5.2 Better management of the Commonwealth's balance sheet
The government’s balance sheet is an important measure of its financial position at a point in time.
While assessments typically focus on the annual ‘bottom line’ as measured by the underlying budget balance, the state of the Commonwealth’s assets and liabilities matters a great deal.
The relative health of the Commonwealth balance sheet heavily influences credit ratings and therefore its borrowing costs. Not only is the balance sheet an important indicator of short term fiscal sustainability and government’s ability to respond to economic shocks, it also reflects the debt and other liabilities that future generations must repay.
The Commission considers there are advantages in raising community awareness of the balance sheet’s importance. A greater focus on it would broaden the debate on fiscal policy and encourage better asset management.
As outlined above, the Commonwealth holds some $110.1 billion of non-financial assets, with responsibility for managing them on a day to day basis devolved to individual agencies. Section 10.1 considers the potential to privatise several Commonwealth entities and assets. Further recommendations for improving management of the Commonwealth’s property portfolio are outlines in Section 10.2.
Prudent asset management practices suggest governments should adequately fund not only upfront expenditure on assets, but also ongoing capital maintenance and operating costs.
As described in Section 4.2, a significant pressure on the balance sheet is unfunded defined benefit scheme superannuation liabilities for public servants and military personnel. The Military Superannuation and Benefits Scheme is projected to be the main driver of the Commonwealth’s superannuation liability growth from 2030.
The 2007 Report of the Review into Military Superannuation Arrangements recommended there be no change to the indexation arrangements for the current military superannuation scheme, that the scheme be closed to new entrants and a new scheme based on an accumulation plan be opened for new Australian Defence Force members.
The Military Superannuation and Benefits Scheme is now the only major Commonwealth scheme with unfunded defined benefits that remains open to new members, and hence is generating uncapped and increasing unfunded liabilities. These liabilities will have to be paid for by future generations.
Steps should be taken now to better manage them. Any changes must, however, recognise the obligation Australia has to look after our serving personnel. The Commission recommends that the Military Superannuation and Benefits Scheme be closed to new members and replaced by an accumulation scheme for new Australian Defence Force personnel. The new scheme should be designed in a way that recognises the special contribution these Australians make to the defence of the nation. Any new scheme should continue to provide a defined benefit where a member dies or is medically discharged from the Defence Force. This death and disability element will complement the accumulation component of the scheme.
Closure of the Military Superannuation and Benefits Scheme would result in a significant reduction in the Commonwealth’s unfunded superannuation liability potentially in the order of $200 million by 2020. This would make a significant contribution to repairing the long-term financial position of the Commonwealth.
If the Military Superannuation and Benefits Scheme is closed and replaced by a funded accumulation scheme for new military personnel there will be an immediate increase in cash costs to government. This arises because employer contributions would be made directly to the new scheme in respect of members’ services, whereas the reduction in outlays from closing the Military Superannuation and Benefits Scheme arises from reduced pension payments in the longer term.
While the increased cash outlays would depend on the design of the new scheme, including the contribution rate and death and disability arrangements, these outlays over the first four years could be around $400 million.
As outlined above, the Future Fund was established to enhance the ability of the Commonwealth to discharge annual unfunded superannuation benefit payments. Under current arrangements, draw downs from the Future Fund will occur from 2020.
The effect of drawing down pension payments, from that date, will be a decrease in cash costs to government, as payments will be met from Future Fund monies rather than consolidated revenue.
In relation to civilian superannuation, while the major defined benefit schemes have been closed already, the liability will nevertheless continue to grow until around 2030 in relation to existing contributors.
The Government should move over time to a ‘funded’ model for those defined benefit schemes, where the employer contribution would be paid to the superannuation trustee, the Commonwealth Superannuation Corporation, rather than retained in consolidated revenue. This is the arrangement the Commonwealth currently follows for its accumulation schemes.
This would reduce the Commonwealth’s medium to long-term liability, but lead to a significant and immediate increase in cash costs to government, estimated to be around $1.4 billion per year. If this option is also implemented in relation to the existing military scheme, this cost would rise to about $2.7 billion per year.
Given the significant cash impacts of funding future employer contributions, the Government should consider allowing earlier drawdowns from the Future Fund (that is, before 2020). This would effectively offset, in part or full, the costs of a new accumulation scheme and, or the funding of defined benefit schemes in future years. This action would require amendments to the Future Fund Act 2006.
Recommendation 3: Better balance sheet management – unfunded superannuation liabilities
Unfunded superannuation liabilities on the Commonwealth's balance sheet represent a significant risk to the long-term financial position of the Commonwealth and should be better managed. The Commission recommends that the Government:
- close the Military Superannuation and Benefits Scheme to new entrants, with a new scheme established based on an accumulation plan opened for new Australian Defence Force members;
- as part of prudent financial management, move over time to a ‘funded model’ for existing defined benefit superannuation schemes; and
- in recognition of the upfront costs of a ‘funded model’ approach, consider allowing earlier drawdowns from the Future Fund to offset the costs of the new military accumulation scheme and future funding of existing defined benefit schemes. This would require amendments to the Future Fund Act 2006.
More generally, in considering issues around the balance sheet it is important to recognise governments take risks onto their balance sheet when they provide guarantees and loans (including concessional loans) to various people and organisations.
