Cullen Speaks To Funds Management 2000 Summit
Hon Dr Michael Cullen
Speech To Funds Management 2000 Summit
Dr Cullen's speech to Funds Management Summit 2000, Auckland Centra Hotel
Last week I announced the details of the government’s plan to partially pre-fund New Zealand Superannuation. The details will be familiar to this audience and I will not bore you with repetition. Instead, I want to comment on two issues that are starting to emerge in the public debate: is it sustainable in a fiscal sense, and what economic impacts will it have?
Before I do that, I want to reiterate some points about the basic structure of the policy to counter some misunderstandings that are emerging.
Firstly, the scheme is not about the government saving on behalf of individuals. The government is saving on behalf of itself. The standard jargon internationally sees retirement income as being the sum total of three income tiers. The first is the income provided by the state, the second the income generated through employment based superannuation and the third is the extra that individuals voluntarily save by themselves through various savings vehicles.
If the new scheme involved either the second or third of these tiers it would be the government saving for individuals, but it does not. All other things remaining unchanged, the cost to the government of financing its first tier obligations will more than double. On any scenario, the bulk of that cost will be met out of government revenue in the year that the public pension has to be paid. The scheme announced last week will build up a fund to meet some of the extra costs to the state of that first tier, universal retirement income payment.
This does not mean that there is no need for either second or third tier, individualised retirement income provision. The state pension – New Zealand Superannuation - is and will ever only be a basic retirement income. If people aspire to more comfort in retirement than NZS offers, they will need to save to provide for it. I am not indifferent to the incentive regime that surrounds second and third tier provision. I do not think that it is producing the desirable level of private savings. I will open up policy development and policy debate on what we should do about it once we have put this particular part of the package – securing confidence in the future of the first tier – behind us.
Finally, there is some comment that confidence will only be restored if there is a broad based political consensus around the basis of any scheme. I agree with that. My problem is that I have been Labour’s superannuation spokesperson for thirteen years now. In that time the need for consensus has never been far from the formal political agenda and the content of consensus never close to it.
My view is that the enduring consensuses internationally – like around the US or Australian schemes – have followed rather than led scheme design. The government’s proposal has a facility for political parties to sign up to the new scheme. Public opinion will be the ultimate determinant of the depth of any emerging consensus. That is why we need to get a robust scheme up and running. We simply cannot afford political skirmishing for another thirteen years. This is the time for leadership, and my hope is that at the end of the day that leadership will be shown by Parliament as a whole.
Let me get back now to the question of whether the scheme is sustainable.
The basic criticism coming from the National Party is that the government is over-promising. My response is that we are doing exactly the opposite. The promise, in this context, is to sustain a floor level of universal superannuation relative to the average wage.
The planks that constitute that floor are:
The age of entitlement will be 65.
The married couple rate will be a minimum of 65 percent of the after tax average wage.
The single living-alone and single sharing rates will be 65 and 60 percent of the married rate, respectively.
Recipients must live in New Zealand and have lived here for at least ten years after age 20, five of which are after age 50.
There will be no income or asset test on entitlements.
Critics suggest that there has not been a robust debate in constructing that floor. I disagree. There has been endless debate, year after year, as entitlements have been juggled. More importantly, the political tolerances have been well tested. The so-called Muldoon super established a generous pension payable from an early age. Since then, the gross relationship to the average wage has been converted to net, the age of entitlement has been raised from 60 to 65, and the percentage floor has fallen from 80 to 65. These are all big reductions. They reflect a degree of realism and tolerance by the voting public.
Public tolerance appears to have drawn the line on two additional changes: means testing the entitlement and reducing it below 65 percent of the average wage.
Even National has accepted that it made a mistake in lowering the 65 percent floor. So the promise, with no concrete suggestion from any political party to reduce it, is the current base entitlement.
Now take two scenarios. One is that we put a dollar in a fund, earning net interest at 6 percent a year, and the other that we do nothing. What happens in 25 years time? In 25 years time, the dollar invested today is worth $4.30. If the government has not prefunded NZS, it has to find that amount from current taxes to meet part of the cost of the promise.
Prefunding can only increase the likelihood that the promise will be kept.
The thing that makes the promise realistic is the power of compound interest.
If the government is over-promising, it can only be over-promising if National intends to cut some aspect or aspects of the current platform of entitlements: cut the level, delink from wages, introduce an income and asset test or increase age of eligibility.
Some commentators have been upfront in advocating that sort of cut: Ulf Schoefish and Michael Littlewood are two such. But National is still coy. It says that we are over-promising, but does not say what part of the promise has to go.
