John Wilson says it’s time we revisited how superannuation fund asset allocations are set for different members.
Prior to the introduction of compulsory superannuation, in 1992, the typical super fund paid inflation-adjusted pensions based on some ratio of final salary, depending on the length of service. The employer contributed money to its superannuation fund to cover the anticipated cost of providing this benefit, known as a defined benefit, or DB fund. In this situation, the employer takes all the risk.
Compulsory superannuation changed all this. The employer’s obligation is confined to paying the annual legislated amount, with the employee assuming all other risks. The system is now largely an accumulation or defined contribution (DC) structure.
Some 80 per cent of the money in superannuation is now in accumulation funds, with the members’ retirement incomes directly dependent on contributions and the investment returns achieved on their account balances. This rises to 86 per cent when self-managed funds are taken into account.
WHOSE MONEY IS IT?
Given the accumulative nature of superannuation, it is no surprise that older members account for most of the money and have higher average balances. The age distribution of vested benefits varies significantly according to the fund type.
However, and importantly for asset allocation and fund design, in each category, more than half the assets are held by those older than 50 years. The greater concentration of older members in retail funds reflects the fact that historically many fund members have switched from a not-for-profit fund to a for-profit fund around their retirement date. While this is also a reason for the higher concentration of older members in self-managed funds, the large proportion of self-employed members suggests that tax management is important in determining the contribution flows.
INVESTMENT APPROACH
With this background, does the way the money is invested make sense? Not-for-profit funds, while they offer a limited range of investment options, hold 65 per cent of their assets in the default option, either because members deliberately choose that option or don’t want to make a choice. The analysis will focus on these default options.
In a sample of 12 representative funds, the average proportion of growth assets held by the default option is about 80 per cent. A fundamental question arises, namely: “Is it appropriate to have 80 per cent in growth assets, given the current pricing of sharemarkets and also the age structure of the owners of the assets?”
STARTING POINTS MATTER
While it is tempting to be fully invested in equities on a “buy-and-hold” basis because of their superior long-term returns, the volatility of this average belies the usefulness of this strategy. It is far better to be invested in equities when they are priced to produce above-average returns – that is, above 6.75 per cent per annum real returns – and not be involved when they are priced for lower than average returns. The question is whether this can be done; is there a way to assess future equity returns?
One of the reasons that share prices fluctuate widely is that the market’s pricing is heavily influenced by the level of profit margins. When margins are high, investors believe they will stay high and raise share prices, thereby accepting lower starting yields, in the belief that elevated profit margins will underpin strong future profit growth. Conversely, when profit margins are low, investors see that as a guide to the future and demand higher starting yields to compensate for the sluggish outlook for profit growth. Profit margins, however, revert to average: they do not stay abnormally high nor unusually low for long periods. A straightforward way to adjust for this is to calculate the market’s price-earnings ratio using a 10-year average of earnings.
It is possible to compare these cyclically adjusted price-earnings multiples with subsequent market returns to see if they provide any guide as to what returns investors can expect from the sharemarket. There is a clear coincidence of low starting multiples and subsequent high returns and vice versa.
Based on this, the best guess is that the US sharemarket will have lacklustre returns over the next 10 years. The cyclical-adjusted price-earnings ratio is currently 19.9, with the S&P 500 at 11,005. The average real return when this ratio has previously been at these levels has been 3.4 per cent per annum, with a spread of 9.0 per cent per annum on the high side and minus 3.3 percent per annum on the low. The high correlation of international sharemarkets with the US sharemarket means that the return for global markets will also be lacklustre, along with those from “equity-equivalent” alternative assets, which are considered growth assets.
The answer to the first part of the question is that if you are concerned about returns over the next 10 years, this is not the time to have a high exposure to equities, or equity equivalents.
ENDING POINTS MATTER, TOO
The second part of the question is related to the first. For those nearing retirement, the investment earnings in the last few years are by far the most important because they determine the level of capital available to fund retirement.
Members of Australia’s superannuation system resemble regular savers who put aside 9 per cent of their wages each year for 35 years, reinvesting investment income along the way. Clearly, if you save over the course of 35 years, every one of the returns in individual years will have some impact on the amount you accumulate. But, for a 35-year saver, the real return in the last year is 35 times more important than the return in the first; the return in the second-last year is 34 times more important, and so on. Think of the amount that the 35-year saver accumulates as being 35 different lump sums, one for each year. Only one of these, the first, is affected by the return in the first year, but all 35 are affected by the return in the last.
Not-for-profit aged funds have 57 per cent of their assets held on behalf of those 50 years and older. With the prospect of a low real return from equities over the coming decade and the likelihood of negative returns, it would be prudent to secure the capital available for retirement by being invested in fixed interest securities rather than in equities.
Similarly, retirees should be very defensive in their asset allocation. Even when the sharemarket is fairly valued (in the case of the US market, priced to return the long term average of 6.75 per cent per annum real), the expected income difference between being invested in equities and being invested in inflation-linked bonds is modest; about 12 per cent per annum for those with a 20-year life expectancy.
This assumes that the equity return is guaranteed, which, of course, it isn’t. The risk of not achieving the expected return from holding shares means that retirees should rely overwhelmingly on more secure income sources. Of course, the argument is even stronger if the expected return from equities is below average, as it is now.
THE FUNDS’ CONSTITUENCY
Whether rational or not, it is easy to understand why the default option isn’t managed for those with most of the money; that is, older members. Younger employees dominate the membership of not-for-profit funds. This is especially so for industry funds, with half their members under 35 years and over 80 per cent of members below 50 years. Primarily the client of the fund is the employer, which wants to ensure that the designated fund does a “good job” and does not cause employees to become disgruntled; more precisely, it wants the selected fund to avoid doing a “bad job” relative to others.
The best way to avoid standing out from the crowd is to be part of it, and this behaviour is evident in both the broad asset allocation and in the selection of asset classes for the default options.
As a result, there is tight grouping of returns; the average per annum rate of return for our sample of 12 funds for the five years to June 2009 was 4.8 per cent with a high of 6.3 per cent and a low of 3.7 per cent.
It is unlikely that this focus on the “average” member will change.
AGE-BASED DEFAULT OPTIONS
A practical solution to meeting the needs of older members is to change the default option according to the member’s age. Age-based default options are offered by only a handful of the twenty largest not-for-profit funds.
Although the age brackets vary, all the funds significantly increase defensive assets as the members’ age increases. However, in our sample of 12 funds, only one of the funds has a majority of defensive assets for those aged 60 years and over.
