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Challenges for New Zealand's Future Pension System

21 July 2010

Can the New Zealand Superannuation scheme survive the ageing of New Zealand's population, and if not, what should be done about it? A speech given to the Asset Allocation Summit at the Hilton Hotel in Auckland

The extent to which the state should carry responsibility for the living standards of older New Zealanders has been a long-standing bone of political contention.

As most of us know, in 1898 New Zealand was among the first countries in the world to introduce an age pension, preceded only by Germany and Denmark nearly a decade earlier.

But it was clearly designed to be a very basic safety net to alleviate poverty among a carefully defined part of the total population. It was means tested both on income and on assets; it was denied to Asians, many Maori, and those who deserted their spouses; it was provided only to those who had lived in the country for at least 25 years; and it was provided only to those "of good moral character" who had, for a period of at least five years prior to claiming the pension, led "a sober and reputable life".[1] As a result, only about one in three people over the age of eligibility actually received it.

In 1938, there was a fundamental change: a means-tested pension available at the age of 60 was introduced, with an initially-modest "universal" pension at 65. From this point on, New Zealanders became accustomed to thinking that the state should provide not just a benefit to those unable to care for themselves in their later years but also some form of income to all older New Zealanders, irrespective of their capacity to take care of their own needs.

The Labour Government of 1972-75 introduced a compulsory savings scheme designed to oblige people to provide for their own retirement income. Contributions from employees and employers were to increase gradually to 8% of earnings and to be held in individual accounts. But the Muldoon Government scrapped that on assuming office in late 1975 and introduced a very generous taxpayer-funded scheme providing a married couple a pension equal to 80% of the average wage from the age of 60, without any form of means testing.

Successive governments have tried to reduce the fiscal cost of that scheme in the years since. The Lange Labour Government introduced a surcharge on the pension, effectively taking it away from high-income New Zealanders, and the Bolger National Government, after promising to remove that surcharge, actually increased it. Over the nineties, the generosity of the pension was itself reduced, so that for a married couple the after-tax amount was equivalent to only 65% of the net average wage (now 66%), and the age of eligibility was progressively raised to 65.

What we have now has many attractions. It's easy to administer. It's universal, so that those who spend less time in the paid workforce during their lives (especially women) are not disadvantaged. And because the pension is set at a level above the poverty threshold - indeed, higher relative to average earnings than the basic pension in any other OECD country[2] - OECD data unsurprisingly suggest that no OECD country has a lower level of poverty among those aged over 65 than New Zealand does.[3] Statistics New Zealand data confirm this impression, with poverty levels among those over 65 being lower than in any other age group.

At the moment, partly because the New Zealand pension is paid at a flat rate to everybody regardless of previous income, the fiscal cost of the scheme is relatively low by international standards - at just 4.4% of GDP, above that in Ireland (3.4%), Australia (3.5%) and Canada (4.1%), but well below the OECD average of 7.2% and far below the cost in some European countries (seven of which have schemes where the taxpayer-funded pension costs in excess of 10% of GDP).

Selected OECD countries	Expenditure on public pensions relative to GDP (%)
Ireland	3.4
Australia	3.5
Canada	4.1
New Zealand	4.4
OECD average	7.2
Portugal	10.2
Germany	11.4
Greece	11.5
France	12.4
Italy	14.0

Source: Pensions at a Glance 2009.

Moreover, when taxpayer subsidies for private sector pensions are taken into account, New Zealand's relative position looks even better. In Ireland, for example, the cost of taxpayer subsidies to private sector pension schemes amounts to 1.9% of GDP, taking the total fiscal cost of Irish pensions to 5.3% of GDP. In Australia, the cost of such subsidies amounts to 3.2% of GDP, taking the total fiscal cost of Australian pensions to 6.7%. Of course, the taxpayer subsidies provided to KiwiSaver schemes also need to be taken into account (some 0.6% of GDP). But even adding that cost in, the total fiscal cost of New Zealand pensions amounts to just 5.0% of GDP - probably a lower fiscal cost than in any other developed country. Given that we probably have less poverty among those over 65 than any other developed country, this is an achievement to be proud of.

