RDP 2004-01: The Impact of Superannuation on Household Saving 3. Superannuation and Household Saving

One of the concerns behind the introduction of the compulsory superannuation scheme was the decline of the household saving rate in Australia following its peak in the mid 1970s (see Figure 2). This raises the issue of whether superannuation has been able to stem the slide in the household saving rate.^[5] At first glance, this would not appear to be the case, since – although there has been strong growth in superannuation assets – household saving has continued to fall.

However, the fall in household saving may have been exacerbated by measurement issues, which are discussed in Section 3.1. Since these do not explain all of the fall in household saving, we consider a number of changes that occurred in the economic environment over the last 20 years and that are likely to have affected the household saving rate, such as the financial deregulation of the 1980s and the increase in household wealth during the 1990s. In Section 3.2, we therefore develop a small theoretical model based on an overlapping-generations framework to illustrate the impact on household saving of superannuation, financial deregulation and an increase in capital gains on household assets.

3.1 Household Saving: Measurement and Trends

Two sources of measurement problems have been suggested in the literature on household saving: inflation bias, and the trend to incorporation (see Edey and Gower (2000); Commonwealth Treasury of Australia (1999)). The inflation bias explanation argues that measured household saving is biased upwards in times of high inflation due to the treatment of net interest receipts in the National Accounts.^[6] To correct this problem, household net saving in Figure 2 has been adjusted to reflect the reduced value of households' net interest-bearing assets (for details, see Appendix A). The adjusted series is much more stable through the 1970s, and has converged towards the unadjusted series through the 1990s due to lower inflation and rising household debt.

Another potential source of mismeasurement is that the trend to incorporation may have resulted in a downward bias in household saving, as saving by unincorporated enterprises (which is classified as household saving) is gradually being reclassified as saving by corporations.^[7] This would imply that there is a corresponding rise in the saving rate of non-financial corporations, but Figure 2 suggests that this rise is only small compared to the fall in household saving. In fact, the mildly inverse correlation between household and non-financial corporations saving over the last 40 years instead may be due to the inflation effect, since households were net holders of interest-bearing assets, while non-financial corporations were net debtors of these assets. When the inflation-adjusted series are compared since 1989, there is little evidence of an inverse relationship. This suggests that the trend to incorporation may not have been a major cause of the fall in household saving.

Another factor contributing to the fall in household saving is the reduction in reported government superannuation contributions. This is likely to be a result of the gradual phasing-out of unfunded government superannuation schemes, for which the ABS imputes contributions into household disposable income. We focus in this paper on personal saving decisions by households, and therefore remove the employer superannuation contributions from household saving.

After making the inflation adjustment and removing employer superannuation contributions, measured household saving still shows some downward trend (Figure 3). Part of this decline may be due to households offsetting their superannuation contributions, capital gains on household assets, or the effects of financial deregulation, as our model of household saving in Section 3.2 shows.

3.2 A Small Analytical Model of Household Saving

This section illustrates the effect of financial deregulation, superannuation and (unexpected) capital gains on household saving using a small theoretical model. Our model is based on the overlapping generations framework introduced by Samuelson (1958), which has also been used by Miles (1992) and Bayoumi (1992) to analyse the effects of financial deregulation on consumption. We will briefly describe the set-up of the model and then informally discuss the results for the different scenarios. A more formal treatment of the model results, including some numerical examples, can be found in Appendix B.

We start with the basic overlapping-generations model of a small open economy. Consumers in our model live for three periods. Consumers are young in the first, middle-aged in the second period and old in the third period, and consume and , respectively. They optimise the (log-) utility they get from life-time consumption, discounting future consumption at the rate β with 0 ≤ β ≤ 1.

Consumers receive an endowment in each period, which could be thought of as labour income. When they are young they have a low income , for instance because they are in education; at middle age, during their working life, they have a high income ; and they have a lower (labour) income in old age.

Although the endowment is not storable, consumers can buy (or borrow) financial investments at the exogenous world interest rate r, which is assumed to be constant. In the basic case there are no restrictions on how much consumers can borrow. Thus they can go into debt or accumulate wealth in the first and second period. For simplicity, they are assumed to have no initial wealth beyond their endowment and they leave no bequests – that is, their wealth after the third period is zero. This implies the following intertemporal budget constraint:

Consumers choose their consumption to maximise their lifetime utility subject to the intertemporal budget constraint. They can use borrowing and lending to smooth consumption relative to their income stream. With our typical income profile, consumers will want to go into debt while they are young (and have a low income), pay off that debt and accumulate wealth while they are in high-income working age and finally consume that wealth when they are old.

