Focus on Saving: Towards consensus

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Monday, July 21st 2003, 5:21PM

Summary

 

1. All savings matter: they improve the financial flexibility that people have. All savings impact on the financial circumstances of people as they enter retirement.  While steps should be taken to encourage savings in general, particular attention needs to go on the contribution savings make to the living standards of the retired.

 

2. The recent survey of living standards of the elderly indicated that in the main, retired people lived with an acceptable level of comfort. The issue for savings policy is whether current policy settings and current savings practices are sustaining the wealth accumulation that will replicate that retirement income pattern for future generations.

 

3. The indications are that there are major risks that they will not. Participation in employment based superannuation schemes has declined dramatically since 1990. Household debt as a proportion of household income has almost doubled in that time. Credit card debt is increasing rapidly, and anecdotal evidence is that people are withdrawing retirement savings to get it under control. A recent Australian survey indicated that the incidence of inheritances could be falling for future generations.

 

4. All of these factors suggest that while there is no need for panic action, savings policy needs to be designed around the mitigation and management of the risk that retirement income in the future will fall short of what is regarded as acceptable. If that happens, extra costs will be imposed on individuals and on the government. Both should therefore make a contribution towards enhancing private savings.

 

5. Just how strong that contribution ought to be depends on an assessment of how serious the deterioration in savings is. That assessment will change over time, and any savings policy needs to be flexible enough to intensify or ease the measures being taken to encourage savings.

 

6. The workplace is an efficient vehicle to use for mobilising individual savings. The difficulty is that the motivations on employers or unions to pursue an active agenda to promote retirement saving as a component of the remuneration package are weak.

 

7. In these circumstances, there are two broad mechanisms that can be deployed to boost savings: incentives and compulsion. Further, it is possible to envisage escalating levels of intervention associated with either incentives or compulsion, and combinations of the two. Both tend to be costly and they intrude on individual choice. The consequence is that the blend and degree of incentive and compulsion that are used should be no more than is needed to respond to the level of risk that is assessed to exist.

 

8. A process for agreeing on the intensity of intervention that is needed, and on the most effective and efficient blend of incentive and compulsion used to deliver it is the first step needed for firming up a savings policy, and for tracking and adjusting it in the future.

 

Background.

In early June, the ISI circulated an issues paper on savings policy to a number of interested organisations and individuals.

 

In order to progress the debate, this paper consolidates the issues around a number of themes that allow a comprehensive savings policy framework to be developed.  It does not start with a blank sheet of paper: instead it works off a proposition that there is a need to lift national savings, and within that to raise personal savings levels and personal wealth.

 

Starting assumptions on the need to save.

Discussions on the issues paper established that there is a body of opinion that does not accept that the need to increase savings has been well established. At the very least the concern is that “the problem” is poorly or loosely defined, with the result that it is hard to discuss “solutions”.

 

This paper starts from an acceptance that there are macroeconomic and personal advantages to be had from an increase in the savings rate. These are not always the same thing. It is possible to increase national savings by reducing the ability of individuals to save (for example by a government raising taxes to improve government, and hence national, savings levels).

 

In general, though, the aim should be to increase both, and both should be seen as a constraint on each other (government savings should not be achieved by crowding out the capacity of individuals to save and individual saving should not be boosted by an even larger decrease in government saving).

 

The survey of the living standards of the elderly concluded that in the main, retirement income was sufficient to permit acceptable levels of comfort, except where the individual had experienced one or more “life shocks” (poor health, unemployment, matrimonial property settlement etc) in the immediate pre-retirement period.

 

The model on which this adequacy was built was a “package” of somewhere between sixty and seventy percent of income coming from New Zealand Superannuation, past savings and/or superannuation scheme supplementing that, and the retiree occupying an owned home. (There was, though, considerable variation in other income, with a substantial proportion of the retired principally dependent on NZS. Despite that, private income (or running down savings) is part and parcel of comfortable retirement.  The Household Savings Survey identified inheritance as a strong contributor to differences in wealth between households.

