Crunch time for liquidity

Published in ASFA Super Funds Magazine November 2013. See

Australian Superannuation Funds Liquidity

Australia’s superannuation system, best described as a hybrid structure that consists of a combination of compulsory superannuation contributions and individual investment choice, is regarded internationally as one of the best systems in the world. One of the central features of Australia’s superannuation system was that in establishing the legislative framework for the Superannuation Guarantee the Federal Government quite deliberately did not overly restrict the investments of superannuation funds. However whilst the Sole Purpose test allows superannuation funds to determine an investment strategy that is appropriate to members, choice of fund has in reality limited the capacity of superannuation funds to invest in illiquid investments that include unlisted infrastructure, property and venture capital.

As part of APRA’s Investment Governance Prudential Standard (SPS530) which became effective on 1 July 2013 superannuation funds are required to manage their liquidity. Liquidity itself is the technical term that refers to the ability of a superannuation funds to meet its obligations as they fall due. SPS530 codified what was becoming an industry norm, providing APRA with the power to manage what was up until the passage of legislation a guide to trustees.
One of the fundamental public policy issues that deserve further research is whether Australia’s choice of fund system, by limiting the capacity of funds to invest in illiquid assets, actually reduces long term retirement benefits.

One of the attractive features of illiquid investments is their ability to deliver an illiquidity premium. The extent of such premiums is subject to much debate and reflects the maturity of the underlying asset class. In a December 2012 paper APRA examined the issue of illiquid investments concluding that funds with moderate illiquid investments experience higher risk adjusted returns.
APRA found that not-for-profit funds have a higher illiquid asset allocation on average compared to among not-for-profit funds and that those with higher allocations to illiquid investments tended to be larger funds. According to APRA one of the main drivers of investment in illiquid assets was that funds with larger positive net cash flows and fewer members approaching the drawdown phase of their membership allocated a greater proportion of their portfolios to illiquid assets.

The challenge for Australia’s superannuation system is demographics. Australia’s compulsory superannuation system was established 20 years ago. In the early days of the system retirees had often only received compulsory superannuation contributions for a short period of time, with relatively small account balances. With twenty years of compulsory superannuation contributions behind them, retirees are now leaving work with decent superannuation account balances. Because superannuation trustees must be able to meet their obligation to pay out superannuation benefits on retirement the older the demographics of a fund, the more liquidity that is required.

As members age superannuation funds will need to consider their overall asset allocation. With 4.5 million baby boomers approaching retirement in the next decade this is likely to be a significant issue for the superannuation system, and not just individual superannuation funds. As APRA stated in a 2008 discussion paper “Not only will this demographic ‘bulge’ provide challenges for the Government in the coming years in terms of health care, social security and workforce participation rates, but it will also create a range of challenges for superannuation funds, not the least being the need for increased liquidity management so that benefit payment obligations can continue to be met going forward. While the proportion of benefit payments taken as lump sums will hopefully trend downwards, in dollar terms it is reasonable to expect that this drain may increase significantly in coming years as more and more ‘Baby Boomers’ move into retirement, and take their lump sum with them.”

As Australia’s superannuation system matures one of the questions that need to be considered is what is the role of illiquid assets? The demographic trend would suggest (all things being equal) that overall the portion that superannuation funds will be able to invest in illiquid assets will decline over time. Is this a good thing in terms of retirement outcomes?

One of the debated questions is whether, if unconstrained by regulation, superannuation funds would increase their allocation to illiquid investments? The ability to match long dated commitments with long term assets seems to make superannuation funds a perfect match for illiquid investments. However illiquid assets have other risks that need to be considered in determining an appropriate asset allocation. Risks include transaction risk (the risk that it can take an uncertain time to sell the asset, at an uncertain price) and valuation risk (the risk that the assets cannot be accurately valued). Illiquid assets such as infrastructure, property and venture capital may also require funds to have sufficient in-house experience to manage assets, adding to the cost and complexity of managing a portfolio.

An important public policy question is whether superannuation funds should be given flexibility that would enable an increase in illiquid investments? There have been a number of recent suggestions about the merits of establishing either a back stop facility through the Reserve Bank, or enabling superannuation funds to borrow through a line of credit offered by a bank.

