Risky Retirement

What You Get Out is What You Put in is A Worrying Principle for A Retiement Scheme.
Listener: 4 May, 1996.

Keywords: Social Policy;

When I began preparing this column the political party ACT had a well established policy, based on principles with which if one did not agree, at least one could understand. They have since changed their leader who has announced that parts of the policy would be changed to make them electorally attractive. Thus far their policy on retirement has not been altered, but it may be. However I am more interested in the principles. Because the ACT proposal is (or was) the most extreme scheme, it nicely illustrates key issues.

Once upon a time the world’s state retirement schemes were categorized into funded and pay-as-you-go. Since 1898 the New Zealand has been Paygo. Each year the government pays out of general revenue New Zealand Superannuation. However overseas schemes often depend on the retirees having contributed to a fund, which was invested, and their state retirement benefit was the proceedings from this fund. In principle ACT wants to phase out the Paygo scheme and replace it with a funded scheme in which individuals would contribute 7 or more percent of their income. It is invested in private market securities, with the contributions and investment returns rates determining (on an actuarial basis) the retirement income.

However the distinction between Paygo and funded is not as crucial as at first appeared. Many of the funded schemes in Europe are potentially “bankrupt”, because they have insufficient assets to pay the superannuation to which they are committed. They rely on the additional revenue from current workers to cover the deficit (hoping the day will never come when that is insufficient). These funded schemes are really Paygo.

The important distinction is between “benefit determined” and “contribution determined” schemes. New Zealand has always had benefit determined state schemes, where the level of the benefit is set and tax is raised to pay those benefits. The near bankrupt European schemes are also benefit determined schemes, although instead of a flat rate benefit like New Zealand, each individual’s benefit entitlement is related to her or his individual past earnings (say a certain percentage of the average of the best ten years). The financial problems of the scheme arise because when the retirees were earning they were not contributing enough to fund the benefits they were promised.

The ACT scheme tries to be exactly the opposite. Its benefits are contribution determined: what you get out is what you put in (Wygiswyp). The contributions of individuals, increased by the returns on the investment, determine the retirement benefit. Most private retirement schemes in New Zealand are Wygiswyp, inevitably so because they cannot guaranteed a final benefit level. Many New Zealanders like a private retirement scheme because they have the guarantee of a state benefit, and their private scheme and/or other savings (including their house) gives them a top up. It is a bit of a gamble. While they can usually rely on their fund managers to invest prudently (although Robert Maxwell’s plundering of his employees’ funds warns that does not always happen), the managers cannot ensure a return, and hence a particular payment level in retirement.

It is this aspect of the ACT presentation which is worrying. Everyone should know that under a Wygiswyp scheme the rich get higher pensions than the poor. (I will discuss women and retirement later in the year.) Since ACT appears to be aiming for the rich vote (it is unfortunate that their leaders ran policies in the 1980s which impoverished so many of its potential voters), we can allow for that. However ACT is not saying enough that they cannot guarantee the returns they promise. Their calculations may prove wildly wrong. (There has been a dispute about the high rates of return that the ACT scheme needs to obtain the levels the politicians claim. Perhaps they are right, but if so, they are promising penalizing high mortgage interest rates as well.)

Moreover, since by the time their scheme comes to maturity the ACT politicians will gone on to the great debating chamber in the sky, the public will have no comeback at all if the promises are not kept. This is particularly strange for a party which advertised that “you have to use your party vote to keep the government honest” (above a picture of Roger Douglas). They have not been explicit explaining their retirement scheme, and the risks and possibilities it offers.

This would be less worrying if retirement policy was stable, that once it began going down a particular track it would not fall off. But recall how the 1975 contribution determined scheme precipitated the Muldoon scheme whose fiscal impact probably stressed the economy more than any other single action by Muldoon. There is now a fragile agreement that we should have a first tier benefit determined state scheme. Even that is under threat from proposals such as ACT’s. If the state provided retirement depends solely upon a Wygiswyp scheme like ACT’s it may well fail to deliver as the politicians’ promise, and convert into a Paygo one.