At any point in time, there is a young, a middle-aged and an old generation, and aggregate consumption, net wealth and saving are the sum of the individual generations' consumption decisions. Note that, since consumers have access to an international capital market, the economy as a whole can run a current account surplus or deficit if borrowing by domestic households falls short (or exceeds) lending by domestic households, or, in other words, aggregate household saving does not need to be equal to zero.^[8]

3.2.1 Financial deregulation and borrowing

Let us first consider the special case where financial markets in our economy are such that households face borrowing constraints, for instance because they do not have sufficient collateral.^[9] In steady state, if households are unable to borrow without collateral (that is, households' net wealth cannot become negative), the young generation will be able to consume just their endowment in the first period. The middle-age generation will, however, accumulate wealth and save some of their income for retirement. Compared with the case when there are no borrowing constraints, consumers are forced to consume less when they are young and more when they are older. Since they do not pay interest on debt anymore, (undiscounted) life-time consumption is higher in the case with borrowing constraints, but the consumption path is less smooth. Since the young generation is not allowed to incur debt, the stock of aggregate net wealth is also higher compared with the first scenario (in fact, with borrowing constraints aggregate net wealth cannot be negative).

What happens now if the borrowing constraints are reduced or even eliminated? As discussed in the previous paragraph easier access to personal loans and home loans is likely to allow households to bring consumption forward, thus changing individual consumption and saving patterns. Households are now better off since they can smooth consumption relative to their income. For our endowment path, in steady state this results in lower aggregate consumption, since the average aggregate stock of net wealth is lower and therefore less interest income is earned (remember that net wealth can be positive or negative, since households have access to an international capital market).^[10] A detailed numerical example is discussed in Appendix B, and we find that the differences in aggregate consumption between the two cases can be entirely explained by differences in interest income. Aggregate saving, which is defined as the difference between income and consumption, is therefore the same in either model. In fact, in our simple model, with no population growth and a constant endowment profile, in steady state aggregate saving is always zero – with or without borrowing constraints. Or in other words, in the long run, flows into wealth are matched by outflows, and therefore aggregate net wealth is constant (though at different levels).

While saving is unchanged in the long run, during the transition from one steady state to the other saving can change in order to allow for the adjustment in the long-run net wealth stock. As a result, in our model saving is lower for a transition period of two generations. This is because the middle-age and old generations, which were financially constrained in their youth, postponed consumption and therefore remain on their ‘original’ consumption path. On the other hand, the young generation is already consuming on the ‘new’ path, which allows them to bring consumption forward. While the population still comprises consumers that were financially constrained in their youth consumption will be higher (and saving will be lower) than in the steady state. The amount of net wealth, which includes the young generation's debt, will gradually fall to the new level while consumption adjusts back to the new steady-state level.

Financial deregulation has often been cited as a major reason for the slide in household saving in Australia, with lower credit constraints allowing households to greatly expand their borrowing.^[11] Our model shows that, after financial deregulation – for a transition period – saving can be expected to be lower while debt levels rise. Ultimately though, saving is expected to return to the pre-deregulation levels, but the transition period in our model comprises two generations.

3.2.2 Superannuation offset

We will now modify our model in order to illustrate the effects of the introduction of a compulsory superannuation scheme. We consider two broad channels through which superannuation can affect saving. The first is by forcing some consumers to save more since the superannuation scheme is compulsory. The second is by providing information to consumers about ‘appropriate’ levels of saving, thus reducing some uncertainty or myopia which consumers may face. We will discuss each channel in turn.

The effect of forced saving

We introduce superannuation in our model by assuming that a fixed percentage s of labour income (that is, the endowment) is not available for consumption in the first two periods but will be saved, and – together with the interest on the saving – is available for consumption when old.

The utility function remains the same, but the intertemporal budget constraint needs to be modified. Saving in each period can now be split into voluntary saving ((1 − s)e_t − c_t) and compulsory saving se_t:

Note that the intertemporal budget constraint in Equation (3) is essentially unchanged from Equation (2), implying the same desired consumption path. We can distinguish three cases of actual consumption and saving based on the level of forced saving relative to desired saving, and also on the (in)ability to borrow.

