The Negative Returns of Superannuation Funds on Retirement Savings - Essay Example

Executive Summary This essay paper assesses the performance and impacts of the negative returns of superannuation funds on retirement savings particularly as it regards a long term fund cycle. The Australian market industry as a frontrunner in the sector was chosen with readings and quotes from published reports from experienced participants. The negative returns have a direct operational and nominal impact on the retirement savings. The issue of communication and active involvement of trustees was clearly emphasised and the element of education of facilitators and beneficiaries well discussed. The option of Hedge funds as a viable alternative to help offset impacts on returns was suggested as well to reduce the usual direct capital loss to Total savings on pension by employees. 1. Introduction For the first time in many years, superannuation funds have to communicate news of a negative annual return to members, many of whom may never have experienced such an outcome. Trustees may also be reviewing their investment strategies in light of the continued difficult environment in financial markets. However, the advice from consultants and superannuation industry bodies is that one year of negative returns is no cause for alarm. Rather, it’s an opportunity to review both strategy and member education. Preliminary figures for growth funds in 2001-02 suggest an average decline in fund balances of 4.5 per cent, with the worst return recorded in an Aon survey of growth funds being a fall of 8.9 per cent, and the best a positive return of 2.1 per cent. Such returns may prompt some trustees to consider changing their mix of investments, with the aim of protecting members’ funds from continued weakness in equity markets in particular. However, Aon Consulting Senior Investment Consultant Jonathan Ramsay (wavelength, 2002) says a knee-jerk reaction to negative returns – and dire headlines about those returns – is not warranted if a suitable long-term investment strategy is already in place. Instead, the changing investment environment should be regarded as an opportunity to review carefully a fund’s long-term strategy – and then stick with it, if it is the right one. It is also an opportunity to educate fund members about that investment strategy, their investment time horizons, and the potential for negative returns occasionally throughout the investment cycle. “In a difficult environment, funds can look for new ideas to improve investment strategies,” says Ramsay. “There may well be ways in which diversification can be improved, risk can be adjusted, or the overall strategy made more appropriate. “This is very different from making a tactical asset allocation shift. It is not about fixing something that is inherently broken; it is about optimising a solution which is perhaps not yet at its best,” Ramsay says. 2. Member Unprepared Years of bullish equity markets mean investors have been unprepared for the current market realignment. “The fact that people are surprised by what is, in many respects, a normal set of circumstances is perhaps as much a problem as the investment returns themselves,” he says. In Australia, individuals have been given a lot of choice, amid the swift development of a sophisticated defined-contribution environment, without perhaps being given a commensurate level of education. Most people’s investment experience relates to 20 years of steadily rising markets. They now have to broaden their understanding of what a ‘normal’ investment environment is, says Ramsay. A key part of the education process is an emphasis on super as a long-term investment. Ramsay says an important tenet to remember is that timing the market is difficult, so it is crucial to stick to a long-term strategy regardless of where the market appears to be going in the short term. Also, it is critical to remember that if an investor has a long-time horizon – say retirement in 25 years – then short-term volatility is of almost no consequence. “Having the benefit of, say, a 30-year time horizon means that a young person is in the rare position of being able to pay for improved long term performance by taking on volatility,” Ramsay says. An investor closer to retirement should take a more conservative approach to avoid losing income-generating capital, because they have less time for market ups and downs to average out. While concern about further equity market downside may prompt trustees to consider placing more funds in cash, there are alternatives when it comes to finessing a long-term investment strategy that retains an emphasis on equities as the major element of a portfolio, while increasing diversification, Ramsay says. These different strategies include using hedge funds, buying small-capitalisation stocks, and adopting long-short funds. There’s no need for performance expectations to fall, as the aim is to achieve the same return but with less volatility, Ramsay says. Traditional fund allocation has focused on large-cap domestic stocks with international exposure limited to household names. This would usually account for 70 per cent of a growth-oriented portfolio, with the remaining 30 per cent allocated to fixed-interest investments, primarily sovereign debt. In the current environment, Ramsay suggests the 70 per cent equity proportion of a fund be split into 10 per cent hedge