But the fiscal costs of New Zealand Superannuation are clearly going to increase, and increase very substantially if the present parameters remain unchanged.

One major reason for the relatively low fiscal cost of the scheme at present is that we are enjoying a "demographic sweet spot", with a relatively low proportion of the population above the age of 65. That's about to change, as the first of the baby boomer generation start reaching 65 next year. As the Secretary to the Treasury, John Whitehead, noted in a speech when he released the latest "Long-Term Fiscal Statement" on 29 October last year:

"By 2050, the total population is projected to have grown by 25%, while the number of people aged over 65 is projected to have increased 150%. By mid-century, the number of people 85 and older will have grown by 400% - from 64,000 now to 330,000."[4]

As a consequence, it's estimated that the fiscal cost of New Zealand Super will increase from its present level of 4.4% of GDP to over 8%. Of course, that's still lower than the current fiscal cost of the age pension in Greece (at 11.5%) and some other European countries, as noted, but that's not a lot of consolation given the fiscal challenges those countries currently face!

Part of the reason for this prospect is the sharp fall-off in the birth rate, but the main driver of the increased cost is the arrival at age 65 of the baby boomer generation, and in particular the increased life expectancy which we all enjoy. Over the past half century, life expectancy at birth has increased by nearly two years every decade. While that increase is projected to slow, a person turning 65 in 2050 can expect to live an additional 24 years, more than four years longer than a 65 year-old in 2008[5], and of course considerably longer than when the age pension was first introduced for those reaching 65 in 1898.

When the increased fiscal cost of healthcare and long-term care for the elderly is added to the increased fiscal cost of New Zealand Superannuation if the present parameters remain, it's clear that, if we're to avoid a substantial increase in the tax burden on that portion of the population which is still employed, something needs to change.

In a modest way, Michael Cullen may have tried to do something about that by setting up the New Zealand Superannuation Fund. When the Cullen Fund was first set up, the government was running substantial surpluses and had been since 1994. The government's debt was falling fairly rapidly, and my hunch is that Michael Cullen was under pressure from within his own caucus to increase government spending rather than to use the large surpluses to further reduce debt or, horrors, reduce the tax burden on hard-working New Zealanders. So I suspect he hit upon the idea of setting up a piggy bank in which to salt away some of the surpluses in order to mitigate the future fiscal cost of the Super scheme.

Of course, while this may have made political sense - pointing to a gradually filling piggy bank is easier than pointing to a gradually diminishing debt, and is doubly attractive when that piggy bank can be erroneously described as in some sense guaranteeing New Zealand Super for decades ahead - this made no economic sense at all. No prudent household with a mortgage would use temporary cash surpluses to buy shares in New York or petrol stations in New Zealand.

Michael Littlewood has noted that at the end of June last year, the government's total debt (including that of the SOEs) was some $62 billion, so that the $16 billion of assets in the Cullen Fund was in effect all funded by borrowed money.

"If the Guardians (of the Fund) do not achieve a return of at least the cost of the Government's most expensive debt each year, the NZ Superannuation Fund has lost taxpayers real money. Over the six years to last June 30 (the last period for which audited accounts are available), the fund's Guardians have missed that most basic target by a significant amount. The accumulated loss was about $2.6 billion at June 30. This is on the basis that the contributions to the fund could have been allocated instead to repay the longest-dated (10-year) government debt instead of investing it through the fund. The recovery in investment markets to last November reduced that estimated loss to 'only' $1.4 billion."[6]

And of course, as Michael Littlewood noted, the Fund should have earned a margin above the cost of government debt, to reflect the greater risk of investing in equity markets.[7]

When politicians call for the Government to continue contributing to the Fund even today, when the government is borrowing a net $10 billion a year, they simply demonstrate that they either don't understand basic fiscal arithmetic or have supreme confidence in their ability to dupe the public. Why anybody would recommend increasing our borrowing still further in order to invest in (mainly) foreign assets absolutely escapes me - especially at a time of widespread concern about the level of sovereign debt. And the situation is not fundamentally changed when the Government gets back into surplus, hopefully in the middle of the next decade.

