Part 5: Building up saving, and running nest eggs down

Part 5: Building up saving, and running nest eggs down Looking at the tax settings on savings and capitalare we there yet? Broad base, low rate and superannuation taxation Questions about whether tax is an effective tool to encourage savings: if so, how? Chair: Craig Elliffe, the University of Auckland 1

Two speakers: Peter Neilson Chief Executive, Financial Services Council Steve Mack, Principal Advisor, The Treasury

Retirement Policy Research Centre Forum Retirement Income Policy: The future is now The case for change: tax and default suggestions from the industry by Peter Neilson, Chief Executive Financial Services Council 2.50pm to 3.10pm 17 April 2014 Case Room 2, Level 0 University of Auckland Business School Grafton Road Auckland

4 What is the problem with KiwiSaver and Retirement Incomes Policy? The Retirement Income Policy Issues New Zealanders say they need 2 times NZ Super for a comfortable retirement. Only 8% say they can be comfortable on NZ Super alone. In most developed countries middle income employees contribute into a super scheme that provides them with a retirement income of 60-80% of their pre-retirement income compared with around 42% for someone on an average wage retiring on NZ Super alone in New Zealand. For someone on the minimum wage we estimate they would need to save 13.1% of their pre-tax income over 40 years to fund a comfortable income in retirement at 2 times NZ Super on current policy settings if they have defaulted into a conservative KiwiSaver fund.

5 What is the problem with KiwiSaver and Retirement Incomes Policy? The Retirement Income Policy Issues Only about 6% of KiwiSavers are currently saving enough to reach that level of income in retirement (saving 10% or more of income). The biggest drivers for achieving a comfortable retirement are: the investment style of your KiwiSaver fund, then the tax rate you pay in your KiwiSaver fund and finally the fees you pay. On current KiwiSaver policy settings most middle income New Zealanders cannot afford to save enough to fund a comfortable retirement.

6 How do New Zealanders currently build their wealth? What the Report is Not About Age 45 5. Use your funds left over to invest in rental property, KiwiSaver, term deposits or shares. 1. How we will provide retirement incomes in Age 32 4. Insure your assets, life and ability to earn. the next 20 years so if you are already Age 30 3. Buy a house or flat with the aim to owning your retired or soon will be, it is not about you. accommodation without a mortgage by the time you retire. 2. Relitigating Age 20 2. Get a good the job and debate keep as many members about of your National family in employment as possible and save to invest. Savings. Age Age 2 1. Get the best possible education and training to earn a good income. At all levels education is strongly subsidised by the taxpayer. 2 20 30 32 45 70

7 Why the tax on KiwiSaver fund earnings matters Source: Savings Working Group Final Report Page 79

8 The greater the leverage (level of debt) in the rental property and the shorter it is held, the lower is the effective tax rate Years before rental property is sold Leverage ratio 0% 50% 80% 100% 10 years 22.68% 10.22% (4.55%) (6.05%) 20 years 23.42% 12.83% 1.47% (2.83%) 30 years 24.13% 14.79% 5.20% (1.02%) 40 years 24.80% 16.37% 7.90% 0.37% 50 years 25.45% 17.71% 10.02% 1.55% These examples are for an investor in the 33 % tax bracket. The tax rates in (brackets) are negative. In effect the tax system pays you (subsidises you) to receive this form of income.

9 Why is the effective tax rate on compounding return products What like KiwiSaver the and Report bank term is Not deposits About much higher than for investments in rental property? 1. How we will provide retirement incomes in New Zealand stands out as the only country that combines: Comprehensive the next accrual 20 years taxation so of the if returns you are from debt already instruments. No retired capital gains or tax soon on rental will property be, for it most is not investors. about you. Unconstrained deductibility of interest on debt used to purchase rental 2. property. Relitigating the debate about National Savings. We have the largest bias in favour of investing in rental property and against saving for retirement in financial assets such as KiwiSaver or bank term deposits of any comparable country we could find. In most countries the tax system is strongly biased in favour of retirement savings in superannuation products and against investment in rental property.

10 What Creates the Rental Property Tax Bias Over Debt Instruments and KiwiSaver? What is taxed? the Report is Not About With debt instruments capital gains are taxed, on rental properties they generally are not. 1. How we will provide retirement incomes in When it is taxed? Under the accruals next tax 20 regime years accumulating so if earnings you from are savings already including any retired or soon will be, it is not about you. capital gains are taxed as they occur reducing the net amount that can be reinvested whereas even if a capital gain on rental property were taxed it would only be taxed on realisation (when it was sold). 2. Relitigating the debate about National Deductibility of nominal interest Savings. The part of interest that is not economic income (the compensation for inflation) is deductible from the rental property income and from an investor s other income when they exceed the net rental return. For a typical rental property investor in the 33% tax bracket, saving for retirement after age 40 by investing in rental property and re-gearing up (increasing leverage) as their equity increases and deducting the nominal cost of interest from their other income, the tax advantage over investing in KiwiSaver is overwhelming.

