The 12 th Australian Colloquium of Superannuation Researchers: Shortchanged? Pension Fund Governance and Retirement Provision, S St John

Tags: retirement, New Zealand, New Zealand Superannuation, retirement saving, equity release, home equity, tax, intergenerational equity, superannuation, Periodic Report Group, living standards, inflation, asset test, retirement income, Government Superannuation Fund, risks, GSF, retirement incomes, state sector, defined contribution, private pensions, Global Retirement Trust, marginal tax rate, exempt assets, baby-boom generation, imminent retirement, residential care, risk, annuity payments, Auckland New Zealand, St John, The Government, withholding tax, employer contributions, middle income, superannuation schemes, private sector employers, ASB Group Investments Limited, private sector, Life Office, annuity products, retirement security, fund earnings, David Cunliffe, Susan St John, Aon Consulting New Zealand Ltd, income protection
Content: The 12th Australian Colloquium of Superannuation Researchers: Shortchanged? Pension Fund Governance and Retirement Provision UNSW Sydney 12-13th July 2004 Planning for the drawdown phase of retirement saving in New Zealand1 Susan St John Abstract The decumulation or drawdown phase has been largely ignored in the discussion on retirement saving in New Zealand to date. With the imminent retirement of the large baby-boom cohorts from 2010, just 6 years away immediate attention to this issue is warranted. This is not just an issue for the baby-boom cohorts themselves but also for the working age population. Fundamentally it is a question of who should pay, not only for pensions, but also health and long-term care costs. Debates over the intergenerational equity of the current arrangements have already begun and can be expected to intensify. In the meantime, there are few indications of long-term policy development with the New Zealand Superannuation Amendment Bill signalling the demise of the 6-yearly Periodic Report Group reviews of retirement income policy. This paper examines whether the products that are emerging in the policy vacuum in New Zealand have potential to address the critical pressures and intergenerational concerns surrounding the ageing of the baby-boom generation. Susan St John PhD Senior Lecturer Economics Department Auckland University Private Bag 92019 Auckland New Zealand fax 09 373 7427 ph 09 3737599 ext 87432 [email protected] 1 Draft paper represents work in progress. Comments welcome. 1
1 Introduction Converting assets to income in an orderly fashion will become an increasingly important issue for the ageing populations and economies of many nations. Conventional annuities have many weaknesses, not least a diminishing supply of long bonds from governments. However, without a sharing of longevity risk the task of achieving a satisfactory income in old age will become impossible for many. Furthermore, it is likely that such sharing will have to become intra rather than intergenerational (as it is now) if it is to be workable in the future. (Wadsworth, Findlater, & Boardman, 2001) The decumulation or drawdown phase has been relatively ignored in discussion on retirement saving in New Zealand to date. It is interesting to ask why, given the importance of the issue for so many people when they face a period in retirement that nowadays may be as long as the time they spent working and saving. It is also of increasing importance as the retirement of the large baby-boom cohorts begins in 2010, just 6 years away. Middle income baby-boomers can expect to live on average significantly longer than their parents and during this time must eke out their modest savings to augment New Zealand Superannuation in a risky environment. 2 This is not just an issue for the baby-boom cohorts themselves but also for the working age population. Debates over the intergenerational equity of the current arrangements have already begun and can be expected to intensify.3 In light of the inevitable pressures over what should be funded from taxation and what should be expected to be funded by the old themselves, intragenerational sharing of risk is likely to become an important focus (Chen, 1994, 2003a). Insurance products of various kinds can provide this sharing of the risks among the retired as a group, alleviating the immediate pressure on the working age population and ensuring that policies do not simply subsidise inheritances unfairly. To date, New Zealand has had few mechanisms for the annuitisation of accumulated capital or for the release of home equity. This serious gap is beginning to be addressed, but only by the private sector and only in the form of new home equity 2 For full discussion of these issues see St John (2003c). 3 For example, the inequity of student loans for the young and universal pensions for the old was raised recently A thirty year-old commented that getting the pension at age 65 for the likes of high paid executives was `like working and getting the dole'(The Sunday Star Times March 14: 2004). 2
release products. The theoretical and practical problems of fully private and unsubsidised products makes this move unlikely to be more than a palliative for the maladies of the middle income baby-boom retirement. 2 The context of retirement incomes policies in New Zealand Periodic Report Group 2003 The Retirement Income Act 1993 requires government to appoint a Periodic Report Group (PRG) to conduct a six-yearly review of retirement incomes policies. The Act arose out of `The Accord', signed by the major political parties in 1993 and which itself is appended to the Act. The most recent PRG review took place in 2003 and the report was released in December (Periodic Report Group, 2003). Very little funding had been available to the PRG for consultation and for raising long-term broad issues in the public arena and the report had received almost no public comment. The report largely concentrates on the need to improve workplace superannuation while discussing sustainability issues only in broad terms. It could hardly be said to be the wideranging independent assessment of retirement incomes policies envisaged by the Retirement Income Act 1993, and provided by the previous two reports (Periodic Report Group, 1997a, 1997b; Report of The Taskforce on Private Provision for Retirement, 1992). While the 2003 PRG accepted their rather restrictive terms of reference and concentrated on private provision, their report nevertheless, cautions that there is "no room for complacency about the current system's ability to provide for future cohorts" (p8). After a cursory mention of the age, rates and targeting issues of New Zealand Superannuation the reports states: "All these options will require an informed public debate and support before the government considers changing New Zealand Superannuation entitlements in the future" (p43). Given that the next Periodic Report Group was not to be until 2009, the eve of the baby boom retirement, it might have been expected that 2003 was the time to have the `informed debate'. As discussed below, the government is currently seeking to abandon such reports altogether. 3
In concentrating on the accumulation phase, the 2003 PRG identifies risks for younger cohorts of middle-income New Zealanders as those that could potentially lead to lower levels of private provision and lower standards of living in retirement. These risks were: the impact of increasing financial liabilities on private provision for retirement the impact of student loans and home ownership on private provision for retirement the impact of labour force participation by those aged 65 plus on net worth, retirement income and decisions to retire. p 96 The decumulation phase of retirement saving received only cursory attention. In a brief section entitled "The problems of post retirement and the role of annuities" it was acknowledged that: Debate about private provision in New Zealand is focused on asset accumulation; there has been little focus to date on converting assets to income. Converting assets to income will become increasingly important in New Zealand as the population ages. (p 89) It might be asked whether there ever will be a suitable time for this issue to be discussed. The focus on the accumulation phase while a worthy and necessary one in many respects, may be misplaced for two important reasons. The first is that it is too late for many of those in the baby-boom cohorts whose ability to save more is already constrained through job losses, sickness or demands of family. The second is that the use of assets by the retired to support their own retirement is vital if important intergenerational equity issues are to be addressed. More intragenerational risk sharing has the potential to relieve the pressure on the working age population so that they can also save for their own retirement. During the term of the 2003 PRG, the government itself proposed a new state sector scheme (see below) and undermined the PRG in various other ways including announcing new tax proposals for work-based superannuation. After the delivery of the report the government accepted the recommendation of the 2003 PRG itself that such exercises in the future be abandoned. 4
The New Zealand Superannuation Act 2001 The New Zealand Superannuation Amendment Bill, before the House in July 2004, seeks to repeal the Retirement Income Act 1993 and transfer the main provisions surrounding the role of the Retirement Commissioner to the New Zealand Superannuation Act. This amended Act should then contain all the relevant legislation for New Zealand Superannuation. All references to the 1993 Accord are to be removed along with the requirement for 6yearly Periodic Reports. The rationale is that the Accord is defunct and that there are adequate consultation provisions in The New Zealand Superannuation Act. The Act "has provided a new opportunity for political parties to indicate their support for the retirement incomes policies and supersedes the need for the Accord provisions currently set out in the Retirement Income Act" ("New Zealand Superannuation Amendment Bill," 2004). There is indeed a mechanism in schedule 4 of the Act for parties to indicate their support of Part 1 of the Act which sets out the parameters of New Zealand Superannuation and Part 2 establishes the New Zealand Superannuation Fund. It is however questionable whether this fulfils the spirit of consensual multiparty policy development as envisaged in the Accord. In abandoning the 6-yearly reviews, New Zealand has lost an independent process for review of retirement policies. In fairness, the 2003 PRG did suggest that instead of the 6-yearly reviews there should be a work programme and that the Retirement Commissioner should conduct a review at the end of 2007. There is however no provision for any of this in the legislation. In the meantime the government has set up a working party on employment-based superannuation to report in August 2004. Tax changes for superannuation In the New Zealand system, saving in a superannuation scheme is supposed to be treated the same for tax purposes as saving in a bank account. It has however proved difficult to achieve this with a progressive tax scale when the tax rate applying to superannuation schemes is 33%. The Taxation (Annual Rates, GST, Trans-Tasman Imputation and Miscellaneous Provisions) Act 2003 addresses the tax penalties 5