Moreover, one of the big risks of the Super Fund is that political pressures will grow to invest the funds in projects which, while politically popular, simply don't stack up on the basis of any kind of careful cost/benefit analysis - Transmission Gully, a tunnel for trains under Auckland, and a bunch of low-yielding dairy farms have all been suggested by politicians as good projects for the Super Fund. If we want to reduce the country's growth potential, it's obviously vital that we keep squandering scarce capital on low return projects.

As the 2025 Taskforce urged in its first report last year, the Super Fund should be wound up without delay, and the proceeds used to repay government debt.[8]

Well, if the Super Fund is not a good way to ease the fiscal pressures of our ageing population, what might be done?

There appears to be no plausible alternative than to look at the parameters of the pension scheme itself, and in that regard there are only three parameters which are of sufficient importance to be relevant.

First, it might be possible to introduce a surcharge, or a means test of the kind that New Zealand used to have and that the Australians take for granted. Yeah right! There seems to be absolutely no chance of this happening in the foreseeable future - both the Labour Government of the eighties and the National Government of the nineties tried to make the surcharge stick and found it politically too tough. The surcharge was so deeply resented by those who felt that they were being penalized for prudently making provision for their own retirement - often after paying relatively high income taxes during their working lives - that there were quite determined efforts to avoid paying it. And avoiding the surcharge wasn't terribly difficult, so that for many people the surcharge became a voluntary tax.

Second, it might be feasible to somewhat reduce the fiscal cost of the pension by linking it for a time to inflation rather than to wages. As I've already noted, the level of New Zealand Super is higher, relative to average incomes, than is the case for the basic pension in any other OECD country; and with poverty levels among those over 65 already lower than for any of the age groups actually funding the pension, that seems hard to justify.

Jenny Shipley's National Government tried to do this in the late nineties. The intention was to link the pension to inflation until the amount paid to a married couple fell from 65% of the average wage to 60%. But the Government failed to adequately explain to a suspicious electorate what they were trying to do. They were not helped by a hostile media. I well recall an article which appeared in the main Wellington newspaper on the day before New Zealand Super was due to start being linked to the CPI rather than to wages: the article hysterically and erroneously claimed that thousands of elderly New Zealanders were about to be thrown into direst poverty, even though of course the real value of New Zealand Super was not going to change at all. It was an outrageously false claim, and I'm surprised the Government didn't take the newspaper to the Press Council.

The 2025 Taskforce recommended that for a time at least it would be desirable to link New Zealand Super to the CPI rather than to wages - effectively maintaining the real value of the pension for a time, but not increasing it with wages.[9]

But the most obvious parameter to change is the age at which people become eligible for the pension. We raised the age of eligibility from 60 to 65 in the nineties and there was widespread acceptance of the need for that change. Nobody seriously suggests lowering that age again. There is a widespread understanding that we are living much longer than we were in the past, and that that is a continuing trend. Most 65 year-olds no longer feel "elderly", or ready for the scrap-heap.

Last year, Australia announced that the age of eligibility for their age pension will be progressively raised to 67. Germany and the US are also raising the age of eligibility to 67, and the UK is going for 68. Denmark is targeting 67, and then indexing the age of eligibility to future improvements in life expectancy.

In my own view, raising the age of eligibility could be made more politically acceptable if we were to allow a degree of flexibility regarding when the pension is actually taken. If the age of eligibility were 67, for example, under a policy allowing flexibility regarding the age at which it could be drawn somebody might choose to take the pension at, say, 65. At that younger age, the amount received would be actuarially adjusted downwards, and would remain at that lower level (with regular upward adjustments with wages of course) until death. Conversely, if somebody chose to defer drawing the pension until, say 69 or 70, the amount received would be actuarially adjusted upwards.

