- On 01/05/2020
- assets, COVID-19, Liquidity
The superannuation industry has had phenomenal growth over the last 30 years, much of it attributable to the increasing mandatory employer contributions (now sitting at 9.5% of wages). Our Superannuation Market Projections Report 2019 showed that industry assets grew by nearly 10% a year in the decade to June 2019. Although this rate is unsustainable in the long run, we did project (pre-coronavirus) a further 7% a year growth rate over the following 10 years. That will need to be reviewed once we understand the full impact of the COVID-19 pandemic.
World-leading investment returns have also been a major contributor to the industry’s growth. The major factor here is asset allocation. Over long periods, those funds with higher allocations to growth assets do better as they milk the equity risk premium. When the mandatory SG system began in 1992, superannuation funds mainly invested in listed (public) assets with a small allocation to property (usually via a fund manager). However, asset consultants and funds began to see the value in private assets which provided higher potential returns through an illiquidity premium.
Initially, superannuation funds began to invest in infrastructure and many large funds benefited from State government privatisations. These private assets, including airports, toll roads and ports, have a monopoly rent which provides a regular income which grows with economic activity. The new owners often revamped and geared the assets, which enhanced the income streams giving even stronger returns.
Since then, funds have invested in other private assets such as direct property holdings, private equity, and venture capital. The mix varies by superannuation fund, based on their own cash flows and membership demographics but the overall results have been similar over long periods as we showed in an Insight column last October.
These real assets have benefited from the decline in interest rates over the last 15 years – the reduced discount rates have increased the valuations. The relative stability of their cash flows during an extended period of economic growth has led to many funds increasingly using these assets as proxies for government bonds, but with higher returns.
Over time, some funds have used the relative price stability of unlisted assets to shift higher amounts into growth assets, even for pension accounts. The guaranteed cash flows from SG contributions gives positive net income for the industry and provides a cash buffer and strong overall liquidity. Until recently, many funds were concerned about how to allocate the huge cash flows, given many assets appeared to be expensive. They did not want to leave too much in cash and bonds given the low interest rates currently on offer.
Cash flows vary from fund to fund. Many have strong brands and retain the bulk of their members in the MySuper default investment strategy. However, most funds offer a range of investment choices and they must transfer assets immediately if a member requires a new allocation – or if they retire into a different portfolio. Members can also opt to join a different fund and these roll-overs must be dealt with promptly. Further, large employers could use a Successor Fund Transfer (SFT) to move their employees to or from a different fund. All these events impact on cash flows and must be included in any liquidity stress testing.
Some funds experienced liquidity issues following the GFC in 2007/8. There were a handful of funds which had problems due to high allocations to unlisted assets and there were also funds which invested in property funds or mortgage trusts which were frozen after their own liquidity issues (not enough cash to pay withdrawals).
APRA released SPG530 in 2013 to deal with many aspects of Investment Governance, including liquidity management, which must be monitored and managed on an ongoing basis. Each fund must set up a Liquidity Management Plan (LMP) and this must be stress-tested against likely poor outcomes. APRA states that:
An RSE licensee may also consider, for example, RSE-specific events such as large-scale redundancies within an employer-sponsor, successor fund transfers or market-driven events such as illiquidity of underlying investments as observed during the global financial crisis.
Much of the retail superannuation segment has been developed with multiple products and a plethora of investment choices. This has meant a dilution of the investment funds, giving mass but not scale. The structure has meant that MySuper products have not held a high proportion of the RSE’s total assets, so liquidity needs were greater and accumulated over several products. Consequently, the entry to unlisted assets was generally later and at lower levels than for industry and public offer funds.
Valuing unlisted assets
One claimed advantage of unlisted assets is that they are not subject to the volatile daily prices of the stock markets. While this is true, the underlying worth of the assets should be no different. Over time, this plays out, but, in the short term, listed prices are driven by confidence and expectations and emotions (fear and greed), as well as supply and demand for the stock, so they are often priced at a premium or discount to theoretical values.
The main disadvantage of unlisted assets is that they are illiquid, and any sale is more complex and slower than an on-market transaction. This shows up in the illiquidity premium. Where, for instance, infrastructure and property assets are held via a listed vehicle, the market prices of the listed vehicle generally stand at a discount to the value of the underlying assets.
In this pandemic, all assets have fallen in value. They will resettle once we understand the expected future earnings pattern better. Some will go back to a similar pre-virus world; others will be permanently impaired. Since unlisted assets are only valued periodically, they lag the immediacy of listed markets to changes in circumstances and, as a result, there could be arbitrage opportunities.
Superannuation funds are required to ensure equity between different groups of members. New members (or new contributions) should not pay more for an asset than it is worth. The difficulty is in assessing the value of an asset in these uncertain economic times. How do you value a convention centre when there may be no (international) conferences in the next two years? What about airports if international travel is largely stopped until the end of 2021? In practice, the funds will increase the frequency of valuations to ensure they are reasonably up to date as economic circumstances change. That might mean that the initial falls of 5% to 15% on some unlisted assets could be lowered again later if future earnings are expected to be lower for longer.
Impact of the early release of super
All liquidity plans were unsettled by the recent legislation to allow members to withdraw up to $10,000 tax free before 1 July and then again before 1 October. This Coronavirus event could lead to $25 to $50 billion of unforeseen withdrawals over the next four months (as most of the second instalment will take place early in July).
The media and government have taken the view that funds should have allowed for this in their LMPs. This is harsh as the legislation is new and very little notice of payment was given. These calls are essentially berating Trustee Boards for not having provided for the sovereign risk of the Government requiring cash withdrawals well outside their own enunciated (but not yet legislated) Objective of Superannuation.
Most funds will manage, but some operate for members in industries with high levels of unemployment and their regular cash flow has been severely disrupted. None of this could have been foreseen!
The heavily impacted funds might need to sell some assets to support their cash flows. Not only does this mean selling at depressed prices, but it reduces the scope to buy other discounted assets as they become available. Fortunately, we are not aware of any funds that will need to ask APRA for approval to cease rollovers due to illiquidity (Section 6.36 of the SIS Act).
One of the implications of the Early Release scheme is that funds will hold more money in cash (earning very little). They will be worried that this precedent could be repeated, and they need to be better prepared. Superannuation funds with a significant proportion of members in those industries most affected at the moment (such as hospitality, retail and tourism) may seek to attract more members in other areas as well as building up membership of their account-based pensions. This will provide an increased buffer against another one of these (hopefully) one-in-a-hundred-year events.
Over the next decade, the superannuation industry is not likely to have the same earnings pattern as enjoyed over the last 20 years. This will mean new targets – is CPI + 3% to 4% still viable over the next ten years? Perhaps it will be if CPI is negative for some of this time!
If targets are reduced, that will flow into communications material, online calculators and financial advice models. It will also reduce projected future retirement benefits for members and possibly reduce confidence in the system, despite its clear value for most Australians.
It is also fair to say that forcing superannuation funds to hold more liquidity in anticipation of another unexpected Government requirement will reduce the long-term earning capacity of superannuation and eventually lead to lower tax revenue and higher Age Pension costs.