Recently Jeremy Cooper and Senator Bowen made preliminary statements regarding the forthcoming changes to the superannuation industry into the Governance, Efficiency, Structure and Operation of Australia’s Superannuation System (“the Cooper Review”). Much of what has been said to date on the reforms has received general agreement but I’m not sure that the Cooper Review is focused on perhaps the most important issue; namely, asset allocation. Superannuation returns are the major topic in the current debate. In particular, much has been said about the impact of fees on superannuation returns. However, superannuation returns are not primarily driven by fees. To be blunt, fees are effectively a sideshow; a distraction to the real driver of investment returns, namely, asset allocation. Rather, superannuation returns are essentially driven by asset allocation and, as noted by the OECD, that the current fixation for equities in Australia is causing an adverse impact upon superannuation returns.
This was recognized, initially at least, by the Cooper Review as the initial phase noted, “Australian super funds seem to have had a bias towards equities in their portfolios … This meant that Australians' superannuation savings were more vulnerable to the global market turmoil”. Since then, the Cooper Review appears to have swept asset allocation under the carpet. Specifically, in December 2009 the Cooper Review commented that “the Panel sees no reason to pursue this issue”.
In my view, this approach is erroneous for the following reasons:
First, Australian superannuation funds approach the task of asset allocation from a perspective that is now antiquated whereby asset allocation is set by firstly making assumptions about future asset performance. Here, assets that are expected to derive high future returns are termed “growth” assets, while assets that are expected to have a lower future returns, are termed “defensive” assets such as fixed income assets, are then selected to dampen the volatility of return. In other words, fund managers effectively allocate according to assumptions of what they do not know, namely, future asset return.
Secondly, Australian super funds are operating under the illusion that equities will provide a hedge to inflation when the available evidence on that assumption is scant, even over the long term. In fact, if there is any relationship at all, it appears that inflation and equity returns are actually marginally negatively correlated. This should not be particularly surprising given the poor performance of equity markets during the inflationary 1970’s and subsequent strong performance since inflation has trended lower.
Thirdly, the dispersion of risk taking that the defined contribution (“DC”) creates has been harnessed by the fund management industry to effectively load a disparate group of investors with the most risky (and incidentally highest fee) asset classes. Importantly, it should be realized that the DC structure is not a green light to take on risk. Most DC members maintain a relatively static approach to contribution levels. Unlike defined benefit (“DB”) plans, it is not common practice for the adequacy of individual contributions to be reviewed in the light of investment performance. Generally, the implication is that contributions are unlikely to be an effective regulator of the relative appropriateness of asset accumulation, thereby leaving the investor even more reliant on appropriate investment earnings relative to the situation in a DB plan. In addition, regardless of whether the contributor is DB or DC, contributors expect positive real returns.
One can only hypothesize, as to why this situation has been allowed to evolve. Similarly, why has the debate moved from asset allocation to fees? Let’s not dismiss fees. They are relevant. However, by simply implementing reforms that reduce fees, the risk is that the fund management industry has one way of maintaining fees; that is, by keeping members in the most risky asset classes where alpha opportunities, or “promises” of benchmark outperformance, are the highest. It is on the basis of these “promises” that fees are determined so the higher the “promise”, the higher the fee. Equity allocations are, therefore, one of the few ways left for fund managers to capture high fees.
In conclusion, while the Cooper Review commenced with such promise, it appears to have taken a benign turn by retreating from reviewing the crucial issue of asset allocation and improving asset diversification with a higher fixed income allocation. In other words, the Cooper Review risks being seen as an exercise in effectively papering over the cracks in our superannuation system rather than addressing the really important questions. While world best practice effectively tackles the problem of asset allocation from a completely different perspective, it appears that Australia will continue with the outdated framework used since the 1970s. Hopefully, we don’t look back on the Cooper Review as an opportunity lost.
