The A$1.4trn ($1.45trn) Australian pension industry is undergoing a period of unprecedented legislative change aimed at boosting retirement incomes even as investment returns rebounded in the first half of 2012. The bulk of the reforms (18 separate pieces of legislation were being considered by parliament mid-year) are posing major compliance and operational challenges for the mature industry.

 Nonetheless, the industry was still ranked third best from 18 countries surveyed by the latest Melbourne Mercer Global Pension Index based on adequacy, sustainability and integrity. Australia’s ranking improved to 75.7 from 75 in 2012 as overall pension fund assets increased and labour force participation rates rose among those aged 55-64.

The bulk of the government’s legislative changes form part of its Stronger Super package, which is aimed at improving efficiency and lowering costs. A major component of the reforms includes MySuper – a simple, cost-effective offering designed to replace default funds. With about 80% of the market still in default funds, the definition of “accrued balances” which will be caught under the legislation remains the “hottest issue” among funds, according to the Association of Superannuation Funds of Australia (ASFA) Chief Executive Pauline Vamos. “People that have fundamentally exercised choice for their portfolio – it’s going to impact them.”

Super changes
ASFA, which represents pension funds which comprise more than 90% of the Australian marketplace, is lobbying to shift the MySuper start date from October 2013 to July 2014. Another legislative change, SuperStream, aims to improve the back-office efficiency of the super industry via auto-consolidation of small member account balances from January 2014. While the reform will slash the number of inactive pension accounts (there are currently about 31 million or about two for every Australian aged 15-65) the industry remains concerned about the size of a new levy to pay for it. ASFA’s Vamos said the SuperStream reform would ultimately prove to be the “jewel in the crown” among the slate of legislative changes underway but the proposed A$467m levy (over seven years) represented a substantial cost increase to absorb.

“We want to see at least the amount taken upfront reduced because the system is not settled – there’s still not clarity on where the money is going to go,” she says. “That’s a lot of money out of member’s accounts. We’re also very concerned that this is structural build of infrastructure of the system and therefore self-managed funds should also be contributing to that levy.”

The industry is also grappling with the implementation of new standards from the government regulator, the Australian Prudential Regulation Authority, and the commencement of new financial advice standards which ban conflicted structures. The ongoing regulatory pressure is one factor, along with the need to achieve the scale necessary to compete in the market, that is driving consolidation across the industry. The number of corporate, retail, industry and public sector funds fell by 34 to 352 over the 12 months ended June 2012, according to data from the prudential regulator.

Super mergers
J.P. Morgan Worldwide Securities Services head of sales and client management in Australasia, Bryan Gray, says the company had seen a significant amount of recent merger activity. J.P. Morgan is the second largest custodian in the Australian market with about A$400bn in assets. “The larger funds in the market place are really positioning themselves as a one-stop shop at low-cost and really driving the economies of scale to benefit their members. As we move into a MySuper environment next year that is going to be quite important.”

The average Australian pension fund holds about A$2.3bn in assets according to research by local consultancy CoreData, still well below the A$10+ billion mark that is generally recognised as a cut-off point where the benefits of scale kick in. The country’s second largest pension fund, the A$46bn AustralianSuper, recently won the contract to manage the A$1.7bn IBM staff superannuation fund while the StatewideSuper and Local Super merged to create a new A$4bn fund with 160,000 members. CareSuper and Asset Super will merge this year to create a A$6.5bn fund although another major merger between Equipsuper and Vision Super collapsed after the two funds were unable to reach agreement. “We expect, based on intelligence gathered from the industry, that the number of super funds will shrink by up to 40% over the next decade,” a recent research paper by CoreData said.

Meanwhile, the hectic pace of consolidation is set to continue after the federal government agreed in August to extend legislation allowing funds to merge without triggering potential tax losses on capital of up to 2%.

Managing costs
Growing scale is driving lower fees across the industry: costs are still a key focus for the industry as the MySuper regime is rolled out. A number of larger funds in the industry, such as AustralianSuper, have been bringing investment management in-house while other funds have been able to negotiate lower fees. A recent report by consultancy RiceWarner found total average pension fees declined by 12% to 1.2% in 2011. However, while investment management fees fell (to an average of 0.58%), operating fees were being driven up by increasing regulatory costs.