11 Why Saving a Little for a Long Time in KiwiSaver Does Not Work In New Zealand What the Report is Not About The Effective Tax Rate impact increases the longer the term of saving Annual savings required Impact of tax on 1. How we Years will of saving provide retirement incomes in No tax With Tax cumulative return the next 20 10 years $37,481 so if $40,479 you are already 44.3% retired or 20 soon $15,112 will be, $17,918 it is not about 47.7% you. 30 $8,024 $10,529 51.2% 2. Relitigating the debate about National 40 $4,736 $6,930 54.7% Savings. 50 $2,948 $4,845 58.2% Assumptions: 4% real rate of return, 2% inflation, 28% PIR (Prescribed Investor Rate). Required annual savings shown is in 2013 dollars, and is assumed to increase with inflation. The longer you save in KiwiSaver the greater the tax impact on the cumulative returns but if you try to save over a shorter period of time the contributions required each year are not affordable for most New Zealanders.

Why does investment style and tax matter? 12 Mean Median Minimum Income level in 2013 54.6 46.9 28.2 159.5 What Where does the money the come Report from? is Not About Total investment returns if no tax or fees paid 1245 1083 689 3457 1. How we will provide retirement incomes in KiwiSaver balance at age 65 if no tax or fees paid 1664 1447 919 4624 the next 20 years so if you are already Where does the money go? Tax paid at current PIR rates on investment retired or soon will be, it is not about you. 2. Combined Relitigating tax loss effect the debate 595 444 about 180 1955 National then fees. Fees actually paid 153 134 93 382 Savings. Wage Decile 10 $ 000 $ 000 $ 000 $ 000 KiwiSaver s contributions over 40 years 390 335 201 1138 Government s contributions ($1000 start-up + $521 pa annum indexed) 29 29 29 29 returns 232 208 88 928 Loss of compounding investment returns from tax payments not able to be reinvested 362 235 92 1027 Loss of compounding investment returns from fee payments not able to be reinvested 5 61 63 65 Combined fee loss effect 158 195 156 447 Actual KiwiSaver balance available at age 65 after impact of tax and fees 911 809 584 2222 Current effective tax rates on investment returns 47.8% 41.0% 26.1% 56.6% Starting current PIR tax rates on KiwiSaver funds^ 17.5% 17.5% 10.5% 28.0% Marginal income tax rates 30.0% 17.5% 17.5% 33.0% Table 2: Decomposition of Scenario A* (Conservative portfolio 4.0% return for mean income, contribution rate 13.1%) * While relative effect sizes are not independent of the order in which they are calculated, the hierarchy of impacts is robust; investment returns matter most, then taxes and ^ As KiwiSaver balances accumulate the associated returns typically tip someone into the next PIR tax bracket.

13 Why does investment style and tax matter? What the Report is Not About Income for PIR Scenario A Scenario E Scenario E bands Conservative Balanced Growth 1. How Inflation we rate will provide retirement 2.00% 2.00% incomes 2.00% in Gross real rate 6.42% 7.80% 8.60% the Fee next rate 20 years so if 1.10% you are 1.05% already 1.15% Gross real after fees 5.26% 6.68% 7.37% retired or soon will be, it is not about you. KiwiSaver fund PIR Tax rates and income bands* Current PIR rate FSC Proposed PIR Rates Up to $48,000 10.5% 4.3% 4.3% $48,0000 to 17.5% 8.0% 8.0% 2. Relitigating the $70,000 debate about National Over $70,000 28.0% 15.0% 15.0% Savings. Real after tax rates of return (Related PIR tax rate) Table 1: Conservative to Balanced or Growth Portfolios - KiwiSaver Scenarios to Fund a Comfortable Retirement at Two Times New Zealand Superannuation 4.50% (10.5%) 6.31% (4.3%) 6.96% (4.3%) 4.00% (17.5%) 5.99% (8.0%) 6.62% (8.0%) 3.24% (28.0%) 5.38% (15.0%) 5.97% (15.0%) Contribution rate required to achieve target balance 13.1% 7.6% 6.1% * For more detail see http://www.ird.govt.nz/toii/pir/workout/

