Does welfare sap the will to save?

Recently, Jeremy Sammut of the Centre for Independent Studies has had a number of opinion pieces published in the Australian Welfare saps the will to save on March 5 and “Welfare killed saving” (December 18) and a longer paper published by CIS – A Streak of Hypocrisy: Reactions to the Global Financial Crisis and Generational Debt.

A common theme in these pieces that more generous age pensions have diluted incentives to save in Australia and therefore that we need to scale back existing pensions rather than increase them (and target them more) as advocated by groups such as the Brotherhood of St Laurence.

In Australia the real level of the age pension has doubled since 1970 – so are more generous age pensions responsible for low savings rates? My answer to this question is to ask two more questions first, are Australian household savings rates low and second, are Australian pensions generous?

On the surface, the idea that the existence of government pensions reduces household savings seems just like common sense. For example, some US commentators have argued that China needs to build a more comprehensive social safety net for the retired in order to reduce their high level of savings.

However, the effects of pensions on savings are ambiguous, because government pensions reduce the need for private savings, but if they induce early retirement rather than continued work, the might encourage people to save more for their retirement years.

The effects of social security payments on household savings has been hotly debated for at least the past 35 years, with Martin Feldstein arguing that the US social security system reduced overall private saving by nearly 60 per cent, and that more generous benefits internationally are associated with reduced household savings. These arguments have also been extensively criticized, not least because of a significant programming error in Feldsteins original study.

In the December quarter of last year the Australian household savings rate leapt dramatically. The fact that this jump in measured household savings occurred precisely at a time when significant increases in age pensions were being publicly predicted suggests that there are factors other than the anticipated level of the age pension that influence savings rates.

One issue is how savings rates are measured. For example, the Reserve Banks May 2006 Statement on Monetary Policy pointed out that conventional measures of saving are calculated from the national accounts and do not include in income (and therefore saving) the part of returns on investments that comes as capital gains. In the case of equity investments, for example, only the return in the form of dividends is included as income, even though historically this has accounted for only about one-third of the overall return on equities.

The RBA goes on to point out that in countries like Australia where the composition of household investments has shifted from bank deposits and fixed income to equity holdings, the conventional measure of saving has increasingly understated the true extent of household saving. The RBA states that a more meaningful measure of household saving is the change in household net financial wealth – defined as household financial assets (bank deposits, bonds, equities and unit trusts) less non-housing debt.

On this measure the net financial wealth of Australian households, per head of working-age population rose from $32,000 in 1991 to $90,000 in 2005. In 2005, when the conventional savings rate in Australia was negative, the rate calculated on the basis of the change in net financial wealth was around 25% of household disposable income. Averaged over the decade 1994 to 2004, the RBA preferred measure was about six times higher than the conventional measure.

A 2006 Reserve Bank study by Paul Hiebert also found that declines in household or personal savings in English-speaking countries appear to have been correlated with large capital gains and rapid financial innovation. That is, the reason why active saving by households declined up until the end of 2008 is that passive savings through capital gains have been so strong. The Treasury has also recently prepared an analysis of household savings in Australia that points to many of the same issues.

The most recent OECD data on net household savings rates found that in 2005 when the conventional household savings rate in Australia was negative, the OECD countries with the highest conventional household savings rates between 7% and 12% of household disposable income were Austria, Belgium, France, Germany, Italy and Switzerland.

In 2005 Australia spent 3.2 per cent of GDP on age and related pensions, which was less than half the OECD average (6.5 per cent of GDP). Spending on age pensions was actually highest – more than 10 per cent of GDP – in Austria, France, Germany, Greece, Italy and Poland that is, mainly the countries with much higher conventional savings rates than Australia. These countries also all have much older age structures than Australia, and continue to age more rapidly than Australia, circumstances that are usually expected to lead to lower not higher household savings rates.

In fact, while a small number of countries with high levels of pension spending and generous earnings-related pension benefits do have negative household savings rates, overall the cross-national relationship between social welfare spending and household savings is positive that is the more countries spend on age pensions, the higher their conventional household savings rates appears to be. But this positive correlation is probably spurious, mainly because of the limitations of the conventional measure of household savings rates discussed above.

When we look at household income surveys we also find that people of pension age in Australia have one of the lowest levels of reliance on Government pensions in the OECD, and one of the highest levels of self-provision. Government benefits make up just under half the cash disposable income of people over 65 in Australia compared to 70% for the OECD on average, and 80 to 90% of the income of people over 65 in countries like Austria, Belgium, France, Germany, Italy and Switzerland (i.e. the countries that have high savings rates).

Household surveys also show that older Australians also have much higher levels of savings both in the form of housing wealth and financial assets. A recent study by my colleague at the Social Policy Research Centre, Bruce Bradbury, reinforces these points. In 2003-04, Australians over 65 years of age had housing wealth in owner-occupied housing that was equivalent to more than seven years worth of their average household disposable income. This was more than twice the average for the other OECD countries for which data are available. Older Australians also had average levels of financial assets that were equivalent to roughly 8 years worth of their disposable incomes, a level at least 50% higher than the average for other countries.

