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Cullen: NZ Shareholders Association

Hon Dr Michael Cullen
Deputy Prime Minister, Attorney-General, Minister of Finance, Minister for Tertiary Education, Leader of the House

11 August 2006 Speech Notes

Embargoed until: Friday 11 August 2006 at 1.30pm

Address to NZ Shareholders Association AGM


Alexandra Park Raceway, Greenlane Road, Auckland


This afternoon I would like to cover two main issues in my remarks. First, you have asked me to talk about the investment philosophy and portfolio of the NZ Superannuation Fund. And, second, I would like to talk about the changes to the taxation of overseas investment.

The NZ Superannuation Fund has been one of the better performing funds in New Zealand over the past year. Their investment philosophy is entirely the responsibility of the Guardians, and they have made it very clear that they are managing the Fund on an active basis, favouring growth assets over income assets.

In fact 80 percent of the Fund is invested in growth assets. The Guardians have also decided to invest a significant part of the fund into non-listed assets, such as infrastructure, commodities, private equity, and forestry.

The Fund has no requirement for withdrawals until the mid 2020’s, and therefore significant investment into less liquid growth assets is entirely appropriate.

I am very happy with the Guardians investment philosophy and strategy. Clearly the returns to date have been very good, even considering the favourable investment climate since the Fund began investing. The return of the Fund has exceeded its benchmark international market indices, and is delivering on its overall objective of outperforming the risk free rate by 2.5 per cent per annum.

In this context it is useful to recap on the Fund’s governing legislation. It was designed to ensure that an independent governing body with explicit commercial objectives managed the Fund.

A key element of the policy was that the Fund would not be available to the government of the day to use for any other purpose. This requirement placed a clear boundary on the scope of the investment objectives for the Fund. It implied that the investment strategy must be value-maximising for the Fund as a distinct unit and that this is the primary investment objective. It implicitly excluded other potential objectives for the investment strategy, including:

- broader social outcomes;

- performance of the domestic economy; and

- financial and fiscal management of the Crown as a whole.

The Guardians of New Zealand Superannuation was established as a Crown entity. Its sole function is to manage and administer the investment of the Fund.

The legislated investment objectives for the Fund provide a complete basis for the administration of the Fund. The Guardians must invest the Fund on a prudent, commercial basis and, in doing so, must manage and administer the Fund in a manner consistent with best practice portfolio management; and maximise return without undue risk to the Fund as a whole; and avoid prejudice to New Zealand’s reputation as a responsible member of the world community.

The board of the Guardians is free to interpret these objectives in determining the investment strategy for the Fund.

The legislation does, however, include a power for the Minister to give directions to the board. This provision is drafted so that a direction cannot be inconsistent with the board’s duty to invest the Fund on a prudent, commercial basis and the direction is required to be published. Further, the board only has to “have regard to” a direction, not necessarily to comply with it blindly. Although this arguably renders a direction little different from any comment the Minister might care to make, this was seen as an important provision to make it clear that, despite the explicit independence of the board, the government is nonetheless entitled to express a view about its expectations as to the Fund’s performance. To date no direction has been made to the board.

Like any Crown entity, accountability to the public is very important. The board is required to establish a statement of investment policies, standards, and procedures. Before the start of each year, the board is also required to include information about its plans for the Fund in its statement of intent. At the end of each year, the board is required to produce audited financial statements for the Fund, which are to be included in the board’s annual report to Parliament. This emphasis on self-reporting is balanced by a requirement for a periodic independent performance review of the practice of the board and the performance of the Fund.

In practice, the Guardians are very open in providing information on its investment strategy, and I encourage you to view their website which includes, among other things, all the statutory documents just described, plus monthly investment performance reports, and a list of all those external managers the Guardians have employed to help invest the Fund.

One issue that arises in the media from time to time is the amount the Fund has allocated to New Zealand assets, in particular New Zealand equities. The Fund has an allocation of 7.5 percent in New Zealand equities. The Guardians determined this figure based on a number of factors, including the size of the listed domestic equity market relative to the potential size of the Superfund, and the requirement for the Fund to diversify.

The Fund currently owns over 1 percent of the domestic equity market, and it is easy to see that this figure will grow quickly as the Fund grows.

Government funds in other countries do tend to allocate a greater proportion to domestic equities. But the NZ equity market is of course relatively small by world standards, and even a 7.5 percent allocation represents a significant exposure. You could say it's positive that the Guardians see that sort of scope for investment opportunities here in New Zealand. And it would certainly be great to see that figure grow over time, as a result of further prudent and commercial domestic investments.

It should also be noted the Guardians have a long term strategic allocation of 35 percent of the Fund to alternative assets and property. Alternatives include infrastructure, private equity, forestry, commodities and absolute return assets. While they have not set specific targets for New Zealand assets within those categories, they are open to opportunities. For example, they have already invested in New Zealand forests, private equity and property. Other government funds, such as ACC, have invested in venture capital through the Venture Investment Fund. There is certainly the possibility the Guardians could choose to do similarly as their investment strategy into alternative asset classes develops.