 

The question is whether this “model” is holding up as the generations move through. There is clear evidence of a substantial reduction of participation in work-based superannuation schemes, and household debt has soared. The typical work cycle now involves people starting work later in life (after more extended education and training), with a student debt, and with the likelihood that they will have interrupted work spans. These conditions could well reduce the prospects of saving during working life. A recent Australian survey concluded that inheritances may be playing a decreasing role in the wealth accumulation process.

 

The risk is that more and more people enter retirement in a similar financial condition to those among the current retired who have had a “life shock” (few assets, possibly debts, very little investment income). In future, will the condition that now emerges after a “life shock” be more common and in fact be a result of “life style”?

 

The counter argument is to say that we do not know what is happening with new or alternative forms of savings behaviour.  People have more debt, but they may have more assets as well. They are not in superannuation schemes but they may have personal financial portfolios.

 

There are firm statistical indicators of change and the documented change reveals deterioration. If there has been a compensating change “off camera”, (people accumulating assets in new and different forms) then there is no problem. If savings are increased from a currently “adequate” base, in twenty or forty year’s time retirees will be more than comfortable. If there has not been a compensating change, then in twenty or forty year’s time there is a problem and it is too late to do anything about it.

 

The only options will be to tolerate poverty in retirement or increase the universal pension to take up the slack. But this will be at a time when the demographic structure makes any widespread increase in public supports to retirement income extremely expensive, and when there are risks that the demographic structure will be generating fiscal pressures around financing health care.

 

Sensible risk management suggests that it is time to move on with a pro-savings agenda.

 

It is important to stress that this paper does not focus on a target level of savings, or prefer a particular form of savings. It works from an assumption that there are risks that the somewhat comforting profile revealed by the living standards survey will not last. A response therefore involves risk mitigation. It has to be sufficiently flexible to adapt, over time, as perceptions about the risks of generating comfortable living standards in retirement change.

 

The fact that there is still some concern around whether a problem exists, and whether it has been sufficiently defined may, however, rule out more intrusive interventions (like particular forms of compulsion), at least in the immediate future.

 

The challenge is to design a process that is purposeful enough to get around the “paralysis of analysis”, but flexible enough to respond to more clarity emerging on problem definition.

 

The core dilemma: grow or save?

There is a body of opinion that sees “saving” as (largely) irrelevant. In this school of thought, the issue is not what people save, but the size of the economy in the future (and the size of the economically active population). If there is more to go around, it is easier to tax and redistribute it. If we have a small economy, claims to a share of a shrinking cake are not worth much.

 

Growth (and/or immigration) are seen as the answers. Growth is important, and a higher level of national savings would capture a larger share of the future output for New Zealanders (compared with more reliance on the savings of foreigners to finance investment). However, growth is not the answer. This is because wellbeing in retirement is only partly an absolute: adequacy is also relative to the living standards of the rest of society.

 

By way of example, New Zealand Superannuation is linked to the average wage. A growing economy would normally generate higher wages, and raise the absolute value of NZS without changing its relative value. It is the relative value that is usually the policy target. A growing economy makes for richer people, not fewer people, and it is the numbers in retirement that generate the claims on future production.

 

Immigration is also not a viable route to sustaining higher levels of income transfers out of current production. Even a strong level of net inward migration (say 20,000 a year) increases the population by only half a percent a year. The relevant aspect, though, is not the change in the size of the population but the proportion of the population that is economically active that determines the capacity of the government to base income adequacy on transfers. That half a percent increase in the population has to be of sufficiently different composition from the current population to change participation rates in a material way. The arithmetic is against it.

 

It is not a case of save or grow: it is a case of save and grow. Both matter.

 

The changing focus: saving, retirement savings, retirement income or retirement income policy?

The debate on savings policy tends to migrate between discussing saving, retirement savings and retirement income. This is not entirely surprising: they are linked.

 

Saving, for whatever reason and over whatever time period, will impact on the net asset position of individuals at the point of retirement. Retirement savings are different in two important respects: generally they must be a larger quantum and be locked in for longer periods than other forms of saving. Despite that, the distinction is not as clear cut as that: all savings impact on the financial assets of the retiree.