involved in saving in superannuation schemes. 4 The changes are, however, only a small step in the direction of achieving tax neutrality for retirement saving. Employers are now able to reduce the withholding tax on contributions to the marginal tax rate of the employee, but it is not mandatory for them to do so. Given the complexities of charging a different withholding tax for different employees it is unlikely that this option will be widely used. In any case, taxing employer contributions at the correct tax rate does not address the over-taxation of fund earnings for taxpayers earning under $38,000 per annum. Nor do the changes require an adjustment for those on a 39% tax rate who benefit from the 33% rate applying to contributions and fund earnings. This means that the anomaly persists that in New Zealand, only the top income contributors are tax-subsidised into superannuation saving. Tax Savings Product Working Group In May 2004 the government announced that it would appoint a savings group to report in August 2004. The terms of reference suggest that the task will be far from easy. The task is to design a voluntary, generic working place product to be offered by all employers taking into account the needs of low and middle income employees. There are many difficult issues, such as whether there should be automatic enrolment, how part-time and casual workers might be included, rules around early withdrawal, management and approval of schemes and how this can be achieved in a tax neutral environment. Terms of reference to the Working Group indicate that any consideration of a tax incentive for this new product is to be a separate exercise in which government looks at the tax treatment of all savings products. A new state sector scheme The defined benefit Government Superannuation Fund (GSF) has been closed to new member since 1992 contributing to the decline in private pensions in New Zealand. An assortment of defined contribution schemes, some under the umbrella of the Global Retirement Trust, (GRT) were introduced for various parts of the public 4 For a discussion of these tax issues St John (2001). 6
sector, but coverage has been uneven. A new `State Sector Superannuation Scheme' will commence in 2004 as a portable defined contribution scheme in which the government as employer will match contributions up to 1.5% of gross salary in the first year rising to 3% in the second year. There will be a wide choice of investment styles, risk/return options, fee structures, and different add-on products such as life and other insurances. Employees can choose a provider, of which three remain out of the original four: AMP Financial Services (NZ) Ltd (AMP), ASB Group Investments Limited (ASB), and AXA New Zealand (AXA). 5 The government has been keen to promote the new scheme as providing a role model for other private sector employees. But it is not clear how private sector employers can match a government whose source of subsidy is the general taxpayer. The money for the subsidy is `new money' costing 35 million in 2004/5 rising to 58.1 million in each of the following three years. At the 5th Annual Super funds Summit in Wellington on the 6th May 2004, the Minister, David Cunliffe, cast doubt on the continuance of the subsidy. He implied that after two years the government would review it to see if sufficient numbers were taking part, adding to the general uncertainty among providers. In light of the generous implied subsidy from taxpayers in general, it might have been expected that the state would be looking for some social return in the drawdown phase. The sums are locked in until retirement age but the opportunity to link the new scheme to an appropriate new annuity product has not been seized. 3 The decumulation phase Far fewer private pensions Pensions and annuities are the tools whereby an orderly run down of accumulated capital can occur. The social value of pensions and annuities is that there is a regular 5 Global Retirement Trust (GRT) in a surprise move pulled out, apparently after concerns that it would be difficult to compete with other firms who could use the scheme as a loss leader for sales of other insurance products. The GRT is a not-for-profit specialist state sector superannuation provider set up after the closure of the GSF in 1992. 7
source of income for ongoing expenses and long-term care, and that those that live the longest are subsidised by those who die young rather than the working age population. With the closure of the Government Superannuation Fund (GSF) and the trends in company plans since 1990, far fewer New Zealanders will have even a modest pension in retirement in the future, let alone one that is inflation-proofed. This trend is already apparent. Table 1 shows that in the 2001 Census only 12.3 per cent of recent retirees aged 65-69 had income from an occupational pension scheme or a private annuity. This is less than those with such income for all age bands from 70 and over and supports the thesis that new cohorts entering retirement are less likely than previous ones to have pension or annuity income.
Table 1: The receipt of income from private superannuation and annuities by age
Male Female
50-54 1,581 924
Numbers with income from private super/annuities age 55-59 60-64 65-69 70-74 75-79 80-84 3,552 7,209 9,810 10,185 8,949 5,076 2,211 6,363 5,922 6,360 6,024 4,518
85+ Total 2,799 49,161 4,143 36,465
Percentage of population in age group with
private superannuation income
Total
1.1
3.2
8.8 12.3
14 15.8 15.7 14.3 8.4
Source: Census 2001
Defined benefit schemes, i.e. ones that pay pensions, have been diminishing in the context of overall falling membership of employment-based superannuation, both for the private and public sectors and reflects an OECD-wide trend (see for example Disney & Johnson, 2001). The debate in other countries now focuses on what to do with the lump sums generated in defined contribution schemes, driving increased attention to the annuities market.