This is not me scoring political points. The issue is absolutely pivotal to the debate about the funding proposal. If we are to protect entitlements, the money will have to come from somewhere. If it isn’t saved now there will have to be radically higher taxes in the near future.
I hear talk that the government can guarantee NZS for the current retired and those near retirement, but not for the generations that follow. This is not helpful. For a start, there will be an arbitrary reduction of entitlement and clearly some anomalies, depending on where the government draws the line on who is near retirement. Secondly, the scheme would be dreadfully unfair on the generation that pays the cost of retired baby boomers but misses out itself.
Finally, the key question remains unanswered – how are those people going to live in retirement. The cute answer is that the government will cut their taxes and they can save for themselves. This doesn’t work. The same dollar that National says isn’t available for prefunding is the very dollar it is holding out for tax cuts to facilitate private provision to fill the gap left by a shrinking NZS!
There is a valid matter that does need to be confronted: is the funding path envisaged for prefunding sustainable in a fiscal sense? Can we afford the surpluses inherent in the early projections of amounts required?
It is important at the outset to keep a sense of perspective on the nature of the fiscal challenge we face. We should not be spooked by illusions. The first is historical illusion, the second money illusion.
First, historical illusion. The common view is that governments in the past have not been able to run consistent fiscal surpluses, so why should governments of the future be expected to. This is simply wrong. By and large, governments ran surpluses, except in exceptional circumstances like the 1930s depression.
The aberration was the response to the 1970s oil shocks. The increases of producer subsidies and the think big underwriting created a large hole in the public finances, and it took the period from the end of the Muldoon era to the end of the 1980s to fill it in. Since then, there has been a natural tendency for surpluses to emerge, and we have only failed to capture the benefits of fiscal reconstruction that took place in the late 1980s because the previous government adopted a policy of dissipating surpluses by introducing rounds of tax cuts.
The period of regular deficits was the unusual period in our recent history: it is just that it is the proximate period in our life experiences.
Money illusion is the other danger. Opponents of the scheme run large numbers across our personal radar screens to lull us into the inertia that desperation brings. It is important to remember that over time, two things happen. The nominal value of money rises even with low, but persistent inflation. It is important to focus on the real value of money. Secondly, the economy grows, and with it the tax base. It is the value of real money in relation to the size of our economy that determines our capacity to make payments into the fund.
When the issue of fiscal affordability is assessed, we should be looking at today's equivalent money in relation to the level of real GDP in the future.
On this basis, the numbers are not so scary.
The highest annual contribution to the fund is $2.4 billion in today's money. That peak contribution is scheduled for 2010. By then, though, GDP will have grown, so the contribution is around 1.7 percent of GDP.
Indeed, as a proportion of GDP the contribution peaks in 2005 at a little less than 1.8 percent of GDP.
By 2016, the annual contribution is less than $2 billion in today's dollars. By 2019 it is less than the equivalent of one percent of GDP. By 2026 new injections cease.
Overall, then, there is a tight period from 2005 to 2010 during which something like 1.7 to 1.8 percent of GDP has to be put into the fund. That tightness reduces gradually over the following 15 years. It is a discipline, but not the fiscal straightjacket it is being portrayed as.
It is easy to get carried away with fashions, but equally most fashions exist because they resonate with the public. One of the current fashions is goal setting. We are encouraged to set goals, individually and collectively, and to monitor progress towards meeting them. As long as the goals are realistic, they help discipline expectations and behaviour. Goals on inflation targets, on fiscal balance and on government debt have been useful contributors to improving performance in each of those areas. I have no reason to doubt that the same will not hold true for our superannuation fund.
This raises the question about whether the savings will squeeze out all other spending – both current spending on government programmes and the financing of its future capital programme.
A lot of work was done on this in collaboration with our Alliance coalition partner, because as you can imagine it was a major concern of theirs.
I will start with operating discretion. The government has established a long term goal of keeping its operating expenses at around 35 percent of GDP. It is hard to know what the longer term expense elements will be. In the Fiscal Strategy Report this year, we established what we called a “fiscal allowance”.
The fiscal allowance was not a specific policy commitment. Rather, it was an amount that reflected the fiscal flexibility that the government had. It could be absorbed responding to weaker than expected economic and fiscal results, by spending initiatives, by revenue initiatives or by accelerating contributions to the super fund. That amount was set at an extra $1,200 million per year for each year after 2003/04.
With that allowance, and the prefunding, the government still operates within its 35 percent spending target, with a degree of comfort and over the ten year fiscal projection that is used in defining progress outlooks. That, remember, is the decade under which contributions impose the greatest discipline on the government.