The chief executive of the A$9.9bn HOSTPLUS fund, David Elia, says some of its investment managers had recently agreed to lower fees after less-than-expected performance in a challenging market environment. “We’ve had three or four managers that have done exactly that.”

The MySuper legislation also aims to boost disclosure of fees: ASFA is lobbying to shift the disclosure from the likelihood of negative returns measured over a 20-year period to a standard risk measure, which will show the risk of not achieving a specific retirement outcome.

The fast-growing pension industry has now reached the level of Australia’s A$1.45trn gross domestic product and will grow faster as the superannuation guarantee (SG), which requires employers to invest 9% of employee salary into a fund of their choice, begins to rise in 2013. It will reach 12% by 2020. CoreData predicts that by 2017 the total assets in the sector will be close to one-third larger than Australia’s annual GDP.

A further A$68bn of inflows flowed into the pension market in the first half of 2012 according to Australian Bureau of Statistics data. While much of that was directed towards cash and term deposits, it was driven by conservative self-managed super investors rather than institutional investors. Pension funds still invested about A$14bn into the equity market in the first half of 2012 although selling foreign fixed income securities, perhaps due to low returns, according to Deutsche Bank analysts.

Exposure to equities
Earlier this year, former Treasury secretary Ken Henry warned the Australian pension industry was over-exposed to shares and questioned the reluctance of fund managers to invest in corporate bonds. Australia had the third highest exposure to equities (behind only the United States and Finland) among 27 OECD countries, according to the Melbourne Mercer Global Pension Index survey. It estimated total growth assets held by Australian funds were between 71-80%.

JANA Investment Advisers chairman Ken Marshman says corporate credit was providing attractive returns – 3% above the cash rate – and its clients now hold positions of 10-15% compared to zero exposure a decade ago. Nonetheless, equities continued to present good value in an uncertain and volatile market. “This is perhaps one of the most difficult times for asset allocation in our view because on the one hand you’ve got a whole lot of big macro serious issues, high levels of debt and stagnant economic conditions… and also some high risk events coming up around the corner. On the other hand, we think that at the individual stock level, the pricing of many stocks is particularly attractive – so you’ve got this huge dilemma.”

Marshman says Australian funds have lowered their equity allocations from about 60% to 55% since the onset of the GFC, although much of that has been funnelled into other growth assets. “In general most of these so-called ‘risky’ assets or growth assets are reasonable priced,” he says. “In fact, equities today are priced on the assumption that there will be no growth in profits for the next decade.”

Australian funds’ strong exposure to equities and other growth assets underpinned strong investment gains in the third quarter of 2012 as global share markets rebounded. By the end of September, the median Australian pension fund’s default balanced investment option was back in line with the pre-GFC peaks reached in October 2007, according to research house SuperRatings.

Over the year to September 30, the median fund was up 8.2% – a sharp turnaround compared to the median 1.9% loss posted in 2011. Investment returns over the five-year period to September were 0.2% per annum but over the 10-year period climbed to an impressive 6.3% per annum.

Vamos said the higher equity allocations suited Australia’s predominately defined contribution schemes, where the investor bears the risk, while shares also represented a good option to fast-track growth in retirement balances over the long term. “People focus on the last three years but we had double-digit returns for years and years, so that meant the growth in account balances was enormous… if funds were always conservatively invested, sure you wouldn’t have the volatility, but there’s no way you’d be at the levels of the average account balance you have to today.”

HOSTPLUS’ Elia said the fund has poured about A$700m back into equity markets over the past 12-18 months. Its exposure now stands at about 58%, 3 percentage points above its equities benchmark.

“Now is the time to make money – you just don’t know it,” he said. “Those funds which have remained quite disciplined and taken advantage of the buying opportunities with a long term view I think have done exceptionally well.” However, he also warned of more volatility ahead.

The ongoing relative strength of the Australian economy and equity market has been underpinned by its strong resources and mining sector, which is feeding growth in emerging Asian markets. China’s economy expanded 7.4% in the third quarter compared to the same period a year earlier, although that was also its seventh consecutive quarter of slowing growth. Nearly half of all listed companies on the Australian Securities Exchange are in the resource sector while resource companies now account for around a third of the market’s capitalisation, up from about 15% a decade ago, according to the Reserve Bank of Australia.

“That is the bigger question,” Marshman says. “If China’s growth was to go from 7% to 4% or 5% - which is still high globally – what would that mean for the Australian equity market generally?”