Maximising Superannuation Capital
printed in ASFA Super Funds Magazine June 2013
As the superannuation system climbed over $1 trillion of assets it first began to attract attention from public policy makers. As the system approached $1.5 trillion public policy makers became more heavily engaged, launching inquiries commencing with the Cooper Review that have resulted in the range of Stronger Super reforms that have been targeted at improving efficiency and reducing costs. Most recently there has been intense focus on the level and distribution of superannuation taxation concessions.
If we think that the attention of public policy makers will wane once these reforms are over then think again. With Treasury predictions that superannuation will hit $6 trillion by 2037 the system will become the largest financial asset in the country. The way in which superannuation invests will influence not only economic activity but indeed the structure of the Australian economy, financial stability and of course the wellbeing of millions of Australians in retirement.
Understanding the importance of superannuation to the nation ASFA commissioned Deloitte Access Economics to produce a report that examined whether Australia’s superannuation system is meeting its primary objective of helping individuals to fund their retirement. The report, Maximising Superannuation Capital, explores the impact of the growth of superannuation in the context of providing retirement benefits (income and capital) for people in retirement, linking savers and investors within the wider financial system, and supporting financial stability in the Australian economy.
The key conclusion of the report is that the superannuation system is flexible enough to meet the needs of the nation in the future. The report confirms that the superannuation industry has the flexibility to respond to the transition from accumulation to draw-down by evolving business models and developing new products.
The growth of the superannuation system should not compromise the stability of the financial system, even as the pool of funds grows.
Further the report found that whilst the superannuation system already supports Australia’s long- term economic growth it has the flexibility to accommodate future demands for capital.
One of the questions commonly asked is whether superannuation can do more to invest in assets including infrastructure and venture capital. DAE found that Australian superannuation funds invest a large majority of assets within Australia, exhibiting significant home bias. The Australian superannuation already invests more in its home country than other pension system.
Recognising that public policy makers may want to consider whether superannuation can do more to support particular investments the report found that the best way to do this was through incentives, rather than mandating. The report states “while incentives may help to maximise the economic impact of superannuation capital, mandated allocation risks leading superannuation away from its primary purpose―funding income in retirement. Market forces determine that capital will flow where it is most valued. This obviates the need for any specific interventions mandating asset allocation of superannuation fund investment strategies, as this is an invitation to poor performance and lower returns.”
DAE considered whether the superannuation system has the capacity to adapt to the demographic and structural challenges arising from Australia’s ageing population. Recognizing that Australia’s superannuation system is approaching a transition as the Baby Boomer generation approaches retirement shifting, a significant portion of assets from accumulation stage to ‘de-accumulation’ phase. Australia’s demographic shift means that retirees will make up a greater portion of the population in the future. Retirees will also live longer.
Australia’s superannuation system has been designed to deliver a lump sum. A challenge is for individuals to turn this into a retirement income stream. DAE argue that an individual’s ability to manage risk will hinge on the availability of suitable instruments to manage this risk. The shift in phases will be associated with several changes. Those in the de-accumulation phase face different risks, and have different priorities. Managing these effectively will be vital to the performance of the superannuation system in the future.
One solution is likely to be to make retirement income streams more attractive than lump sum payments. DAE proposed other options to address shortcomings in individuals’ ability to manage retirement income risks including continuing to improve financial literacy, offering incentives for the take-up of products well suited to managing retirement risk such as by encouraging products that provide an income stream in retirement and developing other products that yield a reliable income stream, such as Australian Pensioner Bonds.
DAE conclude that the superannuation industry is well positioned to manage a transition to de-accumulation. The transition will impact the business models of superannuation funds, as more accounts transition from the accumulation phase to the draw-down phase. Inevitably, as more of their members move into retirement, superannuation funds will adapt their business models and products to the retirement phase.
SMSFs present a challenge
The report identified that the size of SMSFs and their importance to the superannuation industry mean that there are a few key questions that need to be addressed to ensure the long term stability of this part of the superannuation industry.
According to DAE a potential longer-term problem arises from policies that encourage the growth of SMSFs. Typically SMSFs are managed at a family level. Generally, one person will be the primary manager of the account. If a person were to die, leave the relationship, or otherwise become unable to make investment decisions, it is unclear if the other individual would have the financial literacy to continue to manage the SMSF.
There are also risks associated with ageing of individual trustees, and consequent ability to manage the fund in the de-accumulation phase. It is also unclear whether the asset allocation of SMSFs, as they currently are, is the most appropriate asset allocation for investment as individuals move out of the accumulation phase and into the retirement phase.
The report found that superannuation has the capacity to support stability of Australia’s financial system. By their nature, superannuation funds have a longer-term view of investment. Their key role is to seek the best risk/reward trade-off and, in doing so, they pursue an investment strategy that duration-matches their long-dated liabilities. As a result, they tend to invest in less volatile, longer-term assets and are consequently more concerned about corporate governance than other investors.
Superannuation and banking operate different but complementary business models, with different risks to manage. For its part, the Financial Stability Board (FSB) seems not to be especially concerned about the impact of defined contribution (DC) pension funds on systemic stability. Indeed, during the GFC superannuation funds repatriated FUM which helped augment the supply of capital for domestic banks and large corporates.
