Opportunities to Improve the Financial Security of New Zealanders by Peter Neilson, Chief Executive Financial Services Council Presentation to the Financial Services Federation CEOs 1.00 to 2.00pm Wednesday 24 September 2014 Wellington Club 88 The Terrace Wellington

Contents The Financial Vulnerability of New Zealanders Pathways to financial well being Insurance uptake: the Other Missing Million Income protection insurance “Mind the Gap” Fair Tax for Savers Where to now for KiwiSaver 2

What the Report is Not About 1.How we will provide retirement incomes in the next 20 years so if you are already retired or soon will be, it is not about you. 2.Relitigating the debate about National Savings. Some numbers to put the current vulnerability of New Zealanders into focus Only 8% of New Zealanders think NZ Super ($357 per week maximum after tax for an individual) is sufficient to retire on. (Horizon Nov 2013) Only 15% of New Zealanders have income protection insurance. (Horizon Oct 2012) For New Zealanders: Only 15% say they have sufficient savings to last six months if they were made redundant. 26% would not be able to pay their bills after just one week. 54% have insufficient savings to last 4 weeks after being made redundant. The majority of New Zealanders are financially living close to the edge and unemployment, sickness or retirement could put them quickly over that edge. 3

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

5 Source: Horizon Research Savings and Retirement Survey October 2013

Retirement in the 20 th Century Retirement in the 21 st Century Funding retirement incomes in 1955 Over 65 population less than 300,000 Life expectancy at years for males and 16.9 years for females. Seven working age people support one pensioner. Age pensions cost 3% of GDP when the universal pension was available from 65. Funding retirement incomes in 2055 Over 65 population reaches almost 1.7 million. Life expectancy at 65 – 31.3 years for males and 33.9 years for females. Two working age people support one pensioner. Age pensions will cost 9-10% of GDP if the age of eligibility for NZ Superannuation stays at 65. 6

What the Report is Not About 1.How we will provide retirement incomes in the next 20 years so if you are already retired or soon will be, it is not about you. 2.Relitigating the debate about National Savings. The Income Protection Insurance Gap If you have an accident in New Zealand and are off work for more than one week, ACC will pay you 80% of your previous earnings until you return to work. 100% of New Zealanders are covered by ACC and what you receive is not impacted by the earnings of your partner. If you are sick and off work for longer than your sickness or annual leave covers, you are eligible for a sickness benefit that is slightly lower than NZ Superannuation but if your partner also has earnings above the benefit level you will not be eligible for a sickness benefit. Many New Zealand families living with long term sickness find they are too rich to receive a sickness benefit but too poor to pay the rent or mortgage. Here is the kicker, you are 2 to 3 times more likely to be off work for six months or more because of sickness than you are for an accident. There are 972,000 households in New Zealand with a household income above benefit levels that are without income protection insurance. Our missing million customers. Most people with a mortgage have life insurance but only a minority have income protection insurance. Your partner is currently more secure in your home if you die than if you have a long term illness. 7

What the Report is Not About 1.How we will provide retirement incomes in the next 20 years so if you are already retired or soon will be, it is not about you. 2.Relitigating the debate about National Savings. What can we do about the Income Protection Insurance Gap? The industry has funded the FSC study undertaken by Massey University into the size of the personal insurance gap. Of the $650b gap about 2/3rds of it is related to income protection insurance. The launch of the Massey report put this issue on the agenda but we will need sustained follow-ups to keep it there. We know from our focus group and polling work undertaken by Nielsen’s and Horizon, that: Potential customers find the whole topic intimidating, the language impenetrable and mistrust the industry and perceive the products as expensive. We make people offers they don’t understand, we talk numbers when they want to talk about preserving their family going forward, the purchase, underwriting and claims processes are all seen negatively. We are talking with the industry about how to overcome these issues and achieve ongoing promotion and increased take-up of income protection insurance. 8

What the Report is Not About 1.How we will provide retirement incomes in the next 20 years so if you are already retired or soon will be, it is not about you. 2.Relitigating the debate about National Savings. What can we do about the Income Protection Insurance Gap? Continued... There is product innovation to make products simpler and more flexible. (If you want to see an example look at KiwiBank’s online calculator and Life and Living insurance product or ANZ’s Lifestyle product or the AIA Group products.) There are more places where you can work out what you need and obtain a quote without feeling hassled. (See Cigna’s Income Protection Policy on its website.) We will be talking more with the IRD and Ministers about the issues to do with the taxation of income protection insurance. At the moment lump-sum policy premiums are not deductible and payouts are tax free, whereas payments based on a percentage of previous earnings are taxable and the premiums are deductible. A 128 page technical paper provided little help in clarifying this issue. If the industry does not respond to fill this market gap, it is likely eventually that either ACC will be extended to cover illness or a base level of life and income protection insurance will be bundled into KiwiSaver. In the meantime take our advice and ask your adviser, bank or broker about income protection insurance. 9

