Investment Magazine November 2016 by Conexus Financial

INTELLIGENCE FOR INSTITUTIONAL INVESTORS

ISSUE 133

Considering all the

ALTERNATIVES

Local Government Super CIO CRAIG TURNBULL is using illiquid strategies to chase better returns â&#x20AC;&#x201C; with lower risk

RETIREMENT INCOME EXPLORING THE MANY FACTORS THAT MUST BE CONSIDERED IN DESIGNING A CIPR IRISH TIMES IRELAND IS LOOKING TO AUSTRALIA AND NEW ZEALAND AS IT SETS OUT TO DESIGN A SUPER SYSTEM AIST THE BILLIONS OF UNPAID SUPER EACH YEAR DESERVES MORE DISCUSSION THAN IT GETS ROUNDTABLE THE CHALLENGES AND RISKS IN FIXED INCOME MARKETS, INCLUDING LIQUIDITY AND VOLATILITY

NOVEMBER 2016

b ig d a ta

CONTENTS NOVEMBER 2016

EDITORâ&#x20AC;&#x2122;S LETTER New editor Sally Rose dives into the retirement income dilemma.

CIO PROFILE Craig Turnbull from Local Government Super talks about how he is exploring a range of alternative strategies to keep the fund on track.

RETIREMENT INCOMES A recent gathering in Canberra explored the wide range of factors that must be considered in designing successful retirement income strategies.

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RE-IMAGINING DEFAULT Like it or not, all funds need to get ready to cope with what the Productivity Commissionâ&#x20AC;&#x2122;s review into default super throws up.

MERCER PENSION INDEX Why Australia is loosening its grip on third place in the Melbourne Mercer Global Pension Index.

IN FOCUS StatePlus talks about why it is deploying smart beta strategies across its equity portfolios to decrease volatility.

IRISH TIMES

Jeremy Cooper writes about his recent trip to help Ireland map out what its new superannuation system should look like.

AIST There is one figure that deserves a lot more attention than it gets: the estimated $6 billion a year missing super guarantee contributions from employers.

ROUNDTABLE The challenges and risks in fixed income markets, including liquidity and volatility, were discussed at a roundtable hosted by Investment Magazine.

N O V E M B E R 2016

\ FROM THE EDITOR

EDITORIAL MANAGING EDITOR

SALLY ROSE / sally.rose@conexusfinancial.com.au

Keith Barrett EDITOR

Sally Rose DIRECTOR OF INSTITUTIONAL CONTENT

A LETTER from the editor

Amanda White JOURNALIST

Dan Purves ART DIRECTOR

Kelly Patterson GRAPHIC DESIGNER

Suzanne Elworthy SUB-EDITOR

A FOCUS ON RETIREMENT

Susi Banks PHOTOGRAPHER

Matt Fatches

matt@mattfatches.com.au

USTRALIA MIGHT HAVE one of the best superannuation systems in the world for growing workers’ savings, but perhaps the biggest challenge facing the sector today is how to become expert in managing that money for people when they retire. We didn’t set out for the November issue of Investment Magazine to have such a strong “retirement incomes” flavour. It just happened naturally, a reflection the issue is front of mind for many industry leaders. As the Committee for Sustainable Retirement Incomes outlined in its recent whitepaper, super funds in the process of designing a comprehensive income product in retirement (CIPR) for their members need to understand how it will interact with age pension eligibility, housing needs, health and aged care costs, and access to financial advice. The demographic shift to an ageing population, combined with the challenging market outlook, is also reshaping investment strategies. In our cover story, Local Government Super chief investment officer Craig Turnbull details how he is shoring up the fund’s ability to keep delivering reliable income streams, by investing in a broader range of alternative assets. Challenger’s Jeremy Cooper delivers a missive from Ireland. Only now in the birthing throes of implementing a universal pension system Ireland has the chance to

NOVEMBER 2016

learn from Australia, and get a retirement incomes framework in place from the outset. Closer to home, how different funds are tackling the retirement income challenge is sure to be a hot topic of debate among the judging panel for the 2017 Conexus Financial Superannuation Awards. Controversially, the 2016 judging panel chose to withhold the award for innovation and transformation. It will be exciting to see what some of the country’s top super funds have been working on since. The annual awards recognise excellence in the industry, and are noted for their independence and rigour. Actuarial and consulting firm Rice Warner will oversee the 2017 judging process, drawing on its comprehensive database to crossreference the information provided by funds on their nomination forms. Three new categories have been added: best insurance offering, best advice offering, and best technology and innovation offering. In total there are 12 categories up for grabs, including: superannuation fund of the year, pension fund of the year, and chief investment officer of the year. I’m delighted to have taken on the role of Investment Magazine editor this month. Hopefully I’ll get the chance to meet many of you at the Conexus Superannuation Awards at Ivy Ballroom in Sydney on March 9, 2017. Ñ

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\ INTERVIE W

LGS

considering all the

ALTERNATIVES By Dan Purves

Local Government Super has received accolades for environmentally sustainable investing, but chief investment officer CRAIG TURNBULL is equally concerned with questions of FINANCIAL SUSTAINABILITY. A MEMBER BASE hurtling towards retirement, when the investment outlook bodes many years ahead of weak growth with ultra-low cash and bond yields, poses a major challenge for Local Government Super’s (LGS) Craig Turnbull. The chief investment officer has already responded quickly by lowering the return target on the fund’s DB option, to keep member expectations in check, and tilting more of the investment portfolio into alternative unlisted assets to try and bolster long-term performance. Over the past couple of years LGS has been shifting capital out of listed stocks and bonds and re-deploying it into semi-liquid, defensive illiquid and absolute return strategies. The goal in diversifying into these alternative asset classes is to put the fund in a stronger position to continue delivering stable returns. This is critical as the core demographic of its membership shifts rapidly towards retirement age. Turnbull is best known in the industry as a pioneer of, and passionate advocate for, sustainable investing – in the sense

NOVEMBER 2016

of accounting for environmental, social and governance (ESG) risks. Measuring the climate change impact of companies and projects the fund invests in has long been a focus. In May, the Asset Owners Disclosure Project ranked LGS as the number one institution in Australia for environmentally sustainable investing. Even more impressive, LGS was ranked number two globally in the study of more than 500 institutions. But, speaking to Inverstment Magazine, Turnbull is preoccupied by more prosaic questions about financial sustainability. His recent push into alternative unlisted asset classes is a trend that is set to continue at the nearly $10 billion public sector fund, which manages the compulsory retirement savings of around 90,000 current and former NSW local government employees. The LGS investment committee, headed by James Montague, recently voted to approve Turnbull’s plan to keep shifting more of the portfolio into “illiquid” assets over the next three years.

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INTERVIE W \

Of the $9.6 billion LGS has under management, $4.1 billion is in accumulation funds, $1.9 billion in pension funds, and $1.7 billion in defined benefit funds, with the rest in other funds that are partly funded by employers.

HIGHER RETURN FOR UNRELATED RISKS

As one-fifth of assets are already in the drawdown phase, Turnbull is trying to develop strategies that do not introduce any more equity, interest rate or credit risk, but rather can give a higher return for unrelated risks. “The main worry is how to get the return we are looking for in a low return environment. We have lowered the investment objective for the defined benefit fund and it will be a challenge to reach the objectives for the other funds,” Turnbull says. Eight years ago, he hired an asset consultant to advise the fund on how to build up its holdings in private equity, private credit, infrastructure, and hedge funds. A goal was set to build holdings across these alternative asset classes up to the value of 25 per cent of the total portfolio. “It’s taken five or six years to do that, but we [are] pretty well at our limits now,” Turnbull says. At June 30, the asset allocation in its balanced option was 31.41 per cent in equites, 7.16 per cent in property, 10.59 per cent in private equity and semiliquids, 0.87 per cent in commodities, 25.47 per cent in fixed interest, 4.64 per cent in bonds, 12.16 per cent in absolute return funds, 3.71 per cent in defensive illiquids, and 3.99 per cent in cash. Earlier this year John Peterson was recruited to the newly created role of portfolio manager illiquids, bringing LGS’s in-house investment team to nine. Turnbull has headed LGS’s investment team for more than eight years, having been appointed by chief executive Peter Lambert six months after he took the reins.