If desired saving exceeds forced saving, the introduction of superannuation in our model does not affect the saving rate or the retirement income: the consumer will simply offset the compulsory superannuation by a reduction in other savings, leaving overall saving unchanged.

On the other hand, the consumer may wish to save less than the superannuation contributions as is the case for our typical endowment profile, where young consumers would like to borrow and thus their desired saving is negative. If the consumer faces no borrowing constraint, she can offset the superannuation contributions with debt, allowing her to keep consumption and net saving at the desired level.

The situation changes, however, when the consumer wishes to save less than the compulsory superannuation but cannot borrow to offset the saving in superannuation contributions. Then, consumption in the first two periods will be lower, and consumption in retirement will be higher. If borrowing is zero, wealth is at least as much as the sum of superannuation contributions for each generation, leading to a higher aggregate stock of wealth in every period.^[12]

In this last scenario the introduction of superannuation increases saving of the young and middle-aged generations and – at least temporarily – also increases aggregate saving.^[13] Ultimately, aggregate saving will return to the initial level, since contributions to superannuation wealth by the young and middle-age generation will be matched by outflows to the old generation, supporting their retirement consumption. However, in the transition period (which, in our model, is two generations) saving is higher since the contributions to superannuation wealth exceed the withdrawals during this period, and the net wealth stock gradually adjusts to the higher steady-state level. This also implies that when superannuation is introduced, the consumption of the old generation gradually increases to a higher steady-state level.

Stepping away from the simplicity of our model, in the real world the strength of this channel when compulsory superannuation is introduced will depend on how many consumers are liquidity-constrained or financially-constrained households, which consume all or most of their income. For instance, Debelle and Preston (1995) estimate that around 20–25 per cent of households were liquidity-constrained in the 1990s. These households would have had difficulty offsetting compulsory superannuation, unless they were able to borrow.

The effect of reducing uncertainty

We will now consider a different channel through which superannuation might change the consumption path chosen by consumers. In this case, rather than ‘constraining’, compulsory superannuation resolves some uncertainty around the adequate level of saving for retirement. This might be the case if some households are myopic and underestimate the need to finance consumption in old age, or they overestimate available income in retirement. Superannuation could then serve to indicate the ‘appropriate’ level of saving necessary for adequate retirement provision. In this case, we do not need a specific constraint (such as ‘no borrowing’) to affect consumption and saving, since the desired consumption path itself changes.

In our model an overestimation of retirement incomes would imply an expected which is too high, and myopia would imply a time preference parameter that is too low (thus discounting future consumption needs by too much). In both cases, consumption is being brought forward through time.

If the superannuation scheme now provides a signal that actual retirement incomes might be lower (or that the time preference rate should be increased) consumption is postponed in order to be able to finance a higher retirement consumption. While saving returns to its starting level in the long run, it increases during the transitional period, while the younger generation postpones consumption, and the older generation (which has consumed more in their youth) is still on the old consumption path with a low retirement consumption. As a result, aggregate net wealth increases gradually to a higher level where it stabilises (reflecting the lower debt of the young generation in steady state).^[14]

The empirical relevance of this channel is supported by a number of surveys that have found that households have difficulties in estimating how much saving is needed for an adequate retirement provision. For instance, a recent ANZ Survey of Adult Financial Literacy in Australia (Roy Morgan Research 2003) found that only 37 per cent of respondents had worked out how much they needed to save for their retirement.^[15]

In summary, our analysis highlighted that compulsory superannuation can increase saving, particularly for two groups of households. One group is liquidity-constrained or financially-constrained households, which consume all or most of their income. A second group are myopic households who may underestimate how much long-term saving is necessary to accumulate sufficient funds for retirement. Indeed, some evidence of myopic and liquidity-constrained behaviour can be found in the reasons sighted by jobholders for not making voluntary superannuation contributions. Around a quarter of jobholders indicated that they were not interested in making voluntary contributions, while another quarter could not afford to make voluntary contributions.^[16] Compulsory superannuation forces these households to save more, unless they are able (and willing) to offset it with either reduced short-term savings or increased borrowing.