What the Report is Not About 1.How we will provide retirement incomes in the next 20 years so if you are already retired or soon will be, it is not about you. 2.Relitigating the debate about National Savings. How do New Zealanders currently build their wealth? At present most New Zealanders start serious saving for retirement only when they reach their late 40s or early 50s. In most countries it is usually considered easier to save by putting a little away each week for a long time and earning compound returns (the interest on your interest) to help build up most of your retirement nest egg. Why do New Zealanders seem to prefer to invest in property rather than KiwiSaver? Why does saving for retirement tend to occur late in our working lives and tend to favour rental property over KiwiSaver? 10

What the Report is Not About 1.How we will provide retirement incomes in the next 20 years so if you are already retired or soon will be, it is not about you. 2.Relitigating the debate about National Savings. The Case for change: tax and default suggestions from the industry conclusions The adoption of an accruals income tax system in the 1980s has resulted in the over-taxation of compound return products like conservative fund KiwiSaver assets (bonds) and bank term deposits. KiwiSavers can lose more than 50% of their investment earnings to the impact of the high effective tax rate on interest on interest earned by their KiwiSaver conservative fund. This means that a middle or low income earner who defaults into a conservative KiwiSaver fund needs to save over 10% of their income to earn enough to fund a comfortable retirement at about 2 times NZ Super. 11

What the Report is Not About 1.How we will provide retirement incomes in the next 20 years so if you are already retired or soon will be, it is not about you. 2.Relitigating the debate about National Savings. The Case for change: tax and default suggestions from the industry conclusions In the meantime higher income investors, the smart money, investing in rental property are likely to face an effective tax rate of around 1% if they gear up the property by 80%. If most New Zealanders are low to medium income employees to achieve a comfortable retirement income based on NZ Super plus KiwiSaver then the default arrangements need to change so that KiwiSavers who default go into balanced or growth funds. Most default KiwiSavers would accept this if they have access to capital guarantees on their savings that they have to pay for. It will also require contributions to rise from the current minimum of 6% (3% employees, 3% employer). For new KiwiSavers the FSC has suggested contributions start at 1% and phase-in over 7 years to reach 7% (3.5% employee, 3.5% Employer) to fund a comfortable retirement. Capital guarantees could cost another 1% and the base level of life cover and income protection could be added for a further 1% for a total of 9.25% split between the employee and the employer. 12

Why the tax on KiwiSaver fund earnings matters 13 Source: Savings Working Group Final Report Page 79

14 Source: p83 Savings Working Group 2011 Report The tax bias against retirement income savings compared with rental property investment has been raised by the Savings Working Group back in 2011 using an analysis of effective tax rates prepared by the Treasury Box 6: Effective tax rates on different classes of investments The following figure shows the effect of inflation and other factors on the effective real tax rates on different classes of assets for investors on 17.5% and 33% marginal tax rates, when the inflation rate is 2% and nominal interest rates are 6%. For rental housing, 50% of the return is assumed to be rent and 50% in non taxable capital gains. The large differences in effective rates distort the way people hold their savings and are likely to have played a part in New Zealanders’ attraction to owner-occupied and rental housing since these asset classes are tax preferred over shares and debt instruments. The SWG’s tax proposals, including broadening PIE and inflation indexation, would reduce these differences by lowering tax rages on the returns from non-property saving options. They would provide a higher after-tax return and thus a more attractive alternative to property investment and would be likely to raise the efficiency of investment and restrain house prices. The previous Government also received similar advice in the 2008 final report of the House Prices Unit: House Price Increases and Housing in New Zealand (DPMC)

What the Report is Not About 1.How we will provide retirement incomes in the next 20 years so if you are already retired or soon will be, it is not about you. 2.Relitigating the debate about National Savings. Why is the effective tax rate on compounding return products like KiwiSaver and bank term deposits much higher than for investments in rental property? New Zealand stands out as the only country that combines: Comprehensive accrual taxation of the returns from debt instruments. No capital gains tax on rental property for most investors. Unconstrained deductibility of interest on debt used to purchase rental property. 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. 15

What the Report is Not About 1.How we will provide retirement incomes in the next 20 years so if you are already retired or soon will be, it is not about you. 2.Relitigating the debate about National Savings. What Creates the Rental Property Tax Bias Over Debt Instruments and KiwiSaver? What is taxed? With debt instruments capital gains are taxed, on rental properties they generally are not. When it is taxed? Under the accruals tax regime accumulating earnings from savings including any 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). Deductibility of nominal interest 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. 16

What the Report is Not About 1.How we will provide retirement incomes in the next 20 years so if you are already retired or soon will be, it is not about you. 2.Relitigating the debate about National Savings. Why Saving a Little for a Long Time in KiwiSaver Does Not Work In New Zealand 17 Years of saving Annual savings required Impact of tax on cumulative return No taxWith Tax 10$37,481$40, % 20$15,112$17, % 30$8,024$10, % 40$4,736$6, % 50$2,948$4, % The Effective Tax Rate impact increases the longer the term of saving 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.