There is that level of fiscal flexibility even with prefunding. It is not extravagant, but nor is it excessively tight. It is as much tolerance as finance markets and the monetary authorities would probably be comfortable with. In other words, even if we wanted to spend more than the headroom we have, after prefunding, the constraints of modern global finance markets would probably stop us doing so.
The contributions to the fund would be a capital appropriation. The key here is that after the contribution, gross and net debt – ignoring the balances building up in the fund – would need to remain within the long-term objective limit of gross debt not more than 30 percent of GDP and net debt no more than 20 percent of GDP.
This raises the completely spurious argument of will the government borrow to put money into the fund. There are two extremes to this. One would say as long as there was a dollar in the fund, the government could not add a single cent to its debt or it would be borrowing to pay into the fund. The other extreme is that the government would say that it will never borrow for super, only for health , education, prisons, defence equipment and the rest.
Practical considerations suggest the real answer falls somewhere inside these two extremes. The government has a capital expenditure programme. It has to finance it. It therefore needs to manage its debt. At times nominal debt will increase, and at times it will fall. The point is not whether at any point in time nominal debt is increasing or not. The point is whether the capital expenditure represents quality investments, and the associated debt burden is manageable.
Again, the projections show gross and net debt well below the target ceiling over the next decade, even alongside small increases in nominal debt in some years.
The Alliance has argued that we need a much more systematic approach to medium term prioritisation of capital spending, and this will develop alongside the prefunding to ensure that we manage capital needs and superannuation funding in a harmonious way. It is a big plus for the policy development process, and was necessary anyway.
On all fronts then, the proposal is fiscally sustainable, and consistent with prudent and sensible fiscal management.
What will it do to the economy?
The bald advice from Treasury is that the prefunding proposal itself is not expected to have significant macroeconomic effects. They argue that retirement income policies in general could have economic effects, but they could be adopted regardless of whether or not the fund existed.
In lay terms, if the fund did not exist, governments could do many other things. They could change tax rates, change policies towards investments in SOEs or in granting student loans, or borrow. They could cut the level of NZS entitlements, change other spending programmes, alter policies towards the private savings for retirement or run surpluses to accelerate the reduction of debt.
Because the future is so uncertain, it isn’t possible to isolate the effects that prefunding itself may have from the effects that other policies may have. I think Treasury was bound by constitutional conventions and professional ethics to avoid speculation about what other governments might do instead of pre-funding. That is their job. My job is to do the opposite. I have to speculate on what governments might do if pre-funding does not go ahead, because I have to put realistic choices in front of the public. If not this, then what?
As I have said, I don’t expect a substantial increase in spending compared with what might have been if prefunding does go ahead, although over time there could be some weakening of discipline on both the quantity and quality of public spending. The spending discretion is constrained by the realities of financial market disciplines.
Instead, my core expectation is that in the short term, the temptation will be to create an impression of a more rapid run down of government debt than if the pre-fund had taken place, but reality will be that debt reduction will be by a lesser amount than would have been building up in the fund. In short, the savings rate will be lower. There will be tax cuts in one form or another, and the emerging demographic pressures will simply build.
On the scenario of lower national savings, primarily through lower government savings, and higher private spending, we can anticipate various less than desirable economic results, in both the medium term – say ten years – and longer terms – say twenty five.
I would expect that a lower trajectory of national saving would tend to postpone and reduce an improvement in the balance of payments deficit.
I am reasonably confident that any fund would increase the liquidity of domestic capital markets. In the absence of a fund, we will continue to rely more on foreign market sentiment. In a pure market model, the fund would be too small, as a part of global markets, to make a difference. The market, though, is not pure. There are scale economies associated with analysis of opportunities, and there are country specific exchange risks that fund managers have to take into account. I cannot accept that even with purely commercial motivations, a fund manager in New York will have the same information about New Zealand investment opportunities and the same exchange risk tolerances as a fund manager in Wellington.
I do see a better flow of funds through both bond and equity markets, and that will tend to improve prospects for investment, production and employment. The fund will be managed on an arms length, commercially prudent basis. The government will not be directing investments into ventures that do not stack up commercially. This is no soft loans facility. But I do think that a robust New Zealand based investment fund can only be good for us.
The worst thing you can say about the fund, from an economic point of view, is that it will make no difference.
That is in the medium term. In the longer term, if there is no fund, we will face a fiscal crunch as a future government tries to find the money. We cannot predict how that will spill out, but it will not be a pretty economic, let alone social or political sight.
The scheme has been launched. I am proud of the design, and would like to congratulate everyone – from inside the government and from the savings industry – who has made a constructive contribution to that design. I do not rule out fine tuning some details about how it might operate, but basically I think the framework is sound.
Let consensus emerge!