Andrew Coleman says young Kiwis should be able to choose what they want from the pension scheme menu and the family should discuss whether there's a better way to split the bill

By Andrew Coleman*

Between 1975 and 1977, New Zealand scrapped the compulsory saving scheme that was introduced in August 1974 and adopted what is now the most unusual retirement income and tax policies in the OECD.

It is becoming increasingly obvious that this system has problems, particularly for people aged under 45. To mark the 50th anniversary of the compulsory saving scheme, this series of articles re-examines whether New Zealand’s retirement income policies could be modified or redesigned to better suit the 21 st century.

The focus of this and the last two articles is the economic costs of adopting a pay-as-you go pension scheme rather than a save-as-you-go scheme.

Making the transition: double pay or no pay?

An economy is called ‘dynamically efficient’ when the return to capital investments exceeds the growth rate of the economy, or “r > g”. Most modern industrial countries are dynamically efficient. When a country has a dynamically efficient economy, current and future generations of young people would be better off if they lived in a country with a pension scheme that was funded on a save-as-you-go basis rather than a pay-as-you-basis.

This is because the funds invested in a save-as-you-go pension scheme can be used to make high yielding investments, raising the returns from their contributions or allowing reductions in the taxes necessary to obtain any level of retirement incomes. In addition, the extra capital is likely to raise productivity and wages.

Many young New Zealanders may enjoy the vision of a highly paid, capital-rich economy with low taxes and high pensions. However, there is a catch. Once a country has adopted a pay-as-you-go pension scheme, it can’t be changed without making at least some people worse off than otherwise. This transition issue, identified by Peter Diamond and Edmund Phelps, is one of the key social and political obstacles confronting attempts to change retirement income systems.

In article 3, it was suggested that a save-as-you-go pension scheme can be likened to a bath-tub, with water flowing in from younger generations through a tax-tap, and flowing out to older generations through a pension plug-hole. The “water” in the tub is income generating capital investments. In contrast, a pay-as-you-go pension scheme is like a pipe, where nothing is accumulated. If a country wants to shift from a pay-as-you-go to a save-as-you-go pension system, it is necessary to fill the bath-tub during the transition and this either requires the inflow from the tax-tap to be turned up, or the outflow from the pension-plughole to be turned down, or both.

Once the bath-tub reaches its desired level, the flows can be changed so that each generation achieves its desired retirement income goals, whatever they may be. Until then, however, there need to be net inflows.

One strategy to build up the fund is to reduce outflows by immediately cutting pensions on current retirees. This is possible, but almost no countries have attempted to make the transition this way. Because most countries realise that it is difficult for many retired people to reduce their expenditures, any cuts are typically modest – or only imposed on wealthy or high income people through means tests.

Means-tests of one type or another were part of the New Zealand landscape between 1980 and 1997.

However, they have not been a feature of the New Zealand landscape since 1997, partly because they were considered unfair by many people. Means-tests lie at the heart of whether pensions are considered welfare or contributory based. In a means-tested welfare system, the people who have paid the most taxes on average receive the smallest pensions, sometimes nothing.

In a contributory scheme, the people who pay the most in social security taxes get the largest pensions because their taxes are treated as savings and there is widespread agreement that people who save more should keep most of their returns. New Zealand does not have a contributory government pension system, which perhaps explains why such a large fraction of the population thinks means-tests are a part of the solution to pension affordability.

When you frame a pension as a welfare-benefit rather than a return to saving, it becomes much easier to reduce the amount received by people who work past age 65, or people who are wealthy. Nonetheless, nationally representative surveys conducted in 2014 and 2022 indicated means-testing is very unpopular in New Zealand. Consequently, while means-test could be part of a transition scheme, politicians may find a less contentious option more appealing.

A second strategy to reduce the outflows is to gradually reduce future pension outflows. This could be done by gradually raising the age of eligibility, as many other countries have done, to 67 or 68 or even 70.

If done quickly, this could reduce the size of the outflows. Realistically, however, over the next few years it will only slow down the increase in the outflows because the population is living longer. Even if the age of eligibility is increased, it will still be necessary to keep taxes at current levels so that the difference can be used to increase the “bath-tub” fund.

An alternative approach requires increasing the amount going into the “bath-tub” fund by increasing taxes immediately, rather than waiting to increase them in the future. Since 2001 New Zealand has adopted this approach, but only on an “on-off” basis. When the New Zealand Superannuation Fund was set up in 2001, the government ran a budget surplus and some of the balance was added to the fund.

These contributions were stopped in 2009, and restarted in 2017. The Fund had accumulated more than $60 billion worth of assets by 2023. This is a good start, but it is only a start. Nonetheless, if New Zealanders start paying more taxes now and continue this over the next 20 or 30 years, and placed them in the Superannuation Fund, it would help make the transition and reduce how much taxes will have to be paid in the future.

