existing personal income tax is not to be increased to pay for New Zealand Superannuation.

The transfer to the Fund of a dollar of personal tax revenue to pay a dollar of New Zealand Superannuation to an existing superannuitant involves no change of substance. It is like putting a dollar of wages directly into the housekeeping jar instead of the tin for general spending. Neither total tax nor spending is changed.

The transfer to the Fund of a dollar of personal tax revenue in excess of that required to fund current New Zealand Superannuation, assuming no change in overall tax or spending, reduces the government's operating surplus by a dollar before taking account of the Fund. Ignoring administration costs, the amount in the Fund increases by a dollar. The government's operating surplus, including the Fund, would therefore be unchanged. The surplus has gone from one government jar to another. The apparent partial funding of New Zealand Superannuation is matched by an equal reduction in money available to fund other activities in the future. For instance, general government debt may increase; health spending may reduce or there may be less available for education. Peter is robbed to pay Paul. Again there is no change in substance.

A surplus in the Fund cannot be built up without being matched by an equal reduction elsewhere in the government's accounts unless tax is increased and/or existing spending is reduced. The partial or full funding of New Zealand Superannuation means nothing unless this happens. A dollar of personal taxes cannot fund both the Fund and existing spending. Similarly, the same tax dollar cannot fund both New Zealand Superannuation for existing retirees and surpluses in the Fund which are required to fund future superannuation payments.

We want Labour to explain how shifting tax from one government pocket to another affects the economic substance of the future affordability of New Zealand Superannuation as the number of recipients grows.

How much will be needed? The New Zealand "Superannuation Tax" will have to be set at a level well in excess of present spending on New Zealand Superannuation if such superannuation is to be partially or fully funded in the longer term as Labour intends. This requires the Fund to generate a surplus after meeting the annual cost of paying New Zealand Superannuation to current retirees. Surpluses must build up capital in the Fund. The underlying idea of a fully funded retirement income scheme is that a taxpayer contributes over his or her working life building up a nest egg, comprising contributions and related investment income, which is drawn down in retirement. The Fund cannot generate significant investment income unless it makes substantial surpluses, at least until it reaches full maturity in many years' time.

We want Labour to explain how much extra tax it thinks will be needed over the next 20 years or so to build up the Fund in the way it describes.

Current workers pay twice: A change from the present pay-as-you-go (PAYG) approach to a fully-funded basis requires workers during the transition to pay twice. Those workers must meet, through their taxes, the costs of New Zealand Superannuation for current retirees as at present. In addition, they must fund surpluses which, together with related investment income, will provide for their own superannuation when they retire. So it is impossible to change to a fully or partly funded superannuation scheme without increasing taxes and/or reducing spending on New Zealand Superannuation or other goods and services like education, health and welfare.

We want Labour to explain how asking today's workers to pay twice (at least partially) for New Zealand Superannuation helps to grow the economy or deliver the other government services that Labour says it wants to increase spending on.

Costs will increase: The cost of any superannuation scheme (public or private; pre-funded or PAYG) is the benefits that the scheme pays. It doesn't matter how the scheme is paid for – whether from taxes, contributions paid in earlier years or from investment income. Labour proposes to increase the generosity of New Zealand Superannuation by raising its level relative to wages (reversing the recent reduction introduced by the National government). That will increase its future cost both because of the increased benefits and the larger number of people who will receive them. On the other hand, it is committed not to increase personal taxes to finance the Fund. These two commitments are potentially incompatible with the adoption of a fully or partially funded scheme. The most likely outcome is higher debt than otherwise because surpluses that would be used to reduce debt would be transferred to the Fund.

Spending on superannuation, even on a PAYG basis, will increase under Labour's policy. Other spending will need to be cut, if personal tax is not increased. Without the required tax increase and/or cut in spending, Labour's funding proposal is essentially the present PAYG scheme with higher superannuation payments, additional administration costs and a lower surplus than otherwise.

