How can superannuation funds invest in innovation?

This week I spoke at the Ausbiotech conference in Melbourne on the role of superannuation investing in life sciences, proposing the establishment of a Superannuation Innovation Forum.

Following are notes from my speech:

Superannuation and Life Sciences Speech
AUSBiotech Conference, Crown Conference Centre, Melbourne
Tuesday 6 October 11.30am – 12.00pm

Today I want to focus on how we can get superannuation funds to invest in innovation.

This question is directly related to life sciences. But it is broader. If we can establish the right environment, then we will see investment flow to technology companies, advanced manufacturing and other entrepreneurial companies benefit.

There is a ground dog day element to this discussion that as a nation we have never been able to quite address.

The fundamental reason why is that government, superannuation and industry talk at each other – not to each other.

One of the perennial problems is that when talking about innovation, government become besotted with the idea of establishing a venture capital culture in Australia. This is backed by Ministerial tours to Silicon Valley and discussions with venture capitalists.

I am afraid that our policy makers have spent far less time talking to the heads of superannuation funds – who are literally next door.
So let’s talk about the obstacles that are preventing capital flowing to innovation.

Government

Part of the problem is that the Governments own rules make it difficult.

Superannuation funds have been required to manage liquidity in order to meet redemption requests and member choice requests.

This is one of the real costs of the choice of fund that we all individually are able to access. My ability to transfer assets within a couple of days anywhere in the system means that superannuation funds can only ever invest a tiny proportion of investments in unlisted assets.

There has been discussion on the need for liquidity facilities and special rules that could enable super funds to invest more in illiquid assets – but unfortunately we have not seen progress on this issue in the recent Financial System Inquiry.

Venture Capital

The second issue is the venture capital model.

Venture capital is at its heart an investment structure. One of the problems with venture capital is that it is not ideal for superannuation funds. The key issues are:

1. Investment volatility
2. Fees
3. Flipping

Again we need to understand the impact of one arm of government policy – which requires disclosure of fees and has established low cost accounts – MySuper. Venture capital is more expensive and for a system that has been designed to be fee sensitive this is an issue.

Returns from VC have also been volatile, which is again not suited to a system where individuals carry investment risk.

Where super funds do invest in VC one of the problems they encounter is the flipping culture. If superannuation funds do take risks on illiquid investments they have no incentive to sell to realise a short term capital gain. They have an interest in holding for the long term.

Superannuation

The third issue is the superannuation industry itself. A key factor that supports investment is knowledge. In the case of infrastructure investment, we have built up knowledge over the last 20 years. The result of this accumulated knowledge is that superannuation funds feel more comfortable allocating to infrastructure. This same level of knowledge does not currently exist in sufficient depth in innovation.
How do move forward?

The first thing I am advocating is the establishment of a Superannuation Innovation Forum – an independent group funded by Government, industry and stakeholders – whose job it would be bring the superannuation industry, government and industry together to develop solutions.

One of the functions of such a group should be to develop investment models that enable superannuation funds to invest. This could involve collaborative models and may require changes to regulation.

The forum should involve all stakeholders, including the ASX – which will remain the major source of capital flow from superannuation funds and which is already a major source of capital flow for small cap stocks.

What kinds of outcomes could we see?

One thing I would like to see is the emergence of a series of Autralian Innovation Companies that are listed on the ASX with the major shareholders being superannuation funds. The purpose of these companies would be to invest in our entrepreneurial companies – including life sciences. When investments succeed the Australian Innovation Company would not sell – it would use the cash-flow to fund future investments with the aim of building a company that in the end has global scale.

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The problem with Grattan’s default fund tender

The Grattan Institute this week released a report into Australia’s superannuation system proposing that the Government should introduce a tender for default funds.

The aim of the default tender would be to reduce costs in the system – something that would have long term benefits for future retirees through increased account balances.

Grattan argue that a core criteria of the default fund tender would be fees. There are a number of ways that a superannuation fund reduce fees. One way, as identified by Grattan, is through scale. Another way is to invest passively, something that Grattan supports on the basis of the track record that active managers have beating their indexes.

Leaving aside the debate about passive and active management, there is a need to consider the impact that index investment has on capital markets and capital formation.

According to Jeffrey Wurgler, Nomura Professor of Finance at the NYU Stern School of Business, the dominance of indexed linked investing is having economic consequences.