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NOVEMBER 201 6

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Immediately prior to becoming chief investment officer, Turnbull spent three years as head of real estate securities for MacarthurCook. A number of MacarthurCook property trusts became distressed in the global financial crisis, before being de-listed or sold off, so Turnbull has first-hand experience of the liquidity risks associated with investing in unlisted assets.

ILLIQUIDS AN ‘ESSENTIAL INGREDIENT’

Still he is confident, that with the right mix of assets and tenures, illiquids will prove an essential ingredient in the years ahead if LGS is going to have a reasonable chance of meeting its stated return targets. The return target for LGS’s defined benefit option was recently lowered to 6.5 per cent from 7 per cent including inflation as measured by the consumer price index (CPI). The conservative option, favoured by retirees, is at the much more modest CPI plus 2 per cent. Over the past three, five and 10 years the conservative option has delivered an average annual return of 5.21 per cent, 5.95 per cent and 3.86 per cent respectively. But Turnbull is worried it could be impossible to repeat those sorts of results in the year ahead. “On the view that inflation could revert back to 2 or 3 per cent and you need to earn a 2 per cent margin above that, it raises the question of how to get 6 or 7 per cent return?” Return targets on the balanced and growth options have not yet been lowered, but remain under review. A need for yield is why Turnbull started shifting money out of low-risk sovereign bonds into riskier corporate credit. The Australian bond mandate is now aligned to a “composite benchmark” that includes an allocation to local corporate bonds. PIMCO and Brandywine Global Investment Management have been appointed to manage a “high conviction” composite international bond portfolio. Diverting capital from sovereign bonds into corporate bonds heightens the risk of a blowout in credit spreads, as happened in the global financial crisis of 2008. “It’s not too hard to imagine a scenario where the returns on bonds could be actually negative. The rates wouldn’t have to rise very far for that to happen,” says Turnbull. Because of this, LGS has been downweighting its bond allocation at the strategic level, though they remain vital for diversification.

NOVEMBER 2016

In May, the Asset Owners Disclosure Project ranked LGS as the number one institution in Australia for environmentally sustainable investing. Even more impressive, LGS was ranked number two globally in the study of more than 500 institutions.

“If things go bad they are the one thing that can go up for you,” he says. They also have the ability to go underweight tactically, and recently with bond yields 2 per cent and lower, that capability to underweight has been utilised. “The same thing with cash,” Turnbull says. “If anything, you would logically be moving further away out of bonds and cash into something else that gives a better return.”

BEST FIXED INCOME OPPORTUNITIES

One area where LGS is hunting for value is semi-liquid fixed income funds. These are funds with an investment duration typically of five to six years. These funds provide exposure to the best fixed income opportunities in the market, and can include distressed credit and private credit. LGS already has a $291 million portfolio of defensive illiquid assets. Two-thirds of this is invested in long term infrastructure holdings. A stake in a pharmaceuticals royalties trust is another defensive illiquid holding that has performed well. Turnbull says defensive illiquids have been the “star performers” of the portfolio in recent years. “There is some sensitivity with infrastructure in the way that it’s valued, but valuation discount rates used in our portfolio are still up around 10 per cent.” Another asset class that offers strong returns but can require a lot of patience, similar to infrastructure, is private equity. “In private equity there is often a J curve effect, you go down before you start coming

up, so you have to be very patient,” Turnbull says. The super fund has private equity mandates with 14 managers including Cerberus, Terra Australis, Bain Capital, Paul Capital Partners, EQT, Hawkesbridge Capital and Quadrant. Eight years after the fund began allocating more to private equity, the strategy is really starting to pay off. In pursuit of more stable returns Turnbull has also restructured the absolute returns portfolio, which tanked in the global financial crisis, and built it out to roughly $1 billion. In the December quarter of 2008 the absolute returns portfolio lost 20 per cent, which came as a shock due to a lack of transparency on how much equity risk was within it. “That was too volatile for our liking and there was a big restructuring post-GFC,” Turnbull says. “It started off with all credit spreads, but as spreads came in we’ve reduced credit and started introducing other strategies.” These include hedge fund beta strategies, low-cost illiquid strategies, risk premia strategies, as well as picking strict general strategies and working off indexes. Other unusual components of the absolute return portfolio include a “commodity trading advisor trend-following strategy”, and a hedge fund invested in energy markets. Over the seven years to June 2016, the LGS balanced option has returned 7.5 per cent. The industry average over this period was 8.2 per cent, according to SuperRatings. Ñ

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\ P OST RETIREMENT

Aligning the pillars

POST-RETIREMENT By Dan Purves

CIPR

Age pension

With compulsory superannuation starting only 25 years ago, the relative immaturity of the system has led to a focus on accumulation. As the former cottage industry has swollen into a $2.1 trillion powerhouse, that focus is transferring to the deaccumulation stage, as Australia undergoes a demographic shift to an aging population. Link Advice chief executive Ross Bowden gave an indication of the scale of the issue. Link Group administers approximately 10 million accounts for industry super funds in Australia – yet only 154,000 of these are account-based pensions. The pressing question for super funds, and all those concerned with adequacy in retirement, is how to build financial products that will effectively meet the diverse needs of retirees. Following a recommendation of the 2014 Financial System Inquiry, led by David Murray, the government has said it will make it a requirement for all default super funds to offer retiring members a comprehensive income product for retirement (CIPR). These clumsily named CIPRs will need to integrate with the three-pillar structure of the retirement income system (the government funded age pension, compulsory saving through NOVEMBER 2016

the superannuation guarantee, and voluntary superannuation saving), as well as the wider retirement ecosystem, which includes housing, aged and health care, and financial advice. The Committee for Sustainable Retirement Incomes (CSRI) suggested three design principles were needed in every CIPR. Firstly, longevity risk protection, probably involving some form of mortality pooling. Secondly, CIPRs would need to provide regular and sustainable income streams. Thirdly, there would need to be the ability to account for cognitive impairment at older age, so that income can be provided with little to no intervention. However, for the development of products to really proceed, the Department of Social Security needs to clarify how the income stream would impact the means test and age pension. To help resolve this, assistant treasurer Kelly O’Dwyer told the CSRI forum the government would likely release a consultation paper outlining CIPR requirements in more detail by the end of the year. StatePlus chief executive Graeme Arnott warned that as CIPRs begin to hit the market, many people will choose the “default” pre-selected for them, and as such, it was critical to get the design right.

The government-funded age pension is the social safety net of Australia’s retirement income system and how CIPRs interrelate with it will be critical to their success. As previously reported in Investment Magazine, HESTA thinks about the age pension as almost serving as a bond in members’ finances, because it gives a low but reliable income stream. Annuities maker Challenger, which has taken a lead role in developing CIPRs with a number of super funds, talks about the age pension as a base in its income layering strategy. The government has promised to change the tax rules to reduce regulatory restrictions to the development of a market in deferred annuities. However, in its policy paper A holistic view of the retirement income system – overview and summary the CSRI states “the new assets test to come into effect from January 2017 effectively has too high a taper that discriminates against annuities, and is likely to encourage behaviour aimed at avoidance”. It recommends consideration should be given to introducing a merged means test that would encourage retirees to draw down their assets, and would more broadly support the adoption of CIPRs and annuities.

