Australia facing pensions crisis

Nearly two decades after mandatory employer superannuation contributions came into play, the system is experiencing its first existential crisis – two years of back to back financial years of negative returns, plus a flurry of government investigations and reports into the sustainability and possible future adjustments to superannuation. 

The industry is tacking into the headwinds of uncertainty on financial and structural fronts, responding with increased communication, more sophisticated education and advisory outlets, and looking to the future by designing products to answer post-retirement investment and income needs. Meanwhile, investment managers and custodians are emphasising their “value proposition” to clients, resisting pressure to reduce fees by improving their service.

The average return for median options within Australian superannuation funds was -12.89% for the financial year ending June 30, 2009, according to Super Ratings. The “median option refers to “balanced” option with exposure to growth style assets of between 60% and 76%,” the agency said. That marks the second financial year in a row with double digit negative returns, the first time since 1992, the year the superannuation guarantee came into effect. Naturally, this erosion of value creates an environment of instability for the majority of defined benefit members of superannuation funds. 

“There has been really a loss in confidence in superannuation for a number of people,” said Fiona Reynolds, CEO of the Australian Institute of Superannuation Trustees (AIST), an industry body representing not-for-profit superannuation funds. 

“Some people pay no attention to their superannuation at all, but the headlines of [some] superannuation funds down 20%, negative returns combined with a new government who are doing a number of reviews into superannuation gives people the sense that there is something wrong with the system when there isn’t.”

Individual members of the predominately defined contribution superannuation system are more pessimistic about the system’s ability to provide adequate retirement income.

“We do have a Mercer Super Sentiment Index, and what we’ve been doing is tracking how people feel about their superannuation,” said Mercer’s Asia Pacific retirement leader Tim Jenkins. ”Between June and December 2008, the number of people rating superannuation as a poor or a fair way to save for their retirement went from 17% to 34% – so it basically doubled.” 

Tax review 

Adding to this sense of uncertainty for both members and managers of superannuation funds are a number of reports launched by the government led by Prime Minister Kevin Rudd – particularly a wide-ranging review of the Australian taxation system and a specific review into measures pertaining to superannuation. 

The so-called Henry Tax review – named after secretary to the Treasury Dr. Ken Henry, who is leading the review – tabled its interim report on retirement in May, and among other things, mooted raising the retirement age from 65 to 67 and raising the age at which individuals could access their superannuation savings to 67 as well. 

Subsequently, PM Rudd backed away from raising access age, but the net impact of discussions has been to raise the sentiment of insecurity surrounding superannuation’s foundations.

“I felt that with that interim review, it examined all three pillars – the Aged Pension, compulsory super and voluntary contributions,” said Reynolds of AIST. “The interim report really put most of the heavy lifting on the aged pensions. It won’t consider an increase to compulsory super, and among other things, it suggested raising the preservation age to 67. It didn’t come up with more incentives for people to put more into super.” 

With this as the background, superannuation funds are in the process of rebuilding the assets lost over the past two years, and are focusing on reducing costs and generating further efficiencies. This has taken several avenues – either switching from active to passive managers, terminating mandates and selecting new managers, and/or increasing the amount of assets that are managed in-house.

“While we’ve had a nice spike up in the market, there’s still a way to go to get back to the levels where we were two years ago,” said State Street Global Advisors managing director Rob Goodlad. “Clients are confronted with an environment that’s confusing, and the outlook, which has been reinforced by the [US Federal Reserve] and the [Reserve Bank of Australia] is that the economic outlook is quite benign into 2010 and 2011. Risk premiums with both capital and liquidity are at their highs, so the conundrum is while there is a need to rebuild wealth, it’s not clear how they’re going to be able to do that.

“The problem is that there is this risk aversion that is coming through in an environment where you need to increase the risk to get the returns back up. The upshot is who can blame both members of super funds and retirees for that matter for this lack of confidence? Who can blame them when the return profiles remain low and the government is tinkering with the system?”

Combating volatility

Superannuation funds are starting to shake up their management line-ups after two years of volatility. The $9.5bn Telstra Super – the superannuation plan for employees of Telecom Telstra Corporation – recently awarded Martin Currie Investment Management a A$115m mandate for the firm’s global alpha strategy. Telstra Super awarded the mandate to Martin Currie in its process of reviewing all of its fund managers after appointing a new asset consultant, JANA, said Telstra Super chief investment officer Stephen Merlicek.

“JANA started at the beginning of the year, and we have been doing a review of our strategic asset allocation and managers,” Merlicek said. “A lot of managers have performed poorly for a lot of funds over the GFC. A lot of people are asking the question, is passive the way to go? We’re probably of the view that it’s been an unusual time and active managers will come back into their own. It’s the wrong time to go to passive/momentum strategies going forward.”