According to Professor Wurgler “There is no doubt that indices and associated investment products are innovations that on the whole have benefited many individuals and institutions. On the other hand, their popularity has created underappreciated side effects.. (which) stem from the finite ability of stock markets to absorb index-shaped demands for stocks. Not unlike the life cycles of some other major financial innovations, the increasing popularity of index-linked investing may well be reducing its ability to deliver its advertised benefits while at the same time increasing its broader economic costs.

Wurgler documents a number of impacts of index investing including Index Inclusion Effects. On average, stocks that have been added to the S&P between 1990 and 2005 have increased almost nine percent around the event.

Once a stock becomes part of an index it starts to move with the index, something Wurgler describes as comovement. Over time index members slowly detach from the rest of the market. Evidence is also suggesting that increased index investing is associated with increased volatility in the market. Other impacts include on debt finance, with research demonstrating that new S&P 500 inclusions increase their rate of equity issuance and reduce their leverage.

As an investment strategy, indexing can make sense. However, the danger with the Grattan proposal is that we create policy settings that encourage indexing without any consideration whatsoever as to whether there is even the possibility that there could be an impact on the market and the Australian economy.

A default fund tender is not a bad idea. But before we proceed we need to consider all the impacts. The size of the superannuation pool means that superannuation is now interconnected with the Australian economy. And it also why it is time that the Grattan Institute established a permanent work stream on superannuation.

LINKS
On the Economic Consequences of Index-Linked Investing
Jeffrey Wurgler
Nomura Professor of Finance, NYU Stern School of Business
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1667188

Challenging The Attack on Growth Assets

It is perhaps advisable in life not to take on academics as the one thing that they do well is to argue. However the time has come for a stronger defence of the role of growth assets in investment portfolios.

My focus is a paper by professors Geoffrey Kingston and Lance Fisher from the Department of Economics at Macquarie University entitled “Down the retirement risk zone with gun and camera.” I have attached a link to the paper and recent trade press articles at the end of this blog.

Kingston and Fisher’s paper consider retirement risks and considers issues such as sequencing risk. Their core argument is that superannuation investors should reduce exposure to growth assets. They state:

We argue that sequencing risk has largely been a consequence of the dominant strategy for allocating assets in superannuation accounts. That strategy is aggressive constant-mix: allocate a high and stable share of the portfolio to growth assets. Almost all Australian providers have stubbornly adhered to aggressive constant-mix, despite the lingering fallout from 2008. That aggressive constant-mix is the industry standard is no coincidence. Superannuation balances typically peak in the neighbourhood of retirement, and the fees charged by fund managers are usually higher for growth assets than interest-bearing ones. So providers profit from aggressive constant-mix. Strong vertical integration of the Australian personal finance industry implies that financial planners typically benefit as well. And trustees enjoy a quiet life when people of different ages in the same workplace see the same superannuation returns when they compare annual statements.

If we didn’t get the message that the superannuation industry is not behaving responsibly then the authors drive the point home stating that “it is time that Australian practice shifted away from mindless constant-mix. Responsibility rests with the industry, ASIC, APRA and individual households.”

The first point is that by putting growth and defensive assets in a bucket is problematic. The superannuation industry has done a good job of educating consumers that fixed interest and bonds are defensive investments whilst shares are growth assets. However the superannuation industry itself has moved away from a simple classification of risk with the Standard Risk Measure providing guidance for how risk should be classified.

The point is that what are considered defensive investments such as bonds can be risky, whilst so called growth assets such as shares can have low volatility.

No one would think of Greek sovereign bonds as having low risk. Similarly there are companies such as Coca Cola that are less risky than other equity investments.

The other point is to understand growth and defensive investments in an Australian context.

One of the things that has always been said to me is that equity portfolios are managed differently to fixed interest portfolios. In order to achieve the desired risk and return objective from an equity portfolio a relatively small number of stocks are required. By contrast because fixed interest investments have a cap on their returns, but still have the capacity to lose capital, to deliver the desired risk and return objective it is necessary to invest in a breadth of investments. Fixed interest portfolios typically have a larger number of investments.

This represents the problem in the Australian context. The structure of the Australian capital market is that we have a small number of very large companies, and a large number of very small companies. The superannuation industry has already collectively reached the point where it will be necessary to invest more offshore as the local market is unable to absorb the flow of super contributions.

There has been a lot of discussion about the need to develop a corporate bond market in Australia. Whilst I would expect that the Australian market would evolve over time, if Australian superannuation funds shifted their investment strategies as Kingston and Fisher are advocating, the result would be that superannuation capital would flow offshore in order to find the diversity of fixed interest investments that would be required. That would require superannuation investors to increase the hedging of their portfolios in order to manage one of the major risks to capital; currency risk.