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P OST RETIREMENT \

A RANGE OF industry, government, consumer and academic experts at the Committee for Sustainable Retirement Incomes Leadership Forum discussed the FIVE SEPARATE COMPONENTS that need to be considered if retirement solutions are to be adequately developed.

Aged and health care Aged care has emerged as a major priority in retirement planning, according to CSRI chair Dr Michael Keating. “We really do need to think and design a retirement income system around the demands that will be made on people for aged care,” Keating said. Keating was previously involved in establishing compulsory superannuation during the Paul Keating government. With an estimated 50 per cent of Baby Boomers needing residential aged care at some point in their later years, there will be increased pressure on the budget as the government provides financial support in this area. As a result, there is a policy aim to shift more of the costs towards consumers. With current legislation, retirees are able to pay for aged care costs either from their income or assets (the home being the most common), however care providers have the power to influence this in their own commercial interests. “As a result, there needs to be better coordination of aged care policies with retirement income policies, most notably the treatment of housing in the means test and aged care,” CSRI chief executive Patricia Pascuzzo said.

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Housing – the unofficial fourth pillar There is broad agreement among stakeholders that housing needs to be considered as the “fourth pillar” in the retirement income system, as home ownership was a significant determinant of adequacy. One of the challenges was how to structure products for those who were asset rich (homeowners) but income poor. The ability to access this equity could conceivably lead to more security and the ability to cover other costs, such as aged care. One of the delegates at the Leadership Forum pointed out that current legislation makes it very difficult for homeowners to free the equity in their house, through downsizing for example, as if they chose to do so they would be penalised under means testing and stamp duty. As such, governments needed to examine policies to both remove market impediments and protect retirees from financial abuse by those who would seek to game the system for their own commercial interest. In addition, as the 15 per cent of retirees who were not homeowners frequently faced significant financial hardship because of rent, it was important to look at what assistance could be provided to them.

Financial advice and communication There is no element of compulsion in CIPRs, according to Jenny Wilkinson, head of the treasury’s retirement income policy division. “It is very important that everybody understands that nobody will be defaulted into a CIPR, and an active choice will need to be made by the member to take it up,” Wilkinson said. As a result, super funds would need to offer guidance to members to assist them in making an appropriate choice, which would likely require the rules for scaled and intra-fund advice to be modified. With a suite of products needed to service the different needs of members, it will also be necessary to allow consumer-friendly product comparison. CIPRs fail at the first hurdle with an acronym that is only mildly better than what would have come from shortening “retirement income products”. The forum put forward a new acronym that would easily lend itself to communication and marketing with delegates responding favourably to “Sustainable Lifetime Income Products for People in Retirement” or SLIPPeRs. Ñ

NOVEMBER 201 6

\ PRODUCTIVIT Y COMMISSION

Firestorm inbound on default

SUPER REVIEW

The PRODUCTIVITY COMMISSION has been charged with reviewing the default superannuation system, and whichever way the review leans, OPINION WILL BE DIVIDED as to who will benefit most. By Sally Rose

OPPONENTS OF A looming shake-up of the default superannuation rules warn it could hit the liquidity of affected funds, leading to an exodus of capital from the infrastructure sector and lower returns to members. Meanwhile advocates for the proposed changes, that could strip unions of their role in how employers can decide what super fund is named as the default for their workers, argue more competition would lead to economies of scale and boost infrastructure investment. The Turnbull government has tasked the Productivity Commission with conducting major review of the rules governing how employers can decide what super fund manages their workers’ compulsory retirement savings. The industry funds, that benefit most from the status quo, want it maintained. The bank-owned and other retail funds want it overhauled to give them more access to the burgeoning default market. There are billions of reasons to accuse both sides of being motivated by self-interest. Roughly $9 billion a year flows into the almost $500 billion default sector. Those numbers are only set to increase. Deloitte has forecast the nation’s $2.1 trillion super pool to swell to $9.5 trillion by 2035, as the population grows and the super guarantee rate rises from 9.5 per cent to 12 per cent. At present, employers are limited to choosing from a shortlist of between two to 15 funds, named in the relevant union-negotiated modern award. This process is arbitrated by industrial watchdog the Fair Work Commission, although its powers have been in limbo for two years following a successful legal injunction by retail super lobby the Financial Services Council. Since 2013, only products that are licensed by the Australian Prudential and Regulation Authority (APRA) as MySuper providers can be registered as a default fund. The MySuper licensing regime was introduced to ensure those workers who did not, or could not, choose their own fund were placed in an appropriate no-frills option. The Productivity Commission is considering a range of alternatives

NOVEMBER 2016

Given the banks are on the nose I am not so certain they would get away with it. Imagine the headlines

to the current industry-based default selection process. Options include a tender-style system, allowing employers to choose any MySuper product, or even stripping businesses of their responsibility to name a default fund altogether. Rice Warner head of actuarial research Nathan Bonarius said that although any changes to the default rules are still at least three years away, and it remains unclear what those changes will be, funds should already be thinking about what the shake-up could mean for them. “We don’t know what the final legislation will look … but it is clear that, given the sorts of options being considered, this could be an absolutely massive change for the sector,” Bonarius said. The threat of losing default flows is not only a worry for the operational team, but could also have big implications for the investment team. APRA requires all super funds to regularly model what changes to patterns in member inflows and outflows means for its liquidity risk profile. If there is more money flowing out of a fund than into it then the investment team need to ensure they have enough flexibility to sell assets to free up cash. This means unlisted illiquid assets like infrastructure, property, and private equity become less desirable. Industry funds typically have higher allocations to infrastructure than their retail rivals. The industry fund sector has also historically produced stronger net returns. Tasplan chair Naomi Edwards is staunchly opposed to a restructure of the default rules. The current system has “provided enormous stability” to the industry super fund sector, enabling it to become a major player in Australian and global infrastructure, she said. This was tipped to be particularly important in the coming decade, as investment chiefs turn to infrastructure and other unlisted asset classes to help boost returns amid lacklustre outlook for stocks, bonds, and cash. The current default system helped protect individuals and small employers with poor financial literacy making “bad choices”, she said. Regardless of what super trustees and executives think should happen to the default rules, they have a fiduciary duty to be prepared for change. AustralianSuper chief executive Ian Silk said earlier this year the fund had been readying for the demise of the default system “for a decade”. AustralianSuper is the country’s largest industry fund, with $100 billion under management, and is named in 82 awards – more than any other provider.

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PRODUCTIVIT Y COMMISSION \

Of the 10 super trustees with funds named as a default option in the most modern awards, nine are industry funds. SunSuper is named in 56 awards, CareSuper in 52, and Tasplan in 45. Statewide Super gets a nod in 27 awards, LUCRF in 17, and Hostplus in 15. AMP is the only retail superannuation provider to feature prominently in the default system, being named in 15 modern awards. Rounding out the top 10 list of funds named in the most modern awards are Austsafe and HESTA, featuring in 15 and 13 awards respectively. There are also dozens of smaller funds that may only be featured on a handful of awards, but are almost entirely reliant on default mandates for inflows. “A lot of industry funds are in a very privileged position at the moment,” JANA executive director John Coombe said. Coombe thinks it is a furphy to argue an overhaul of the default system would force funds to take a more short-term approach to investing. He predicted that even if employers were allowed to pick a default fund unhindered by union negotiations, few would want the burden. “If you’re McDonald’s and every kid who starts work is automatically signed up to a default account with REST Industry Super then that is a fantastic outcome for the business,” Coombe said. The industry super lobby has argued letting bank-owned super funds compete more freely for defaults would lead to employers signing workers up to inferior products so the business could get a better deal on other services from the bank. Coombe thinks such fears are overblown. “Given the banks are on the nose I am not so certain they would get away with it. Imagine the headlines.”