funds, 30 per cent domestic shares and 30 per cent foreign shares. Within the latter 60 per cent, he advises that a moderate allocation be given to long-short funds and 10-25 per cent be allocated to Australian and international small cap stocks. Also, the 30 per cent fixed-interest allocation could be diversified to include types of debt other than Australian government paper, such as international sovereign debt, corporate bonds, emerging-market debt, high-yield bonds and mortgage securities. Such diversification is evident in the Macquarie Global Bond Solution. Nicholas Brookes, Chief Executive of the Corporate Superannuation Association says some corporate super funds may be re-balancing in the current environment. Some may be topping up with equities, to maintain a consistent proportion of funds in shares, while others may be questioning the value of committing new cash flow to shares and instead considering cash assets. 3. Fund investment performance Under choice funds will need to keep more cash on hand to pay transferring members out. Asset consultants therefore should be advising trustees in the choice environment that they need to revisit the asset allocation ranges with a higher rating for cash. As it is well known over time cash will under perform all other asset classes. So this will act as a break on fund returns at a time when returns are under enough pressure. A further dilemma for investment managers in a volatile stock market environment is the timing of investment decisions in a falling market leading to higher cash holdings. If held for too long, this could be in breach of the fund’s trust deed. With a $532 billion in superannuation assets, this figure is projected to grow to $1.7 trillion by 2020(Aon annual report, 2002). It seems to me that much of that growth will be invested more traditionally through chasing up prices for the top 50 or so stocks on the Australian secondary market – or flowing overseas where 25 per cent of Australian superannuation assets are currently invested. This does little for the rural economy, for innovation and for job growth. It would be better if a steady flow of superannuation assets could be invested by trustees in long term value adding projects like infrastructure and venture capital, projects that actually boost growth and consequently improve the lot of all Australians. Institutional investment A comment by one of Australia’s top directors, who had top company experience in an earlier life within the funds management industry, was that he believed that there should be an inquiry into the efficiency of the funds management industry. That led me to an examination of the report by Paul Myners on Institutional Investment in the UK. Mr Myners was asked to look at the factors which encourage institutional investors to focus overwhelmingly on quoted equities and gilts and avoid investing in small and medium sized enterprises and other smaller companies. The report has raised a number of issues related to the adequacy of fund governance, the competencies of trustees, and the adequacy of the disclosure regime for fund managers. It should be noted that the UK is well behind Australia in terms of its regulatory framework. For example, they are only just coming to terms with issues like investment choice. Despite its deficiencies, the Australian regulatory framework is much more robust that that of the UK. It is one of the goals of my Committee to keep Australia at the forefront of world’s best practice. 4. Communication is the key But without exception, regular communication from corporate funds to members via workshops, forums and newsletters is emphasising the importance of having a long-term view, he says. Investors can ride out the peaks and troughs of market performance if they believe their fund is operated diligently and prudently, he says. “The whole thing rests on trust, in that members know the decisions are made for the long term on a fiduciary basis and that their trustees are not panicking in the short term.” Aon live wire Principal Louise Kanis says communicating poor returns can be used as an opportunity to refocus members on the basic principles of long-term investment. It is a chance to create relevance and to attract the interest of all investors, not just those about to retire and most concerned with the state of their savings. It is problematical that super funds communicate annually to comply with regulations but expect members to acquire a level of understanding of investment principles through this sole communication, she says. With broader communication strategies, the messages would be that things are never as rosy as they seem in good times, and never as bleak as they seem in bad times. Fund managers also have to avoid sending inconsistent messages, such as boasting about annual returns while emphasising that super is a long-term investment strategy. Kanis advises funds to weight their communication towards educating members about their time horizon, rather than annual returns. Expectation management is a critical part of education, and the approach needs to be based on an ongoing, built-in strategy. Simple messages and repetition can help build a basic understanding among members. Kanis says funds tend to squash too many messages into one brochure, report or statement, rather than providing perhaps three to five basic and pertinent messages. One of the most important lessons