One of the questions for investors approaching retirement is volatility. Inflection Point Capital Management is looking at whether it is possible to achieve a lower volatility portfolio by investing in a portfolio of quality stocks. Inflection Point Capital’s methodology looks not only at environmental, social and governance factors as an indication of management quality, but factors such as innovation and agility. One of the things that we understand is that the world in the future will be volatile. A confluence of megatrends from climate change through to digital disruption and demographics will shape our society in coming decades. The companies that understand and adapt to their environment will also be those that are likely to provide investors with lower volatility.

Managing retirement risk is an issue that will impact on all western societies. Answers lie, not necessarily in investing in defensive investments, but considering new ways of investing.

Links

Recent Trade Press on the Kingston and Fisher paper:

http://finsia.com/news/news-article/2014/08/12/super-asset-allocations-leaving-investors-at-risk
http://www.superreview.com.au/news/superannuation/super-funds-urged-to-move-away-from-growth-assets

Geoffrey Kingston and Lance Fisher, Down the retirement risk zone with gun and camera, Department of Economics at Macquarie University, CIFR WORKING PAPER NO. 005/2014
MARCH 2014
See http://www.cifr.edu.au and http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2440977

Superannuation’s Licence to Operate

(First printed in ASFA Magazine June 2014)

Western Australia Premier Colin Barnett recently delivered a blunt speech to Western Australia’s booming gas and petroleum industry.

Barnett stated “I put it to you, it’s a hard narrative to sell to the community or a government that we are going to increase production of gas and we are going to export it and in the meantime gas supplies might be diminished and the domestic price will go up. I am a politician. I am pretty good at selling a story. I find that one tough to sell. You can’t say to people gas production is going up and by the way your supplies are going down and the price is going up. Stop reading American management books. Think a bit broader. The ultimate social licence is not what you may think it is.”

Barnett went on to state, “the ultimate [social] licence is getting agreement and alignment with both the national and state governments in Australia. That’s the licence that counts. That’s the one you must secure to develop Australia’s natural resources.”

Whilst focused on the gas industry, Barnett’s comments raise the question what does ‘licence to operate’ mean for the superannuation industry?

Social licence is at best a fuzzy term. Unlike our driving licence there is no grand department where companies and industries can line up to have their ‘social licence’ stamped and renewed. The best definition of social licence can be described as a stakeholder perception of the legitimacy of a project, a company or an industry. Using that definition the superannuation industry has a problem.

Over the last few years superannuation has taken a battering that shows no sign of abating. In the last months alone media commentators have lambasted Australia’s superannuation system and have gone as far as saying that superannuation has failed. How did we get here? More importantly what we can do about it?

A starting point is to understand why stakeholders may be criticizing super. Rather than jumping into a debate on fees, investment returns and customer service, let’s take a step back and look at the different groups of stakeholders that have a problem about super; members, government, civil society and business and try to understand what they are concerned about.

For superannuation members the challenge is that superannuation at its heart is a product that is based on an aspiration that life in the future can be better. Perhaps that is part of the problem. The promise that superannuation is holding out, to make the future better, may be in itself a source of stakeholder discontent. The problem with an aspirational product is that if the reality falls short of the objective then the customer is left more dissatisfied than if the product was just an everyday consumer good where there weren’t great expectations.

For twenty years following the introduction of the SG the superannuation industry didn’t have to worry too much about aspirations falling short. That was because most of the people in our system had not retired. For those that retired in the last 15 years they knew that they were late to super and therefore their expectations were lower. However as the baby boomers reach retirement we are dealing with a group that does have aspirational expectations in regards to their super. For Generation Y and Z, who are entering the workplace with the expectation that they will retire at 70 there is a cynical view as to whether a better future is possible at all.

The second key stakeholder is government. Superannuation has been cast as a two pillar relationship between member and fund. In fact it has always been a three pillar relationship – member, fund and government. There are many ways over the last twenty years that the Federal Government has demonstrated that they are a key part of the superannuation system. By and large however Governments have been a silent stakeholder. When economic times were good and the cost of superannuation on the Federal Budget was manageable, the Government largely left superannuation funds alone.