JANA is part of National Australia Bank’s wealth management division. The potential hit to a fund’s operating and investment model from the loss of a default mandate really depends on how big the employer is, Coombe said. “If Woolworths decided to direct all of their new employees into a different fund that would clearly have a big impact on REST, but if the milkbar on the corner changes default funds, who cares?” REST chief executive Damian Hill declined to comment on his fund’s forward strategic planning, but flagged a loss of default status would likely lead to a worsening in its liquidity risk profile and ultimately a reduction in allocations to less liquid asset classes such as infrastructure. Hill said a move to a market-based model of default fund selection would be a mistake and likely lead to a heavier reliance on passive investment strategies across the industry. Industry Super Australia spokesman Matt Linden said the architecture of the default system was pivotal to the ability of industry funds to “maintain optimal asset allocations” to maximise risk-adjusted returns. Financial Services Council chief executive Sally Loane lambasted this and predicted increased competition in the default sector would actually lead to more super savings flowing into infrastructure. “Protectionist industrial frameworks deliver what Cbus chairman Steve Bracks described recently as a ‘secure funding model’ to a privileged few funds,” Loane said. Forcing funds to be more competitive to win default mandates would likely lead to a wave of fund mergers leaving fewer players with the scale to invest more in infrastructure assets, she said. Ñ

\ IN FOCUS

HOW STATEPLUS is smoothing the ride WITH

SMART BETA By Dan Purves

Working with providers like STATE STREET, and its asset consultant MERCER, STATEPLUS has enhanced its retirement income proposition through the clever use of smart beta strategies.

NOVEMBER 2016

STATEPLUS HAS NEARLY half of its equity Dinham said the inclusion of a range of smart portfolio deployed via smart beta strategies. beta products in the portfolio allowed for the The approach has been so successful in introduction of certain desirable characteristics, reducing volatility and protecting returns that the such as being able to reduce the risk to value $40 billion fund is now considering the use of premium, as well as lowering fees. smart beta in managing its fixed income portfolio. “Smart beta” describes an increasingly popular Prioritising risk management over chasing style of investment product that emulates the returns helps the wealth management and advice low costs of passive index investing, while still business deliver reliable income streams to its capturing some of the benefits of active selection. retired clients. In traditional index investing, indices are Roughly 85 per cent of the industry fund’s constructed with reference only to market members have already stopped working capitalisation. Smart beta strategists use full time and started drawing down on their alternative index construction rules to create superannuation. indices that are based on other benchmarks. In response to the needs of its older-thanFactors commonly used as the basis for industry-average client constructing smart beta base, StatePlus, formerly equity indices include State Super Financial price-to-earnings, price-toServices, has emerged book, and volatility ratios. as one of the first super funds to truly specialise ACHIEVING in retirement income. THE BEST The use of smart beta RISK-WEIGHTED of the industry plays a big role in helping RETURN fund’s members StatePlus to balance risk When it comes to have already stopped management with reliable managing retirement working full time returns. This is crucial income portfolios, one of so its roughly 60,000 the most important factors and started drawing clients can enjoy the best to consider is how much down on their standard of living possible risk capital is exposed to superannuation in retirement, which for in the pursuit of returns. some could be a period State Street Global of 30 or 40 years. Advisors (SSGA) is one “Our clients don’t want us to shoot for the of the providers that Sydney-based StatePlus has stars … they want us to not lose their money,” smart beta mandates with, specifically designed StatePlus head of research Richard Dinham said. to help achieve the best risk-weighted return. “A smoother ride through retirement really SSGA’s deputy head of research global pays dividends as the compounding effect is equity beta solutions Taie Wang said smart beta powerful over time, even if it’s often overlooked.” strategies had an important role to play in helping

85%

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\ IN FOCUS

beta strategies is paying off for StatePlus. “Both our value and low volatility strategies outperformed through Brexit.” Mercer director of strategic research Hendrie Koster also sees good reasons to use smart beta in a retirement income portfolio. Smart beta strategies targeting low volatility can be effective tools to help mitigate sequencing risk at a time when super fund members have relatively large saving pots and need a way to reduce the impact of market volatility, Koster said.

Our clients don’t want us to shoot for the stars … they want us to not lose their money. A smoother ride through retirement really pays dividends as the compounding effect is powerful over time, even if it’s often overlooked.

super funds manage risk on behalf of members in and approaching retirement. “An important concept to these smart beta strategies is ‘exposure per unit of active risk’,” Wang said. Exposure per unit of active risk is a way of measuring how much risk an investor is taking on to achieve more exposure to the factor they want in an equity portfolio, she said. “This can also be applied to other asset classes, such as fixed income, as long as the objective is a factor exposure.” However, there is nuance to that, depending on whether the strategy is benchmark-aware or not. “Most smart beta strategies are constructed in a benchmark-aware way,” Wang said. “So it is appropriate to use an active exposure per unit of active risk, which can otherwise be described as the tracking error.” To illustrate her point, Wang describes a scenario where an institutional investor is looking to invest into a value strategy, such as underpriced stocks in the World Developed Market. In this scenario, Product A is a very concentrated portfolio that holds only 50 low valuation stocks, while Product B is a broad portfolio that holds all 1600 stocks in the universe and tilts the stock weights mildly away from cap-weight towards lower valuation stocks.

MORE EFFICIENT, LESS RISKY, SMART BETA OPTION

“Product A might give you a higher exposure to valuation due to its high concentration into value stocks, while Product B may only give you mild

NOVEMBER 2016

exposure to value,” Wang said. “However, Product A may at the same time give you a very high tracking error – deviating far from the cap-weighted benchmark – while Product B’s tracking error is much smaller.” Comparing the products in terms of active exposure per unit of tracking error, Product B is shown to be a more efficient, less risky, smart beta option that still provides exposure to valuation upside, she said. However, some strategies (especially in the low volatility space) are built in a benchmarkagnostic way, meaning the pricing differential is not a constraint. This means the portfolio could deviate significantly away from the cap-weighted benchmark. “In this case, an approach based on total exposure per unit of total risk might be more suitable,” Wang said. Dinham said the thinking behind why StatePlus had underpinned its portfolio with smart beta strategies was that if the market falls 5 per cent, they might limit their losses to 2 per cent, leaving less ground to make up when the market turned. “That’s the type of pattern of returns we’re trying to achieve. Still taking risk, but minimising that downside where we can, so we have a smooth outcome from compounding over time,” he said. “It’s amazing how that plays out over time in terms of better outcomes for clients.” Dinham said the heavy falls and spiking volatility in the aftermath of the Brexit vote was a real test that showed how a heavy tilt to smart

