After the flurry of coverage a couple of weeks ago over the remuneration of Adrian Orr, chief executive of the New Zealand Superannuation Fund, debate seems to have turned towards the more substantive issues around the role of the Fund. The chief executive has been out, in his usual feisty and rather opportunistic style, defending the Fund, advocating for it to be given more money to invest and so on. One could reasonably question whether the latter in particular is the role of a public servant. His job, surely, is to invest the money the government has chosen, under the terms of the legislation, to place with NZSF. Wisely, in my view, no more money has been placed with Fund since 2009 (although even then I thought it was shame the government didn’t simply wind up the Fund). But this is now an election campaign issue, with the Labour Party vocally calling for an immediate restart of contributions. That is perhaps understandable from a party which now, once again, favours keeping the NZS age at 65 indefinitely – which was pretty much their position back when the Fund was first set up. But it is a debate senior public servants shouldn’t be participating in in public. Whatever one’s view of the NZSF itself, there are simply fewer grounds for it if one thinks the age of NZS eligibility should be increased over time, as life expectancy improves.
What has also interested me is the vocal support Orr has had from various journalists. In the Orr interview I listened to, on Radio New Zealand’s Nine to Noon on Monday, Kathryn Ryan seemed to see her role as being to help Orr get “the truth” across, cheering him on as he went, rather than asking any searching or challenging questions. And this morning, in the Dominion-Post, Vernon Small is channelling the Orr lines, but in even more strident tones. He concludes that we’d be “barking mad” not to be putting more money into the NZSF each and every year.
Well, perhaps. But Orr in particular was guilty of downplaying quite a lot of important considerations.
First, for all the breathless excitement about the NZSF’s investment returns (around 10 per cent per annum, pre-tax, over the life of the Fund), there has been no hint from chief executive, or his media supporters, of the rather more disciplined approach official NZSF documents, presumably adopted by the Board, take:
It is our expectation, given our long-term mandate and risk appetite, that we will return at least the Treasury Bill return + 2.7% p.a. over any 20-year moving average period.
By design, it is a highly risky Fund (“high octane” was Orr’s description) and performance can only seriously evaluated over quite long periods of time – 20 year periods in the organisation’s own telling. But Orr (or Ryan or Small) didn’t make that point.
Kathryn Ryan’s breathless praise of the investment performance included, a couple of times, “even over the global financial crisis”. That period was certainly pretty dramatic, but for equity markets it just doesn’t look that unusual in the longer sweep of history. Here is a chart of the S&P500, in real terms and on a log scale.
The fall in equity prices over 2008/09 looks like the sort of fall one might expect every 15 or 20 years – and that one was shorter-lived than most. If you take lots of risk in equity and bond markets, the last 15 years haven’t been a hard time to make money. As far as I can see, the NZSF has more or less been compensated for those risks (it has forced us citizens to bear) but no more than that. (I was however amused by the shameless attempt of the Fund’s head of asset allocation, in response to a recent OIA request, to suggest that returns from January 2009 – near the trough of global markets – was a meaningful number to use in evaluating the Fund’s performance.)
So the problem with the Fund isn’t that its investment management choices (both those they would loosely classify as “passive” and those equally loosely classified as “active” – the distinction is pretty arbitrary) have been particularly bad, or good. They’ve probably been about what one might reasonably expect over that period. And if we closed the Fund now, or shifted all the money back to low-risk assets, we could crystallise the gains and be thankful that, despite all the risk run, we made money rather than lost money. But nothing in the Fund’s investment strategy will protect taxpayers if, and when, markets turn bad again.
Orr continues to misrepresents the NZSF as a “sovereign wealth fund”. It simply isn’t. We aren’t Norway or Abu Dhabi, managing for an intergenerational perspective, oil wealth that has been turned into cash. All the money put into the NZSF has either been raised from taxes or borrowed. There isn’t a pool of money that naturally needs investing. Rather, the government has established a high-risk investment management subsidiary to punt on world markets. That simply isn’t – and never has been – a natural business of government.