Superannuation and national savings
One area of debate is whether superannuation has had a positive or negative impact on Australia’s banking system. DAE concluded that the increase in superannuation assets has occurred at a time when authorised deposit-taking institutions’ (ADIs) share of system assets has also been rising. While assets of superannuation funds have grown, assets of ADIs have grown faster. Between 1999 and 2012, superannuation assets grew from 16% to 22% of system assets, while ADIs increased their share from 46% to 60%. Consequently, superannuation does not appear to be attracting funds away from banks, to the detriment of traditional borrowers from banks, but from life offices and managed funds. However DAE identified that this could change in the future.
Historically, Australia has not generated enough domestic savings to fund domestic investment needs, relying on offshore lenders to make up the difference. Available evidence supports the notion that compulsory superannuation has contributed to national saving. As a share of GDP, Australia’s national saving has tended to be higher than that in other advanced economies and has increased since the late 80s, whereas saving in other advanced economies has declined. This higher and increasing trend in national saving is in line with the introduction of award-based superannuation in 1985 and the compulsory superannuation guarantee system in 1992. Moreover, while funding investment through national saving lowers the risk profile of a country and thereby contributes to financial stability, this offshore investment provides a hedge to the country’s domestic investments, also lowering risk.
One of the challenges that superannuation funds have is the requirement to manage liquidity of investments. APRA’s new Investment Governance Prudential Standard (SPS530), which will become effective on 1 July 2013, requires superannuation funds to formulate and implement a liquidity management plan and undertake comprehensive stress testing of investment portfolios in a range of stress scenarios.
DAE argue that APRA’s requirements for high levels of liquid assets are a disincentive for superannuation funds to invest in long-term and illiquid assets. It is not clear how strong this disincentive is but changes to regulation are intended to change behaviour. There is evidence to show that funds investing in illiquid assets are able to capture an illiquidity premium. A recent APRA paper entitled, ‘Risk and return of illiquid investments: A trade-off for superannuation funds offering transferable accounts’ (APRA, 2012) shows that ‘funds with moderate allocations to illiquid investments experience higher risk-adjusted returns, which suggests that they capture a risk premium for investing in these assets’.
One potential solution to alleviate the liquidity requirements for superannuation funds would be to establish a liquidity facility for superannuation funds. A liquidity backstop for superannuation funds, with appropriate ‘haircuts’ to guard against moral hazard, may provide a solution that would satisfy APRA and leave superannuation funds free to make investment decisions that best meet their members’ needs. The Committed Liquidity Facility (CLF) the Reserve Bank of Australia (RBA) manages for ADIs could be considered as a model. The facility would operate in a similar way to that provided by the RBA for banks. Currently, banks can enter into a repurchase or repo agreement with the RBA, whereby banks can sell Commonwealth bonds and eligible securities to the RBA and buy them back at a later date. The repo agreement is essentially a secured loan, with the proceeds providing short-term liquidity. Under the proposal, superannuation funds regulated by APRA could utilise this facility alongside banks. This arrangement would also create incentives for superannuation funds to hold more repo-eligible securities, in particular fixed income securities. DAE state that the merits of a liquidity backstop need to be demonstrated.
Contributing More to the Economy
Superannuation funds already contribute to the national economy. Australia’s superannuation system has a strong home country bias which means that the contribution of the Australian system is likely to be more than other nation’s pension system.
According to DAE it is not obvious that superannuation funds can plug gaps in financial markets. If capital flows to where it is most highly valued, this may explain why some sectors miss out. If capital will find its way to profitable investment, then all worthwhile opportunities will be pursued. The challenge is to find a way to prioritise these opportunities so the most worthwhile ones get funded first. If superannuation funds are asked to help meet economic objectives, it should not be in a manner detrimental to returns on fund members’ retirement savings.
The report examined a range of areas where superannuation funds could fill gaps. One area that was identified was investments in small and medium-size businesses, where superannuation funds would need more credit skills and access to more research on small companies.
Overall DAE argued that if the cost of leaving gaps unfilled is deemed significant and higher levels of investment by superannuation funds is regarded as essential, a more activist approach will be required. The best way to do this is not to mandate investments but to develop more instruments that are suited to superannuation funds (capabilities) and their members (risk preferences). Intermediaries will continue to play a part in facilitating superannuation funds’ involvement. For example, investment banks have traditionally brought new products to the market. Superannuation funds have taken up these new products where appropriate to the needs of their members.
DAE expect that the superannuation industry business model will evolve in response to current issues. Importantly they identify that superannuation cannot provide all the answers to managing retirement income risk―since superannuation is co-mingled with other sources of income and capital such as the age pension, houses and other assets―and that therefore other things must be done to complement superannuation.
Superannuation will continue to grow for many decades to come. Superannuation prudently overseen, should not compromise financial system stability. While incentives may help to maximise the economic impact of superannuation capital, mandated allocation will lead superannuation away from its primary purpose of providing retirement benefits for people in retirement.
ASFA invites comments on the report Maximising Superannuation Capital which can be found at: