The economics of PAYGO and SAYGO retirement schemes in NZ

The economics of PAYGO and SAYGOretirement schemes in New ZealandAndrew ColemanUniversity of Otago andMotu Economic and Public Policy ResearchMarch 2012

Peter Diamond(MIT, Nobel prize 2010)1. If r < g, it is efficient toimmediately adopt a PAYGOsystem as there is too much capital2. Empirically r>g, and in long runSAYGO is more efficient thanPAYGO because compoundingreturns mean you can have lowercontributions for same pension3. If you start with PAYGO, thetransition is difficult as onegeneration has to double pay.

More recent research4. The transition is not asdifficult as once thought5. Risk considerations meanthat a mixed PAYGO-SAYGO system is best.6. But how much SAYGO,and what form?

Martin Feldstein(Harvard University, CEA under Reagan)•1984: The transition is toohard to manage

Martin Feldstein2005 AEA Presidential address“I now know I was wrong”When returns are high, thetransition can be managedusing private accounts.

Basic issues(1) PAYGO (2) SAYGOProductivitygrowthPopulationgrowthAssetsaccumulatedProvides capitalreturns(3)Important issues(i)Divergent capitalpaths(ii) Labeling(iii)Intergenerationalcosts

Basic issues(1) PAYGOProductivitygrowthPopulationgrowth

Basic issues(1) PAYGO (2) SAYGOAssetsaccumulatedProvidescapital returns

Basic issues(1) PAYGO (2) SAYGO(3)Important issues(i)Divergent capitalpaths(ii) Labeling(iii)Intergenerationalcosts

(i) Divergent capital pathsWhen a PAYGO scheme starts (US, 1938),– Retired people get more resources and increase consumption– Working age people pay taxes, and because they arepromised a future pension they accumulate less capital butmaintain consumption– Total consumption increases– Capital accumulation reduces, reducing future size of theeconomy

ConsumptionSAYGOSAYGOCapitaltimetime

(ii) LabellingThe same result occurs if– Government adopts a PAYGO system• old people get resources now,• working age pay taxes now, get pension later– Government borrows from working age people to give apension to the old, and repays them with interest whenretired• Capital accumulation falls as government crowds out private sectorasset accumulation– Different labels but same result…..the distinction with aSAYGO system is that no capital is accumulated.

(iii) Intergenerational costs.When r>g, a PAYGO scheme imposes costs on allsubsequent generations as their taxes could haveearned more invested in capital.– The consumption gain to the initial generation is offset byconsumption losses to all subsequent generations.The sum of these costs, discounted at the return to capitalequals the initial transferA near meaningless result, as it is true whether r = 5% orr = 15%.

(iii) Intergenerational costs.The main issue is that adopting a PAYGO imposes costson some generations to transfer to others.The costs on subsequent generations is higher the higheris the gap between r and gWhen the population growth rate slows, later generationshave higher costs than earlier ones.Increasing the SAYGO component imposes costs on thetransition generation to lower subsequent costs.

The Main ArgumentThe cost of the current scheme will rise, imposinglarger costs on future generationsReducing the size of the PAYGO scheme andincreasing the SAYGO component will partially shiftthese costs from the future to the presentThe transition can be managed to increase capitalaccumulationSeveral different SAYGO options can be considered

So….what are the numbers like for NZ?

tax ratesTransition PathsProjected pension expenditure due to demographic change12%8%4%PAYGO regime0%2011 2021 2031 2041 2051 2061

PAYGOPublic flatrateXPublicearningsrelatedMandatoryprivateVoluntaryprivateSAYGOXX XX

Relative efficiencyLong term relative efficiency ofSAYGO and PAYGO• Mimic economy and population in 2050• Real return = 4%• Productivity growth = 1.5%, wage = $90000• 45 year working life, 19 year pension

Relative efficiencyResults r = 4%T N R g W g R S t TotalassetsSAYGOtax ratePAYGOtax rateSAYGO/PAYGO1 45 19 4.0% 1.5% 1.5% $419,310 $557b 3.2% 7.2% 44%2 45 19 4.0% 1.5% 0.0% $366,437 $475b 2.8% 6.2% 45%3 47 17 4.0% 1.5% 1.5% $383,732 $457b 2.9% 6.2% 47%4 47 17 4.0% 1.5% 0.0% $339,422 $396b 2.4% 5.4% 44%

Relative efficiency• SAYGO requires approximately half thecontributions as PAYGO• A very large quantity of assets (nearly 2xGDP)is required to make full transition

Transition PathsFinding Transition Paths• Find paths that end at long rate SAYGO rateafter N years.• Over the transition period, the fund mustaccumulate the required level of assets.• Infinite variety of paths: look for ones withsmooth transition.