The Fund itself doesn’t have to worry where its money comes from. But citizens do. Who knows what governments would have done with the money if the NZSF had never been established. I suspect much of it would have been wasted on increased government spending. But it would have been possible to have cut the most distortionary taxes – those on business income – quite heavily, which would probably have given risen to a lot more business investment in New Zealand. None of the analyses of the returns of the Fund ever seem to take into account, for example, the deadweight costs of taxes. On mightn’t expect NZSF to do so – they are just investment managers – but if they don’t they aren’t really in a legitimate position to be calling for more public money to be steered their way.
Orr cites a number of other advantages for the Fund. He argues that it has contributed to developing New Zealand capital markets. I’d be interested to see the evidence for that claim. Most of the Fund’s assets are invested abroad, by intentional design. What would New Zealanders have done with money if they’d had it as individuals? And I don’t quite see how sweetheart inside deals, whereby ACC and NZSF – neither with any particular expertise in retail banking – take chunks of Kiwibank from NZ Post, enhance New Zealand capital markets. No doubt having a hulking behemoth (by New Zealand standards) like NZSF generates more activity – NZDMO got to issue more bonds than otherwise, and then NZSF buys more (mostly overseas) assets – but are the capital markets really better – and by what standards – for the presence of the Fund?
I also heard him argue that the NZSF somehow reduces risk and improves certainty. I wasn’t quite sure what he was referring to, but it seemed to be about the future of NZS itself. But again, he is really talking beyond his pay grade. The future of NZS is a political issue that really has little or nothing to do with the NZSF size/performance. It isn’t like a contractural funded defined benefit pension scheme. Presumably the overall state of government finances, overall tax burdens, and a community consensus on what is fair and reasonable are more likely to shape the future of NZS than the presence (and investment returns) of NZSF. And in thinking about the overall government balance sheet – something Orr doesn’t seem to, and isn’t paid to, think much about – NZSF is currently only about 10 per cent of total assets.
He is on similarly shaky ground when he talks about save as you go approaches beating out pay as you go approaches. I’m sure we can all agree that saving for the future typically makes sense – the power of compound interest and all that – but that insight doesn’t help at all in deciding what, if any, role NZSF should have. After all, we could wind NZSF up today, use the proceeds to repay government debt, and nothing would change about accumulated public sector savings. Higher public sector savings is mostly a choice between taxing more and spending less. As it is, I’d probably be happier if overall government net debt (including NZSF assets) was quite a bit lower than it is (ie build up government savings a bit more), but at least until all the gross government debt is repaid the government simply doesn’t have to be in the financial investment management business – it is a pure discretionary choice. We haven’t been there so far in the 14 year life of the Fund, and it doesn’t look likely that we will be in the next few decades either. And Orr gives no weight at all to the failures of government, which often see additional Crown revenues wasted rather than saved.
Orr, and his defenders, have also been keen to scoff at any analogies with how a household might approach decisions. I heard him say something along the lines of “if governments could act like households, we wouldn’t need governments”, which is true, but irrelevant in this context. One role governments play, on behalf of households collectively, is to absorb collectively some of residual risks that individuals aren’t well-placed to handle. That might tell you that often governments can’t, or won’t or shouldn’t cut spending in severe downturns, because some of their obligations increase then (and they are willing to let automatic stabilisers work). For that reason, governments should be wary of revenue sources, or investment returns, that are very highly positively correlated with the economic cycle. For example, one reason to be wary of capital gains taxes is that they tend to flatter government finances in good times, only for the revenue to dry up just when governments need it most (see Ireland last decade for a classic case study). The same might well be said of highly risky asset portfolios – even if they do quite well over the very long haul, they will look particularly poorly at just the times when government finances are under most pressure for other reasons. In fact, if the pressures get serious enough, governments might come under pressure to liquidate those risky holdings right at the bottom of the cycle. Those aren’t issues Orr has worry about – he is simply paid to maximise returns on his little chunk of government resources, subject to acceptable risk – but citizens, and people worry about overall government finances through time should do.