 

There is also some evidence that savings are influenced by habit: the earlier individuals start to save, the more they are likely to save and hence “saving” in a more general sense is likely to be strongly associated with retirement saving.

 

At the other end of the spectrum, retirement savings will generate some income in retirement, and consumption in retirement can involve drawing on saving. Hence there is no clear cut distinction between retirement savings and retirement income. However, indications are that while there is a large variation between individuals (the distribution of wealth is twice as unequal as the distribution of income), in general something like two-thirds of retirement income does not come from retirement savings: it comes from direct income transfers via New Zealand Superannuation.

 

It is true that savings increase personal financial flexibility. It is also likely that a higher savings rate will finance a higher level of investment or at least enable New Zealand nationals to capture more of the income that flows from that investment. This is not to say, though, that there is much that a savings policy can or ought to do to boost savings generally. The key thing for policy is to focus on social and economic end results that are adverse and avoidable, and difficult or costly to correct if remedial action is not taken in a timely manner.

 

As mentioned earlier, a “snapshot” taken around the turn of the century produced a picture of the retired as having generally adequate living standards. The real question is if nothing is done and another snapshot is take in twenty years time, what will that picture look like? People will cope. Societies adapt and muddle through all sorts of circumstances. Coping may, though, involve imposing avoidable hardship on a bigger section of the retired, or squeeze government spending in other areas of public benefit.

 

In retirement, options have closed, and time to rebuild has elapsed. It is because of this that the focus of policy is on retirement income. Savings, in this context, is a factor that contributes to the adequacy of retirement income.

 

“Policy” is, though, not only what governments do. It can also require changes in the way that employers, unions and the providers of savings products go about their business.

 

In this paper, the emphasis is on policies needed to change savings patterns so that retirement savings make a contribution to the adequacy of retirement incomes.

 

Savings and income.

“Income” is in many ways a transitional concept: in itself it doesn’t contribute anything to personal or national wellbeing. It is purely a means to an end, a bit like money.  Money doesn’t make people any better off: they can’t eat it or wear it or shelter under it.  “Income” and “money” are simply means to an end: they are a medium.

 

Income is not even the medium through which people claim rights to use resources. Income doesn’t guarantee anything. An extreme episode in history reminds us of this. During the hyper-inflation in Germany in the 1920s, income was losing its capacity to command resources so rapidly that workers were demanding pay each lunchtime, so they could throw the pay over the factory fence to waiting spouses who would run to the shops before the value of the income eroded further.

 

Income is the medium through which individuals, groups or nations obtain a capacity to negotiate for the rights to acquire resources (“goods and services”). Those resources can be used (consumed) or stored for later use (saved). Typically, the capacity to claim is itself stored (a financial asset).

 

This concept helps to focus thinking about “saving”.

 

The traditional approach is to think of saving in three “tiers” or “pillars”:

 

·        The state provided universal pension or state mandated universal savings obligation.

 

·        Employment based (usually retirement aligned) saving.

 

·        Individual, voluntary saving.

 

Thinking about income as merely a means to the end of current or postponed consumption recasts the “three pillars”. The first tier or pillar need not be saving at all. It can merely be the redistribution of the capacity to negotiate for the use of resources. The government taxes the “medium” of some and transfers it to others (the retired, or people over a certain age if it is an age benefit).

 

It is only that portion of the “first tier” that is met out of government saving, or that is compulsorily saved by the individual, that is a store of the capacity to bid for resources. In New Zealand, first tier “saving” for retirement income is 1.6 percent of GDP (when the phase-in of the NZS Fund is complete) plus earnings reinvested.

 

This does not mean that NZS is not an essential component of the retirement income package. It clearly is. The state is providing bargaining power equal to (say), two-thirds of the comfortable consumption needs of the retired through a regular, and predictable, and (hopefully!) reliable flow of money.