Transition Pathstax ratesSAYGO transitions - 1Transition tax rates50 year transition to full SAYGO regime12%SAYGO regimesincrease 2012 taxes by 2.2% GDP8%4%PAYGO tax path0%0 5 10 15 20 25 30 35 40 45yearsSAYGO regime ends at3.2 % GDP

Transition Pathstax ratesSAYGO transitions - 3Transition tax rates60 year transition to 0.72 SAYGO regime12%SAYGO regimeincrease 2012 taxes by 2.8%GDP8%4%PAYGO regime0%0 5 10 15 20 25 30 35 40 45 50 55yearsSAYGO regime ends at4.3 % GDP

Transition Pathstax ratesSAYGO transitions - 4Transition tax rates60 year transition to 0.50 SAYGO regime12%SAYGO regimeincrease 2012 taxes by 2.2% GDP8%4%PAYGO regime0%0 5 10 15 20 25 30 35 40 45 50 55yearsSAYGO regime ends at5.2 % GDP

A partial transition can be obtained keeping taxesbelow long term PAYGO rate, and reductionspossible sooner.

Double PayDouble Pay• To make the transition, some cohorts will needto pay more.• Is this fair?• We can calculate how much each cohort haspaid, and how much each cohort can expect toreceive

Double Pay• I look at a cohort turning 60 in 1981 or 2011 or2041 etc• I calculate the number of person years thecohort lives from 20 – pension age, and afterthe number after pension age• The ratio provides an estimate of the number ofyears someone is supported for each year theyare “working age”

Double PayDependency ratioI then calculate in each year the ratio of the number ofpeople receiving a benefit to the number of peopleaged 20 – 65This is the number of people you provide support to in aparticular yearWhen averaged over 45 years, this is the average numberof people you support each year you are working age

Double PayTable 3 Cohort eligibility ratios and average dependency ratios by birth cohortYearturning 60Years

Double PayDependency ratioI then calculate in each year the ratio of the number ofpeople receiving a benefit to the number of peopleaged 20 – 65This is the number of people you provide support to in aparticular yearWhen averaged over 45 years, this is the average numberof people you support each year you are working age

Double PayTable 3 Cohort eligibility ratios and average dependency ratios by birth cohortYearturning 60Years

Double PayAverage Dependency ratio and Cohort Eligibility ratio,cohorts turning 60 1975 - 204560%50%40%Cohort eligibilityFraction of life spent overage of eligibility for cohortturning 60 in year30%20%10%Average Dependency ratioaverage dependency ratioin preceeding 40 years1976 1981 1986 1991 1996 2001 2006 2011 2016 2021 2026 2031 2036 2041 2046

Double PayFor all cohorts turning 60 between 1980 – 2031, peopleget a pension for at least 80% more person years thanthey provided a pension to others.The cohort turning 60 in 2046, still gets a pension for atleast 50% more person years than they provided apension to others.

Double PayThis is somewhat crude.• We need to take into account the size of thepension• Taxes are paid for all of your life, not just whenyou are 20 - 65

Double PayAverage pension tax contributions and receipts by cohort25.0%Receipts adjusted for size of cohort20.0%15.0%10.0%5.0%Payments adjusted for post-retirement tax contributions0.0%1976 1981 1986 1991 1996 2001 2006 2011 2016 2021 2026 2031 2036 2041 2046Cohort turning 60 in particular year

Double PayBottom lineAlmost all cohorts can expect to get twice asmuch in pension benefits as they paid in taxesto provide benefits to others.

Will savings rise during thetransition?Suppose the government increases taxes now to prefundNZ Superannuation/ operate private accounts system.Will this raise capital accumulation?It won’t if the private sector reduces its other savingIt probably will if the contribution increase comes byrestraining consumption increases as income risesThis worked in Australia

SAYGO optionsPAYGOPublic flatrateXPublicearningsrelatedMandatoryprivateVoluntaryprivateSAYGOX X X X

Private accounts are only one optionPrivate accounts link benefits to contributions and reducethe disincentives of high marginal taxes.They can be arranged so that most people are better off(Feldstein &Samwick, Feldstein & Liebman)FSC proposal provides a plan to run down savings inretirement

If we cut PAYGO, we use voluntarySAYGOSuppose the government raised the age of eligibility.This reduces the size of the PAYGO componentIf households save more, this is an unstructuredSAYGO response.This is perfectly coherent…..and there are costs to tellpeople when and how to save.

If we cut PAYGO, we use voluntarySAYGOThis is the option favoured by people to the right ofFeldstein in many countries.But most countries prefer structured saving arrangementsNZ already has smallest structured retirement savingarrangements in OECD….do we want to shrink itfurther?

AustraliaAustralia• Since 1992, Australia has adopted a mixedSAYGO-PAYGO system• Means tested Government pension ($A19500currently) at age 65 (rising to 67)• Mandatory individual account with 9%contributions (rising to 12%)

AustraliaAustralia – NZretirement income for median personAustraliaNew Zealand2035 $A41000 $NZ225002055 $A60800 $NZ33100

Australia• Australians currently pay more in and get muchmore out.• However, the amount they pay in will rise bylittle between now and 2050• In NZ, the amount we pay in will nearly doublebetween now and 2050

Australia• By 2050, Australians will pay in 9.7% of GDPversus 7.4% of GDP in NZ• They will get a pension out that is 52% of percapita GDP versus 34% of per capita GDP

Saving HabitsSpending Halfbits

Conclusions1. SAYGO is more efficient2. Transition to a partial scheme is feasible3. Making current cohorts pay more is fair4. If we don’t change, we will have much less efficientscheme than Australia

Waiting for Highlanders to bridge the gap