Labour is unlikely to set its New Zealand Superannuation Tax at the level that is required to enable New Zealand Superannuation to be anywhere near fully funded because that would imply that personal tax should be raised substantially. This is a further reason why its Fund proposal is fiscal window dressing.

We want Labour to explain what the contribution rate will need to be to the Fund (expressed as a proportion of GDP) to achieve its stated objective of at least smoothing the costs of New Zealand Superannuation over the next 50-60 years and where that extra money will come from.

Funding or PAYG? The establishment of a fully or partly funded scheme does not reduce the cost of New Zealand Superannuation, other things being equal. A transfer to the Fund of a dollar today that increases in value with net investment income of, say, 5% a year (before adjusting for inflation) to $7 in 40 years' time is exactly equivalent to a PAYG payment of $7 (plus an adjustment for inflation) in 40 years' time. In the latter case the taxpayer can invest a dollar today and earn the same investment income as the Fund to pay his or her tax bill in 40 years' time.

Similarly, the transfer of a dollar of personal income tax to the Fund which increases to $7 in 40 years' time is matched by a dollar plus related forgone earnings elsewhere in the government sector which, other things being equal, can be expected to have an opportunity cost of $7 in 40 years' time.

Contrary to Labour's claim, the proposal provides no additional security about "where the money (for New Zealand Superannuation) will come from." It will effectively continue to come from tax revenue. There is no separate source of funding for New Zealand Superannuation.

There are no compelling grounds for fully or partly funding New Zealand Superannuation or similar non-contributory public programmes such as the invalid's benefit or health spending that are presently funded on a PAYG basis. The future funding of these schemes primarily depends on the prosperity of the economy and the government's power to tax. Private superannuation schemes are not able to tax residents. This is the main reason why they seek to provide security for contributors by fully funding their schemes. Governments face no such problem because of their ability to tax.

Labour's proposal is an example of a "fallacy of composition". It's a good idea for individuals or employers to put aside money for future superannuation payments. However, it does not follow that what's right for an individual is necessarily right for the country. Building up the Fund will re-arrange claims on today's economy between earners and non-earners but does not necessarily increase the security of either. Only a stronger economy can do that.

The proposed Fund may, in fact, cost more than the current arrangements. First, there are the direct risks of investment losses; next, there are the administration costs of running the Fund; lastly there are the indirect costs such as the dead-weight costs on the economy of collecting more tax today than is needed to meet the government's immediate obligations.

We want Labour to explain how changing the funding basis of New Zealand Superannuation will save money over the current PAYG arrangements; why the proposed Fund is more "secure" than the capacity of future governments to tax and how rearranging economic claims in today's economy will better prepare future New Zealanders for the impact of a growing aged population.

Entrenching the Fund: Labour says the Fund will not be available to the government of the day to use for any purpose other than the payment of New Zealand Superannuation. It is considering legislation to ensure that future governments cannot "break the ring-fence around the Fund and choose to use the money for some other purpose." Labour knows that this is impracticable. There is no constitutional power to entrench legislation in New Zealand. Any Act of Parliament that required, say, a 75% majority to alter the Fund can itself be repealed by a simple majority. A future government cannot be prevented from reducing or abolishing the New Zealand Superannuation Tax or using the Fund for purposes other than the payment of New Zealand Superannuation. It is inconsistent with New Zealand's democratic principles to attempt to bind a future government as proposed by Labour.

We want Labour to explain how it can prevent the 75% majority being changed by a future government to a lower proportion.

Where will the money be invested? The extra amount of tax required each year to achieve Labour's objective could well peak at $3 billion a year during the build up period of about 35 years. For a number of reasons, nearly all of that money will have to be invested overseas. The New Zealand market will not be able to absorb much but, even if it could, the main reason for investing outside New Zealand is a lack of local diversification. We don't have the range of companies and industries that such a large pool of assets will require.