The New Zealand Superannuation Fund is one leg of the government’s strategy to increase our domestic savings rate. The other is the KiwiSaver Scheme, which will provide a very large section of the population with a long term savings vehicle that is easy and convenient to use, while enjoying the benefit of lower costs through the use of the PAYE system to arrange regular contributions.

The scheme is aimed at that significant portion of the population who either fail to develop a savings plan, or who do so very late in their working lives when their realistic goals are quite limited.

More broadly, however, the objective is to change the culture of saving in New Zealand, so that the skills around creating and managing wealth are better understood and more widely practiced.

I would expect that these policies provide an opportunity for the NZ Shareholders Association to expand its membership. I was criticised last year for expressing a wish that the average Kiwi will become a shareholder as well as a homeowner. I still hold that view, and I assume you all share it too.

It is in this context, of a push to get more Kiwis saving, that the regime for taxation of offshore investment became untenable. It has long been recognised as unfair, but successive government’s lacked the nerve to address the problem.

The changes are in three areas:

First, the new rules will remove a number of tax disadvantages for investors using managed funds, many of whom are ordinary, middle income savers. Lower income savers investing in vehicles that adopt the new rules will in future be taxed at their correct tax rate. Currently, lower-income savers are taxed at 33 percent on their savings even though their correct rate may be 19.5 percent. This creates a significant tax disincentive for lower-income savers to use managed funds in order to have access to a diversified range of investments. Those whose tax rate is 39 percent will continue to have their savings taxed at 33 percent.

Second, capital gains on New Zealand and Australian shares held via a vehicle like a managed fund will no longer be taxed. This will increase the gains for those who choose to invest in these types of vehicles and offset the advantage of those who invest directly in NZ and Australian shares because they are only taxed on dividends. Both these measures put managed funds on an equal footing with direct investors. It is especially important for encouraging people to save through KiwiSaver.

Third, we will remove the current anomaly whereby individuals who invest directly in one of the eight so-called "grey list" countries escape a reasonable share of tax. This arises because they generally pay tax only on dividends, and many companies in "grey list" countries pay very little by way of dividends. This tax treatment advantages direct investors over other savers, such as ordinary lower and middle-income people who use managed funds that are taxed on the funds' earnings.

The new rules will resolve the problem by requiring a reasonable level of tax to be paid by direct investors who have substantial share portfolios outside Australia. This is not a full capital gains tax. The amount to be taxed will be capped at 5 percent of the increase in value of the investment in any one year, not the full unrealised capital gain. The increase in value will be limited to only 85 percent of the actual increase in value.

In addition to creating a fairer tax regime, the changes will remove the current bias against investment outside the grey list. The current rules discourage investment in important destinations such as many high growth Asian countries and emerging economies in South America. It is unconscionable in a global market that we have tax rules that artificially limit what baskets New Zealand investors place their eggs in.

This is no tax grab as some critics like to paint. The changes will cost the government around $110 million in foregone revenue; however, in our view this a price worth paying to remove unhelpful distortions in our investment markets.

I do confess to being a little surprised at how visceral and in some instances ill informed the response to the new policy has been. No one should lament the passing of what was an illogical, outdated and patently unfair regime based on the grey list concept. And while there are undoubtedly some investors who will find that the after tax returns on their portfolios will not be as high as they had hoped, every New Zealand investor will benefit from a taxation regime that is consistent and transparent.

As always there will be winners and losers. The losers in this case will tend to be sophisticated direct investors who have enjoyed considerable tax advantages under the old regime and who have the ability to easily adjust their investment arrangements.

The winners will be thousands of ordinary, hard working New Zealanders who want to achieve long term financial security, but lack the confidence and the tolerance for risk to pursue a strategy of direct investment.

Also winners will be investors who are alert to opportunities in markets like China, Japan and India. Currently, investors pay a full 100 percent capital gains tax each year on investments in those and other non-grey list countries. The proposed new regime means in most years they will pay tax on 5 percent of the opening value of their shares, limited to 85 percent of any gain they make. This is a far better outcome for investments in these countries than under the current tax rules.

The current rules steer such investors towards UK-based trusts that invest in such markets. However, the choice to invest through a trust should be made on the basis of the competency of the management of those trusts, not on any tax advantage.

It also needs to be stressed that the new rules would only apply where an investor has shares costing more than $50,000 outside New Zealand and Australia. This should mean that the majority of New Zealanders with portfolio share investments will not be affected by the changes, and will continue to pay tax as they currently do.

The new rules create opportunities for investment advisors to provide their clients with a broader range of advice on investment options from all the world’s growing economies. Admittedly, some favoured products will fall by the wayside, but that is a small price to pay for opening up a world that has been effectively closed to New Zealand investors.

The furore over these changes sends a tacit message to the government that it would have been better to let sleeping dogs lie. We reject that message. This was a sleeping dog that was tripping investors up and smothering opportunities for portfolio growth. Rousing it from its slumber and moving it out of the way is the right thing to do for New Zealand investors.

Thank you.


ENDS

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