There are various ways that taxes could be increased now, and placed in the New Zealand Superannuation Fund. One way would be to increase income taxes across the board. An alternative is to introduce a new social security tax on labour incomes, with the proceeds placed in the Fund. A different option would be to introduce a special retirement income tax on older people, say on those between age 50 and age 65, similar to the surcharge that exists in Switzerland.

People in this age group typically find it easier to save than younger people who have lower incomes and who often have children at home. A fourth option would be to introduce a tax on residential land. This should be an attractive option for many young people, for it is likely to reduce property prices while producing revenue that could prevent much steeper increases in taxes than are currently scheduled. It would reduce the distortionary nature of some of the taxes we currently use. The Stanford economist Antonio Rangel has looked at this option in detail.

Of course, young New Zealanders may wish to opt for a very different retirement system for themselves than the scheme adopted by older New Zealanders. This may require a very different transitional arrangement. Suppose young people wanted a contributory government pension scheme, or a compulsory saving scheme (one possibility is discussed later in this series).

They would need to contribute to their own saving accounts to provide their own future pensions while simultaneously needing to help pay for the pensions paid by older people. This is the infamous “double pay” problem – that if pensions aren’t cut, any transition from a pay-as-you-go to a save-as-you-go scheme requires the transition generation to pay the previous generation’s pensions and save for their own. Who wants to do that if they can go to Australia?

Yet this problem is not insurmountable. If people under 45 were making greater contributions to their own accounts, the country could decide to reduce the income taxes they pay but increase taxes on people over 45 to make up the difference. This would split the bill and allow New Zealanders to make the transition to a much more efficient and ultimately less costly save-as-you-go pension scheme.

It is sometimes said that a society should not bother to raise current taxes to make investments that reduce future taxes when there are urgent current expenditure needs such as education or healthcare. During an emergency such as a war or a huge natural disaster, this argument has some merit. But during ordinary times, it really conflates two distinct arguments.

The first is whether current taxes are sufficiently large to pay for ordinary government expenses.

The second is whether different generations should be expected to pay a disproportionately large share of the costs of programmes such as education or retirement income that have expenditures that occur at different stages of a person’s life than when they pay most of their taxes. Historically, most people in most countries have provided resources to future generations by funding expenditures such as education, technological investment or infrastructure.

However, in the last 50 years the flow of transfers has been steadily reversed in most OECD countries and now, with the exception of technological developments, increasingly involves a transfer from future generations to current generations.

Whether a society ultimately chooses to give to future generations or take from future generations is a matter of preferences and maybe ethics. Personally, I suspect that if older generations wish to take from future generations by dumping a disproportional share of the costs of current expenditure programmes upon them, it would at least be polite to ask for permission and maybe to say “thank you”.

The transition to a save-as-you-go system sounds difficult. Yet, if the transition to a more efficient system is not made, and pension entitlements are not cut, taxes will have to be increased on young people and future generations. If New Zealand doesn’t do something sooner, it will have to do something bigger at a later date.

If these discussions are not held now, and current pension entitlements maintained, young people will face higher and higher taxes. Young people might choose to pay higher taxes in the future – or they could choose to reduce the pensions older people receive, or leave to countries where the balance between taxes paid and benefits received is more favourable. None of these options sounds particularly appealing.

As always, political leadership will be needed to navigate this process. The best way to start is to acknowledge that different generations are being asked to pay very different amounts for the pensions they have received or will receive, and that change is possible. Of course, change does not have to occur simply because it is possible. But there is no reason why change cannot occur either, particularly if young people want a scheme that is better aligned to the way they want to live and older people don’t want their children to pay much higher taxes than they faced for a similar level of benefits.

It might be helpful to finish with an analogy. At the moment it is as if young Kiwis are being taken out to dinner by their parents, told what to eat, and left to pay for most of the meals. Perhaps it is time for change. Young Kiwis should get to choose what they want from the menu and the family should discuss whether there is a better way to split the bill. The answers to such a conversation may surprise us all.

*This series and an accompanying paper are based on work I started in 2020 with Jeanne-Marie Bonnet while we were both at the University of Otago. I am very grateful for her assistance and insights. All errors remain my own.

(This article is part 5 in the series. Part 1 is here, part 2 is here, part 3 is here, and part 4 is here).

**Andrew Coleman is a visiting professor at the Asia School of Business. This article is his personal view of retirement policy in New Zealand, based on academic study.

Coleman is on extended leave from the Reserve Bank of New Zealand, while working overseas. The views expressed in this article do not represent the RBNZ and are unrelated to work conducted at the Bank, which has no responsibility for retirement policy in New Zealand.