It is fair to say that the Australian superannuation system is well-regarded globally, with periodic reminders about how we compare to our peers. The 2015 Melbourne Mercer Global Pension Index, for example, rates the Australian system a “B+”, behind only Denmark and the Netherlands who each hold “A” ratings. On a more detailed level, Australia holds “A” ratings for both “adequacy” and “integrity”, with the highest adequacy score of all retirement systems rated by the index. While such indexes admittedly provide relative ratings, they at least suggest that the Australian system is reasonably well-designed and run. And yet the casual domestic observer may arrive at exactly the opposite conclusion, based on endless coverage calling into question one aspect of the system or another.
Anyone with even a passing interest in superannuation will recall myriad reviews and inquiries – e.g. the Cooper Review, the Financial System Inquiry led by David Murray (“the Murray Inquiry”) – and numerous policy measures that flowed from them e.g. MySuper, SuperStream. Based on a recommendation of the Murray Inquiry, the Productivity Commission has recently commenced a study into “superannuation efficiency and competitiveness”, with a further two inquiries flagged, before the government of the day (in around 2020) considers the outcomes of this series of reviews. Parallel with the Productivity Commission review, the Commonwealth Treasury has commenced a consultation process regarding the “objective of superannuation.” As if this weren’t enough, such policy deliberations are taking place within (pre-election) political debates about the appropriateness of superannuation taxation settings, and whether changes to such settings may assist in improving the Commonwealth’s fiscal position. Perhaps the temptation of $2 trillion in retirement savings is too much for politicians to resist.
While government adjusts policy settings, and political parties take their ideological positions, superannuation funds strive to deliver on their promises in the wake of the global financial crisis (GFC) and what can only be described as a post-crisis grind, characterised by historically low interest rates and mixed economic signals. These mixed economic signals, and what they mean for the future of investment returns, are exercising the minds of chief investment officers (CIOs) Australia-wide. The fundamental question is: what returns can we expect going forward? If the worst forecasts come to pass we might see decades of economic stagnation reminiscent of what Japan has experienced since the late 1980s. If we believe the optimistic forecasts – usually thanks to commentators with a “horse in the race” – we have nothing to worry about.
Using Dimson, Marsh and Staunton long-term returns (1900-2012), our research for the Financial Services Institute of Australasia – How Safe are Safe Withdrawal Rates in Retirement? An Australian Perspective (March 2014) – showed that Australia had the highest annual average real stock returns of all countries in the dataset, with a relatively low level of risk (where risk is measured as standard deviation of returns). The research went on to show that the retirement outcomes for a representative Australian were, at best, mixed. If we are to believe that modest retirement outcomes rely on stellar stock returns, we wonder aloud what outcomes might be like if returns aren’t so stellar. What might be the challenges of a low-return world?
Such a question is even more relevant given the way investors form expectations about future investment returns, and what they mean for the adequacy the Australian system is thought to deliver (at least on a relative basis). In our experience, investment professionals take one or more of a handful of approaches. The most naïve of these is to assume the future distribution of returns is taken from the past, and then to use one or more parametric or non-parametric quantitative techniques to simulate what the future might hold (given the historical data). This is what we did in our aforementioned research and it highlighted for us that assuming the future will mirror the past is a significant (perhaps heroic) assumption.
An alternative is to take a more bottom-up fundamental approach. In research we conducted on behalf of Challenger – The (un)Predictable Equity Risk Premium (November 2015) – we considered the future of the equity risk premium as one of the key drivers of superannuation funds returns. In the analysis, we estimated a lower future equity risk premium of between 3.0–4.5% per annum (over bond returns), with significant variation (read “risk”) even over longer investment horizons.
While there is some evidence that calls into question future investment returns, the future, as the saying goes, is uncertain. Those of us who research and/or practise in the area of pension finance are essentially dealing with a field where decision making under such uncertainty is the core task. In the context of uncertainty, how do decision-makers chart a course? What are the fiduciary challenges in a low-return world?
First, we outline some high-level outcome-oriented considerations that fiduciaries might focus on if they aren’t already:
- Pension finance is about more than just returns – While the financial literature doesn’t always acknowledge it, wealth is a function of more than returns. Therefore, fiduciaries have a range of levers at their disposal. For example, how might fiduciaries improve plan design to “nudge” members to increase contributions in order to improve their retirement outcomes?
- Plan design is more than “to retirement” – Increasingly superannuation funds are taking a whole-of-life approach to plan design, and consciously seeking to retain members after retirement. Research indicates that improved plan design in the post-retirement phase can dramatically improve retirement outcomes for members.
- Retirement adequacy is more than wealth at retirement – While having a healthy stock of wealth at retirement is a good thing, product innovation and high-quality advice is necessary to ensure that this wealth lasts for the remainder of the retiree’s life.
Second, we list a number of topical technical matters that are usually the province of investment committees and CIOs, but which still make it to the fiduciary table. In one way or another, each of these matters is focused on shoring up return or managing risk:
- Duration – Given pension liabilities are long duration in nature, some argue that the liberal use of long-duration bonds on the asset side is an appropriate response. With 100-year bonds being issued (e.g. Republic of Mexico, Kingdom of Belgium, EDF of France), long duration positions are increasingly possible.
- Credit – In search of yield, investors are tending to increase their exposure to lower quality credits. What this means for portfolio risk in subdued economic conditions is yet to be seen.
- Defensive assets – Traditionally, high-quality bonds and cash have been seen as the defensive assets of choice for superannuation funds. With such low expected returns, these asset classes are increasingly regarded as risky versus typical superannuation return objectives. In the current environment, what assets are defensive assets?
- Illiquidity – There is a theoretical case that in exchange for forgoing liquidity the investor should expect some compensation. However, during the GFC, excessive levels of illiquid assets did no favours to certain investors. Fiduciaries need to consider the trade-off between the (arguably) higher expected returns from unlisted assets, and the associated risks.
- Home bias – With the superannuation system already being larger than the Australian economy, and growing faster than it, where do investors go to earn the returns they need to achieve fund objectives, especially in light of the benefits of, and incentives to, invest at home? Foreign markets, including emerging markets, will continue to be on the radar of fiduciaries and the investment teams that serve them.
While debate regarding the “best” path to addressing contemporary investment issues will continue, a necessary enabling capability for managing these risks is best-practice fiduciary governance. Robust governance is necessary, perhaps now more than ever, to manage complexity and grapple with the challenges of a low-return world.
By A/Prof Robert J Bianchi, Prof Michael E Drew, Dr Adam N Walk, and Dr Osei K Wiafe, Griffith Centre for Personal Finance and Superannuation, Griffith University.
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