The lion’s share of the mandate to Martin Currie came after Telstra Super terminated a mandate with Alliance Bernstein, Merlicek said.

Meanwhile, earlier this year the $28bn industry superannuation fund Australian Super consolidated half of its domestic equities portfolio – $3bn – to a passive equities fund managed by Industry Funds Management.

“Active managers have been under more scrutiny than they’ve been for a long time,” said Watson Wyatt’s head of investment consulting in Australia Graeme Miller. 

“I think institutional investors as asset owners have been, for the first time in a while, asking the question about the value delivered by all agents and active managers in particular. If there has been a trend, it has been away from active strategies to more passive strategies. Within active strategies themselves, my observation is that there’s been a trend towards higher conviction, more concentrated, lower tracking error mandates where the [perceived] cost per unit is expected to be greater.”

SSgA, is seeing more mandates to its passive programme and is increasing its emphasis on its beta solutions, Goodlad said.

“There is a lot of focus in the industry on how can we bring costs down,” Goodlad said. “This comes down to the diversified beta solutions and low cost. We are finding that more and more organisations are coming to us for passive solutions. We have seen more passive business in the last six months than in the last six years.”

Goodlad also noted that SSgA’s ETF products have also “grown dramatically in the last four months,” even though three of their ETF products have been listed on the ASX since 2001.

Changing dollar prices 

After the dramatic swings in the Australian dollar, particularly in October and November 2008 where the Australian dollar lost 30% of its value against the US dollar and with similarly dramatic erosion against other currencies, managing foreign exchange positions has come up higher on the agenda for superannuation funds.

“A lot of trustees that were hedging the Australian dollar were thinking they were reducing currency risk,” said Merlicek of Telstra Super. “That’s been one of our good calls. While we have a currency overlay manager, we have a dynamic hedge and we have swung the benchmark around. When we got to the high 80s/90s [against the US dollar], we changed the benchmark and pulled the hedges off. When we had the 30% fall, we got the benefit of that.”

Telstra Super sets its benchmarks on hedges internally and uses Pareto Partners to manage the overlay, Merlicek said. 

 “We leave the day to day tactical to Pareto. What we do is swing the benchmark around,” he said. “When we have extreme moves – when it gets to the 90s, we pull the hedge off, when we get to the 50s we put it back on. We made those calls when there were extreme movements. That’s helped the fund a lot.”

NAB Asset Servicing, the custody arm of National Australia Bank, reported increased demand for its passive currency overlay products, said director of sales and marketing Patrick Liddy. 

“We are getting more and more clients coming to us and saying they want us to do that for them,” he said. “It depends on what the client wants. We’re never going to do an active overlay, but we look at the parameters, managed on a value proposition and balanced weekly or monthly.”

In multiple interviews with Global Pensions, professionals at banks and investment funds emphasised their moves to improve and communicate their “value proposition”. In the custodial space, this demand for further education and transparency has meant an increased need for data provision to their clients.

“Investors who are worried and are asking more questions and detail about what the return statements look like,” said JP Morgan Worldwide Securities Services, Australia and New Zealand chief executive Jane Perry. “Administration groups have been predominately affected because they’re being inundated with these requests.”

JP Morgan has seen an upswing in the amount of data clients are demanding for both education and information purposes as well as risk management, and are looking to several products already available overseas to introduce to Australian clients, Perry said. Because superannuation funds have built their in-house personnel and expertise, staff are asking the custodians to increase the frequency and depth of data reporting from the custodian, a trend that will continue in the future, said JP Morgan Worldwide Securities Services’ head of product, Australia and New Zealand, David Braga.

“I think they’ll be seeking a lot of return data from the custodian and I think they’re going to be running a lot more of their own analytic tools,” he said. “They are looking to bring that in-house. They’re looking to the custodian for the source of truth around the data, but control the analysis directly. They’re demanding the raw data from the custodian, using the breadth of service, but the consolidation will be done in-house.”

In a bid to increase efficiencies, superannuation funds are also looking at brokerage charges and how to increase cross-trading within portfolios before buying or selling securities outside the portfolio, areas where custodians can provide information. NCS this year officially launched its Master Manager product, which helps superannuation funds manage costs through an online offering. 

“What we’re seeing is that people really want to get leakages out of the system,” said Liddy.” If you have a look at what happens in the equity market, if we look at leakage from a brokerage perspective, there’s a 22 basis point cost for commission. People want to get rid of that, get rid of market impact and tax in the portfolio. The Master Manager product is perfect for that. We have one client that has saved $23m in a six month period after changing the way they behave. That’s taking out leakages/inefficiencies for small cost.”