 

This takes pressure off the need to save the rest of the package that will source consumption in retirement.  It also does more than that. If it is there as the backstop, there is less concern that when it comes to retirement, the savings will not be convertible into goods: negative returns on investment, inflation eroding the value of financial assets. A basic, guaranteed state pension can improve the quality of the vehicles in which the stored value is held.

 

Thinking about income and savings in this way also has implications for the design of second and third tier savings products. It may be that the preference of New Zealanders for holding wealth in the form of housing is not just tax driven: a house can be used for shelter, and in the future the owner can access “income” to use in bidding for goods by renting it out. There is much less predictable utility in financial assets!

 

Assessing and responding to future risks.

NZ Superannuation is a core element of the current retirement living setup. It is not sensible to work off a “dire” scenario under which NZS is not available or is heavily pared back. Demographic change will increase the fiscal pressures that NZS generates. In one sense, though, a “mature” NZS will not cost a lot more than some European country first tier schemes already cost. While there may be financial pressures to pare back NZS, political arithmetic suggests that there will be a countervailing democratic force.

 

In the short term, the demographic structure is such that the relative costs of NZS will fall. In the longer term, the NZ Superannuation Fund will contribute something like 25 percent to the total cost. The question is what level of risk surrounds the remaining 75 percent of NZS that is pay-as-you-go, and that contributes about two-thirds of the package that secures the “smiling faces” in the snapshot of the currently retired?

 

There can be no absolute certainty about the sustainability of NZS. It is possible that while NZS can be sustained, the needs of the retired may increase. An example would be if increasing health care costs either increased pressure to adjust eligibility for, or levels of NZS, or increased the proportion of health costs that the individual had to cover. In this case, more income is needed to keep the faces smiling.

 

Individuals will assess the risks that they face from long-run threats to NZS. It is likely, given the demographics, that they will increase for the younger age cohorts. At this stage, though, there is no firm basis on which to map out a collective replacement regime. What can be said with some confidence is that there is very little chance that improving NZS will reduce the need for additional forms of savings to sustain comfortable retirement. 

 

If the second and third tier arrangements are regarded as central to the adequacy of the retirement income package, then it is much more likely that the risks of maintaining a happy retirement snapshot going forward arise out the apparent deterioration in private provision at these second and third tiers.

 

There is always the possibility that at a later date the collective assessment of the sustainability of NZS would dictate that the second and third tiers need to be even further strengthened. A savings policy needs to be flexible enough to accommodate that prospect.

 

For now, it is sufficient to work off the observations that:

 

·        At the personal level, household debt has soared from around 58 percent of household income in 1991, to over 113 percent by 2002.

 

·        Outstanding balances on credit cards have increased by over 50 percent in the last three years.

 

·        In 1991, 22.6 percent of the employed workforce was members of employment based superannuation schemes. By 2001 that had slumped to 14.6 percent.

 

At the very least, a savings policy needs to lay out options for responding to those features. How hard the response has to be, and where the emphasis goes, are matters that ought to be addressed through a focussed process.

 

In the first instance, attention can be given to employment based superannuation.

 

Work-based savings plans.

The issues paper identified work-based savings schemes as efficient and effective in boosting savings levels and in increasing their duration (i.e. in promoting retirement savings). They are also in decline!

 

Work-based schemes have to overcome two hurdles: the employer has to have one on offer, and the worker has to take up the offer. Either or both parties can be left to their own devices, or policy can offer incentives to change practice, or compel the parties to change practice.

 

The issues paper noted that while there are some advantages to the key labour market institutions to encourage superannuation, the motivations are weak and the costs are potentially quite high.

 

Policies to promote access and take-up can be viewed around escalating levels of incentive and compulsion: on both parties.

 

The challenge is to decide:

 

·        where the balance of incentive and compulsion ought to lie as between the employer and the worker,

·        what the balance between incentive and compulsion ought to be, and

·        what level of either incentive or compulsion is appropriate.

 

It is possible to represent the choices as moving ever more aggressively away from the status quo.  Currently, the savings regime is essentially voluntary, and the intention anyway is that there is tax neutrality. The tax regime is not supposed to encourage or discourage saving, or to favour one form of saving vehicle over others.

