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Superannuation in Australia – Ready for the Bond Revolution?

Australia has one of the world’s largest compulsory retirement saving & pension systems known as the Australian National Superannuation Scheme, or super, in short. As at 30 December 2016, the Australian super system has A$2.2 trillion of assets under management – the 4th largest such system in the world.

Superannuation funds operate as trusts with trustees being responsible for the prudential operation of funds and in formulating and implementing an investment strategy. The trustees thus have an obligation to ensure that their asset allocation strategies are designed to meet the long-term nature of the funds’ obligations (i.e. to fund members’ retirement needs years or decades into the future), with appropriate consideration given to risk management along the way.

As super assets are ultimately used to fund members’ retirement expenses, capital preservation (to protect fund assets from capital loss due to investment loss or inflation) and duration matching (to align asset duration with the long-term nature of liabilities) are of added importance compared to other funds. As a result, most pension funds elsewhere in the world have adopted a conservative asset allocation approach with large proportions of assets invested in long-term, stable and relatively low-risk fixed income and real estate assets. Australian super funds, however, have been significantly under-weight in fixed income assets, as compared to developed-country peers such as those in the Organization for Economic Cooperation and Development (OECD). As Figure 1 below illustrates, as at 10 October 2017, Australian super funds allocate just 10.2% of assets under management to fixed income, versus an average of 40.1% across 34 other OECD countries.

Figure 1. Super Fund Asset Allocation to Fixed Income (Australia vs OECD)

Source: OECD, BondAdviser

Conversely, as Figure 2 below shows, Australian super funds allocate a substantially higher percentage of assets under management to equities, at 51.1%, compared to the OECD average of 15.6%.

Figure 2. Super Fund Asset Allocation to Equity (Australia vs OECD)

Source: OECD, BondAdviser

Despite Australian super funds’ significant over-weighting of higher-risk equities and under-weighting of lower-risk fixed income compared to peers, in general, Australian super funds have failed to generate the superior returns expected of such a higher-risk asset allocation strategy. In fact, net returns after expenses in Australia have marginally failed to rank in the top 25% of returns among OECD countries in the last 10 years, as Figure 3 illustrates.

Figure 3. Real 10-Year Average Investment Rate of Return of Pension Providers, Net of Investment Expenses, 2006-2016

Source: OECD, BondAdviser

During the Global Financial Crisis of 2008-2009, Australian super funds delivered a cumulative loss of 21.6%, which was the third worst in the developed world – better only than two nations which saw severeeconomic depressions: Ireland (down 35%) and Iceland (down 22%). This awful performance was despite Australia being largely insulated from any direct impacts of the GFC. Furthermore, Australian super funds again performed poorly last year, returning less than the OECD average, as Figure 4 shows.

Figure 4. Real Investment Rate of Return of Pension Providers, Net of Investment Expenses, Dec 2015 – Dec 2016

Source: OECD, BondAdviser

On the other hand, the Australian sovereign wealth fund, the Future Fund, which was founded in 2006 by then treasurer Peter Costello, has consistently demonstrated that it can deliver superior returns, by comfortably besting its aggressive return target of inflation plus 4.5% over the decade since its inception. As Figure 5 shows, the Future Fund has out-performed the private sector providers by a sizable margin. What is even more important than the returns, was that the Future Fund has achieved the returns with significantly less exposure to higher-risk equities compared to many of the private providers listed in the chart.

Figure 5. 10-Year Annual Returns Net of Fees & Taxes

Source: AFR, BondAdviser

Given the stark contrast in risk-adjusted performance, it is not surprising that the possibly dysfunctional asset-allocation decisions evidenced above have prompted the Future Fund’s chairman, Peter Costello to propose a much larger role in superannuation for an agency like the Future Fund. This could furnish Australian workers with a simple, low-cost and potentially capital-guaranteed option that would be managed by the public sector on their behalf.

The Future Fund could get an expanded role or the government may enhance the reporting of private sector super funds to publish more granular data regularly on returns and risks. This may force rankings to be made on the basis of risk-adjusted returns which would be negative for many funds’ large equity tilts. We would then expect to see major changes in asset-allocation, with higher allocations to capital-starved areas like domestic investment-grade bonds, high-yield debt and other fixed income assets, and potentially re-shaping the liquidity and pricing dynamics of the fixed income market we know. It might be the start of a glorious revolution.