The disappearing annuity market6 Nine life offices offered annuities in 1993 but only four: AMP, Sovereign, Royal & Sun Alliance and Tower were actively selling them in 2002. By 2003, there were only three providers, Tower, AMP and Fidelity Life. The latest survey shows that in 2004 there are just two providers, AMP and Fidelity Life.
6 This section draws on St John ( 2003b). 8
Ass discussed in previous Conference papers (St John, 2002, 2003c) there is considerable variation in the annuity payable for the same purchase price. Rates differ markedly by · Gender · Company · Timing of purchase The vast majority of potential annuitants are on a 21 per cent marginal tax rate rather than the 33 per cent applied to the annuity fund. Thus the product is not perceived by the industry to offer value for money for its clients. Sovereign for example did not sell any annuities at all in 2002 and the cost of continuing to produce a prospectus for this product could not be justified. Table 2 gives annuities for men and women aged 55 and 65 as at February 2004 from the two current providers, purchasable from a capital sum of $10,000 and $100,000 respectively. 7 Table 2 Annuity rates for February 2004 Source: (Aon Consulting New Zealand Ltd, 1993-2004) There is considerable difference between the annuity paid to men and that paid to women for the same capital sum. Women receive annuities that are around 12 per cent less than men's, but collect them for longer on average. Because they live longer, they are affected for longer by the consequences of buying the annuity at the wrong time or from the worst priced company. The difference for an annuity between the two companies in early 2004 was surprisingly large: $643pa for a male aged 65. This represents around $10,609 over 7 Prevailing interest rates are 5 years 5.94% and 10 years 6.11%. 9
16.5 years of average life expectancy. It raised the question as to whether AMP was serious about attracting new business. Timing of purchase is also very important. Over the period Dec 1992-Feb 2004, the worst a 65 year-old male would have done is to buy from AMP in February 2004 (annuity of $6,432) and the best, to buy from AMP in October 1994 (annuity of $9,786). The difference in annual annuity is $3,354 or $55,341 over 16.5 years average life expectancy. The PRG 2003 treatment of annuities and home equity release products was, at best, superficial. The lack of demand for annuities is caused by various factors, including New Zealanders' desire to self-manage their assets and the fact that NZS is a form of annuity payment. Periodic Report Group 2003considers the tax treatment of annuities is a significant barrier to their development. Susan St John describes the tax treatment of annuities as their "death knell".(p 89) Unfortunately the "death knell" comment is taken out of context as the St John paper makes clear this is just the view of those consulted in the industry. In fact, the disappearing annuities market can be seen as the end result of many aspects of market failure in the economic sense. But the PRG 2003 saw the problem only in terms of the non-neutrality of tax treatment recommending: The Government's proposed review of the tax rules applying to life insurance consider the tax barriers to the development of annuities; in particular, home equity reverse annuity mortgages.( p 99) Unfortunately the removal of tax barriers alone is unlikely to do a great deal for annuities and home equity products. Many other features of the current environment that mitigate against annuities especially the powerful adverse selection effect8, the lack of understanding of these products, their administrative cost, and the uncertainty of the longevity risk with improving life expectancy. 8 In the voluntary annuities market the key market failure arises from adverse selection. This may arise in cases where the individual better knows his/her longevity risk than the insurance company. Even if the company knows the risk, discrimination based on expected longevity is not usually feasible except in the case of gender. The result of adverse selection is that the pool of annuitants has a better longevity profile than the population at large. For this reason life insurance companies use their own annuitant mortality tables to price annuities, rather than whole of population life tables and annuities appear expensive to the average-lived annuitant 10
A recent survey of attitudes to annuisation in the UK revealed that, along with a loss of flexibility, a mistrust of institutions was a major factor in negative perceptions of annuities (Gardner & Wadsworth, 2004). In part the mistrust of insurance companies in New Zealand may be driven by a poor regulatory environment, for example, the Life Insurance Act 1908 is almost 100 years old and has not been updated. Effectively, it treats policyholders as unsecured creditors. New Zealand is the only developed Western country that does not provide specific protection for policyholders. In addition, there are effectively no disclosure requirements to protect the consumer and neither is there a requirement to disclosure the financial position or credit rating of the life insurer.9 To summarise: Current annuity products in New Zealand are unappealing because they have the following characteristics: · They appear expensive compared to investing money in short term deposits (high overheads and the role of adverse selection). · They are gender-based, making them poor value to many women, the majority of whom in practice have the same life expectancy as the majority of men · Timing is a lottery-the rate of annuity is locked in once the interest is set. · There is no protection from inflation · There is no protection from growth in livings standards · There are institutional risks and no guarantees. 