when entering a period of low returns is the benefit of dollar-cost averaging –that saving regularly over the long term is a better investment strategy for the average person than chasing investment returns. Kanis says the same principle applies to communication. Consistent messages, rather than reactionary responses to issues, will build a greater depth of understanding. Kanis suggests looking at innovative ways to present information in an annual report – perhaps using different authors for different sections of the report or a third-party endorsement to create interest. She also advises funds to consider alternative communication, if it is cost-effective. “The fact that Embracing the Hedge The hedge fund industry is one of the fastest growing segments of the investment management industry, and absolute-return funds – as hedge funds are also known – are much more accessible in Australia today than they were just a few years ago. There are several reasons for their appeal, especially in the current investment climate. First, their risk-adjusted performance is particularly good over the long term, especially when compared to equities. Historical returns are typically similar to those achieved by growth assets, such as equities, but the risk, in purely quantitative terms, is closer to that of fixed interest or cash. Of course, one also has to take into account ‘soft’ risk factors such as the relative youth of many parts of the industry. Second, the returns from hedge funds tend to have a low correlation with those of equities, so they have strong diversification benefits. Combining hedge funds with traditional asset classes makes it possible to reduce the risk of the overall portfolio. That said, one should be very careful to make sure that such an investment is compatible with a portfolio’s long term objectives rather than just based on what you think is going to happen next year. In addition, the decision is not merely whether to invest, say, 10 per cent of a portfolio in hedge funds, but rather precisely how to go about making that investment. The aim is to achieve maximum diversification, and the key issues are direct investment versus investment via a ‘fund of funds’, and single-strategy managers versus multi-strategy managers. It is possible to have any combination of these four elements. At one end of the spectrum would be investing directly into a single-strategy hedge fund, while at the other end would be investing into a fund of funds that covers managers using a range of strategies. In my view, the diversification interest in the fund of funds route provides an extra level of risk control for an asset class than do single manager funds. It can be helpful to think of individual hedge funds as you would individual companies when considering the utility of a fund of funds approach. Single vs Multi-Strategy Similar arguments apply when it comes to single-strategy versus multi-strategy vehicles, and the latter would probably be the first choice for investors inexperienced with this asset class. Take the example of a single strategy such as short selling. If you assume that equity markets go up more often than they go down, focusing solely on this strategy would mean losing money. But combine that strategy with a range of others and you achieve diversification benefits – when some strategies are performing poorly, others will be helping the overall portfolio. Not only are absolute-return fund strategies uncorrelated with investment markets, they are also uncorrelated with each other. By combining them in a fund of funds, it is possible to reduce the overall risk without reducing the return. However, there are single strategies that have added utility for superannuation funds, and as super funds become more knowledgeable about the various hedge fund strategies they tend to want to target some strategies more than others. Superannuation funds may have exposure to long/short equities already within a multi strategy fund of funds, but they may want to increase that exposure by making a further single-strategy investment. In fact, trustees are already increasingly comfortable with the long-short strategy (Wavelength, autumn 2002), for example, and some have chosen to invest in it on a stand-alone basis, rather than just as part of a more diversified structure. Conclusion This essay uses the Australian market as a case study with help from published reports from practitioners to evaluate the various impacts of negative returns of superannuation funds on retirement savings of employees particularly the preceding year. The impacts have been diverse ranging from low financial returns to administrative problems such as trustees complaints. The various key strategies discussed would facilitate a more involved and participatory scenario with fund trustees to reduce if not totally mitigate impacts of negative share index in the future, a usual occurrence in a long term cycle of market funds. Reference: Wavelength,2002. Gaining the upper hand in a market. http://www.aon.com.au/pdf/general/publications/wavelength/wl_spring_2002.pdf Keane A, & Emmerson R., July,2008. Super returns fall but law changes mean interest is high. http://www.news.com.au/adelaidenow/story/0,22606,23988887-5015842,00.html Dixon D.,July,2008. Asset Check. The Canberra Times. Negative Super Fund Returns for 2007-8. http://www.dixon.com.au/dixon/News.aspx?a=33&s=33&c=994 Read More