Strange times

We live in very strange and uncharted economic times, and the future is increasingly murky.  Yet superannuation funds, admittedly distracted by incessant loads of new legislation, don’t appear to have changed their outlook in communications with members.

Since the global financial crisis (GFC) a decade ago, we have entered a massive global economic experiment:

• We have the novel experience of negative interest rates. At least a dozen European governments have issued bonds with negative coupons.  This started with short durations but three countries (Germany, the Netherlands and Switzerland) have 30-year government bonds with negative yields.  Worse, a Danish bank has exploited this funding situation to offer customers 10-year mortgages at minus 0.5%.
• The RBA cash rate is at a record low of 1% with expectations that it will go to 0.5% within six months. The next step might be quantitative easing.  The only positive outcomes from that event might be the Australian government issuing zero coupon bonds and using the proceeds to fund infrastructure development.
• Global debt¹ is now $US184 trillion or 225% of global GDP. The debt is huge, but it is partly supported by unusually high values of real assets.
• All real assets are overvalued on historical metrics. In an environment of lower-for-much-longer interest rates, price/earnings multiples have jumped from the range 12-15 to 20-30 (and even more for technology stocks).
• Speculative companies perceived to have growth prospects through technological disruption have much higher valuations, even though profit remains elusive (Uber, Tesla, Atlassian).

There are indications that global growth, on which most economics is based, could be negligible for many years.  Slow growing and ageing populations, debt mountains, unforeseen trade wars and low inflation provide a paradigm with new rules and metrics.

Our youngsters will pay twelve times AWOTE to buy a home, when their parents paid no more than three times.  Yet, they will get minimal pay increases, which will slow down their capacity to repay their mortgage debt.

There will be a profound impact on investments for superannuation funds too.  The equity risk premium has grown since the GFC and real asset values have grown as interest rates have fallen.  Consequently, we have had ten years of strong returns which have been great for all members.  But what of the next ten years?

Member objectives

Most people agree that net investment returns are the best measure of whether a superannuation fund has delivered good value to its members.  This return, measured over the long-term for accumulation members, is the investment outcome after deducting fees and taxes.

While fees can be opaque, they can usually be determined.  However, future investment returns are completely unknown.  Members probably rely on past performance as a guide even though every fund has a health warning that these cannot be relied on and should not be used to estimate future returns.

So, the best that members can do is to look at the investment objective for the MySuper strategy.  Many funds have a MySuper objective equal to an annual return of CPI + X% per annum over rolling ten-years.  X is usually 3.5% to 4%.  Most funds have held X as a constant for many years even though times are clearly changing.  Holding the formula steady implies that the target can be reached through all economic conditions, and the sole variable over time is the level of CPI.

Should targets be reset?

We have just completed our tenth consecutive year of positive returns for the mainstream funds.  We question whether the good returns have made funds complacent, even though the risk of a downturn is now much higher².

Every year, we survey asset consultants and large funds about their expectations for all asset classes over the next decade.  The expected outcomes have not changed much even from year to year, though economic circumstances have been different.

For example, these investment experts have been consistent for the last four years in assessing likely returns from each class over the next ten years.  The median estimates for Australian equities have varied from 7.6% to 8.2% a year over the next decade, which is a narrow range.  Hedged international equities have been slightly lower (higher taxes and no franking credits), with a similar narrow range of 7.0% to 7.7%.

Surprisingly, government bonds have also been in a narrow range (2.75% increasing to 3.5% in 2019 survey) and cash is flat at 3% to 3.3%, even though interest rates have moved considerably down over the last four years.

These surveys show that investment experts (and indirectly the superannuation funds) are sticking to conventional forecasts of future performance and are not building in the impact of the global economic crises.

This raises two issues:

• Should funds be telling members that they are likely to average returns of 5% over the next decade, rather than the 7% to which members have become accustomed?
• Should the targets be reset lower in an environment of extremely high real asset prices and a decline in world growth (and future profitability)? Should we consider whether ten years of ‘lower-for-longer’ has expanded to permanently lower interest rates, and a different normal state?

The members most affected are the baby-boomers who are gradually transitioning into retirement.  It has been of tremendous benefit to draw the minimum pension of 5% up to age 75 when the fund was earning 7%.  Many people in their mid-seventies who have been drawing the minimum now have more money than they had at retirement!  That is unlikely to be the case for those retiring today, and fund communications, including retirement calculators, need to show the impact of potentially worse outcomes relative to the past.  Consequently, more members will need to draw down their capital earlier.

Finally, superannuation funds should prepare members for:

• Much lower nominal returns in a low interest rate and inflation environment – potentially being much lower than members have received in recent times.
• Tolerating higher levels of volatility if they are to have a reasonable chance of achieving adequate long-term returns.

¹ https://blogs.imf.org/2019/01/02/new-data-on-global-debt/

² https://www.ricewarner.com/preparing-for-a-market-downturn/