 

In practice, for employment based schemes there are some compliance costs (associated with prospectus requirements and the like) that may be seen to be a negative form of compulsion (“repulsion”?). The tax treatment can be tax neutral or overtax the worker, so on balance there are small tax disincentives.

 

The future involves moving up the scale of either or both of the compulsion or incentive routes. The desirable end point is not clearly fixed, and fixing it requires an element of judgement informed by discussion, analysis and compromise. The end point can shift through time as the effectiveness of any new compulsion/incentive mix becomes apparent, and as the collective assessment of the need to boost employment based savings alters.

 

Private voluntary saving.

There are a number of anomalies in the tax treatment of savings in general, but these are more acute when it comes to private savings. The anomalies arise out the taxation of capital gains and the tax treatment of international investment.

 

When looking at savings policy, “compulsion” tends to be irrelevant for this tier. (Compulsory private saving in effect shifts this form of saving into “first tier” provision of retirement income). It tends to be very difficult to design cost effective tax incentives for this sort of saving (see below). The main reason is that savings shift more easily into tax advantaged vehicles so there is little confidence that incentives generate new and additional saving.

 

Under these conditions, the focus of policy shifts to tax disincentives and the quality, cost and range of products that the industry offers. “Policy” has a strong non-governmental dimension to it as well.

 

Tax distortions are difficult to remove from the private savings environment. Much of the distortion comes from the treatment of capital gains, and all past attempts to grapple with this issue have foundered on the traditional rocks (allowing offsets for capital losses, taxing unrealised gains, taxing when there is no accompanying cash flow to pay the taxes, taxing nominal rather than real gains, making allowances for extra risk associated with any gain, and so on).

 

There is also a strong political aversion to capital gains tax, and it is hard to see this as a focus of savings policy in the near future. Instead, it is best to continue to police the capital/ revenue boundary and concentrate savings policy on some of the more direct issues associated with tax disincentives, the regulatory environment, and the adequacy of the product mix.

 

This leads back to the issues of incentives and compulsion and the forms they may take.

 

Tax and savings

Tax can impact on saving in three ways:

 

·        It can reward saving (“Incentives”)

·        It can discourage saving (“Disincentives”)

·        It can follow saving through time (“Deferral”)

 

Regardless of whether the consideration is around offering incentives, removing disincentives or aligning the tax with when income is consumed, two principles should guide the design of policy.

 

(i)                 Equity.

 

Horizontal equity requires that the tax treatment is the same regardless of the form in which people choose to store their claims to resources.

 

Vertical equity is more subjective. It requires that tax treatments do not favour those who have more income than others. (It can also imply progressivity: that those on lower incomes have a proportionately greater benefit from the tax treatment than those who have more).

 

(ii)               Cost effectiveness.

 

In some writing this is split into three components: costs to the government; efficiency in terms of leveraging actual increases in savings; and impacts on aggregate saving, but in fact they are all aspects of cost effectiveness.

 

Tax incentives.

Tax incentives tend to be inequitable. Unless they are available on an extraordinarily wide basis, they favour some forms of savings vehicle over others (there is no horizontal equity). Those with higher incomes tend to able to save more, and can access the full extent of the available incentive. Incentives that involve exemptions tend to load the reward onto the marginal tax rate, again giving most advantage to the better off. Rebates can introduce progressivity, but only to the extent that the low paid can save enough to access them, and they then lose their strength as an incentive for the higher paid!

 

They are also dubious from a cost effectiveness point of view. In order to be sufficiently attractive they must be quite large, and therefore expensive. There is a high risk that they will increase national savings only slowly (the loss of revenue to the government reduces the savings impact of the new private savings that they stimulate). If the design of the incentive allows existing saving to migrate to the tax advantaged vehicle, national savings might actually fall.

 

Removing disincentives.

The taxation of savings tends to overtax certain vehicles and under-tax others, and is riddled with anomalies and complications.

