Andrew Coleman looks at why we put up with a retirement scheme that imposes such large opportunity costs on young people

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 21st century.

Last week it was observed that the most important “under the hood” pension issue is whether they are funded on a pay-as-you-go basis or a save-as-you go-basis. In a pay-as-you-go system, a government collects taxes and immediately pays them out as pensions and no assets are accumulated. In a save-as-as-you-go system the taxes are accumulated in a sovereign wealth fund and invested before the pensions are paid out at a subsequent date. (In a compulsory saving scheme the contributions are placed in private saving accounts rather than a single large public account).

Because save-as-you-go and pay-as-you-go pension schemes accumulate different amounts of assets, they impose different costs and benefits on different generations of people. Sometimes young people would be better off with a save-as-you-go retirement system and sometimes they would not.  These costs can be calculated using arguments based on the economic ideas developed in the 1960s by Peter Diamond and Edmund Phelps. For those who are interested, modern treatments are Barrel and Weale and Diamond.

One of Diamond and Phelps’ main insights was that the performance of a save-as-you-go scheme relative to a pay-as-you-go scheme depends on whether the economic growth rate is higher or lower than the returns people can get from investing their savings. If there are lots of opportunities to make high yielding investments, funding the Government retirement income system on a pay-as-you-go basis imposes very large costs on current and future generations of young people, because young people end up paying much higher taxes than is necessary to fund their own retirements. However, if investment opportunities are poor, or the size of the economy is growing rapidly because of rapid population growth, the reverse is true. If much of the money people save and invest is wasted, it is better to use a pay-as-you-go system that  simply transfers money from young and middle-aged generations to older people.

The rule discovered by Peter Diamond and Edmund Phelps can be expressed quite simply: a save-as-you-go system works best when the return to capital investments exceeds the growth rate of an economy, or “r > g”. An economy where this is true is called ‘dynamically efficient’. A pay-as-you-go system is better when the returns to capital investments are less than the growth rate of economy, or “r < g.”  This type of economy is called ‘dynamically inefficient.’ If you have a pay-as-you-go system in a dynamically efficient economy, young and future generations face big opportunity costs and would have been better off if previous generations had chosen a save-as-you go system. Most modern economies are dynamically efficient, and this is true for New Zealand over the last 30 years. This suggests that if New Zealand had not cancelled the compulsory saving scheme started in 1975 and replaced it with an expanded pay-as-you-go scheme, current and future generations of young New Zealanders would be much better off.

When an economy is dynamically efficient, the opportunity cost that young people face because they have inherited a pay-as-you-go rather than a save-as-you-go funded scheme is the extra amount they have to pay for in taxes for the pensions they receive. To calculate the size of these costs, suppose that the government initially introduced a save-as-you-go pension scheme, one that collected taxes from a particular generation of working age people and placed them in a Government-run investment fund such as the New Zealand Superannuation Fund. These contributions, plus all the interest and dividends and business earnings would be accumulated and used to pay the pensions of the contributors when they eventually retire, at which point the investment fund would be run down to zero. For example, suppose you put $1000 in an account every year from age 25 to 65, and compounded it at a 5% real rate of return (this is the average rate of return to investments, not the interest rate). At age 65 you would have $127,000, which is enough to give you a pension of $8600 every year for 25 years.

If the government introduced a pay-as-you-go scheme instead, the funds it collects would not be invested. But this does not mean the return to a pay-as-you-go scheme is zero. Rather, when the amount of the pension is a constant fraction of wages, the return to a pay-as-you-go scheme is approximately the growth rate of the economy, or the “g” in the formula “r  > g”. The growth rate of the economy has two parts. The first part is the increase in average output per worker, which is closely related but not identical to the growth rate in wages.  Wage growth is a part of the return to a pay-as-you-go pension because the pension increases as wages increase. The second part of economic growth comes from the increase in the size of the workforce, which in the longer term is about the same as the population growth. When the population is growing, there are many more working-age people than retired people, and the return reflects the fact that each person only has to pay a fraction of the pension they are likely to receive.