SHIFT FROM SAVINGS TO RETIREMENT INCOME

It is an approach more superannuation funds will have to consider in the coming years. For the first two-and-a-half decades of compulsory super, most funds have been almost solely focused on helping members accumulate savings during their working lives. Now the industry is being forced to turn its attention to how convert the nation’s $2.1 trillion and growing super pool into retirement income. The government plans to mandate that all super funds must offer retiring members a comprehensive income product for retirement (CIPR), as an alternative to a lump sum payout. Koster predicted the incoming CIPR rules could lead to more funds turning to smart beta strategies to enable them to deliver low-cost default pension accounts. “Similar to the impact of MySuper, we could see a number of funds launch low-cost CIPRs, as an alternative to those relying on more expensive actively-managed approaches,” he said. SSGA’s Wang said the ultra-low interest rate environment meant the impact of fees on net investment income was amplified. Dinham agreed, although he remains worried about how markets might react if the US Federal Reserve raises rates more quickly than expected. “Everyone is looking for the magic pudding for retirement incomes, and we don’t even know all the details about what CIPRs will have to look like yet,” he said. It is expected that most CIPRs will include some form of annuity to help manage longevity risk – the risk that people will outlive their savings. It remains to be seen if the inclusion of annuities as a component of CIPRs will be mandated. Smart beta products, while no panacea to all the challenges involved in CIPR design, likely have an important role to play as a building block in the solutions many funds develop. Ñ

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YOU VALUE LONG-TERM PERFORMANCE. AND YOUR PRINCIPLES. SO DO WE. Northern Trust believes that your ESG partner should share your commitment to responsibility. It’s why we made Pensions & Investments’ list of the world’s leading asset managers — as well as Corporate Responsibility Magazine’s list of the 100 Best Corporate Citizens. And why we’ve been a proud signatory to the Principles for Responsible Investment since 2009. We offer you the tools, research, shared vision and holistic approach we believe you need for performance-driven responsible investing.

ACHIEVE GREATER

Call Bert Rebelo on +61 3 9947 9385 or visit northerntrust.com/holistic ASSET MANAGEMENT \ EQUITY \ FIXED \ MULTI-MANAGER

FOR ASIA-PACIFIC MARKETS, THIS MATERIAL IS DIRECTED TO EXPERT, INSTITUTIONAL, PROFESSIONAL AND WHOLESALE INVESTORS ONLY AND SHOULD NOT BE RELIED UPON BY RETAIL CLIENTS OR INVESTORS. © 2016 Northern Trust Corporation. Head Office: 50 South La Salle Street, Chicago, Illinois 60603 U.S.A. Incorporated with limited liability in the U.S. Products and services provided by subsidiaries of Northern Trust Corporation may vary in different markets and are offered in accordance with local regulation. For legal and regulatory information about individual market offices, visit northerntrust.com/disclosures. Pensions & Investments rankings based on worldwide assets under management of $875 billion as of December 31, 2015 and are not indicative of future performance. Pensions & Investments 2016 Special Report on Money Managers appeared in the publication’s May 30, 2016 issue and online at www.pionline.com/specialreports/money-managers. Ranking information reprinted with permission, Pensions & Investments, copyright Crain Communications, Inc. Corporate Responsibility Magazine’s 2016 list of the 100 Best Corporate Citizens appeared in the publication’s March/April 2016 issue and online at www.thecro.com/category/ topics/100-best-corporate-citizens. Northern Trust Asset Management is composed of Northern Trust Investments, Inc., Northern Trust Global Investments Limited, Northern Trust Global Investments Japan, K.K., NT Global Advisors, Inc., 50 South Capital Advisors, LLC, and personnel of The Northern Trust Company of Hong Kong Limited and The Northern Trust Company.

\ ADVERTORIAL XXX

This communication is for Wholesale Clients only, as defined in subsection 761G(7) of the Corporations Act 2001 (Cth) (the ‘Act’) and must not be relied on by anyone else.

A REMEDY FOR EMBATTLED BOND INVESTORS –

ABSOLUTE RETURN GLOBAL BOND STRATEGIES With interest rates at unprecedentedly low levels and many bond valuations substantially stretched, bond investors are understandably despondent about the poor level of returns currently on offer, as well as the impact of eventual monetary tightening on portfolios.

TO FIND OUT MORE ABOUT our investment capabilities visit australia.standardlifeinvestments.com

NOVEMBER 2016

i th more than 40% of government bonds paying negative yields, bond investors are hard-pressed to find income. At the same time, the spectre of rising rates is never far from mind. If rates do pick up, investors face the prospect of capital losses as bond prices fall. Meanwhile, ongoing uncertainty and speculation over the pace and timing of rate hikes will continue to generate periodic bouts of volatility, leaving bond portfolios vulnerable. In this environment, a traditional bond strategy is likely to struggle, leading

investors to question the role of fixed income as a defensive asset class. Standard Life Investments designed the Absolute Return Global Bond Strategies (ARGBS) Fund aimed at combating these challenges. Importantly, the wide asset class flexibility of ARGBS helps to unlock an exceptionally broad opportunity set. As well as enhancing potential for positive returns, this approach provides valuable diversification benefits, giving ARGBS the defensive characteristics that bond investors seek.

ENHANCED, LOW-RISK BOND RETURNS

Targeting positive returns in a diverse range of market conditions, ARGBS aims to achieve returns similar to those investors could expect from a long-term investment in global bond markets but with lower risk. Specifically, the strategy targets cash*+3% per annum (gross of fees) evaluated over rolling 3-year timeframes, with expected volatility of 2%-4% per annum. *Cash is defined as 3-month Bloomberg Aus Bond Bank Bill Index

investmentmagazine.com.au

ADVERTORIAL XXX \

ARGBS is benchmarked against cash, rather than an index, focusing on delivering absolute returns. By venturing outside traditional government bonds and credit markets ARGBS is able to invest in an exceptionally broad and diverse investment universe, enhancing both return potential and our ability to spread risk. To achieve ARGBS’ risk/return objectives, investments are made across seven distinct risk buckets: credit, cross-market, yield curve, duration, currencies, inflation and volatility. Additionally, the portfolio is carefully constructed to ensure that no one risk dominates. This gives the potential to perform in a wide range of market conditions, helping insulate the portfolio against market shocks (see Chart 1).

Potential for positive returns, even when markets fall Importantly, ARGBS’ flexible investment mandate allows the implementation of relative value strategies. These provide the potential for positive returns even when markets are falling. This is particularly relevant today when there is marked regional divergence in terms of economic outlook and central bank monetary policy. For example, ARGBS can invest to benefit from views on rates in Europe versus those in the US. Implementation of these views might involve the use of bonds or currencies to do this. The ability to take long or short positions in certain markets/securities, and to be selective about where risk is taken means ARGBS shows very low correlation with underlying bond markets. This makes it an excellent diversifier in a wider portfolio.

Long-term investment focus Contributing to ARGBS’ solid performance record is a long-term investment approach. This and the Fund’s ability to weather shortterm market storms allows the potential to exploit genuine value opportunities, rather

investmentmagazine.com.au

9.0%

Curve

Expected volatility with NO diversification benefit – 8.7% Inflation

8.0% Cross Market

7.0% 6.0%

Credit Diversification benefits

5.0%

6.2%

Duration

4.0% 3.0% FX

2.0% 1.0%

2.5%

Expected volatility

0.0% Ja pa Lo ne ng se U Ye S n Lo D vs ol ng la Ko rv In re di s an an Au Lo st R W ng ra up on lia U e S e n vs D D ol ol Ko la la Lo rv r re ng Lo an s ng Po Sw W un Pe on ed d ru Lo is St h vi ng e an K rli U ng So ron S e lv D vs ol s la Eu Ta rv iw ro s an Si ng D ol ap la or r e D FX olla r Sw H e ed dg is in h Au g D st ur ra at In Eu lia io do n n ro ne D pe ur si an at an io R U R n ea S at EM lY In es ve ie H vs ld ar st s m U d S en C ur D tG ol re la ra nc U r de K y So In C ve re ve st di re m t ig en tG nD eb t Sh rad e or C t-d re di at t ed H C ig C on h re tin Yi di ge U el t S d n tC St C U re K ee ap di vs pe ita t G ne lB er rv on m s a U ds Eu n S D In ro ur fla pe at tio an io n n Fl C at ur te ve ne St r ee Lo pe ng Eu ne U ro K r pe In U an fla S tio Lo R n ea ng lY En ie d ld Ja S s pa te ep ne en se er St ee p D en iv er er Ex si fic pe at ct io ed n Vo la til ity

Genuine risk diversification

10.0%

Lo ng

WHAT IS DIFFERENT ABOUT ARGBS?

CUMULATIVE STAND-ALONE RISK %

CHART 1 | INVESTMENT RISK BASED PORTFOLIO CONSTRUCTION

STRATEGIES Sources: Standard Life Investments UK ARGBS portfolio, UBS Delta, 30 September 2016. TABLE 1 | ARGBS PERFORMANCE (AUD) YTD (%)

1 YEAR (%)

3 YEARS P.A. %

5 YEARS P.A. %

SINCE INC. P.A.%

SLI Absolute Return Global Bond Strategies Trust (Gross)

3.40

5.30

4.39

4.98

5.15

SLI Absolute Return Global Bond Strategies Trust (Net)

2.83

4.51

3.65

4.28

4.45

Bloomberg Aus Bond Bank Bill Index (Benchmark)

1.63

2.19

2.44

2.94

3.13

Relative Gross Performance v Benchmark

1.74

3.04

1.91

1.98

1.96

2.12

1.95*

1.98*

2.20

Volatility

Past performance is not a reliable indicator of future performance. For information purposes, we show the historical performance of the underlying master fund, the SICAV Absolute Return Global Bond Strategies Fund in GBP share class converted from Sterling to Australian Dollar from inception (30 March 2011) to 18 October 2012; then Australian Dollar Share class from 18 October 2012 to 2 June 2014 and the Australian Trust thereafter to end September 2016. *ARGBS converted to AUD to 18/10/2012, AUD shareclass to 1/6/2014 and Australian Trust thereafter.

than be distracted by short-term market turbulence. The investment team’s approach and culture of idea-sharing allows ARGBS to benefit from the company-wide expertise. Additionally, a team-based approach to the investment process provides a platform for the Fund’s long-term consistency and stability.

Performance Since inception, 29 March 2011, ARGBS has returned 5.15% gross per annum, outperforming the benchmark (Bloomberg Aus Bond Bank Bill Index). Moreover, the Fund has delivered this performance with average realised volatility of just circa 2.2% per annum (see Table 1), inside its expected volatility range, in market environments where we have seen both rising and falling interest rates and both tightening and widening credit spreads.

Standard Life Investments Limited (ABN 36 142 665 227) is incorporated in Scotland (No.SC123321) and is exempt from the requirement to hold an Australian financial services licence under paragraph 911A(2)(l) of the Corporations Act 2001 (Cth) (the ‘Act’) in respect of the provision of financial services as defined in Schedule A of the relief instrument no.10/0264 dated 9 April 2010 issued to Standard Life Investments Limited by the Australian Securities and Investments Commission. These financial services are provided only to wholesale clients as defined in subsection 761G(7) of the Act. Standard Life Investments Limited is regulated in the United Kingdom by the Financial Conduct Authority under the laws of the United Kingdom, which differ from Australian laws. © 2016 Standard Life, images reproduced under licence.

NOVEMBER 201 6

\ COLUMN

IRELAND IS IN the process of establishing a universal pension scheme and its policymakers are looking to learn from more developed systems, like Australia’s. One of the key lessons is not to relegate the retirement phase to an afterthought. It is now nearly 25 years since Australia mandated compulsory superannuation for workers. Despite having one of the most advanced retirement savings policies in the world, we are still working on significant policy changes like articulating super’s purpose and adding some structure to the retirement phase. Meanwhile Ireland is starting from scratch. More than half of all Irish workers lack any form of private pension (superannuation) and its government needs to address a looming retirement funding gap. It is a massive challenge for a nation that has in recent years had to deal with a difficult economy. Ireland’s banks were hit hard and its unemployment rate spiked to as high as 15 per cent in the wake of the 2008 global financial crisis. However, as a late arrival to the universal pension savings game, Ireland’s one big advantage is that it can learn from other systems already in place.

BY JEREMY COOPER ___

Jeremy Cooper is chair, retirement income at Challenger Limited.

AUTO-ENROLMENT

Ireland looks to get its own MySaver Ireland’s ambitious new universal pension scheme should begin with retirement in mind.

I was recently invited to participate in the Irish Pension Reform Summit, hosted by the country’s insurance industry association, Insurance Ireland. Delegates from around the world discussed what is, and isn’t, working well in other relevant countries.

ENORMOUS CHALLENGE

Ireland has a coverage problem. In 2013, the Organisation for Economic Co-operation and Development recommended it address this by introducing a universal defined contribution (DC) pension model. Since then, various parties have been working on making this a reality.

NOVEMBER 2016

From a regulatory perspective, establishing a universal pension system over the top of existing state and non-universal private pension arrangements is far from straightforward. That’s part of the reason why compulsory systems like Australia’s remains relatively rare globally. Suffice to say, the conversation in Ireland is all about auto-enrolment, whereas the name suggests, you are automatically signed up when you start a job, but can opt-out if you wish. This is how New Zealand’s KiwiSaver scheme works.

To put the magnitude of the challenge they face into perspective, imagine what Australia would look like without the DC super system introduced by the Keating government in 1992. Imagine we had a well-developed pension, funds and insurance sector with a wide range of products, but most Australian workers were not using it to save for retirement. That is what Ireland looks like today. The Irish pensions industry has more than enough skill and capacity to provide a 21st century DC pension product, but it can’t get the necessary uptake or coverage.

Insurance Ireland has called the proposal ‘MySaver’. One can’t help note the hat tip to the Australian MySuper and New Zealand’s KiwiSaver. I told the Irish summit participants not to get too hung up on compulsion. It is not essential to get started and there are examples of successful auto-enrolment models in other countries, such as New Zealand and the United Kingdom. There is also a movement to adopt an autoenrolment scheme in the United States. When thinking about establishing an autoenrolment system, intelligent design is key. What do the defaults look like? What shape does the governance take in systems where not all pension products are in a trust framework? An auto-enrolment product like the proposed Irish MySaver would focus principally on those workers who currently have no pension, rather than upsetting existing arrangements, such as defined benefit (DB) pensions. While opting out is allowable, the experience from systems such as those in New Zealand indicate that any opt-out parameters should be relatively restrictive. This is not only for the sake of encouraging citizens to save, but also to reduce the burden on trustees and administrators. The ability to opt out adds complexity to the system, especially if it can be actioned any later than the first few weeks of starting employment. Auto-enrolling countries are talking about tightening the windows around opting out and some have mechanisms that allow workers to opt back in later.

CONTRIBUTION RATES

Ireland is setting some ambitious objectives for its new MySaver scheme. In terms of coverage, the target is to include 90 per cent of the workforce within seven years. As to the question of adequacy, the long-term goal is to target a 50 per cent replacement rate of income in retirement.

investmentmagazine.com.au

COLUMN \

If these goals aren’t achieved, Ireland might reconsider mandating pension contributions. However, something similar to the “perfect storm” of politics, industrial consensus and economic conditions that existed in Australia in the early 90s might be required to pull that off. With any pension system design, adequacy is a key metric. What does this look like? There is always talk of replacement rates and coverage rates, but the figures have to be meaningful and achievable for the system in the long-term. What about contribution rates? A universal pension typically starts small. As we all remember, Australia started with 3 per cent employer contributions. In 2016 that is sitting at 9.5 per cent with plans still in train to get to 12 per cent by 2020. Ireland is proposing a starting point where every employee has to contribute 1 per cent of earnings, matched by a 1 per cent contribution from their employer. Contribution rates for both employers and employees would increase by 1 per cent each year for five years, until the workers were

accumulating at a total contribution rate of 10 per cent.