KiwiSaver affordability is an issue Although over 2 million people have signed on to KiwiSaver almost 1 million of those are not currently regularly contributing. Many KiwiSavers have taken a contributions holiday. Some are just putting in enough to receive the $1000 up front incentive and the $521 annual tax credit contribution from the Government. Of those who are contributing, most are contributing 6% of their income (3% from themselves and 3% from their employer), much less than the 10% needed to build a KiwiSaver balance over 40 years sufficient to buy a second pension on top of NZ Super giving a combined income of 2 times NZ Super. Many potential KiwiSavers could not afford to go straight to contributing at 3% along with 3% from their employer but there is no current option to steadily move up contributions by say 1% each year as wages increase. Some potential contributors are concerned, with their money tied up till they are 65, how they would deal with a financial crisis following the death or sickness of a major bread winner in their household. 18

Pathways to a Comfortable Retirement with Greater Income and Wealth Protection 19 KiwiSaver contribution rates required to fund a pension (saving for 40 years) at least equal to a second NZ Super pension so an employee in Decile Two can achieve a comfortable retirement and the cost of providing capital guarantees for first home purchase and your KiwiSaver balance close to retirement, a base level of Income Protection and Life cover (this analysis assumes FSC’s proposed KiwiSaver fund tax changes are applied) 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 Contribution cost of a guarantee on the capital value of your KiwiSaver Account over the three years until you purchase your first home paid for 20 years only Contribution cost of top up insurance contribution rate to achieve a guarantee of 2 times NZ Super after 30 years or more contributions Contribution cost of a 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) Contribution cost of a base level of life and income protection insurance cover (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 you have reached age 45 and to put towards the purchase of such insurance after age 45) Total Contribution Rate (split with employer) % 9.074% * 7.612% Employee Contribution Rate7.018%4.537%3.806% * Note: 9.074% is still less than the 9.25% compulsory Superannuation Guarantee Contribution Rate in Australia

What the Report is Not About 1.How we will provide retirement incomes in the next 20 years so if you are already retired or soon will be, it is not about you. 2.Relitigating the debate about National Savings. 20 Fair Tax for Savers Campaign We asked all parties to acknowledge the over-taxation of long term savings needs to be addressed as fiscal conditions allow. The proposed KiwiSaver fund tax rates are not a concession, they represent what savers would pay on any income earned outside of their KiwiSaver fund. KiwiSaver funds are locked away until a scheme member reaches 65, apart from withdrawals to buy a first home. So each year savers reinvests interest earned on interest for 40 years. Because of the way the taxation of interest on interest reduces your KiwiSaver earnings over 40 years you can lose nearly half of your KiwiSaver earnings to the impact of tax, if you are on the average wage. Someone in the 33% tax bracket loses 54.7% of their KiwiSaver earnings to the impact of tax over 40 years. The same person investing in rental property, 80% funded by borrowing over 40 years, would face an effective tax rate of only 7.9%. Economists have long argued that the part of interest that compensates you for inflation while your money is lent out is not economic income and should not be taxed.

What the Report is Not About 1.How we will provide retirement incomes in the next 20 years so if you are already retired or soon will be, it is not about you. 2.Relitigating the debate about National Savings. 21 Fair Tax for Savers Campaign Think about this example, you lend $10,000 to the bank for 5 years at an interest rate of 5.75% a year. Over 5 years inflation is 2% a year so when you get your $10,000 back it only buys what would have cost you $9,000 when you lent the money. So about $1,000 of the interest you will receive over 5 years is simply to compensate you the loss purchasing power of your original $10,000 invested. If you apply your marginal tax rate say 33%, you have paid about $389 too much tax over 5 years. If only the real part of interest is taxable then to be even handed only the real component of interest should be a tax deductible expense as well. At the moment we overtax interest income from compound interest products like KiwiSaver and term deposits, and tax subsidise, debt financed businesses and property investment

What the Report is Not About 1.How we will provide retirement incomes in the next 20 years so if you are already retired or soon will be, it is not about you. 2.Relitigating the debate about National Savings. 22 Policy on FSC RecommendationsACTConservativeGreen Internet Mana LabourMaoriNationalNZ First United Future NZ Keep NZ Super as it is currently, linked to average wages, with no asset or income tests Gradually step up contributions into KiwiSaver to around 9% of income X? Support day of automatic enrolment X Support day of automati c enrolmen t Support day of automatic enrolment Have KiwiSavers default into balanced or growth funds rather than conservative funds X??X Prepared to look at it ???? Possibly have capital guarantees paid for by the KiwiSaver to reduce the risk of a really bad investment performance either close to retirement or when funds are withdrawn to purchase a first home X??X Prepared to look at it ?? For KiwiFun d ? Fix the over taxation of KiwiSaver funds X??X Acknowledges the issue ?X ? 2014 Where do the Political Parties Stand on the FSC KiwiSaver and the Future of Retirement Income Policy Proposals?