So far we have assumed that the rate of return on superannuation is the same as the rate of return on other forms of saving. However, some forms of superannuation attract tax concessions. Voluntary superannuation, without the existence of tax concessions or regulations limiting access to funds, should be close to a perfect substitute for other forms of saving, with few implications for total saving. However, when tax concessions are introduced, voluntary superannuation can provide higher returns than other forms of saving. While tax incentives can encourage households to save more in superannuation, it is less clear whether they increase total saving. Households that would otherwise consume all their income might decide to save in tax-advantaged superannuation to take advantage of the higher returns and increase lifetime income. However, households that already save voluntarily may merely substitute into superannuation. They may even save less overall since they no longer have to save as much to achieve the same level of lifetime income.

3.2.3 Consuming out of capital gains

Our model can also be used to illustrate the effect of an unexpected, temporary increase in capital gains from investment, such as the rapid increases in the prices of some household assets over the past 20 years. We assume that the increase in wealth is unexpected, that is, ex ante consumption decisions do not take these capital gains into account. Note that the change in wealth due to the asset price increase is not counted as saving (at least in the definition used here), which is the excess of income over consumption and therefore does not include capital gains.

We can model an increase in asset prices as an increase in the stock of wealth for those consumers who hold positive wealth (in our model this is typically the generation which moves from the middle-age to the old generation, since the young generation either has negative wealth or zero wealth at the end of the period). Not surprisingly, consumption of this generation increases, leading to a rise in aggregate consumption and a temporary fall in the saving rate. This result shows what is known in the literature as the ‘wealth effect’ on consumption: an increase in wealth allows higher consumption by those who own the asset. This will lead – at least temporarily – to a lower saving rate.^[17]

Footnotes

In this paper we use the National Accounts measure of household (net) saving, that is, saving is defined as the difference between income and consumption. Alternatively, one could define saving as the change in wealth, thus including capital gains in saving. [5]

During times of high inflation, creditors' real return on interest-bearing assets, which have a fixed nominal principal, is significantly lower than nominal interest rates would suggest. Since households were net holders of these assets, this leads to an upward bias in measured household saving during times of high inflation, such as the 1970s and 1980s. [6]

Other studies that investigate the effect of superannuation on saving, such as Edey and Gower (2000) and Commonwealth Treasury of Australia (1999), therefore have analysed private saving, rather than household saving. However, the ABS no longer produces private sector saving data. [7]

For simplicity, we assume that each generation has an equal number of consumers. In this case – in steady state – aggregate saving is zero. If the population grows or falls over time, aggregate consumption, saving and wealth will also grow or fall. [8]

There is an asymmetry in our model in that consumers never face lending ‘constraints’, that is, they always find a suitable investment opportunity. If no domestic household is able to borrow, households that accumulate wealth are assumed to lend to foreigners. It is beyond the scope of this paper to explicitly model the international capital market, but the investment opportunity could, for example, be provided by a market for government bonds, which are not collateralised. [9]

In our model, higher debt results in lower income for indebted households in the next period, since they face higher interest payments. However, the cost of servicing a loan of the same size has fallen in Australia as the cost of financial intermediation has decreased due to increased competition and innovation in the financial sector. In order to keep our model simple, we have not modelled this effect of financial deregulation. [10]

See, for instance, Edey and Gower (2000) and Ellis and Andrews (2001). For the UK, see Bayoumi (1993). [11]

Formally, this implies a wealth constraint which is different from that in the simple case of ‘no borrowing’ where wealth must be non-negative. [12]

Superannuation can also have an effect on saving in the first two cases if it is not fully offset. This could be, for example, because the interest rate on voluntary saving is not equal to that on superannuation saving (for example due to different tax treatment) or if the interest rate on borrowing is different from that on lending. [13]

Of course, the expectation adjustment could in principle also operate in the other direction. A superannuation contribution rate s might lie below the current saving rate of some consumers. If these consumers are uncertain how much saving is required for adequate retirement provision, they might reduce their saving. Of course, whether such a reduction is optimal will depend on the preferences and the income path of these consumers, that is, whether they saved ‘too much’ to start with. [14]

Also see the ABS Retirement and Retirement Intentions Cat No 6238.0, November 1997, which provides evidence that expected retirement incomes are often optimistic. [15]

Survey of Employment Arrangements and Superannuation in March 2000, reported in ABS Cat No 6360. The proportion of respondents not making voluntary contributions to superannuation may have been affected by the existence of compulsory superannuation at the time of the survey. [16]

Note that this wealth effect on saving stems partly from our definition of saving as the difference between income and consumption, where capital gains represent non-income returns to wealth. [17]