4 What are the risks facing new retirees? Approaching retirement, individuals are confronted by a range of future risks and uncertainties. The primary worry is insufficient income and the associated danger of outliving capital. While New Zealand reduces this risk with a universal state pension, middle-income baby-boom cohorts require more than New Zealand Superannuation to achieve their legitimate income-replacement aspirations. 9 Nevertheless, increased regulation will not necessarily solve the problem as the UK system demonstrates. There, failure of Equitable Life despite regulation has had major repercussions. 11
The extra income that their capital provides is exposed to the risks of inflation, poor and volatile investment returns, and mismanagement. They may be tempted to invest super-conservatively even though the period of their retirement could be 30 or more years and may be a time of rapid economic growth and rising living standards. They run the risk that they either outlive their capital, or have a needlessly restricted retirement while dying with assets intact. They and their families are also exposed to the risk of running down their assets if long-term care is needed, in spite of the recent proposed changes to the asset test (St John, 2003a). Improving longevity is a little understood but growing risk. In the case of data in New Zealand, the pattern has been increasing longevity improvements, with the gains being concentrated at older age groups. The latest abridged life tables for the period 1999­ 2001 show that there have been longevity gains of 3.1 years for males and 2.2 years for females since 1990­92, largely due to the reduction in mortality rates in lateworking age and the first decades of retirement (Statistics New Zealand, 2001). The risk of long-term care One critical, but ignored issue, is that of rising expenditure for healthcare, and in particular long-term care. The first of the baby boom cohorts enters the 85+ group from 2030, and by mid century the numbers over 85 are expected to rise six to sevenfold. This has dramatic implications for residential care subsidies. Legislation to remove asset testing for rest home subsidies, promised in 1999 and introduced to the House in 2004 involves a rise in the level of exempt assets rather than a removal of asset testing. Even so, it is going to be expensive and the five years it has taken for this legislation to emerge has precluded a sound public debate on how the costs of long-term care should be shared (St John, 2003a, 2004). Under existing arrangements if a long-term care applicant's assets exceed the limits they must pay the capped fee of $636 a week. Once assets are down to the exemption income is expected to be used. The new asset limits from 2005 are shown in Table 3. From 2006 these new exempt levels increase by $10,000 a year, but it is clear that the asset test is never removed. 12
Table 3: Exemptions under the asset test for the residential care subsidy
Single
Married one in Married both in
care
care
Today
$15,000
$45,000
+ $30,000
house car and
chattels
From 2005
$150,000
$55,000
+ $150,000
house car and
chattels
While the rise in exempt assets appears substantial, many moderately well-off people, especially when they have a freehold house will still pay the full capped fee. The legislation removes the earned income test for the spouse with one in care but only some Human Rights aspects of the means test have been addressed. The married couple with one in care have a very small increase in their exempt assets and, surprisingly, do not enjoy a greater exemption of assets than a single person when both are in care. How do people currently manage these risks? There are a variety of ways in which risks can be addressed in the absence of sensible annuitisation and insurance options. For example, living standards can be reduced and living arrangements downsized by selling the family home and other assets. Managing one's own capital may or may not result in protection from inflation. Even low rates of inflation can have marked impact on a fixed capital sum or pension. Managed funds in New Zealand over a lengthy period have failed to deliver a real rate of return and in many instances have failed to keep up with inflation. Typically real estate has provided a hedge against inflation, but capital in one's own home has not been generally accessible. Low income people find that the current New Zealand Superannuation payment adequately protects them from most risks. Indeed it is the ideal annuity. But it is only those who assets are no more than $150,000 who can access insurance in the form of 13