14 Contribution Rates What the Report is Not About Table 1: 2013 Incomes and Annual, Weekly and Daily Contributions Cross-Sectional 2013 Mean Median Minimum Wage Longitudinal Decile 10 Decile 2 1. How we $54,600 will provide $46,900 $28,200 retirement $159,500 incomes $30,000 in the Conservative next portfolio, 20 contribution years rate: 13.1% so if you are already $/year $7,153 $6,144 $3,694 $20,895 $3,930 retired $/week or $137 soon $118 will be, $71 it is $400 not about $75 you. $/day $27 $24 $14 $80 $15 2. Relitigating the debate about National Balanced portfolio, contribution rate: 7.6% $/year $4,150 $3,564 $2,143 $12,122 $2,280 Savings. $/week $80 $68 $41 $232 $44 $/day $16 $14 $8 $46 $9 Growth portfolio, contribution rate: 6.1% $/year $3,331 $2,861 $1,720 $9,730 $1,830 $/week $64 $55 $33 $186 $35 $/day $13 $11 $7 $37 $7 Source: SNZ, Infometrics estimates

Why does investment style and tax matter? 15 Mean Median Minimum Decile Wage 10 $ 000 $ 000 $ 000 $ 000 Income level in 2013 54.6 46.9 28.2 159.5 What Where does the money the come Report from? is Not About Kiwisaver s contributions over 40 years 226 194 117 660 Government s contribution ($1000 start-up) 1 1 1 1 Total investment returns if no tax or fees paid 1051 905 551 3035 1. KiwiSaver How balance at we age 65 if no will tax or fees provide paid 1278 1100 retirement 669 3696 incomes 7.6%) in Where does the money go? Tax paid at proposed next PIR rates on 20 investment years returns 96 so if 85 you 30 are 479 already Loss of compounding investment returns from tax payments retired not able to be reinvested or soon will 211 be, 139 it is 44 not 648 about you. Combined tax loss effect 307 224 74 1127 Fees actually paid 110 96 62 291 2. Loss of Relitigating compounding investment returns from the fee debate about National payments not able to be reinvested 80 98 73 233 Combined Savings. fee loss effect 191 194 135 524 Actual KiwiSaver balance available at age 65 after impact of tax and fees 780 682 460 2045 Effective tax rate on investment returns with proposed PIR tax rates on KiwiSaver funds 29.2% 24.8% 13.4% 37.1% Proposed starting PIR tax rates on KiwiSaver funds 8.0% 8.0% 4.3% 15.0% Current effective tax rate on investment returns 47.8% 41.0% 26.1% 56.6% Starting current PIR tax rates on KiwiSaver funds 17.5% 17.5% 10.5% 28.0% Marginal income tax rates 30.0% 17.5% 17.5% 33.0% * Relative effect sizes are not independent of the order in which they are calculated. Table 4: Decomposition of Scenario E* (Balanced portfolio 6.0% return for mean income, no MTC but $1000 up front remains, contribution rate

16 Why does investment style and tax matter? Table 7: Scenario Comparison for Median Income Scenario A Conservative Scenario E Balanced Difference from A Scenario E Growth Difference from A $ 000 $ 000 $ 000 $ 000 $ 000 KiwiSaver s contributions 335 194-141 156-179 Tax paid 208 85-123 85-124 Compounding tax loss effect 235 139-96 163-73 Total tax effect 444 224-219 247-196 Fees paid 134 96-39 94-40 Compounding fees loss effect 61 98 37 112 51 Total fees effect 195 194-1 206 11

17 The FSC proposals including KiwiSaver default settings What the Report is Not About How to get most New Zealand employees to a comfortable retirement (2 times NZS) on a 7-9% contribution rate? By: Keeping NZ Super available on the current formula (66% of the average 1. How we will provide retirement incomes in wage after tax). Any income or means testing of NZ Super increases the the next 20 years so if you are already does retired any reduction or soon in the level will of NZ be, Super it is by linking not about it to prices you. rather contributions required to fund a retirement income at 2 times NZ Super as than wages. 2. Relitigating the debate about National Savings. Moving default KiwiSaver investment portfolios from conservative into portfolios with more growth assets and offset the increased risk with the provision of capital guarantees paid for out of additional contributions. Levelling the playing field for taxing KiwiSaver investments so they face the same effective tax rates as investments in rental property. (Paid for mainly by removing the annual $521 tax credit.) In future have some reduction in fees as account balances and FUM grow.