LUCK OF THE IRISH

The UK is still only at 2 per cent, seven years after first implementing auto-enrolment, aiming to get to 8 per cent (3 per cent employee and 5 per cent employer) by 2019. Time will tell whether Ireland can achieve its aggressive target. Most importantly for Ireland, if it is to succeed where many other DC systems have failed, it must build a universal pension that incorporates a meaningful retirement proposition. Ireland cannot afford to fall into the same trap as other DC systems around the world, including until recently, ours, of focusing solely on the accumulation phase. Luckily for the Irish, they already have a range of retirement income providers and products that strike the balance between access, liquidity and risk management. Ireland’s new private pension system also has a chance to get its back office systems right.

Solutions such as unique identifiers help, as we have already seen in Australia. The rules around eligibility and limits on participation should be simple. Governments need to resist the temptation to tinker with the rules; a temptation that has proved too hard to resist in New Zealand. KiwiSaver has been subject to a number of flip-flops on key aspects of the scheme. Lessons can also be drawn from the experience of the UK’s National Employment Savings Trust (NEST). But Ireland’s universal pension will have to fit with its demographics, workforce and welfare system. Ireland’s workers are predominately young and employed in small-to-medium enterprises, so the system will have to orient itself around this sort of workforce. This is Ireland’s opportunity to ensure that the system integrates retirement thinking from the start, rather than tacking it on later. What might emerge is a synthesis of world’s best practice, tailored for Ireland’s conditions. If I had to call it, this might look like KiwiSaver with a CIPR option in the retirement phase. Ñ

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\ COLUMN

Robots are coming to eat the world, and that’s okay An exciting opportunity for investors is being created by ADVANCES IN ROBOTICS, as the economic scale of real-world problems they can solve increases exponentially.

BY NIKI SCEVAK ___

Niki Scevak is a co-founder of Blackbird Ventures.

THE LATEST WAVE of the industrial revolution is upon us and investors need to get to grips with how robots are reshaping business and work. In 2011 Netscape co-creator-turnedentrepreneur and venture capitalist, Marc Andreessen, proclaimed, “software was eating the world”. He made the statement in his capacity as a director of Hewlett Packard, as the computing giant announced it was looking to jettison its struggling PC business. Andreessen predicted that technology would infiltrate and reinvent every single industry to such an extent that it would be difficult to define what a technology company is in the near future.

NOVEMBER 2016

In the age of autonomous robots, the surface area of problems that software can solve will skyrocket. Like water finding the lowest point, software started with virtual problems Software already helps businesses ‘think’ smarter. Brands rely on software to reach and measure communications with potential customers in the media industry. Banks deploy algorithms to make better credit decisions. Consultants turn to programs to figure out how knowledge workers in skyscrapers can be more productive. Largely these are all problems where software operates neatly in the virtual world. Advances in robotics are now allowing more and more physical world problems to be solved by software. This creates an exciting opportunity for investors, because the economic scale of real world problems automation can now solve dwarfs those in the virtual world.

MANY POSSIBILITIES POSE MANY QUESTIONS

Just consider the vast impact autonomous vehicles are set to have on society. If cars are able to drive themselves, where will people live? If cars don’t crash, what will happen to the car insurance industry? If robot-taxi services are very cheap, why will consumers still buy cars? If network operators own most vehicles, then will vast systems of refuelling stations on high value real estate make any sense? When cars start driving partygoers home what are the chances alcohol consumption will increase? The rise of robotic cars will also change the lives of many workers.

Forget the taxi and truck drivers. Cars programed to follow the road rules and avoid crashes will also put many ambulance paramedics, hospital workers, and highway patrol officers out of a job. Some of those Silicon Valley mobile push-abutton life services might make more sense in a world of robots. On demand clothes washing, grocery delivery and dinner services may actually turn out to be good businesses without the fragile, low-paid, contract labour they currently rely on. Robotics in 2016 is an intriguing sector. The smartphone wars have decimated the price of electrical components and large advances are being made in machine vision (how robots interpret the world around them) and deep learning (how robots decide what actions they should take).

OLD JOBS LOST BUT NEW ONES CREATED

Gimmicks of computers identifying cats and beating world champions at the ancient Chinese game of Go show just how sophisticated artificial intelligence has become. Those same decision-making frameworks will be applied to anything from picking apples with robotic arms to completely automated warehouses run by robots. The lurking question invariably veers towards what will happen to all of those people who lose their jobs. Human imagination is limited usually to seeing the first step and not the second step of what new careers are created. In 1870 half of the US workforce was employed on farms, compared to less than 2 per cent today. In 1960 one third of Americans worked in manufacturing, compared to less than 10 per cent today. No one laments these declines because who wants their kids working on farms or in factories? The wealth of more creative and lessrepetitious career options for workers will grow exponentially with time. For young Australians this means the impact of their work will be able to be seen across the globe and not just in their local neighbourhood. Software is eating the world and now, with robotics and artificial intelligence, every single problem in the world is possible to solve more elegantly. What a time to be alive. Ñ NIKI SCEVAK is part of a panel discussion at the Conexus Financial Fiduciary Investors Symposium in Healesville Victoria, November 14-16.

investmentmagazine.com.au

\ GLOBAL RANKINGS

AUSTR ALIA LOOSENS GRIP ON

third spot

IN WORLD SUPER RANKINGS

AUSTRALIA HAS RANKED THIRD for the best superannuation system in the world for three years in a row, but indicators show that MAY NOT LAST WITHOUT KEY REFORMS. By Sally Rose

USTRALIA RIGHTLY PRIDES itself on having one of the best superannuation systems in the world. But new research shows our global standing is slipping, and calls for bold policy changes to ensure an adequate and sustainable framework for future generations. The 2016 Melbourne Mercer Global Pension Index, released in October, ranked Australia as having the third best retirement income system in the world. Denmark was lauded as having the best retirement income system in the world, for the fifth consecutive year, followed by The Netherlands in second place. Denmark and the Netherlands were the only two countries to receive an A rating, with index scores of 80.5 and 80.1 respectively. Australia received a B+ rating, but a slippage in our overall index value from 79.6 in 2015 to 77.9 hints at some worrying trends. The Melbourne Mercer Global Pensions Index (MMGPI) is produced annually by international consulting firm Mercer, in partnership with The Australian Centre for Financial Studies (ACFS), which is a not-forprofit research centre of Monash University in Melbourne. In 2016 the MMGPI ranked

NOVEMBER 2016

the retirement income systems of 27 countries covering close to 60 per cent of the world’s population. The MMGPI considers more than 40 indicators to compare the retirement income systems of different nations. The calculation of the index is split across its three sub-indices for adequacy, sustainability, and integrity. Adequacy is afforded the highest index weighting at 40 per cent, followed by sustainability at 35 per cent, and integrity at 25 per cent.