rest home subsidies. Others are forced or persuaded that private trusts are necessary to protect their assets. The costs of these may be considerable and the equity of them dubious (Frawley, 1995).10 5 New home equity release products There are now some emerging new products, but are they designed to meet the risks that have been identified above? Two new home equity release schemes have been launched with the most significant one being from Sentinel promoted as `a reason to smile'(Sentinel, 2004). In brief, they allow retirees to exchange some of their housing equity for a lump sum. The outstanding amount together with the fees associated with set-up, including legal advice accumulates at a rate of interest several percentage points above the floating bank rate. In the Sentinel scheme, the current rate is 8.95% compounded monthly. The outstanding amount may never exceed the value of the house and the house must be sold and the loan repaid on death or entry into long-term care. The size of the initial loan depends on the age of the householders (maximum two) and the value of the property. Interestingly, ownership of the house by a family trust is no barrier to the loan. The loan may be used for any purpose including the repayment of any outstanding mortgage. The financial backing of the Sentinel scheme gives some reassurance that the company is sound but there may be little protection for the individual from higher interest rates that may quickly erode the remaining equity. Results to date While the market is very new, some indicative statistics are available for the first three months of 2004.11 These show that there is a potential demand for these products and significant growth in the market can be expected. For the 130 loans with sufficient data, the average age of applicant is 73, the average loan amount is $43,526 and the average house valuation is $327, 027. On average the loans to value ratio for current 10 Australia appears to make more effort to look through these instruments to see if there is effective ownership and enjoyment of the assets for means test purposes (Newman, 1999). 11 Kindly supplied by Richard Coon and Chris Coon of Sentinel 14
loans is 15% compared to a maximum average of 20.8% so that on average loans represent 72.2% of entitlement.
Table 4: Use of home equity release loans
Extra Income
Gifts Repay
Hone
Holidays
Improvements
Goods Purchase
Car Long term
care
32%
24% 24%
47%
29%
23%
33% 8%
Source: Sentinel: personal communication 2004
While there is only limited analysis possible of the data so far, Table 4 shows that the predominant uses of the home equity loan are for home improvements, holidays and car and other purchases.
Thus the purpose of the loans to date appears largely to enhance the lifestyle options of the retiree rather than to prepare for future health costs. It contrasts with the view expressed by experts in the US who see home equity release more in the context of the growing health costs of the elderly.
The need for spendable cash among retirees is likely to increase, as more and more individuals in the baby boom generation face the risk of long-term care in the next several decades. Converting home equity would seem a means that can satisfy several desires. It can augment the income needed for health and long-term care or other needs or desires in later life. It can enable older adults to stay in their own homes, providing substance to the often-repeated ideal of "aging in place." It elevates the role of personal savings as part of retirement security. And it gives meaning to the principle of self-reliance.(Chen Y-P, 2003b)
What risks are being addressed by the new home equity release products? · Dying after an unnecessarily restricted retirement due to the inaccessibility of money in the home and leaving unintended bequests.
· Entering rest-home care and losing capital that may have been used to make retirement more pleasant.
· Having mortgage payments reduce current living standards (where there is still an undischarged mortgage).
· Having the outstanding debt exceed the value of the home .
15
What risks are not being addressed? For the individual · The need for regular ongoing income for the whole of life. The use of home equity early in retirement, together with high interest rates and low house price inflation may preclude any further draw-downs. · The protection for longevity is limited to protection against negative equity. That is, if the home equity purchaser lives longer than expected, they will never owe more than the value of the house but they have no ongoing income protection. · The unforeseen need to move earlier than expected to a lower priced house. The repayment penalty is 5%. · A compounding interest with no explicit guarantees that this is fixed tightly to the floating rate. Rising interest rates that reflect rising inflation and falling or stagnant house prices can make an initial lump sum spend early in retirement very expensive. For society, there are risks that arise from the fragmented policy making for the retired In particular, the use of home-equity release schemes may intentionally or unintentionally, diminish the size of the housing asset to the point where the government becomes liable for the rest home subsidy in full. There is no gifting involved so retrospective looking back at what has happened is very unlikely. Sentinel has been exploring an annuity home equity release product but the tax effects are adverse for most clients, and annuity products are unlikely to be made available in the short-run. Without an annuity there is no protection from increased longevity and the need for extra income for the extra years, and no regular source of income for long-term care and other medical expenses. Tax implications for annuities-based home equity release products Traditionally, life insurance products are taxed under the Life Office taxation regime. This regime taxes Life Office's profits and policyholders returns as a proxy for policy holders. In the case of annuity products the investment return is taxed at 33% which may not be the tax rate of policy holders. It is however a final tax and no imputation 16