After all, it is not as if governments don’t already have other income and investment returns that are quite tied to the economic cycle. Even on the investment front, for good or ill the government has quite large commercial holdings (those SOE stakes), and on the revenue front the tax system effectively makes the government an equity stakeholder in every business in New Zealand.
Orr and his defenders also scoff at household comparisons because, so they note, the government can borrow more cheaply than households. More flamboyantly, here is Vernon Small’s take
As a comparison it may be politically effective but it is about as useful as a chocolate teapot.
Show me the household that can tax, has a central bank to set interest rates and biff around the exchange rate paid at the corner dairy, can borrow more cheaply than any business at rates below any mortgage offered by banks – and can live on for decades past the final days of its family members – and I’ll show you the household that has much to learn from a central government or vice versa.
Actually, the typical government (as distinct from the idealised one no one has ever seen) has operated with a horizon considerably shorter than that of most households. And that is understandable: I care about my kids and potential future grandchildren, who will still be there in decades to come. Politicians – who run governments – face elections quite frequently, and in the course of a single lifetime successions of them run policy all over the show.
And quite how do people think that governments borrow so cheaply? Because they have the power to tax, and that power is mostly exercised not over random stateless aliens, but over New Zealand households. Every debt the New Zealand government takes on involves risks for New Zealand households – risks that at times of stress, governments will disrupt household and business plans by unexpectedly making a grab for a larger share of our incomes/wealth. That risk limits the other risks households can afford to take, and is why I keep stressing that an accountable government can’t think of the cost of funds as simply the government bond rate; it has to price the implicit equity, bearing in mind that the coercion involved in the power to tax is more costly and distortionary than (say) a large company having to issue new debt if times get tough. People like to say that governments can’t (usually) go bust, and so are subject to fewer “bankruptcy constraints” in thinking about undertaking possible long-term activities – but that is typically true only to the extent that they ignore the perspectives and finances or their citizens, who ultimately bear the risks. Ignoring citizens isn’t what governments are supposed to do.
My bottom line remains that NZSF hasn’t done badly what it has been asked to do (if you want a high risk fund that is). Equally, it hasn’t really been put to the test. They probably made some quite good calls at times, but the risks they assume for the taxpayer are very considerable. In that OIA response I referred to earlier, they attempt to rebut some of my arguments, by suggesting that the appropriate hurdle rate of return should depend on the riskiness of the project. I read that and thought: “yes, and that is really to concede my point”. Over the life of the Fund, the standard deviation of annual returns has been almost 13 per cent. Those are really large fluctuations – by design – and in considering establishing (or retaining) a government leveraged investment fund – effectively a business subsidiary of the government – taxpayers need a lot of compensation for that risk. Especially as that risk – in the extremes, which are what matter – is pretty correlated with other risks to government finances directly, and those of household sector finances indirectly, so there isn’t much – if any – overall risk reduction taking place. When typical Australian companies uses hurdle rates in excess of 10 per cent, we shouldn’t be that comfortable in our government running such a risky investment management operation for returns that, over a good 14 years, have only just matched 10 per cent. I’m not suggesting anyone could have done much better than NZSF managers have, just that it wasn’t worth doing at all, evaluated by the sort of standards firms and households apply to their own finances. And all that on a Fund that at present is only around 13 per cent of GDP. The risk dimensions of the Fund become even more important if contributions are resumed and we envisage a Fund that could become a much larger component in the overall Crown balance sheet.
There is a political debate that should be had about NZSF. There is a debate to be had about the future parameters of NZS. But the two aren’t really very logically connected – despite the words in the legislation. If speculative investment management is a natural function of government, it is so regardless of baby boomers ageing, life expectancy or the parameters of any element of the welfare system. Short of New Zealand discovering Norwegian quantities of oil and gas, I suspect it is no appropriate business of government.