Over the last 30 years, the real economic growth rate in New Zealand has averaged just less than 3%, including population growth. If you compound $1000 per year at 3% instead of 5%, you would only be able to afford a pension of $4300, not $8600. The additional return from being able to invest at a much higher rate than the growth rate of the economy means you could double the size of the pension that is available for the same tax payments – or halve the amount of tax you need to pay when you are young for the same pension. This is the opportunity cost that young people face because they are inheriting a pay-as-you-go pension scheme rather than a save-as-you-go scheme. In dollars, the net cost of government pensions in New Zealand is approximately $4200 per adult per year. If we had a fully-funded save-as-you-go system paying the same pensions, the contributions for the same pension would be halved, a saving of $2100 per adult per year.   I know that reading about retirement income policy may be boring, particularly if you are under 30, but for many people an extra $2100 per year per person probably counts as a nice-to-have.

A pay-as-you-go scheme has a second implication – the opportunity cost that a cohort experiences varies over time, as growth rates and investment returns vary. If you are born at a time when the young population is increasing rapidly, there are plenty of young workers to support a small number of old people. This means each person has to only pay a relatively small amount of taxes to pay for pensions, and the opportunity cost is relatively low. Alternatively, if you are born at time when the population growth rate is small and the number of old people is large, each young person has to pay a much larger amount. To some extent, the costs of a pay-as-you-go system on different generations are arbitrary, depending on population growth rates.

It is possible to do quite complex calculations estimating how population growth has affected the lifetime tax payments different cohorts have paid or will pay in the future, relative to the size of the pension payments they can expect to receive. These calculations show that under the current pay-as-you-go pension scheme, most people born before 1971 paid or will pay about half as much in taxes as they can expect to receive in pensions. This is largely because there weren’t many old people around when they were young. (Note that they would have paid even less if the pension scheme were operated on a save-as-you-go basis.) The generations born after 1980 are unlikely to be so lucky. The numbers aren’t certain as they depend on future birth-rates and inward immigration, but the rapid increase in the number of older people means it is extremely likely that people born after 1980 will pay significantly more in taxes, up to 50% more, than people born before 1981 for the pensions they receive. It follows that the decision to fund New Zealand Superannuation out of current taxes made New Zealand Superannuation a much better deal for older people than for people who are currently young – or for their children. This might explain why the decisions to adopt and continue with New Zealand Superannuation were so popular back in 1977 and 1997 – the costs were low because a disproportionately large fraction of the costs were pushed out into the future.

A different way of seeing this is to calculate the fraction of income that is paid out as pensions each year. The Treasury regularly estimates this amount as part of its long-term fiscal forecasts. In 2000, the net cost of pensions was 3.6% of GDP. (This is the cost after an allowance for the tax people pay on the pensions they receive.) Currently the ratio is 4.3% of GDP. By 2070 the ratio is forecast to increase to 6.7%, assuming pension entitlements remain fixed at 65% of the average wage. This is more than a 50% increase, largely because there will be a larger number of people who will be receiving pensions. 

With a save-as-you-go system, there is no need for different cohorts to pay vastly different amounts to receive the same pensions: each cohort can pay enough to pay for their own pensions. This means New Zealanders could choose to reduce the fraction of the bill that young people and future generations will have to pay to fund government pensions, by changing the amount that is funded on a save-as-you-go basis. In fact, they already have, by creating the New Zealand Superannuation Fund. This is a good start, but the contributions are not particularly high – and the survey evidence discussed later suggests a majority of people would support higher contributions.

So why do we put up with a system that imposes such large opportunity costs on young people? Diamond and Phelps also worked out what happens if you try to change from one system to another – and they showed there is a catch. If the economy is dynamically efficient (“r > g”), it is not possible to costlessly change from a pay-as-you-go pension scheme to a save-as-you-go pension scheme. Making changes that reduce the costs on future generations will require some people who are currently alive to pay more or receive less than they would have if they simply stayed with a pay-as-you-go system. This creates all sorts of political problems, making a switch from a pay-as-you-go system to a save-as-you-go system difficult. This topic is the subject of next week’s article.

*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 4 in the series. Part 1 is here, part 2 is here, and part 3 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.