retirement policy research centre forum retirement income policy: the future is now the case for...

Retirement Policy Research Centre ForumRetirement 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 3.10pm17 April 2014

Case Room 2, Level 0University of Auckland Business School

Grafton RoadAuckland

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




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 2

2 20 30 32 45 70Age

Why the tax on KiwiSaver fund earnings matters

7

Source: Savings Working Group Final Report 9

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 investmentsThe 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.

UK Super UK Rental Property

Australian Super

Australian Rental

Property

NZ KiwiSaver NZ Rental Property

-60

-40

-20

0

20

40

60

Tax

(-) /

Sub

sidy

(+)

Tax

Wed

ge +

ve

Tax

Wed

ge +

ve

Tax

Wed

ge -v

e

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




10

Tax rate

0% 10.5% 17.5% 28% 30% 33%

Owner-occupied home, debt-free 0% 0% 0% 0% 0% 0%

General rental property (100% leverage)

0% (1.13%) (1.75%) (2.52%) (2.65%) (2.83%)


0% 0.38% 0.68% 1.20% 1.31% 1.47%


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% 38.05% 38.05%

Foreign shares 0% 13.13% 21.88% 35.00% 37.50% 41.25%

Bank account term deposit 0% 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 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%

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.




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 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 interestThe 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




Why Saving a Little for a Long Time in KiwiSaver Does Not Work In New Zealand

14

Years of savingAnnual savings required

Impact of tax on cumulative returnNo tax With Tax

10 $37,481 $40,479 44.3%

20 $15,112 $17,918 47.7%

30 $8,024 $10,529 51.2%

40 $4,736 $6,930 54.7%

50 $2,948 $4,845 58.2%

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.




Why does investment style and tax matter?

15

Annual $ Marginal income tax rate

KiwiSaver fund PIR tax

rate*

Effective KiwiSaver fund

tax rate

Mean $54,600 30.0% 17.5% 47.8%

Median $46,900 17.5% 10.5% 41.0%

Minimum Wage $28,200 17.5% 10.5% 26.1%

Decile 10 $159,500 33.0% 28.0% 55.6%

Table 3: 2013 Incomes and Tax Rates

Sources: SNZ, Infometrics estimate for mid-point of decile 10.





16

Mean Median Minimum

Wage

Decile10

$’000 $’000 $’000 $’000 Income level in 2013 54.6 46.9 28.2 159.5 Where does the money come from? KiwiSaver’s contributions over 40 years 390 335 201 1138Government’s contributions ($1000 start-up + $521 pa annum indexed) 29 29 29 29Total investment returns if no tax or fees paid 1245 1083 689 3457KiwiSaver balance at age 65 if no tax or fees paid 1664 1447 919 4624 Where does the money go? Tax paid at current PIR rates on investment returns 232 208 88 928Loss of compounding investment returns from tax payments not able to be reinvested 362 235 92 1027Combined tax loss effect 595 444 180 1955 Fees actually paid 153 134 93 382Loss of compounding investment returns from fee payments not able to be reinvested 5 61 63 65Combined 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 then fees.^ As KiwiSaver balances accumulate the associated returns typically tip someone into the next PIR tax bracket.





17

Income for PIR bands

Scenario AConservative

Scenario EBalanced

Scenario EGrowth

Inflation rate 2.00% 2.00% 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 rate FSC Proposed PIR Rates

KiwiSaver fund PIR Tax rates and income bands*

Up to $48,000 10.5% 4.3% 4.3%

$48,0000 to $70,000

17.5% 8.0% 8.0%

Over $70,000 28.0% 15.0% 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 http://www.ird.govt.nz/toii/pir/workout/

Table 1: Conservative to Balanced or Growth Portfolios - KiwiSaver Scenarios to Fund a Comfortable Retirement

at Two Times New Zealand Superannuation

http://www.ird.govt.nz/toii/pir/workout/




Contribution Rates

18

Table 1: 2013 Incomes and Annual, Weekly and Daily Contributions Cross-Sectional 2013 Longitudinal

Mean Median 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





19

Mean Median Minimum

Wage

Decile10

$’000 $’000 $’000 $’000 Income level in 2013 54.6 46.9 28.2 159.5 Where does the money come from? Kiwisaver’s contributions over 40 years 226 194 117 660Government’s contribution ($1000 start-up) 1 1 1 1Total investment returns if no tax or fees paid 1051 905 551 3035KiwiSaver balance at age 65 if no tax or fees paid 1278 1100 669 3696 Where does the money go? Tax paid at proposed PIR rates on investment returns 96 85 30 479Loss of compounding investment returns from tax payments not able to be reinvested 211 139 44 648Combined tax loss effect 307 224 74 1127 Fees actually paid 110 96 62 291Loss of compounding investment returns from fee payments not able to be reinvested 80 98 73 233Combined 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%

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%)

* Relative effect sizes are not independent of the order in which they are calculated.


20

Mean Median Minimum

Wage

Decile10

$’000 $’000 $’000 $’000 Income level in 2013 54.6 46.9 28.2 159.5 Where does the money come from? Kiwisaver’s contributions over 40 years 181 156 94 530Government’s contribution ($1000 start-up) 1 1 1 1Total investment returns if no tax or fees paid 1082 933 570 3114KiwiSaver balance at age 65 if no tax or fees paid 1264 1089 665 3645 Where does the money go? Tax paid at current PIR rates on investment returns 96 85 30 470Loss of compounding investment returns from tax payments not able to be reinvested 233 163 50 735Combined tax loss effect 329 247 80 1205 Fees actually paid 108 94 62 283Loss of compounding investment returns from fee payments not able to be reinvested 96 112 86 269Combined fee loss effect 205 206 147 552 Actual KiwiSaver balance available at age 65 after impact of tax and fees 730 636 437 1888 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 funds 8.0% 8.0% 4.3% 15.0% 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 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%)

* Relative effect sizes are not independent of the order in which they are calculated.





21

Scenario A

Conservative

Scenario E

Balanced

Difference from A

Scenario E

Growth

Difference

from A

$’000 $’000 $’000 $’000 $’000 KiwiSaver’s contributions 390 226 -164 181 -208 Tax paid 232 96 -136 96 -136Compounding tax loss effect 362 211 -152 233 -129

Total tax effect 595 307 -288 329 -265 Fees paid 153 110 -43 108 -45Compounding fees loss effect 5 80 76 96 91

Total fees effect 158 191 32 205 46

Table 6: Scenario Comparison for Mean Income


22

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

Table 7: Scenario Comparison for Median Income




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




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.




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.

12.6

7.6

6.1

Guarantee on the capital value of your KiwiSaver Account over the three years until you purchase your first home.

0.1 0.2

Top up insurance contribution rate to achieve a guarantee of 2 times NZ Super after 30 years or more contributions.

0.31

0.31

0.31

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).

0.125

0.114

0.122

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).

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%

27

18 to 24 years

25 to 34 years

35 to 44 years

45 to 54 years

55 to 64 years

65 to 74 years

75+ years0%

5%

10%

15%

20%

25%

2.3%

20.2%

18.6%

7.1%

2.6%1.7%

0.2%

Age to purchase first home

Source: Horizon Research Savings and Retirement Survey October 2013




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




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

retirement policy research centre forum retirement income policy: the future is now the case for...

Documents