It seems very likely that the exemption of the family home from the pension assets test reinforces incentives for people to maximize housing wealth in retirement. But if we wanted to change those incentives we would either need to include the family home in the assets test in some way or alternatively pay the pension without a means test. More importantly, we would need to address the other institutional features in Australia that favour home ownership.

In summary, the main reason why Australia appears to have very low household savings rates is not because our welfare system is so generous and has displaced private savings; in fact, measured comprehensively our household savings rates are not out of line with other countries and our public pension system is not particularly generous.

In fact, these conclusions are consistent with the argument that more generous pension systems can reduce the level of private savings it is just that Australia doesnt have a particularly generous pension system!

As noted earlier, the real level of the age pension has doubled since 1970, but so has the real level of national income per person. As a percentage of GDP per person, age pensions are now lower than they were in 1970.

It was also well recognised in 1970 that age pensions were completely inadequate. Would anyone today think that a single age pensioner could live on $7,000 a year, which is what we would have if we went back to 1970 levels?

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12 years ago

It’s all very well to talk about how Australia compares with other countries like France. However, France at least is not a very good country to compare with — few people in Australia are going to put up with tax rates like France, and at present the French government simply borrows to pay for the zillion and one social benefits you get yet still doesn’t manage to provide a decent training system for young people. I’m glad I don’t need to rely on the French government in 30 years time when I might have to retire (and I’m glad I don’t work there now, where personal saving is almost impossible due to the crazy levels of tax).

Complaints aside, your post doesn’t really answer what I think are some of the most appropriate questions, which is how much tax is going to be necessary to sustain even the current level of pension and medical expenses Australia is likely to face given an aging population. If the most amount of tax people can pay with ruining the future for other generations or forcing large chunks of the professional population to move country to escape (which I imagine in the future will become about as easy as Kiwis find it to move here) amounts to $7,000 per year per pension, then that’s just something we’ll have to put up with.

So here are two further questions whose answer might provide further light on this. What is your (gu)estimate of the percentage of GDP that will be needed to provide the same level of pensions and health care cover as we have now in 30 years? (Assuming health care costs per person rise slowly as they have for as long as I can remember and that people also live a bit longer too), and on the political side, are working Australians likely to put up with that level of tax or will they simply rebel and vote in a government that cuts back those benefits?

12 years ago

Surely another question worth asking is even if it there was strong evidence that welfare reduced private saving, why is it that it would be better to rely on private saving than government-guaranteed welfare?
It’s inevitable that in a system of private saving, there are going to many people who simply don’t save enough, whether through misfortune or short-sightedness, and they will have to be supported somehow: why would that be a better result than what we have now?

David Coles
David Coles(@david-coles)
12 years ago

Currently you can access your super from age 55 if you retire, increasing to 60 by 2025, and from 65 even if you’re still working. The age pension only kicks in from 65. Does letting people access their super before they can get the pension increase the desire to save? Or does it encourage them to blow through their super and get the pension later on?

Also, given life expectancy is increasing and people can work longer, I think there’s a good basis for increasing those ages.

12 years ago

I’m staggered that “savings” are measured without taking into account the full spectrum of investment opportunities.

A fair amount of our “savings” go into home improvements to prepare for our children growing up (separate rooms needed and study areas and so forth) and to maintain and improve the value of our home because we can sell it if needed.

NPOV, your saving for your future is somebody else’s investment capital in the interim. Also, the pension system you would like could be quite unfair. The next few generations after mine (end of the baby boom) will proportionally have to pay more than me. Is that fair?

12 years ago

pedro, I don’t believe I’ve described the pension system “I would like”.
But I think the argument for a government-backed pension system where everybody is guaranteed a decent social net is sound enough.
As far as fairness goes, in the scope of unfairness in the world, what you describe is a drop in the ocean. Do you seriously think that if governments did nothing to provide social safety nets the world would somehow fairer?

12 years ago

NPOV, I understood you to want a universal pension that is paid irrespective of wealth, sorry if incorrect. Also, you seem to be against encouraging saving for old age. I was simply pointing out that you have generational winners and losers and the more universal the pension scheme the bigger the effect.

Even if the world is very unfair, I don’t think that justifies adding to the amount.

12 years ago

I’m certainly not against “encouraging saving for old age” – I just wouldn’t argue in favour of promising to decrease the current pension in the future simply to encourage people to start saving. For a start, it wouldn’t work – the political backlash would be too great. But even if it we lived under a benign dictatorship where the government knew it could make promises about what it was going to do to pensions in 10/15 years’ time (which it would what it would have to do in order to meaningful boost savings now) I would be highly skeptical that the outcome would be positive, when measured by the effect it would have on the most disadvantaged (or misfortunate).

12 years ago

Yes, I don’t think many people would be in favour of decreasing pensions to increase savings. anyway, saving is compulsory.