credits are available to the policy holder. Annuities are paid fully tax-free under the TTE regime as applies to superannuation in New Zealand. 12 In the case of home equity release products there is an additional problem that arises from the timing of the premium paid.13 In effect the annuity payments are taxed in full at 33% in the hands of the Life Office and the full premium when paid is tax deductible to the Life Office. The wait for the premium following the eventual sale of the house is likely to be 10-30 or more years and the deduction is likely to create taxable losses that cannot be carried back. This makes the product very difficult to introduce. Actuaries have suggested a change the Life Office tax regime to allow for a deduction for the increase the accumulated policy holder liability to overcome this problem but there has been no action to date.14 In the case of a home reversion or shared home equity, an asset is accumulated on the balance sheet and may qualify for a deduction overcoming this problem. Policy implications While there is a place for home equity release products, especially for cash-strapped individuals for whom staying in the family home is a critical consideration, they represent a partial and fragmented response to a major problem. The broad gains for society from encouraging annuities, rather than access to one-off lump sums early in retirement is worthy of a major public policy debate. Suitable annuities that augment New Zealand Superannuation in a realistic way may have wide social benefits (for discussion of these issues see St John, 2003a, 2003c). A more secure middle-income retirement reduces the pressure on workers to provide more directly for their parents. Annuity wealth cannot be gifted away or tied up in trusts, and it is possible to achieve much more intragenerational sharing than would be possible with individual saving. Annuities share the costs of retirement among the retired as a group, as those who die early subsidise those who live the longest. While capital itself can be gifted way, or spent early, annuities provide a transparent income 12 TTE is the shorthand for the tax treatment of superannuation in New Zealand. Contributions ar from after tax income (T), fund earnings are taxed (T) but withdrawals are tax free (E) 13 I am grateful for discussions on this issue to Chris Coon and Richard Coon 17
stream which can help meet the costs of old age care, including long-term care, thus reducing the pressure on general taxpayers. An attractive annuity product to supplement New Zealand Superannuation for middle income New Zealanders might have all or most of the following features: · Be good value for money; · Be inflation-proofed; · Provide flexibility and be less of a lottery than is currently the case; · Allow, in suitable cases, the use of part of the equity in owner- occupied housing for the annuity purchase; · Be gender neutral, given that the majority of both men and women do not experience the extremes of longevity; · Include insurance for catastrophic care costs; · Insure to some degree against growth in living standards. It is evident that the industry cannot provide a product that meets most or all of these criteria on their own. Examination of annuity markets and reverse mortgages overseas reveals that the state usually plays a substantial role in the successful development of these markets (for example Mitchell & McCarthy, 2002). The successful home equity release schemes abroad also have tended to have a high degree of state involvement (Davey, 1998). Surprisingly, there has been comparatively little literature to date devoted to exploring the potential of pooling risks of longevity (requiring lifetime annuities) with the risk of needing long-term care (long-term care insurance). Murtaugh, Spillman, & Warshawsky (2001) propose a method for linking the two risks in a single product in a voluntary market that has the potential to be cheaper by reducing adverse selection, and provide cover for more people. This theme is developed in a recent contribution where it is argued that the combination of a life annuity and long-term care insurance "...has the potential to make them available to a broader range of the population, with minimal underwriting and at lower cost" (Warshawsky, Spillman, & Murtaugh, 2002). 18
Possible interventions One of the advantages of the tax neutral approach to retirement saving accumulation in New Zealand is that it leaves open the possibility of transparent government subsidisation of the decumulation phase to meet explicit social goals. One possibility is that the state's role may include the direct provision of annuities, including allowing some portion of home equity as part of the purchase price. Such a shared appreciation, or home reversion approach has the potential to reduce the moral hazard problem that can plague traditional reverse mortgage products because the owner has an incentive to maintain the total value of the house. The return is the capital gain on the equity share over the lifetime of the insured for as long as they live in the house or until they sell (Caplin, 2002). Another option is private sector provision with the state providing a judicious mix of regulation, monitoring, reinsurance, guarantees, and tax subsidisation. For example, the tax on the annuity fund could be reduced to zero, or state could proviDe Long-term indexed bonds with a taxation regime that guarantees a realistic net real return. Some reinsurance of the excess longevity risk and support for gender-neutral annuities are others. The advantage of this approach is that subsidies and their impacts can be made transparent, and can be designed in ways that encourage the kind of annuities that are of most benefit to middle-income people. Recommendations 1. A suitable framework for investigation of the decumulation phase of retirement saving is established with representation from government, unions and industry. 