New Zealand’s national pension savings scheme has been applauded for its success in enrolling two-thirds of employees, but will the government’s tax plans lead to its demise? Originally published in Pensions Management, 24 March, 2011.
The Kiwisaver scheme has beaten all expectations in its first three years, but it is far from perfect as a default structure. It suffers serious regulatory issues. The common political exercise of running odd ideas up metaphorical flagpoles has brought experts to warn that too much tinkering in the future could prompt the implosion of the New Zealand financial sector, let alone the Kiwisaver.
In the first week of February, the government-appointed Savings Working Group (SWG) recommended the creation of a single, low-cost default Kiwisaver scheme. It fell short of calling for compulsory membership of the scheme, but did recommend soft compulsion. The response from New Zealand’s finance minister, Bill English, was that he’d rule nothing out on re-examining the scheme’s structure, including reassessing the tax benefits.
While the SWG did follow the growing calls for better regulation, there remains a lack of detail, even though yet another policy document had been issued in November.
Nearly two million Kiwisaver members
However, the current version of the Kiwisaver has been a massive success. Nearly 1.6 million employees (according to November 2010 figures) are members, out of a total employment base of 2.5 million. For most of last year it was growing at 1,000 new members a month. This is despite having only the limited investment choice of conservative, balanced or growth products. No emerging bond market funds or Brazil, Russia, India and China (BRIC) indices here.
“Kiwisaver was designed with the lowest common denominator in mind. It’s a fantastic initiative; the tax breaks in place and one-off payment means you’re making money right away,” says Christopher Douglas, co-head of fund research at Morningstar Australasia.
Providers agree. “The Kiwisaver is relatively new and the member base very different to other products. People are learning the basics of financial literacy – what’s risk and return and very often saving for the first time,” outlines Carmel Fisher, founder of Fisher Funds. “Until financial literacy improves, its basic structure is not a bad thing, preventing it blowing up in their faces.”
“Best-of-breed global fund managers would have distribution problems if they came here.”
“We’re not sure a greater selection of funds is that important – most members struggle to decide whether they want conservative, balanced or growth, let alone specific funds,” offers Andrew Gawith, a director at Gareth Morgan Investments.
According to Douglas: “Best-of-breed global fund managers would have distribution problems if they came here.”
But there are drawbacks too. “The reality is it hasn’t been as well implemented as it could have been, being subject to politics and changes on things like tax deductions and exemptions on investments. Governments have tinkered with such ideas since 1975 and that’s why its credibility is low – they keep changing the system,” points out Jonathan Eriksen, a consultant and actuary at Eriksens Global.
Exploting classic behavioural finance – apathy
But he praises it in one fundamental way:”Kiwisaver has been evolving, but it’s a brilliant product in terms of New Zealand society’s behavioural finance.” In this he recognises financial literacy is low and there is a natural suspicion of government schemes, but low contribution levels and auto-enrolment of employees in default conservative plans – banking on apathy to limit opt-outs – have proven to be a coup de grace.
According to Erikson the results are impressive. Based on the current average salary of employees in their 20s, who continue to contribute at the basic levels even into a default conservative fund, most should see a final lump sum of NZ$1m. “More critical is that 60% of the 18-24-year-old age group are in Kiwisaver – fantastic,” he says.
The current system works by any new employee being automatically enrolled in one of six default conservative investment schemes. They can choose their own from more than 50 providers and the tax man takes 2% of their salary, which is matched by their employer and they receive a tax credit of NZ$1,000 a year. This excludes a one-off joining grant of NZ$1,000 from the government. These elements have been tinkered with since inception, but fees are kept low.
Light touch regulatory system a concern
Yet worries abound. Advocacy groups are pointing out New Zealand’s ‘light touch’ regulatory system is too light, while others say the investment selections are ‘primitive’.
On the industry side, low costs have meant a long-term investment view, and tinkering with incentives could be catastrophic should contribution rates fall or stop.