ASFA asked Deloitte Access Economics (DAE) to consider the issue of a liquidity facility as part of the recent “Maximising Superannuation Capital” report. DAE illustrated a model that could operate. “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. By charging ADIs for the liquidity insurance the central bank provides, the appropriate incentive is established for ADIs to manage their liquidity risk. At the same time, the design of the CLF will contain the impact of regulatory-induced demand for liquid assets in an environment where so few exist. 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. Setting up a liquidity backstop for superannuation funds, with appropriate haircuts to guard against moral hazard, may provide a solution that would satisfy APRA and leave the superannuation funds free to make investment decisions that best meet their members’ needs. The CLF that the RBA manages for ADIs is a framework that could be considered. But the net benefit of such a facility for superannuation funds needs to be established first.”

There are a number of issues that need to be considered before concluding whether super funds should be given more flexibility to invest in unlisted assets. There is the potential that changes would introduce moral and economic hazards.

It is also important to consider what liquidity risks a back drop facility would seek to address. Superannuation funds could face a liquidity crunch due to either systemic or idiosyncratic events. A backstop facility is not appropriate to address a situation where a fund faced an outflow due to fraud or reputation risk.

It is likely that any systemic event would be global, and not just limited to Australia. One of the scenarios would be that a drop in the value of the Australian dollar would force funds with currency hedges to find cash to meet hedging commitments. In this scenario one of the questions is whether Australia’s banking system would be in position to provide liquidity to superannuation funds in the event of such a crisis. The experience from the Global Financial Crisis was that superannuation funds provided liquidity to banks, rather than the other way around. If there is a question as to whether the banking system could provide liquidity in the event of a global crisis then the best policy option would be a Reserve Bank facility.

One of the arguments in favour of having a facility in place is that it would prevent a knee jerk reaction by government. In the event of a continued period of disorderly markets a question would arise as to whether the Government should freeze withdrawals from superannuation with the exception of payments to retired members. In this circumstance the ‘too big to fail’ nature of superannuation would make any Government decision of national interest. In such circumstances the likelihood would be that government would also consider a freeze to compulsory superannuation contributions to provide a stimulus to the national economy. A Reserve Bank facility would provide a way for the superannuation system to manage any external shock without huge disruption.

Introducing a liquidity backstop is likely to be considered as part of a Financial Systems Inquiry which the Coalition has committed to establishing. It is important that change is not rushed into. There is currently no liquidity crisis and superannuation funds have not been constrained in making investments in illiquid assets.

The sources of liquidity crunch in Australia’s superannuation system include systemic events and long term demographic changes. The challenge that superannuation funds face managing international investments is the fact that the Australian Dollar is a football that is kicked around during global crises. The need to hedge investments will put ongoing liquidity pressure on Australian super funds. As the superannuation system matures superannuation funds will need to consider there asset allocation. The important point is that the trend is only going one way, and that is to make investing in illquid assets more difficult.

It is worth pointing out that the need for superannuation funds to invest in liquid assets has the potential to have broader impacts on the Australian economy. Australia has a concentrated equities market dominated by banks and financials. As the size of the superannuation pool grows the search for liquidity and diversification will drive superannuation funds to increase their exposure to international equity markets.

If Australian superannuation funds were not required to limit their illiquid investments then it is likely we would see at least some funds change their asset allocation. We do not know how many superannuation funds would change their investment strategies and by how much but we do know that there would be change. The fact that some funds would change their asset allocation can be seen as the explicit cost of having choice. This is not to suggest that we shouldn’t have choice of funds, but we need to recognize that it does potentially have a cost in terms of diversification and risk-adjusted returns.

The good news is that we are not at the limit of the system’s ability to absorb new illiquid investments. The continued cash flow of superannuation contributions into superannuation means superannuation funds remain in a strong position to invest in illiquid investments. The Financial System Inquiry will provide an opportunity to consider whether changes are needed to ensure that the superannuation system continues to deliver long term outcomes for superannuation fund members.

Turning their backs on tobacco

Published in ASFA SuperFunds magazine October 2013,

by Gordon Noble

A growing number of superannuation funds have now divested from tobacco. ASFA recently held a forum with First State Super to provide an opportunity for funds to share their experiences. With Portfolio Holdings Disclosure now legislated with implementation slated for 1 July 2014 it is timely for funds to consider the role that tobacco may, or may not play in their superannuation portfolios.