That raises a number of issues – first there is the immediate impact on New Zealand's balance of payments as all that investment money flows overseas. Next, the citizens of all other developed countries face similar but in most cases, more serious ageing issues than New Zealand. Just as we will want to be drawing down on the Fund to meet payments to superannuitants, other baby boomers around the world will already have started their draw-downs. Some commentators say that such a co-ordinated withdrawal of money from markets will have a significant impact on asset values around the world. Shifting the investment response to the ageing issue from individuals to the government, as Labour proposes, doesn’t change that risk but will probably magnify it. We think that individuals are more likely to respond rationally with their own money to this issue than the government with taxpayers’ money.

Like most "single answer" solutions to public policy issues, the Fund is more likely to increase New Zealand's exposure to risk in the short run (balance of payments) and also in the long run as we reach our peak demand period later and less severely than most other developed countries.

Investing the money: Labour proposes that the Fund be managed independently of the government on a "commercial" basis. All the risk will, however, remain with the government because the level of New Zealand Superannuation payments will continue to be determined by the government. The cost of those future payments will not be directly related to the level that would be actuarially prudent given the levels of the Fund, the New Zealand Superannuation Tax and income tax. Over time, political pressures will influence the Fund's investment strategy. For example, will the Fund be permitted to invest unlimited amounts offshore? Will it be required to hold government debt, or will it be allowed to invest in companies that engage in genetic research or produce genetically modified products? How many worthy local "investments" like new bridges, schools or motorways will form part of the Fund's portfolio?

Another version of compulsion: Labour campaigned vigorously against the Compulsory Retirement Savings Scheme in 1997. It objected to the idea that the government should force New Zealanders to save particular amounts in specified ways. The proposed Fund is compulsory retirement savings in another guise. The government is still telling New Zealanders where retirement savings should be invested. But this time, the government knows better than New Zealanders who should invest the money.

We want Labour to explain the difference in principle between what it proposes now and what it opposed only two years ago.

The lessons of history: History is also against Labour's proposal. The social security charge was intended to fund the contributory health and welfare programmes that were charged to the Social Security Fund in terms of the Social Security Act 1938. Legislation passed by Labour in 1958 credited the successor to the charge, the social security income tax, to the Consolidated Fund to which social security and other spending was then debited. The separate tax was eventually abolished on the recommendation of the Ross Committee because it reflected "an artificial splitting of tax receipts" and social security spending had consistently exceeded the level of the tax. History would be repeated if Labour is elected and implements its superannuation policy.

The things that matter

Here are the things that Labour (and all the other parties) should promote if it is genuinely concerned about the security of future retirees' incomes:

· Affordable state provision: We must have a state-provided safety net (currently New Zealand Superannuation) that is affordable in the long term and that can therefore be seen as a settled, consistent foundation on which New Zealanders can build their retirement income plans.

· To those who need it: We should have an income test so that the state-provided benefit reduces as private income rises. There is also a strong case for an asset test though there are practical problems with implementing it. However, we should not collect taxes and then pay money to people who don’t, on any agreed measure, need it. That applies to other state benefits as well as New Zealand Superannuation though there is a case to treat the old on a more generous basis from other state beneficiaries.

· Level savings playing field: The state should not favour, or penalise, private provision for retirement through the income tax system. It shouldn’t send any signals that one form of saving is better (or worse) than another.

· Freedom to choose: Citizens and employers should be left to make their own decisions on the most appropriate way to make financial provision for retirement. The state can’t know what we need individually. The decisions that we all make individually are more likely to be "right" for New Zealand than decisions by a central bureaucracy, however well-intentioned.

· Inform and educate: The government should make clear why it adopts this strategy and should help us all decide how most appropriately to respond to this framework.

· Regular review: The government should regularly review all the issues that relate to retirement (including housing and health). It must build and maintain public confidence in the overall framework. Only the government has the resources and the ability to collect the required information to do that.

· Gradual change: If we need to change things, that should be a gradual and not an overnight process particularly for the already retired or those close to retirement. Change should be based on good information and a proper, open debate. Change based on anything less will, by definition, be unstable.