“Everyone is alarmed at the talk of doing away with tax credits,” says David Ireland, chairman of Workplace Savings NZ, a pensions industry body. “The scheme is still in its infancy and pulling tax credits from those people who have already joined and are locked in provides the government with moral hazard,” .
“The scheme works well but these rule changes, for example reporting, have already increased costs to the providers, and added confusion,” says Fisher, “and we’re concerned there will be more changes in the future.”
She says that even though her company went with a low cost solution for administration, it has already cost over NZ$500,000.
“Systems and legal disclosures have not been allowed to stand still and government can’t resist fiddling with it.”
From sign-up to poaching
Many providers got into the scheme with an eye to the future and accessing other retail investment markets, while planning to scale up over time with Kiwisaver. Massive marketing spend went into getting people to sign with various providers and now the trend is to poaching those already with other schemes.
According to Eriksen, most schemes have planned a 10-year time horizon to recoup costs and the current levels of contributions, and with the ability for investors to move cost-free between schemes every three months, it puts pressure on smaller providers. It also limits investment vehicle choice requiring high levels of liquidity.
If the government took the tax break away or made it compulsory, it could effectively kill the scheme.
Implosion risk to NZ financial sector
“There’s a very large risk if government changes the rules on Kiwisaver; the whole financial sector in New Zealand would implode,” says Eriksen. This is because schemes have gambled that accounts would continue to receive annual inputs as low as a NZ$3,000 a year for them to start making any money. Proposed changes to government tax-free sums would jeopardise those in schemes continuing to contribute annually and, he believes, could cause a collapse of smaller investment houses.
He points out that while those in the Reserve Bank are well aware of these risks, it’s a fine line in shouting “danger”, panicking the industry and upsetting political masters and judiciously advising government.
But while providers are lobbying frantically to limit change, some is inevitable. Christopher Douglas says from an investor’s perspective there are huge issues over reporting and administration. He should know. Morningstar was heavily criticised by Gareth Morgan Investments over its weekly return tables, especially following the high profile scandal of Huljich Wealth Management, which boosted its returns by the manager pumping his own cash into a failing fund.
“We accept there were problems, but we’ve now got to grips with the anomalies of Kiwisaver reporting because providers were hiding how they quoted their returns,” explains Douglas. It still goes on in the market, with providers not making it clear whether returns include or not things like fees, tax and expenses. “There remains a huge variation in how they charge fees, and no fund offers a total expense ratio,” he says.
Issues on permance reporting
Ireland says there’s an inevitability of changes to performance reporting, and the industry has done itself no favours in procrastinating over the issue. The November position paper had again called for common standards but fell short of Gawith’s demands to use the global investment performance standard. “The government should be ensuring a greater transparency of what providers are up to,” he demands.
The reality is the underlying structure of the Kiwisaver is something of a mess. The government happily picks up tax revenue for capital increases on all investments, though some income streams are tax-free. To add further complexity, many of the funds in various schemes are structured under what is known as a PIE (portfolio investment entity), which gives tax relief to the scheme – but this only applies to Australian and New Zealand equities. Then the tax applied depends on the individual’s own rate.
Of more concern to outsiders is the fact that while most funds do have independent custodians and administrators, it is not a legal requirement. “The reality is that very few small operators have the capacity to act as custodians, and turnkey fund administration solutions are very popular and are often done internally,” explains Eriksen.
“The government is planning legislation to force providers to have genuinely independent trustee services and the key responsibility of the independent trustee is the security of members’ funds,” says Gawith. This is critical since, as Ireland points out, the majority of investors believe the Kiwisaver scheme is government guaranteed: simply not the case.
Worst of all, according to Douglas, is the regulators have only just realised there is no requirement for a licence to launch a scheme, the only oversight being on the fund structure and investment managers.
How November’s regulatory impact statement by the Ministry of Economic Development will be implemented, as well as future government tax plans, will be critical to Kiwisaver’s eventual success.