 

This would seem to be a high priority area for policy development. It can be expensive: the over-taxation of some earnings is nevertheless generating revenue! It is also an incredibly complex area for tax structure design.

 

However, removing disincentives has the capacity to improve horizontal equity and some forms of change can improve vertical equity (by aligning the tax on earnings with the marginal tax rates applying inside a progressive tax scale).

 

Deferral

Aligning the taxation of money flows with when they are held in a form that allows them to be consumed has a certain logic to it. In the extreme case this would involve a much heavier reliance on consumption taxes in the tax mix (to reduce the problems associated with “tracking” when people use their savings, or borrow against them to bring forward consumption). The problem with that is that taxing at the point of consumption clashes with the vertical equity principle of good tax policy. There is therefore a need for compromise.

 

In its most simple form, deferral switches the last “T” and “E” of the TTE structure and corrects for the double taxation of the first “T” (i.e. it is a TEt regime). {A pure form of deferral would go as far as switching to an EET regime}. The question is really whether this is cost effective. The issue is whether it is the return or the tax on the return that is crucial in changing saving behaviour.  “E” will only (temporarily!!) alter the return by up to one-third (5 percent not 7). The prospect of much bigger pre tax returns or aversion to losses may well be much more powerful drivers of savings practice.

 

Apart from the impact of deferral on behaviour, it can also be justified on the grounds of improving inter-temporal equity.

 

Deferral should perhaps best be seen as the area in need of attention after removal of disincentives and before the introduction of incentives.

 

Non-tax incentives and disincentives.

There is a range of incentives that can be provided directly. In general, they limit the risks of savings “migrating”, they can be much more tightly targeted at a particular barrier to savings, they can be structured to encourage or reward particular types of savings, their costs tend to be more predictable and contained and they are more transparent. On the other hand, structuring incentives around types of savings can be distorting, and if they encourage and reward inefficient savings vehicles they can be inequitable and ineffective.

 

Direct incentives can reward either employer or worker, but as a general rule they tend to reward the employer (financial incentives to workers are usually just another form of tax incentive)

 

Incentives to employers would range across, but not be limited to:

 

·        Grants to cover administrative costs such as scheme design, joining fees and administration fees, and payroll costs.

 

·        Provision of bureau services to take over these administrative functions.

 

·        Establishment of umbrella schemes that employers can enlist with.

 

·        Provision of advisory services on scheme design and administration.

 

·        “Matching” employer contributions (which for cost and equity reasons would have to be limited either in dollar amount, and/or for employees earning below particular wage levels).

 

Incentives to employees can either be “front end”, or based on some type of reward system (a bit like consumer loyalty programmes, which “turbo-charge” savings at key milestones. Cost and equity considerations would also tend to limit access to the incentives to fixed dollar amount or to some definition of low pay.

 

Removing non-tax disincentives focuses on cumbersome or costly aspects of the regulatory environment. It is important to avoid removing necessary regulatory protections in the drive to lower compliance barriers.

 

Compulsion.

Compulsion is a relatively intrusive form of public policy because it interferes either with how a worker spends a pay packet or how an employer structures an operation. Interference is not particularly unusual: workers have to pay ACC levies to insure themselves against non-work accidents and employers have to comply with the occupational health and safety legislation. Both are examples of a central authority telling workers how to spend their money or telling employers how to structure parts of their operations.

 

The test is “good cause”.

 

Compulsion on employees.

 

Escalating levels of compulsion would be:

 

·        An obligation to formally withdraw from a superannuation scheme, if membership is not wanted, so that the default option in taking on a job is to be a member of a scheme.

 

·        A requirement to be a member of a scheme if employed beyond a certain age (say 40 when the expectation is that more urgent demands on limited income have eased).

 

·        An obligation to contribute if earning above a certain level of income (this allows the government to supplement contributions of workers with less than the threshold income, and can be an equitable and cost effective way of spreading participation in schemes).

 

·        Compulsory contributions of at least a set dollar amount or a percent of salary.

 

·        Lock-in provisions on any amounts contributed.

 

Compulsion on employers.