Dr Bronwny King, an oncologist at Peter Mac, a Melbourne cancer treatment facility, presented arguments at ASFA’s Tobacco and Superannuation Forum on why funds should divest from tobacco. Bronwyn represents what can be described as a new generation of activists. Articulate and intelligent, Bronwyn discovered by accident that she was effectively invested in tobacco when at the end of a meeting on her superannuation with a representative from First State Super the conversation turned to investment choices. Unaware that she could make investment choices the First State Super representative explained that the fund offered sustainability based investment choices that excluded investments in tobacco. Bronwyn’s reaction was a realization that while she had been treating the victims of tobacco she had at the same time been investing in the companies that manufactured and promoted smoking. Rather than just excluding tobacco from her own investments she felt she needed to do something, aware that many health professionals like her did not always pay sufficient attention to the details of their superannuation.

Bronwyn established Tobacco Free Super, and began campaigning for the removal of tobacco from superannuation fund investments. First State Super became the initial focus of the campaign and as a result of front page coverage in daily newspapers began a board discussion to consider whether the fund should divest from tobacco. As First State Super CEO Michael Dwyer admits the issue of tobacco was on the fund’s radar but as the fund was dealing with a raft of issues in respect to its merger with Health Super, consideration of divestment had slipped down the order of priorities. As newspaper editorials focused on the irony that a fund that promoted that it ‘cared for the carers’ was investing in tobacco consideration of the issue became a priority.

First State Super is not the first fund to divest from tobacco. Funds such as Local Government Super divested many years ago. One of the divers of change of opinion around the role of tobacco is Portfolio Holdings Disclosure. We are currently waiting for regulations to implement the legislated requirement that super funds disclose to members their investments. Once implemented, Portfolio Disclosure will mean that superannuation funds have nowhere to hide in terms of their investments. It will be easy for activists to aggregate fund data to produce consolidated data on the amount that the superannuation industry invests in any particular company or group of companies. We should not fear this. But it will mean that both as individual funds, and as an industry, we need to be prepared to explain why we invest.

For funds that have divested from tobacco there does not appear to have been a financial costs. Funds have found that they have been able to replace tobacco investments with investments with similar attributes – Coca Cola and Pepsi for instance demonstrate inelastic demand and target emerging markets but without the deaths.

One of the features of Australia’s superannuation system was that in establishing the legislative framework for the Superannuation Guarantee the Federal Government quite deliberately did not overly restrict the investments of superannuation funds. It is worth recalling APRA’s February 2001 clarification of the SIS Act outlining a set of Principles. The Principles state that a trustee should exercise care when considering investments to ensure that the provision of retirement benefits for members is the overriding consideration behind the investment decision. “However, the situation may arise where a properly considered and soundly based investment provides “incidental” advantages to members or other persons which could suggest that the fund is maintained, in whole or part, for an improper purpose.” The Principles go on to describe that “such incidental advantages would not necessarily, in isolation, amount to a breach of the sole purpose test. For example, investment in a well-researched and commercially sound project might incidentally create employment opportunities for members; and It is open to trustees to develop features of their fund which add value to, or differentiate it from, other funds.”

There has been little focus on the concept of ‘incidental advantage’ in the broader debate about fiduciary duties. However in the context of a legislative environment that does not restrict investment, there is no legislative and regulatory restrictions so long as investments were made for the purpose of providing retirement benefits.

This may represent a new chapter for responsible investment. Many Australian superannuation funds have become signatories to the United Nations Principles for Responsible Investment. Whilst most attention is placed on engagement activities and ESG integration the PRI consist of six principles. Principle 6 states that signatories will ‘report activities and progress towards implementing the Principles’. For many funds this Principle has been interpreted as reporting to the PRI secretariat about progress implementing the Principles. However if you go back to the original guidance that was developed to assist interpretation it is clear that the founders of the PRI intended that reporting would also be to stakeholders and beneficiaries. Specifically the guidance on Principle 6 suggests that signatories can ‘communicate with beneficiaries about ESG issues and the Principles’ and ‘make use of reporting to raise awareness among a broader group of stakeholders.’

Portfolio Holdings Disclosure is likely to provide the impetus for superannuation funds to turn their attention to reporting their ESG activities to an external audience. Over the next decade superannuation will become increasingly competitive. As funds fight to recruit and retain members an active approach to communicating responsible investment may become an asset.

The superannuation industry, and indeed pension funds globally, is unique in that it has been able to largely escape the demand for corporate social responsibility or sustainability reporting. Whilst a large proportion of listed corporations produce their own sustainability reports, or report in some form on non-financial issues, the reporting by superannuation funds on their own activities is sporadic. Ac super funds increase their engagement with members there will come a time when it is the norm for superannuation funds to produce a sustainability report that provides details of what the fund invests in, how it engages and how it contributes positively to society.