Opportunities, Risks and Rewards of Pre-funded Retirement Income Schemes Dr Andrew Coleman Otago University

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1 Opportunities, Risks and Rewards of Pre-funded Retirement Income Schemes Dr Andrew Coleman Otago University These are the views of the author and do not necessarily represent the views of the New Zealand Treasury

2 Introduction Introduction All OECD governments offer retirement income programmes categorized by the extent benefits are linked to contributions and the extent they are funded on a pay-as-you-go or save-as you-go basis New Zealand currently has a universal pension largely funded on a PAYGO basis. As a fraction of average wages the replacement rate is relatively low. Since 2003 there has been partial SAYGO funding through the New Zealand Superannuation fund.

3 Introduction Types of mandatory retirement income policies PAYGO funded SAYGO funded Universal New Zealand Superannuation New Zealand Superannuation Fund Contribution linked (Sweden, Germany, etc) Australia etc Chile, Denmark, US(?)

4 Introduction Standard theoretical analysis suggests PAYGO-funded retirement schemes of all sorts have four characteristics 1. They alter the incidence of productivity and demographic shocks in ways that are difficult to replicate in private markets. This can be expected to increase welfare. 2. They accumulate no capital, but reduce capital accumulation when first introduced or expanded. 3. They provide a transfer to the first generation of recipients. 4. They impose an opportunity cost on all subsequent generations.

5 Introduction Some famous economists who developed the standard theory Franco Modigliani Peter Diamond Paul Samuelson Edmund Phelps

6 Introduction Increases in longevity, combined with the large increase in the birth rate between 1920 and 1950, mean the size of the NZ Superannuation scheme will increase substantially if nothing is changed. If it continues to be funded on a largely PAYGO basis, this will impose an increasing large opportunity cost on future generations particular as the economic growth rate may fall because of slower population growth. These costs make a PAYGO-funded expansion of New Zealand Superannuation unattractive, at least to people under 35 or those yet born.

7 SAYGO Schemes This raises the central question: How good are the alternative save-as-you-go approaches to retirement income provision?

8 SAYGO Schemes Three possible alternatives: Voluntary saving Prefunding Mandatory saving Raise the age of eligibility for NZS and rely on voluntary saving or longer working lives

9 SAYGO Schemes Current Scheme 2053 Contributory Voluntary Mandatory Universal PAYGO SAYGO

10 SAYGO Schemes Raising age of eligibility 2053 Contributory Voluntary Mandatory Universal PAYGO SAYGO

11 SAYGO Schemes Voluntary saving scheme 2053 Contributory KiwiSaver Voluntary Mandatory Universal PAYGO SAYGO

12 SAYGO Schemes Three possible alternatives: Voluntary saving Prefunding Mandatory saving Maintain the age of eligibility at 65 and have additional prefunding to prevent such high taxes on later generations

13 SAYGO Schemes Current Scheme 2053 Contributory Voluntary Mandatory Universal PAYGO SAYGO

14 SAYGO Schemes SAYGO Scheme 2053 Contributory Voluntary Mandatory Universal PAYGO SAYGO

15 SAYGO Schemes SAYGO Scheme 2053 Lower taxes for the same benefits allows more voluntary saving Contributory Voluntary Mandatory Universal PAYGO SAYGO

16 SAYGO Schemes Three possible alternatives: Voluntary saving Prefunding Mandatory saving Raise the age of eligibility for NZ introduce a supplementary mandatory saving scheme to enable earlier retirement if desired.

17 SAYGO Schemes Current Scheme 2053 Contributory Voluntary Mandatory Universal PAYGO SAYGO

18 SAYGO Schemes Mandatory Saving scheme 2053 Contributory Voluntary Mandatory Universal PAYGO SAYGO

19 SAYGO Schemes By what criteria can different schemes be judged? 1. Economic growth and performance 2. Risk 3. Equity, distribution and fairness 4. Social values and infrastructure 5. Sustainability

20 SAYGO Schemes Categorization of different policies Voluntary (raise age) Prefunding NZS Mandatory scheme Economic Growth Lowest taxes Highest taxes ( but < PAYGO) Least distortionary taxes Individual Risk Most individual risk Least individual risk Moderate individual risk Aggregate risk Moderate aggregate risk Least aggregate risk Moderate aggregate risk

21 SAYGO Schemes Categorization of different policies Voluntary (raise age) Prefunding NZS Mandatory scheme Distribution Least old-age redistribution Most old-age redistribution Medium old-age redistribution Least lifetime redistribution Most lifetime redistribution Least lifetime redistribution Least effect on young Moderate effect on young Most effect on young Least long-run wealth inequality Social Values Voluntary Universality Contributory

22 SAYGO Schemes Summary: Categorization of different policies Voluntary (raise age) Prefunding NZS Mandatory scheme Economic Growth Risk Distribution Social Values Voluntary Universality Contributory

23 Why mandatory schemes? Why mandatory schemes? 1. Counteract tendency to save too little 2. Counteract tendency to invest poorly 3. Reciprocity and social norms increase sustainable support for policies 4. Counteract distortions from other policies, particularly tax 5. Improve risk diversification

24 Why mandatory schemes? 1. Counteract tendency to save too little Behavioural Economics: Left to themselves, many people save too little Working out how much to save is difficult Many people retire wishing they had saved more But some people forced to save too much at very inconvenient times

25 Why mandatory schemes? 2. Counteract tendency to invest poorly Left to themselves, many people invest badly Investing badly is surprisingly easy Incentives exist for unscrupulous people to offer bad advice Incentive exist to steal from wealthy old people

26 Why mandatory schemes? 3. Reciprocity and social norms increase sustainable support for policies Public schemes provide insurance against a variety of random outcomes Low late-life employment opportunities Investment fluctuations Bad health Poor working life opportunities Long life They also provide transfers to people who didn t make much effort to save As a majority of people appear to support transfers to the deserving or unlucky rather than the improvident, a mandatory scheme increases support for retirement income transfers, as everyone has contributed.

27 Why mandatory schemes? 4. Counteract distortions from other policies The Theory of Second Best (Lipsey and Lancaster 1956) Tax laws currently provide an incentive to save too little and invest in tax advantaged assets Even if voluntary saving is best when there are no distortions, it can t be guaranteed to be best when there are distortions Mandatory schemes may correct macroeconomic inefficiencies

28 Why mandatory schemes? 5. Improve Risk Diversification Mandatory programmes can share macroeconomic risk in ways not otherwise possible The government is long-lived and can absorb temporary fluctuations on its balance sheet The government is long lived and can share fluctuations between generations Mandatory powers needed to avoid time inconsistency problems Risk types Productivity Capital Fluctuations Cohort size Longevity

29 Why mandatory schemes? The costs of mandatory programmes Force people to save at inconvenient times Cost falls most heavily on younger people Force people to save in assets they would otherwise not choose But may correct other investment distortions Aren t voluntary

30 The FSC Proposal The FSC Proposal Economic growth and performance Risk Equity, distribution and fairness Social values and infrastructure Sustainability The FSC Proposal Overall, as a hybrid scheme it scores well and provides many positive opportunities to improve welfare.

31 The FSC Proposal The FSC Proposal The main questions The size of the programme is it too big or too small? Does it provide enough macroeconomic risk diversification? Does it need to be mandatory to provide the greatest advantage?

32 Conclusion How good are the alternative save-as-you-go approaches to retirement income provision? All have some positive aspects Mandatory schemes have more costs and provide more benefits Contributory schemes with insurance options are likely to be attractive to many