Such a system would allow people a greater degree of choice about when to retire. It would not directly reduce the fiscal cost of New Zealand Super of course - by definition, the amounts paid would be actuarially equivalent to drawing the pension at the age of eligibility. But by encouraging people to stay in the workforce for longer, it would have fiscal benefits in terms of higher tax revenue and, probably, lower health costs, given that there is evidence that people who remain employed are often healthier, physically and mentally, than those who have left the workforce.

Could we reduce the fiscal cost of New Zealand Super by encouraging more private sector savings? For more private sector savings to reduce the fiscal cost of New Zealand Super it would be necessary to means test New Zealand Super of course, or at least reduce the relationship between the level of the pension and the average wage, and as indicated there seems little enthusiasm for doing either.

Moreover, no government has yet found a reliable way of increasing private sector savings. Despite the quite extraordinary subsidies provided to the KiwiSaver Scheme - subsidies which make joining the Scheme a no-brainer for every New Zealander under the age of 65 - it's not yet clear that it's had a material impact on private sector saving, while it's almost certain that it's had a negative effect on overall national saving (any modest increase in private sector saving being more than offset by the reduction in public sector saving implied by the subsidies).[10]

What about moving to a compulsory savings scheme? Such a move would obviously be hugely popular among professional fund managers, so I should declare my interest! It would probably also be positive for capital markets. The fact that the market capitalization of the NZX, at around $50 billion, is a tiny fraction of the market capitalization of the ASX, at around $1.3 trillion, is a result of a number of factors: most of the companies in New Zealand's main export sector are cooperatives (and not listed on the sharemarket), the government owns most of the infrastructure companies in New Zealand, and foreign companies own most of our banking sector. But it seems very likely that the Australian compulsory savings scheme has also had a materially beneficial impact on the scale and liquidity of the Australian sharemarket.

Would a move to a compulsory scheme be popular beyond the funds management industry? I'm not sure. Certainly Mr Muldoon encountered little pushback when he scrapped the compulsory scheme set up by the 1972-75 Labour Government. And the referendum on compulsory superannuation conducted in 1997 decisively rejected the compulsory scheme proposed at that time, by 92% to 8%, with 80% of eligible voters casting a vote. If a compulsory scheme were accompanied by any form of fiscal subsidy to "sweeten the pill", especially for low income people, it would inevitably need to be accompanied by a means testing of New Zealand Super, and that would reduce its political appeal.

Would a compulsory superannuation scheme increase New Zealand's saving rate? Surprisingly, that's not a foregone conclusion. For some years after the introduction of the Australian compulsory scheme in the early nineties, the Reserve Bank of Australia was not persuaded that the scheme was having any significant effect on saving, with money going into the scheme being diverted from other forms of saving. There now seems to be a growing consensus that the Australian scheme has in fact had some positive effect on the household saving rate, but it is salutary to note that the recent Australian Budget, which increased the employer contribution to their compulsory superannuation scheme from 9% to 12%, estimated that the effect of this quite major change would be to increase national saving by a mere 0.4% of GDP by 2035, suggesting that the overall effect of the compulsory scheme might be to have boosted national savings by no more than perhaps 1.5% of GDP.[11]

It is also worth noting that Australia has a much higher proportion of its elderly population living in poverty than New Zealand does. Indeed, only 2% of New Zealand's population over the age of 65 is classed as living in relative poverty by the OECD (the lowest fraction in the OECD), whereas the equivalent figure in Australia is 26% (the fourth highest fraction in the OECD).[12]

Len Bayliss, at one time chief economist at the Bank of New Zealand and an adviser in the Prime Minister's Office, asked whether New Zealand should adopt a compulsory superannuation scheme, said:

"Without question the response would be negative if based on Australian experience. Australian pension structures are very complex and difficult to understand, involve constant changes to correct deficiencies, fail to tackle old age poverty or achieve their publicised objectives, provide no certainty as to pension levels because of their dependence on volatile/high risk equities, and strongly discriminate against women because of their lower life-time earnings. Although measurement is difficult, the Australian scheme has apparently had a minimal impact on overall savings. On the other hand, there is abundant evidence that the Australian scheme has very substantially increased the profits of the Australian managed funds industry, as well as the incomes of numerous consultants, advisers, actuaries, accountants, and lawyers, all paid for by pensioners!"[13]

So a compulsory scheme has many drawbacks.