The future fiscal position for Government is not so rosy and will be a major reason why the Federal Government focuses on superannuation. Over the next two terms of parliament we can expect to see more focus in this area to make the system sustainable. To understand the reason why this will happen we need to unpack the Federal Budget. We know from the work of the Grattan Institute that the deterioration of the Government’s fiscal position is largely based in a blow out of health expenditure. As the Grattan state, the increase in government spending is driven above all by health spending, which in the past 10 years has risen by more than $40 billion a year in real terms. The cause is not the ageing population but the fact that people are seeing doctors more often, having more tests and operations, and taking more prescription drugs.

We have yet to feel the full impact of our aging population on the Government’s position. Over the next decade a significant portion of baby boomers will retire. By the time the baby boomers have left the work force we will see a permanent change in the structure of the proportion of workers supporting pensioners. This will further erode Government’s fiscal position as the full cost of pensions hits the Federal Budget.

Superannuation is one of the biggest expenses the Federal Government faces. There is a significant political debate about how Governments should handle this. One example is the debate about accessing the pension at 70. Whilst this doesn’t change the amount of money in an individual’s superannuation account for many Australians it will significantly change what they can do with that money. For those, including blue collar workers, that are unable to work until 70 due to physical health, the increase in access age will in reality mean that superannuation will be used to pre-fund retirement before accessing the pension at 70. Instead of super being a top up to the age pension it will be become a pre-funding account.

The age pension debate illustrates why the third major stakeholder, civil society, criticizes super. Superannuation is now in direct competition with other ways that government can spend money. In order to demonstrate why a particular way of spending money is desirable, it is necessary to demonstrate why government expenditure on super is not effective in meeting social goals.

The fourth area of criticism about super relates to the way super invests. When the Australian economy was strong and unemployment was trending downwards – which represents most of the history of the SG – the way in which super invested was largely ignored.

Whilst long predicted by economists it is now clear that the mining and resources boom is on the wane. As manufacturing industries contract there is understandably angst in the community about where jobs are going to come from.

Superannuation collectively is the biggest pie in the Australian economy. How superannuation funds invest will make a material difference to the way in which the economy develops. The Financial System Inquiry will focus on the role that superannuation plays in capital formation. Whatever the Inquiry concludes Australia’s political parties of all persuasions will increasingly focus on how superannuation invests.

To understand why this will happen, it is only necessary to go back to Colin Barnett’s comments at the start of this article. Barnett is right; politicians know how to sell a story. But what he doesn’t say is that they also know how to shift blame to someone else.

The best example of this is the banking industry which has a long history of being the scourge of politicians. In the late 1990’s the banking sector was on the front pages of papers on a regular basis as banks closed branches, increased bank fees and made record profits. There were numerous banking inquiries that provided ample opportunities for politicians to criticize banks. Labor at the time went so far as developing a banking social charter as a core part of its election commitments in the 2001 Federal Election.

One of the things that came out of the period that the banks were subject to public criticism was that the major banks all developed their own commitments to corporate social responsibility and sustainability. Compared to 13 years ago the banks are now regarded as leaders when it comes to sustainability and CSR. This is not to say the banks are perfect, but they have realized that the only way to address social licence issues is by focusing on the issues themselves.

This is also the answer for the superannuation industry. No amount of media campaigning will result in positive outcomes if the fundamental issues that are of concern to members, governments, civil society and business are not addressed. So, how do we start?

The first place to start is to acknowledge that superannuation, like other sectors of the economy, is subject to a social licence. We need to learn the lessons from those that have been here before. One of the lasting outcomes of the early campaigns against Nike and Shell was the development of sustainability reporting. A couple of funds in the superannuation industry have dipped their toes into this area but largely our industry has believed that CSR/ sustainability reporting is for others. It is not.

Sustainability reporting is not an end in itself. It must be back by real concrete work that seeks to address the issues that are of most concern to stakeholders.

The superannuation industry must be careful not to be complacent about its position in society. Social licence may be a fuzzy concept but it is real. We are entering an era of change where everything is up for grabs. When respected commentators say superannuation is failing we shouldn’t ignore them but take a good hard look at what we are doing to ensure that we retain our social licence in coming decades.

Crunch time for liquidity

Published in ASFA Super Funds Magazine November 2013. See http://www.superannuation.asn.au

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, http://www.superannuation.asn.au

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.

Pension and Superannuation Fund Investment in Innovation

Superannuation Fund Investment in Innovation

Melbourne Financial Services Symposium

Thursday 7 March 2013

Today I wanted to talk about why it is important that the superannuation industry work collaboratively to address the challenges that we currently have investing in what may be called innovation assets.

