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Saturday, June 30, 2007

KiwiSaver - not that hot

KiwiSaver - not that hot.

The spin the government is putting on KiwiSaver, suggesting that the employer will contribute to the employees savings is really a nonsense. Sure it will happen for the first year or so and especially with the government helping the employer make the contributions. However, as inflation continues and new salary negotiations come up, the only way an employer will be able to put money into your KiwiSaver is to pay you less. In effect, he will have a quiet talk with you and say this is the amount I can put out for your wages. If you want it all in hand (and pay taxes on the whole package), fine. If you want me to hold back the appropriate amount and put it into KiwiSaver, (without you paying tax on that part) that is fine too. In effect, you will be putting in both your portion and the employers portion and the government will contribute $20. The advantage here is that the portion you give back to your employer is contributed before taxes while the portion you put in is after taxes. Looked at another way, you reduce your taxable income by giving some back to the employer to put in to KiwiSaver for your retirement.

The real problem with KiwiSaver is the way it is taxed. You pay taxes on the money you contribute and you pay taxes on the interest you earn, all at your marginal tax rate. Take and example. Lets look at $100 invested in KiwiSaver over a year. Assume for the example you earn 6%, that inflation is running at 3% and you are in the 33% tax bracket. You may think that 6% is pretty low but ignoring our present interest rates which are caused by a couple of bubbles and the reserve bank continually hiking up the base interest rate, 6% is a far more reasonable expectation in the long run.

After a year, the $100 has grown to $106. Since your earnings are $6, the government takes $2. (I'm assuming you are in the 33% tax bracket but even if you are in the 39% tax bracket, the government has said that they will reduce the percent you pay on KiwiSaver investments to 33%. Big deal!!!) Note here that they are taxing a loss you made because of inflation, which, to an extent, they control. Because of inflation you had to make $103 just to break even so you have a real earning of $1 on a $100 investment. Lets get really picky and index the $1 back to when you made the investment. $1 today will buy what $0.97 would buy when you made the investment. Your true earning rate is 97 cents on a hundred dollar investment or 0.97%. Lets take a concrete example and check how well the first investment made by a typical punter looks at retirement. Lets look at a person on $60,000 a year who invests at 20 and takes his money at 65. We will assume inflation stays at 3% for these 45 years and he earns 6% annually. Remember, the $60,000 is his gross negotiated salary.

He gives back to the boss $2,307.60 leaving him with a taxable income of $57,692.40. His weekly salary is $1,109.47. He puts 4% 0f this into KiwiSaver and the boss puts in the same or $44.38 each. The government puts in $20. From that first week he has $108.76. in his KiwiSaver account. How much did this cost him. Well it cost him the $44.38 he gave back to the boss to invest for him and since he is in the 33% tax bracket, his $44.38 cost him $66.57 or a total of $110.94. The $20 contribution from the government almost made up for the taxes he paid on his portion of his investment.We have already seen that because of tax combined with inflation, his true annual rate of return is 0.97%. Compounding that for the 45 years from 20 to 65 we get an increase factor of 1.544. His first investment made at 20 will be worth $167.93. Since his initial cost was $110.94, he has earned 51% on the investment from his first week. Not a very impressive return for a lifetime of investment.

You may question the fact that I maintain that the true cost of his $44.38 is $66.57. After all you don't see this money anyway and you think of your salary as the amount you take home and not the amount you earn. I do this because it is the government which decides the rules and it doesn't have to be done this way. The Australian government, for instance, charges 15% on money you invest and 15% on your earnings regardless of your tax bracket. The American government (as far as I can determine from their web site) charges nothing for both investment and interest. Run these parameters through your pocket calculator and you will soon realise just how much better their system is. The government doesn't have to give us bribes as they are doing at present. It simply has to stop the prohibitive taxation.

If you want to see who will do well on KiwiSaver, run the above calculations through for someone in the 19.5% tax bracket and specifically for someone earning a gross negotiated salary of $520 per year ($500 before taxes). Because he is only paying a fifth on the money he turns back to his employer and a fifth on his earnings, he does much better out of KiwiSaver than the higher earner. Of course, he may not be able to put that money aside when he is on such a small income but by running his example through, you get an indication of where the problem is. Namely, the way the government taxes our contributions and our earnings.

You may have noticed I have ignored the $1000 the government is putting in at the beginning. It actually doesn't make all that much difference in the long run. Factor it in if you want and see what sort of investment you come out with.

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