To me, New Zealand Super is a very good scheme and should be retained. But we do need to face the inevitability - and in my view it is the inevitability - of an increase in the age of eligibility. The acceptance of this would be greatly helped if we allowed people much greater flexibility as to when they actually start drawing the pension, with early drawing entailing a lower level of pension and later drawing entailing a higher pension. That flexibility would have substantial indirect fiscal benefits but, arguably even more important, it would encourage older New Zealanders to stay productively engaged in the community.

Is this politically feasible? A few weeks ago, political journalist Rob Hosking claimed that when I was Leader of the National Party I "went to Tauranga and mused, eminently sensibly, that young people might not be able to rely on getting their superannuation when they hit 65. Dr Brash was taken into a dark room where the party's backroom folk played him subliminal tapes saying 'never ever ever mention superannuation'. And he never did again. Believe me, I tried."[14]

I don't recall giving a speech about superannuation in Tauranga, though of course I may have done. But I do recall giving quite a major on-the-record speech in Auckland in November 2004. That explicitly flagged the likelihood that, while there should be no change in the parameters of New Zealand Super for those already retired or near retirement, there should be a national conversation, sooner rather than later, about the changes which would be needed in the longer term. I don't recall the sky falling in, or any subliminal tapes!

[1] New Zealand Official Year-book 1900, page 442.

[2] Pensions at a Glance 2009: Retirement Income Systems in OECD Countries, OECD, 2009, page 65.

[3] Ibid., page 64.

[4] "Challenges and Choices: New Zealand's Long-Term Fiscal Statement", 29 October 2009.

[5] Ibid.

[6] New Zealand Herald, 10 May 2010. For a fuller discussion, see "Pre-funding a government's future financial obligations - the New Zealand Superannuation case study", in New Zealand Economic Papers, April 2010, or "Best Practice in Smoothing the Tax Burden: the New Zealand Experience", a paper presented to an international seminar on social security in Malaysia on 13 July 2010. In that paper, Mr Littlewood estimates that the government's loss on the Cullen Fund to 31 May 2010 was $1.14 billion.

[7] The Business Herald of 18 June 2010 reported that to the end of May 2010 the Fund had earned just 5.81% per annum since inception on 30 September 2003, falling a good way short of providing adequate compensation for the riskiness of the portfolio.

[8] Answering the $64,000 Question: Closing the income gap with Australia by 2025, November 2009, pages 110-111.

[9] Ibid., page 91. Because New Zealand Superannuation is not significantly above the New Zealand poverty level, it would not be feasible to link it to the CPI for very long however, lest we move from a situation where poverty among retired New Zealanders is quite low to one where it became relatively high.

[10] "How much new saving will KiwiSaver produce", by J. Gibson and T. Le, Working Paper in Economics, University of Waikato, March 2008.

[11] A recent Australian study concluded that "despite the introduction of a compulsory savings regime through the super guarantee, ... Australians are saving less than their global counterparts. In 2007 Australians fell behind most OECD nations with a debt to income ratio of 158 per cent. Only the United Kingdom was worse off at 186 per cent." Saving Tomorrow: the saving and spending patterns of Australians, AMP.NATSEM Income and Wealth Report, April 2010.

[12] Pensions at a Glance 2009, op. cit., page 64.

[13] From a private communication to the writer dated 10 May 2010.

[14] National Business Review, 4 June 2010.