 

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Superannuation funds consider structured products 

In the search for ways to correct the negative returns of the past two years, superannuation funds are considering structured products as one possible avenue for investment. Structured products – products in which underlying sector assets are overlayed with synthetic instruments to protect against downside risk – are typically used in the retail industry. But they may have applications for defined contribution superannuation funds, which although are freed of bearing longevity and interest rate risks by virtue of their structure, may still need to consider solutions that provide capital protection for members.

Colonial First State opened its Equity Income Fund in March of 2008 for both retail and institutional investors. The underlying assets are Australian equities with option strategies placed on top to generate additional income, said Colonial First State’s senior portfolio manager – structured equities, Rudi Minbatiwala.

“Because this investment process can generate income from a broad range of shares via the option strategies, the fund doesn’t rely on a simple tilt to high yielding stocks to generate the higher level of income and can avoid the potential for concentrated stock or sector exposures in the pursuit of just dividend yield,” he said. “But of particular importance to institutional investors such as superannuation funds is the lower variability in equity investment returns. As a result, the funds returns will not closely match the equity market in the short-term. This reduction in return volatility means that potential uses for the fund may include pension or late cycle superannuation accumulation products or as a reduced beta exposure to match defined benefit or insurance liabilities.”

JP Morgan is in the “final stages” before launching a collateral management product aimed at superannuation funds, said JP Morgan’s Perry. Similarly, State Street Global Advisors is considering capital protected strategies that jump off from products implemented in the US and Europe, said SSgA’s managing director Rob Goodlad. 

“We’re continuing to look at ops in capital protected strategies, and looking more at the retirement or post-retirement market,” he said. “I think that there’s a clear opportunity where the current cost structure for the strategies are too high.”

 

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Decumulation: looking to the future

Even as the superannuation industry grapples with recovering from the past two years, it is also being confronted with another consideration – how to adjust the system to advise members in the accumulation years and then into the post-retirement system. While employers and superannuation funds are not responsible for longevity risk, the industry is looking to ways of guiding individuals into post-retirement with products and services that meet their needs without generating fees that members would perceive as exorbitant. 

“This recent investment experience, when you put it together with the work Watson Wyatt has been doing on longevity, reveals the big issue ahead for members – how should a member invest before and after retirement to outlast the pension,” said Watson Wyatt Australia managing director Andrew Boal. “In doing that, one issue that people focus on is reducing the account balance risk – the investment risk. As they get closer to retirement, do you de-risk investments by going into cash? De-risking isn’t necessarily the optimal way to protect income. Two questions that members will need help with is, when can I retire? And how much can I draw down in retirement, if I’m using an account-based pension. We’re saying you should invest more in equities despite risk.”

Jenkins of Mercer noted that even though superannuation funds may have another 10 years before payments to retirees outstrip the 9% guaranteed contributions from employers, providers have to take action to guide members now.

“In this period providers as a whole of the superannuation funds are starting to look at the post-retirement strategy,” he said. “We can expect to see the emergence of more sophisticated web calculators to assist members to understand the interaction between retirement savings accounts and the pension, and the impact of taking out lump sums.”

The $12bn Sunsuper industry superannuation fund has launched two services to deal with both the advisory and the post retirement questions. Its On Track programme will leverage call centres as the main point of contact for members’ questions on how to plan and manage super and retirement, with further “check-ups” over the accumulation phase and into drawdown, without extra fees for members whose entire super is with the fund, according to Sunsuper. 

“People want advice at specific points at time,” explained Sunsuper chief executive Tony Lally. “We set up the member advice centre in 2006. A phone-based service is offered to members free of charge. It was modular in nature, answering questions like how much insurance, what level of contribution, what are my investment options, etc.,” he said. “On Track was built on top of that – we have built a programme that was far more engaging to members, from an earlier age, and much more comprehensive than the modular product. The intent was to review the superannuation available with Sunsuper, but it also covers non-superannuation assets with a focus on lifestyle.”

Secondly, Sunsuper this year also launched its Today and Tomorrow pension strategy for the drawdown phase, which offers a diversified portfolio of assets with “a high proportion of dividend-generating Australian and international shares, as well as other growth assets,” according to the fund.

“Post retirement, we think income should be a big part of the payment we make to members, because it’s more reliable,” Lally said. “But there are no guarantees to this product. We are researching how to provide guarantees to members, but the research has shown is that the demand isn’t as obvious as we think it is. We were going to build it into the launch, but we’ve deferred it. The difficulty is the expense. That’s what we’ve been grappling with. We need a cost effective solution that is also simple.”

As funds like Sunsuper and others grapple with these implications, ultimately members will seek out superannuation funds that demonstrate quality solutions.

“What we think that means, as people seek to improve their financial knowledge, there’s going to be a flight to quality among superannuation,” said Jenkins of Mercer. “It’s not about just safer investments or lower fees, but towards more communication, more education, further transparency and additional information and advice.”