· Consensus: We must all work towards political and community consensus on all of the above. That job that should not be left just to a task force and certainly not just to the government - we all have a responsibility to make this work. Without consensus between political parties, providers, voters and savers, any one government’s views on retirement income policies won’t provide the stability that New Zealanders need for long term decisions on private provision. We should have learned at least that from the last 26 years of change.

Above all else, the government must help to grow the economy. That's the only way that we can all help to support tomorrow's larger retired population in the manner the community decides that we should aspire to.

Appendix

SECURITY IN RETIREMENT

LABOUR'S SUPERANNUATION POLICY

Labour affirms its support for a publicly funded and provided retirement income scheme as the basis for all New Zealanders’ retirement income provision now and into the long-term future.

The guarantee of an adequate income in retirement is amongst the most fundamental duties of the modern state. Labour will restore the relationship of New Zealand Superannuation to the average wage to what it was before National’s cuts.

Labour will ensure that New Zealand governments now, and in the future, will be able to fulfil these commitments. But, at present, New Zealanders lack a sense of security about the future of New Zealand Superanuation, partly because people cannot be assured of where the money will come from. This is particularly disturbing for those already retired.

It is also a problem which, if nothing is done, will become more serious. The 'baby boom' generation will start retiring early next century and that, combined with lower birth rates, will mean that there are fewer and fewer people in the workforce for every retired person. Our ability to afford superannuation payments out of current taxation revenue will therefore be significantly reduced.

Without change, we will face the prospect of either reducing the level of support relative to other incomes, some form of income testing, or substantial increases in taxation in the long term. Labour rejects all of these options as either unfair or imprudent.

Labour will not introduce any new form of income or asset testing or raise the age of qualification beyond 65 years of age.

The centrepiece of Labour’s solution to ensure its commitments are met will be the creation of the New Zealand Superannuation Fund.

The Fund will be managed on a sound commercial basis to ensure that there are strong long term returns. Surpluses will accumulate in the Fund at a sufficient rate to assist in the future payments of New Zealand Superannuation.

The Fund will be overseen by the Guardians of New Zealand Superannuation - a board selected to represent the interests of senior citizens, those at present in the workforce, and the state. Payments into the Fund will come from New Zealand Superannuation Tax.

New Zealand Superannuation Tax will not be in addition to existing income tax. It will replace an equal part of the income tax on personal income.

The full rate of New Zealand Superannuation Tax will be set so that at a constant level it will be sufficient to fund New Zealand Superannuation over a sixty year timeframe. In order to ensure that there is no increase in the level of personal taxation, New Zealand Superanuation tax will be phased in over time if the fiscal situation makes that necessary.

The problem of sustainability disappears. All New Zealanders can live in the security that New Zealand Superannuation is sustainable as far into the future as any of us can forecast.

Senior Citizens organisations such as Grey Power, Age Concern, and the RSA will be invited to nominate people to be Guardians of the New Zealand Superannuation Fund.

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.

Labour is also considering legislating to ensure that future governments cannot, on their own, break the ring-fencing around the Fund and choose to use the money for some other purpose. This could be achieved by having the provisions governing this aspect of the Fund "entrenched" so that they would require a vote of 75 per cent or more of the Parliament to effect any change. If, after further consideration, this option is favoured, Labour would ensure the question of "entrenchment" of provisions was put to voters as a referendum question before it was bought into force.

The Fund and the Tax will begin operating on 1 April 2001. As soon as the government is formed after the election, Labour will begin work on the necessary legislation as well as engaging in consultation with all other political parties.

This legislation, the New Zealand Superannuation Bill, will be timetabled for introduction into Parliament by 1 June 2000 and enactment by the end of that year. The New Zealand Superannuation Act will thus be able to come into force on 1 April 2001 and will provide the complete legislative basis for the new scheme which will be entirely separate from social welfare provisions.

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