Recent examples include: the guarantee of $700 billion of deposits as part of the Financial Claims Scheme; guarantees of $13 billion of aged care accommodation bonds; guaranteeing $3.3 billion of liabilities of the Export Finance and Insurance Corporation; and loans through the Clean Energy Finance Corporation.
The information on the attendant risks provided to ministers and released publicly on these guarantees and loans is relatively poor.
The expected costs of guarantee calls and most loan defaults are not included in the Budget estimates. This means guarantee and loan costs are not budgeted for on an equivalent basis to the costs of more direct forms of government expenditure, like grants.
By failing to properly price the risk taken on by government, guarantees and loans are not subject to an effective budget constraint, they cannot be prioritised or ranked against other direct forms of expenditure. Government also has an incentive to take on more risk on behalf of taxpayers than is warranted.
The Commission considers the practice of government providing guarantees and loans would benefit from greater transparency through better budget treatment.
The expected costs of all existing and new Commonwealth guarantees should be included in the Budget both in the Budget year and forward estimates. The cost would be determined as an expected value of the guarantee being called (assessed as a probability applied to the amount of the guarantee).
The Contingency Reserve is an allowance used to ensure estimates are based on the best information available at the time of the Budget and to ensure aggregate estimates are as close as possible to expected outcomes. It includes a provision for events and pressures reasonably expected to affect the Budget estimates. The expected costs of guarantees could be included in the Contingency Reserve under this category.
Where the costs materialise they would be booked within the appropriate agency and the amount in the Contingency Reserve would be removed. Where these costs do not eventuate the amount would be backed out from the Contingency Reserve at the end of each year.
For loans, the Commonwealth should recognise the expected amount of loan defaults as a grant at the time of the loan origination. There is already scope under existing accounting standards to recognise the expected costs of loan defaults as a grant in the Budget estimates.
This change in budget treatment would remove the current perverse incentive for guarantees and loans to be viewed as ‘costless’ forms of assistance. If, as is possible, such assistance is effectively prioritised against other direct forms of expenditure it should reduce the incentive for governments to take on more risk on behalf of taxpayers.
At a decision making level, a proposing minister could be required to offset the expected costs of guarantees or loans. Expected costs could also be charged in full or in part to the beneficiary.
Recommendation 4: Better balance sheet management – loans and guarantees
There are risks to the Commonwealth's financial position when the government provides guarantees and loans. The Commission recommends:
- the expected costs of existing and new Commonwealth guarantees be included in the Contingency Reserve across the forward estimates (and removed from the Contingency Reserve at the end of each year if the costs do not eventuate);
- the expected non-repayment amount of loans be recognised as a grant at the time of loan origination;
- the expected costs be included in the Budget where they can be reliably estimated and have an expected cost above $5 million in any year; and
- the Commonwealth continue to regularly and independently re-assess the value of its guarantees and loans.
The government also takes on the risks of ownership and receives returns (such as dividends) on behalf of taxpayers when it partially or fully holds equity. Equity holdings in major government-owned entities include NBN Co, Medibank Private and Australia Post.
Under the relevant accounting standards, the Commonwealth’s equity investments are classified as having no impact on the Budget ‘bottom line’ (the underlying cash balance) if the Commonwealth has a reasonable expectation of a real return on its investment, at least covering the effects of inflation.
For example, the Budget papers record the financing of NBN Co as an equity investment on the basis that the Commonwealth expects to recover its outlay in real terms over time through dividends and sale of the investment in the future.
This ‘hurdle rate of return’ (of around 3 per cent) for the Commonwealth is well below that required by a private investor, who would require a rate of return commensurate with the cost of borrowing and the level of risk undertaken. Under the Government Financial Statistics accounting standards there is no requirement for NBN Co or other equity investments to achieve a risk-adjusted rate of return.
Without commercial discipline, government-owned entities may accept a lower rate of return and take on more risk. While the Commonwealth has a low cost of borrowing by virtue of its ability to source debt and raise tax, this does not mitigate the risks taken on by taxpayers from the financing of risky projects.
The annual change in the value of equity in NBN Co is presented as an ‘other economic flow’ on the balance sheet. Should the Commonwealth no longer expect to receive a real return on its investment, any future equity injections would be classified, partially or fully, as grants. This would worsen the underlying cash balance.
As outlined in Section 10.1, the Commission considers that Commonwealth bodies that operate and compete in contestable markets should be considered for their privatisation potential.
Similarly, as a matter of policy, the Commonwealth should not take equity positions where the activity can be undertaken by the private sector, with private investors, rather than taxpayers, risking their own money.
Where the Commonwealth does take an equity position it should disclose the rate of return it expects to receive and how this compares to the risk-adjusted rate of return that a private investor would need to make the same investment.
Recommendation 5: Better balance sheet management – equity investments
Without commercial discipline, government-owned entities may accept a lower rate of return and take on excessive risk. The Commission recommends:
- the Commonwealth not take equity positions where the activity can be undertaken by the private sector;
- where the Commonwealth does take an equity position it should disclose the rate of return it expects to receive and how this compares to the risk-adjusted rate of return that a private investor would require to make the same investment; and
- the Commonwealth continue to regularly and independently re-assess the value of its equity investments.