Possible Pathways to Retirement Prosperity NZ Super with KiwiSaver Plus Universal KiwiSaver (Compulsory for employees) What the Report is Not About Aim to achieve a comfortable retirement for employees at 2 times NZ Super and the option to retire from age 65 even if the age of eligibility for NZ Super moves out. Don t require those on low, benefit like incomes to make contributions to KiwiSaver (bottom 2 deciles). 1. How we will provide retirement incomes in Move default investors from conservative portfolios to portfolios with more growth assets offsetting the risk with capital guarantees for those either close to purchasing a first home or to retirement. the next 20 years so if you are already annual tax credit to level the tax playing field with rental property investment. retired or soon will be, it is not about you. Remove the tax bias against retirement savings by lowering the PIE marginal tax rates, funded by removing the KiwiSaver $521 Reduce minimum starting contribution for KiwiSaver to say 1% in year one split between you and your employer. Phase in an annual 1% increase split between employee and employer to lift in contributions until the target rate to fund a comfortable 2. retirement Relitigating is reached about 7%. the debate about National Savings. In the future see investment management fees reduced as account balances grow, FUM increases to allow economies of scale and when competition increases. Require a proportion of your KiwiSaver balance at retirement to be used to buy a second pension to the value of NZ Super so you retire on 2 x NZ Super with the balance of your KiwiSaver account available as a lump sum. Include insurance to top up KiwiSaver balances at retirement to purchase a second pension if even with say 30 years of contributions you don t quite get to the balance required to purchase the second pension equivalent to NZ Super. Possibly bundle a base level of life and income protection insurance into KiwiSaver to better meet hardship situations (this will require a additional 1% in contributions). Allow the option of self managed KiwiSaver but without the top up insurance. 18

19 Possible Pathways to Retirement Prosperity NZ Super with KiwiSaver Plus What the Report is Voluntary Not KiwiSaver About Aim to assist those who want to achieve a comfortable retirement income at 2 times NZ Super. 1. Regular How days of automatic we enrolment, will say provide every 3 years from 2015 retirement incomes in Phase out the tax next bias against retirement 20 years savings as Governments so if achieve you surpluses. are already retired or soon will be, it is not about you. Possibly allow KiwiSaver balances to be used to fund a deposit on either a business or tertiary education or a home deposit as is currently provided for. 2. Relitigating the debate about National Savings. Make it a requirement to step up KiwiSaver contribution rates each year until they reach the rate required to fund a comfortable retirement in order to keep earning the KiwiSaver incentives. Currently this rate is 10% over 40 years in the absence of tax reforms to level the playing field for retirement savings in KiwiSaver and investments in rental property. Possibly allow KiwiSavers the option to insure for a capital guarantee on their KiwiSaver account balances (estimated to cost less than 1% in additional contributions). Allow self management of KiwiSaver investments. This would only work if you did not take up the option of capital guarantee.

20 Would capital guarantees make a difference? KiwiSaver Contribution Rates Required to Fund a Pension at least Equal to a Second NZ Super Pension so an Employee in Decile Two Can Achieve a Comfortable Retirement with Capital Guarantees and a Base Level of Income Protection and Life Cover Included In a Conservative Portfolio earning 4% pa In a Balanced Portfolio earning 6% pa In a Growth Portfolio earning 6.6% pa Contribution rate needed to fund the second pension equivalent to NZ Super. Guarantee on the capital value of your KiwiSaver Account over the three years until you purchase your first home. Top up insurance contribution rate to achieve a guarantee of 2 times NZ Super after 30 years or more contributions. Capital guarantee contribution rate (your KiwiSaver nest egg will be guaranteed to be at least as much as it was a year before you retired). Base level of life and income protection cover contribution rate (life cover paying out 2 times your annual salary and up to two years income paid out at 75% of your previous salary or wage after you have used up your annual and sick leave up until age 45). 12.6 7.6 6.1 0.1 0.2 0.31 0.31 0.31 0.125 0.114 0.122 1.0 1.0 1.0 Total Contribution Rate (split with employer). 14.036% 9.124% 7.732% Employee Contribution Rate 7.018% 4.562% 3.866%

21 Age to purchase first home 25% 20% 20.2% 18.6% 15% 10% 7.1% 5% 2.3% 2.6% 1.7% 0% 18 to 24 years 25 to 34 years 35 to 44 years 45 to 54 years 55 to 64 years 65 to 74 years 0.2% 75+ years Source: Horizon Research Savings and Retirement Survey October 2013

For a full version of this presentation and related material visit our website www.fsc.org.nz 22