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

What is the problem with KiwiSaver and Retirement Incomes Policy? 2 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. The Retirement Income Policy Issues

What is the problem with KiwiSaver and Retirement Incomes Policy? 3 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. The Retirement Income Policy Issues

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. 4

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? 5

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? 6 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

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

8 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)

9 For these examples it is assumed there is no debt (leverage) in the property investment and the duration of ownership is 25 years. In New Zealand the leverage level is typically much greater than zero percent which substantially reduces the effective tax rate as does owning the rental property for a shorter period of time than 25 years. Tax Wedge +ve Tax Wedge - ve New Zealand’s tax system has a strong bias in favour of investment in rental property and against other superannuation savings, the opposite of what happens in other similar countries Source: Mirrlees Inquiry Source: Henry Review Source: EY analysis for the FSC

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. 10 Tax rate 0%10.5%17.5%28%30%33% Owner-occupied home, debt-free0% General rental property (100% leverage) 0%(1.13%)(1.75%)(2.52%)(2.65%)(2.83%) General rental property (80% leverage) 0%0.38%0.68%1.20%1.31%1.47% General rental property (50% leverage) 0%4.27%7.01%10.99%11.73%12.83% General rental property (no leverage) 0%7.70%12.70%20.02%21.38%23.42% PIE / KiwiSaver with or without subsidies 0%14.27%23.78%38.05% Foreign shares0%13.13%21.88%35.00%37.50%41.25% Bank account term deposit0%15.60%26.10%41.70%44.70%49.20% New Zealand Effective Tax Rates on different types of investments* * For rental property it is assumed that the property is sold after 20 years and the return is half from the rental income and half from capital gains.

11 Years before rental property is sold Leverage ratio 0%50%80%100% 10 years22.68%10.22%(4.55%)(6.05%) 20 years23.42%12.83%1.47%(2.83%) 30 years24.13%14.79%5.20%(1.02%) 40 years24.80%16.37%7.90%0.37% 50 years25.45%17.71%10.02%1.55% The greater the leverage (level of debt) in the rental property and the shorter it is held, the lower is the effective tax rate 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.

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. 12

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. 13

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 14 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.

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 does investment style and tax matter? 15 Annual $ Marginal income tax rate KiwiSaver fund PIR tax rate* Effective KiwiSaver fund tax rate Mean $54, %17.5%47.8% Median $46, %10.5%41.0% Minimum Wage $28, %10.5%26.1% Decile 10$159, %28.0%55.6% Table 3: 2013 Incomes and Tax Rates Sources: SNZ, Infometrics estimate for mid-point of decile 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. Why does investment style and tax matter? 16 MeanMedian Minimum Wage Decile 10 $’000 Income level in Where does the money come from? KiwiSaver’s contributions over 40 years Government’s contributions ($1000 start-up + $521 pa annum indexed) 29 Total investment returns if no tax or fees paid KiwiSaver balance at age 65 if no tax or fees paid Where does the money go? Tax paid at current PIR rates on investment returns Loss of compounding investment returns from tax payments not able to be reinvested Combined tax loss effect Fees actually paid Loss of compounding investment returns from fee payments not able to be reinvested Combined fee loss effect Actual KiwiSaver balance available at age 65 after impact of tax and fees Current effective tax rates on investment returns47.8%41.0%26.1%56.6% Starting current PIR tax rates on KiwiSaver funds^17.5% 10.5%28.0% Marginal income tax rates30.0%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 then fees. ^ As KiwiSaver balances accumulate the associated returns typically tip someone into the next PIR tax bracket.

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 does investment style and tax matter? 17 Income for PIR bands Scenario A Conservative Scenario E Balanced Scenario E Growth Inflation rate 2.00% Gross real rate 6.42%7.80%8.60% Fee rate 1.10%1.05%1.15% Gross real after fees 5.26%6.68%7.37% Current PIR rateFSC Proposed PIR Rates KiwiSaver fund PIR Tax rates and income bands* Up to $48, %4.3% $48,0000 to $70, %8.0% Over $70, %15.0% Real after tax rates of return (Related PIR tax rate) 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 Table 1: Conservative to Balanced or Growth Portfolios - KiwiSaver Scenarios to Fund a Comfortable Retirement at Two Times New Zealand Superannuation

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. Contribution Rates 18 Table 1: 2013 Incomes and Annual, Weekly and Daily Contributions Cross-Sectional 2013 Longitudinal MeanMedian Minimum Wage Decile 10 Decile 2 $54,600$46,900$28,200$159,500 $30,000 Conservative portfolio, contribution rate: 13.1% $/year $7,153$6,144$3,694$20,895 $3,930 $/week $137$118$71$400 $75 $/day $27$24$14$80 $15 Balanced portfolio, contribution rate: 7.6% $/year $4,150$3,564$2,143$12,122 $2,280 $/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