2. Within this framework the respective roles of private providers and the state are discussed with attention to: o The role of a suitable, limited-value annuity product; o The justification for subsidisation with an assessment of private and social benefits; o The nature of the tax changes required, including not only the removal of existing tax distortions, but an examination of the case for removing tax altogether on the annuity fund; 19
o The issuance of inflation-adjusted saving bonds that guarantee a suitable real rate of return after tax; o The way in which home equity could be used for part of the purchase price; o The justification for making the annuity product gender neutral; o The potential link with long-term care insurance. References Aon Consulting New Zealand Ltd. (1993-2004). The Aon annuity survey, from http://www.aon.co.nz/index.shtm Caplin, A. (2002). Turning assets into cash: problems and prospects in the reversemortgage market. In O. Mitchell, Z. Bodie, P. Hammond & S. Zeldes (Eds.), Innovations in retirement financing. Philadelphia: University of Pennsylvania Press. Chen, Y.-P. (1994). Financing long-term care: An intragenerational social insurance model. The Geneva Papers on Risk and Insurance, 19(73), 490-495. Chen, Y.-P. (2003a). Funding long-term care: applications of the trade-off principle in both public and private sectors. Journal of Aging and Health, 15(1), 15-44. Chen Y-P. (2003b). Reverse mortgages. Encyclopedia of Retirement and Finance, II(J-Z), 679-685. Davey, J. (1998). The prospects and potential of home equity conversion/equity release in New Zealand. Wellington: Office of the Retirement Commissioner. Disney, R., & Johnson, P. (Eds.). (2001). Pension Systems and retirement incomes across OECD countries. Cheltenham: Edward Elgar. Frawley, P. (1995). Abuse of the trust device. Proposals for reform. New Zealand Journal of Taxation Law and Policy, 1(4), 200-224. Gardner, J., & Wadsworth, M. (2004). Who would buy an annuity? An empirical investigation: Watson Wyatt. Mitchell, O., & McCarthy, D. (2002). Annuities for an ageing world (Working Paper No. 9092). Cambridge MA: National Bureau of Economic Research. Murtaugh, C., Spillman, B., & Warshawsky, M. (2001). In sickness and in health: an annuity approach to financing long-term care and retirement income. Journal of Risk and Insurance, 68(2), 225-271. New Zealand Superannuation Amendment Bill. (2004). Newman, J. (1999). Private trusts and private companies. Maintaining the integrity of the means test (Discussion paper). Canberra: Department of Family and Community Services. Periodic Report Group. (1997a). 1997 Retirement income report: A review of the current framework-interim report. Wellington. Periodic Report Group. (1997b). Building Stability. Wellington. Periodic Report Group. (2003). Retirement income report 2003. Wellington. Report of The Taskforce on Private Provision for Retirement. (1992). Private Provision for Retirement: The Options. Wellington. Sentinel. (2004). Introducing the lifetime loan, from http://www.sentinelrs.co.nz 20
St John, S. (2001). New Zealand goes it alone in superannuation policy. Paper presented at the Reform of Superannuation and Pensions. The 9th Annual Colloquium of Superannuation Researchers 9th and 10th July, University of New South Wales, Sydney. St John, S. (2002). Pensions and annuities in New Zealand. Have we lost the plot? Paper presented at the Superannuation and retirement incomes: back to the future. The 10th Annual Colloquium of Superannuation Researchers, July, University of New South Wales, Sydney. St John, S. (2003a). The removal of asset testing and its implications, from http://www.geocities.com/nzwomen/SusanStJohn St John, S. (2003b). The role of annuities in the New Zealand retirement incomes policy mix. Paper prepared for the Periodic Report Group 2003, from http://www.treasury.govt.nz/prg/background.asp St John, S. (2003c). What is wrong with the New Zealand model for pensions? Paper presented at the 11th Annual Colloquium of Superannuation Researchers, 7-8 July, Sydney. St John, S. (2004). Submission to the Social Services Select Committee Social Security (Long-term Residential Care) Amendment Bill, from http://www.geocities.com/nzwomen/SusanStJohn Statistics New Zealand. (2001). Census 2001 Wadsworth, M., Findlater, A., & Boardman, T. (2001). Reinventing annuities. London: The Staple Inn Actuarial Society. Warshawsky, M., Spillman, B., & Murtaugh, C. (2002). Integrating life annuities and long-term care insurance: theory, evidence, practice and policy. In O. Mitchell, Z. Bodie, P. Hammond & S. Zeldes (Eds.), Innovations in retirement financing. Philadelphia: University of Pennsylvania Press. 21

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