In my presentation I will be specifically focusing on the role that the ASX plays in providing opportunities for superannuation funds to invest in innovation companies. Young, start-up companies in areas such as Biotech, Clean Technology and Technology already look to the ASX as a means to raise capital.

To start let’s have a look at where the superannuation system is currently at.
According to the APRA December Quarter statistics the system has $1.51 trillion.

What is of particular interest is the rate growth. Over the last twelve months the value of superannuation investments has increased by $192.2 billion. In the last quarter alone we have seen we have seen $21.9 billion contributed to APRA regulated funds. Total contributions in 2012 were $92.2 billion up from $83.8 billion in 2011.

We can expect that the system will continue to grow. Deloitte estimates that by 2028 the system will have $7 trillion in assets.

I want to look at what this may mean for future asset allocation by superannuation funds.
In particular I want to look at the ASX where super funds invest a significant portion of new monies. The market cap of the ASX is around $1.38 trillion.

There are 2,183 companies in the ASX but 95% of the value of the market is in the ASX 200.
Superannuation funds roughly allocate 95% of their investments in ASX to the ASX 200.
The 5% that super funds do invest outside the ASX 200 is still significant, making up over $21 billion.

But here is the problem. The superannuation industry is rapidly outgrowing the ASX 200.
The continued strong cash flows each month into superannuation mean that funds must invest.
If we assume around $80-90 billion of annual contributions on a typical asset allocation we could expect that funds will invest up to an additional $20 billion into the ASX each year.

This equates to 20 $1 billion companies. Given that 92% of the market is made up of companies with a market cap less than $1 billion this indicates the size of the challenge.

There are already a number of implications of our growing size. Super funds for instance are increasingly drawn to dark pools because the size of some of the larger funds in particular means that it can be hard to execute in the lit market without moving the market.

But the more significant question is where does the super industry turn to for future investment?
The challenge that we have is that outside of the ASX 200 the market is illiquid and concentrated.
While liquidity is largely a function of size there are very good reasons why outside the ASX 200 more than half the market is mining and resources related.

We may think this is due to the all the ore that we have in the ground but in reality it is due to the regulation of the market, in particular the Joint Ore Reserves Committee that has meant that Australia has become an attractive place to list for international mining and resources companies.
There are over 200 ASX companies that solely work in Africa. We also have 15 mining companies based in Mongolia. One of the reasons we have such presence is that ASX has actively sought listings by putting people on the ground in Mongolia to recruit companies.

One option of course is for superannuation funds to seek investments outside of the ASX – and this is happening already. However it makes sense for the superannuation industry to consider how the whole of the ASX could be made a better place for future investments.

There are a number of ways the superannuation industry can work together to create more opportunities in the ASX.

The first thing is to understand that markets are a regulatory construct. The codes that have been developed for the mining industry have supported the development of mining and resources companies. The question is can we use similar codes in other areas to support the development of other sectors. One example is the Code of Best Practice For Reporting by Life Science Companies which is currently being reviewed. We know that there are US biotech companies that are now attracted to list on the ASX because of this Code. Are there ways that this could be further supported?
The second area we can concentrate is for the superannuation industry to collaborate to explore how we can support the development of the ASX. This could take a number of forms including establishing a working group that explicitly focus on this end of the market.

The size – and continued growth – of the superannuation system means that it is in our best interests to address the challenges in the ASX.

To finish it is worth asking the question does this is all matter. Is it a problem if super funds simply increase their allocations to global markets and diversify away from ASX?

It is worth delving for a moment into the economic history of one of the great economic empires of the modern era – the Netherlands. Kevin Phillips in his polemic book Wealth and Democracy examined the decline of the Netherlands which had been a significant merchant power in the 1600’s but by the 1740’s consisted of a divided society with a wealthy Dutch upper class and growing unemployment in towns that had once been thriving places for industrial production. Phillips attributes the decline of the Dutch empire in part to the fact that the Dutch upper class preferred to invest in economies other than their own, a fact that was not seen to be a significant issue at the time. In fact there were elements of Dutch society that advocated that the increased size of the finance sector that grew to service the Dutch upper class would more than compensate for the loss of domestic industries. This did not prove to be the case and the Dutch empire gradually faded, its demise accelerated by numerous wars.

Whilst things may have moved on over the last three hundred years the reality is that the superannuation industry and the economy are interlinked. Our contributions come from millions of Australians who rely on a strong economy for their future work. For that reason alone we have a responsibility to do what we can to make the ASX are better place for future investment.