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 does investment style and tax matter? 19 MeanMedian Minimum Wage Decile 10 $’000 Income level in Where does the money come from? Kiwisaver’s contributions over 40 years Government’s contribution ($1000 start-up) 1111 Total investment returns if no tax or fees paid KiwiSaver balance at age 65 if no tax or fees paid Where does the money go? Tax paid at proposed PIR rates on investment returns Loss of compounding investment returns from tax payments not able to be reinvested Combined tax loss effect Fees actually paid Loss of compounding investment returns from fee payments not able to be reinvested Combined fee loss effect Actual KiwiSaver balance available at age 65 after impact of tax and fees 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 funds8.0% 4.3%15.0% Current effective tax rate on investment returns47.8%41.0%26.1%56.6% Starting current PIR tax rates on KiwiSaver funds17.5% 10.5%28.0% Marginal income tax rates30.0%17.5% 33.0% Table 4: Decomposition of Scenario E* (Balanced portfolio 6.0% return for mean income, no MTC but $1000 up front remains, contribution rate 7.6%) * R elative effect sizes are not independent of the order in which they are calculated.

Why does investment style and tax matter? 20 MeanMedian Minimum Wage Decile 10 $’000 Income level in Where does the money come from? Kiwisaver’s contributions over 40 years Government’s contribution ($1000 start-up) 1111 Total investment returns if no tax or fees paid KiwiSaver balance at age 65 if no tax or fees paid Where does the money go? Tax paid at current PIR rates on investment returns Loss of compounding investment returns from tax payments not able to be reinvested Combined tax loss effect Fees actually paid Loss of compounding investment returns from fee payments not able to be reinvested Combined fee loss effect Actual KiwiSaver balance available at age 65 after impact of tax and fees Effective tax rate on investment returns with proposed PIR tax rates on KiwiSaver funds 30.4% 26.5%14.1%38.7% Proposed PIR tax rate on KiwiSaver funds8.0% 4.3%15.0% Current effective tax rates on investment returns47.8%41.0%26.1%56.6% Starting current PIR tax rates on KiwiSaver funds17.5% 10.5%28.0% Marginal income tax rates30.0%17.5% 33.0% Table 5: Decomposition of Scenario E* (Growth portfolio 6.6% return for mean income, no MTC but $1000 up front government contribution remains, contribution rate 6.1%) * R elative effect sizes are not independent of the order in which they are calculated.

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 does investment style and tax matter? 21 Scenario A Conservative Scenario E Balanced Difference from A Scenario E Growth Difference from A $’000 KiwiSaver’s contributions Tax paid Compounding tax loss effect Total tax effect Fees paid Compounding fees loss effect Total fees effect Table 6: Scenario Comparison for Mean Income

Why does investment style and tax matter? 22 Scenario A Conservative Scenario E Balanced Difference from A Scenario E Growth Difference from A $’000 KiwiSaver’s contributions Tax paid Compounding tax loss effect Total tax effect Fees paid Compounding fees loss effect Total fees effect Table 7: Scenario Comparison for Median Income

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 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 wage after tax). Any income or means testing of NZ Super increases the contributions required to fund a retirement income at 2 times NZ Super as does any reduction in the level of NZ Super by linking it to prices rather than wages. 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. 23 The FSC proposals including KiwiSaver default settings

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. 24 Possible Pathways to Retirement Prosperity NZ Super with KiwiSaver Plus Universal KiwiSaver (Compulsory for employees) 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). 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. Remove the tax bias against retirement savings by lowering the PIE marginal tax rates, funded by removing the KiwiSaver $521 annual tax credit to level the tax playing field with rental property investment. 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 retirement is reached at about 7%. 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.

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. 25 Possible Pathways to Retirement Prosperity NZ Super with KiwiSaver Plus Voluntary KiwiSaver Aim to assist those who want to achieve a comfortable retirement income at 2 times NZ Super. Regular days of automatic enrolment, say every 3 years from 2015 Phase out the tax bias against retirement savings as Governments achieve surpluses. 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. 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.

Would capital guarantees make a difference? 26 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) Total Contribution Rate (split with employer) % 9.124% 7.732% Employee Contribution Rate7.018%4.562%3.866%

27 Source: Horizon Research Savings and Retirement Survey October 2013

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 13% of their income to earn enough to fund a comfortable retirement at about 2 times NZ Super. 28

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. 29