DC in Europe: Australia at a crossroads
Australia has been the poster child of the DC world - yet some are now asking whether there is a better alternative, writes Michael Block
The eyes of the investment world are on Australia. It weathered the powerful headwinds from the great financial crash of 2008 far better than most developed economies. Its public finances are sound. Above all, its national retirement savings continue to defy gravity.
Totalling A$1.4trn (€1.1trn), the savings pot is now the fourth biggest in the world. This is even before the federal government announced its intention to raise the compulsory contribution level from 9% to 12% of employee earnings. The pot size is expected to reach A$6trn by 2030. The authoritative Melbourne Mercer Global Pension index - measuring the quality of pension systems worldwide - ranks Australia second to the Netherlands.
Yet, all that glitters is not gold. A 20-year bull market powered by financials and commodities served to conceal a number of fault lines. These have become visible as the froth of double-digit returns has evaporated in the past four years. For the first time, Australians are questioning whether their system really provides a template for other countries to emulate, or whether there is a better alternative.
Started in 1992, the current system channels employees' retirement dollars into individual defined contribution plans managed by retail or industry-specific superannuation funds, popularly known as ‘supers'. Their members make contributions out of their income and bear the all-important risk that their savings will not be adequate to fund their retirement at the level they desire or for the period that is necessary.
There is no risk-sharing between employers and employees, as in the Netherlands, for example. In Australia, DB schemes have shrunk to less than 10% of superannuation monies, in the hope that the superannuation funds will do a good job and deliver the outcomes that their members want.
Emerging fault lines
The supers manage money in two distinct halves:
• An accumulation phase where funds are invested to maximise a lump sum on retirement, generally within a fund.
• Followed by a decumulation phase, where the monies are used in retirement to provide an income to support a certain lifestyle.
These two phases have an arbitrary divide when a member reaches the age of 60, after which lump sums can be - and usually are - taken tax-free. At that point, there is nothing to compel members to take their superannuation benefit as an annuity or pension.
This unnatural divide between the two halves - often managed by two different entities - makes no sense with an ageing population that will drive over a third of the assets into the decumulation mode over the next ten years. Hence, the government launched a review of the system, the highly acclaimed Cooper Review, which delivered its final report in June 2010.
Before then, the system was in desperate need of basic enhancements such as more independent trustees on fund boards, greater administrative efficiency and lower costs. It also needed substantive enhancements in three crucial areas: performance, fees and retirement products.
Taking them in turn, supers' investment strategies are heavily peer-biased. The short-termism caused by the perceived peer risk has forced many supers to be more concerned with their business risk and the career risks of their executives than with member outcomes.
Paradoxically, nearly every fund strategy has a return target expressed as inflation-plus but its investments are generally managed and assessed against peers. Despite members having the ability to switch funds, very few ever do. So why worry about peer risk?
Supers' default options typically have a mechanical allocation of 70% equities and 30% bonds. With over 80% of members using this option, peer herding ignores a huge undiversified equity risk in today's environment of high volatility. Diversification has relied on buying expensive pseudo-equity products, which merely add liquidity risk without reducing equity risk.
Poor investment outcomes have been inevitable (see the table). Most default funds - which hold nearly 70% of assets across all supers - have neither met their real return objective nor performed well against low cost cash funds.
The second area that requires enhancement relates to economies of scale. The continuing consolidation among supers has yet to deliver cost savings. In contrast, their Dutch peers have exploited their size advantage to secure lower costs that have contributed to outperformance over time.
The final area concerns income options in retirement. The retirement products currently available to Australians are woefully inadequate, with no lifetime annuity market or means to insure against longevity risk. Most members rely upon personal financial planners to assist with the investment of their lump-sum benefit. The supers have stayed out of this area, while being keen to retain their members' monies in accumulation products as long as possible.
Is it any wonder, then, that so many people are opting to manage their own affairs in a self-managed super fund, akin to a private retirement plan in Sweden, the UK or the US? From a late start, this option already holds more than a third of total super assets in Australia.
Another contributory factor is that super fund members are all managed similarly, with no reference to their age, financial circumstances or retirement needs. This one-size-fits-all approach is akin to driving a car without brakes, or risk control, while looking in the rear-view mirror.
This begs an important question in today's investment environment, where old certainties no longer hold: will the trustees grasp the nettle and provide their members with what they need at a fair price, or will they just go on blindly providing the same old rhetoric targeted at the world of double-digit returns that no longer exists?
I am hopeful that the proposed increase in the contribution level to 12% will allow funds to reduce investment risk to achieve adequate retirement benefits.
I am equally hopeful that funds will change the way they operate the artificial barrier between two halves - described above - and think more about maximising retirement incomes than lump sums.
One state government fund has already taken the bold step to look at life-cycle investing - popular in the USA - and no longer to take note of the league tables of peer performance.
Overall, it is highly likely that members will vote with their feet if supers fail to recognise that their old ways of doing things only work in a raging bull market.
With the top 25% of members accounting for around 75% of super monies, some big defections to life-cycle investing might well start an avalanche in the prolonged environment of volatility in this decade.
A former chief investment officer, Michael Block is an independent investment consultant based in Sydney and can be contacted via firstname.lastname@example.org