DEFERRED RISE IN SUPER GUARANTEE

Professor Rodney Maddock of the ACFS, one of the authors, said the decline in Australia’s rating was largely due to a reduction in the nation’s “net replacement rate”. For this the report pointed the blame at last year’s federal budget decision to defer a planned rise in the superannuation guarantee contribution rate. Australia’s compulsory employer contribution rate is currently frozen at 9.5 per cent until 2021, after which it is scheduled to rise 0.5 per each year until it reaches 12 per cent in 2025.

investmentmagazine.com.au

GLOBAL RANKINGS \

The report made four key recommendations on how Australia could improve its retirement income system: 1 | Introducing a requirement that part of the retirement benefit must be taken as an income stream 2 | Increasing labour force participation rate at older ages as life expectancies rise 3 | Introducing a mechanism to increase the pension age as life expectancy continues to increase 4 | Increasing the minimum access age to receive benefits from private pension plans so that access to retirement benefits is restricted to no more than five years before the age pension eligibility age. These are all initiatives the Turnbull government has already shown varying levels of appetite for. A plan to force all super funds to pre-select retiring members into an opt-out account-based pension is well advanced. But moves to keep people working and restricted from drawing on their super for longer continue, unsurprisingly, to prove politically unpopular. Mercer senior actuarial partner David Knox, lead author of the MMGPI, acknowledged that attempts to raise the pension eligibility and super preservation ages would always be political dynamite. To combat this, he supports a push to have both linked to the five-yearly intergenerational report. “It would be so valuable to have a proper mechanism in place to review the pension and preservation ages in line with real economic and demographic data, rather than trying to tackle it on an ad-hoc basis,” Knox said. He told Investment Magazine that, in addition to the four areas for improvement highlighted in the report, another positive feature of the Danish and Dutch systems

investmentmagazine.com.au

Australia should try to emulate was its very high “coverage rates”. This is a measure of the proportion of the adult population participating in the superannuation system.

SELF-EMPLOYED AUSTRALIANS NOT OBLIGATED

The main reason Denmark and The Netherlands have higher coverage rates than Australia is because they capture the self-employed in their mandatory retirement savings schemes. In Australia it is compulsory for employers to contribute to super on behalf of their employees, but self-employed people are not compelled to contribute to their own super. “Too many contractors and self-employed Australians are slipping through the net,” Knox said. “Bringing these people into the compulsory super system would be a difficult political exercise, but it may well be one we need to tackle.” Most self-employed people prefer to invest any excess earnings into growing their business, rather than locking it away in a retirement account. A trend towards more workers being employed on a casual or contract basis means the government must also reconsider the thresholds that exclude them from compulsory super entitlements, he said. Another way to improve the adequacy of Australia’s retirement income system, and catch up with Denmark and The Netherlands in the MMGPI rankings, would be to apply the super guarantee to income support payments. “Whenever someone is on any form of income support – be that disability, parental, or carer’s leave – they should be eligible for super guarantee payments,” Knox said. Financial System Inquiry chairman David Murray said that in an “ideal world” Australia would go beyond plans to raise

the super guarantee to 12 per cent and lift it to 15 per cent, the level he calculates would be required to ensure most workers could save enough for an adequate retirement income. However he does not expect that to happen any time soon. “Australia is facing fiscal constraints. The ability of the government to continue throwing more money at the super system is going to be limited.”

NEED TO GET YOUNG PEOPLE INTERESTED IN SUPER

KPMG demographer and social commentator Bernard Salt said government and the super industry faced a huge challenge to get younger workers engaged with the debate around super and pensions. “Young people are grappling with more immediate financial issue like trying to buy a home and are not particularly interested in debates about superannuation rules and taxes,” Salt said. “But they should be. Laying the groundwork now for a fairer and more efficient super and pension system when they retire is in their best interests.” Industry Super Australia chief executive David Whiteley said the big lesson for Australian policymakers from the 2016 MMGPI findings should be the dominance of countries where unions play a strong role in negotiating workers’ super arrangements. Both Denmark and The Netherlands have an “industrial model” whereby collective agreements between employers and unions decide what the default funds for workers’ compulsory payments are. Australia has historically had a similar system, but the government has tasked the Productivity Commission with conducting a review of this with a view to moving to a more “competitive, efficient, and transparent” model. “If our system made sure people were connected with the best performing funds, then making people work longer would not be necessary,” Whiteley said. Knox disagreed. “What matters most in defining a good system is adequacy, and that’s why lifting the super guarantee, extending working years, and improving coverage are such important reforms.” Ñ

NOVEMBER 201 6

\ AIST

The $6 billion-a-year problem Most employers do not deliberately set out to be errant in paying super. New legislation to introduce ‘single touch payroll’, will see the Tax Office take on a much greater compliance role. IN THE CONTEXT of Australia’s $2.3 trillion superannuation savings pool, it can be all too easy to get blasé about billion dollar statistics. One big number that deserves a lot more attention than it gets is the estimated $6.2 billion of unpaid super that thousands of, mostly low-paid, workers miss out on each year. A 2015 research report produced by Tria Partners for Cbus found that employers were failing to make at least $2.6 billion in super ‘guarantee’ payments a year. But the problem is likely much bigger than that. Industry Super Australia, in a May 2016 submission to the Productivity Commission, said its research indicated the real value of unpaid super is closer to $6.2 billion a year. To put this $6.2 billion into perspective, it is roughly equivalent to the estimated cost savings to the government from Treasurer Scott Morrison’s 2016-17 budget package of super tax measures over the next four years. The budget measures – which mostly impact on a minority of high-income earners and the very wealthy – have been endlessly debated and dissected by journalists, accountants, tax lawyers and super industry groups for the better part of this year. Meanwhile billions in compulsory super guarantee payments – which typically hit low income earners, meaning they are excluded from super altogether – continue to quietly leak out of the system. Tria’s report found four main reasons for non-payment of super: employer noncompliance, the cash economy, sham contracting, and insolvency. IFCC notes that the problem is most acute among small businesses

and in sectors characterised by higher BY rates of business churn, such as TOM GARCIA construction, hospitality and retail. ___ Industry Fund Services (IFS), the Tom Garcia is the chief executive industry’s key collector of unpaid officer at the Australian Institute super, says the law leaves room of Superannuation Trustees. for debate as to whether or not the fiduciary duty of super trustees to act in members’ best interest means they have a duty to chase any super guarantee payments that are in arrears. New legislation to introduce single touch But when employers fail to make the payroll (STP), due to come into effect from July payments, super funds are in the strongest 2018, is expected to see the ATO take on a greater position to enforce compliance. compliance role in regards to super payments. Fund administrators are the first to know STP will harmonise how and when when payments enter arrears and can action employers pay tax, super and salaries. non-payment before amounts outstanding Currently many businesses pay wages grow too large. Some funds are far more active fortnightly but super quarterly. The ATO in pursuing arrears collections than others. will have real-time data on whether or not Importantly, arrears collection does not super has been paid. have to be a combative process that pits super The new rules will be mandatory for large funds against employers. and mid-size businesses, but voluntary for Many employers are quick to rectify the micro-employers with five staff or fewer. situation once prompted, and repayment Still, many small businesses are expected to plans can ensure that arrears collection does synchronise the payment of salary and super not trigger business closure or job losses. as payroll software is amended to incorporate Another reason why some trustees may STP. be reluctant to pursue unclaimed monies On face value, this new technology could go are concerns the costs involved in recovering a long way to solving the unpaid super problem. super will have to be shared across the entire But much will depend on whether the ATO is membership, rather than those who benefit adequately resourced to take action on arrears. from the service. However there are no legal Either way it will be at least two years impediments to a trustee charging an arrears before STP has any real impact, by which time collection fee to individual member accounts, another $12 billion in super could disappear provided the fee is allowed under their trust from the system unless more action is taken. Ñ deed, and the fee is properly disclosed.

AIST Awards Dinner Join us at super’s night of nights! Thursday 24 November 2016 The RACV City Club, Melbourne Visit www.aistawards.asn.au to register.

22-24 March 2017 Gold Coast Convention and Exhibition Centre The Australian Institute of Superannuation Trustee’s (AIST) flagship event, the Conference of Major Superannuation Funds (CMSF) is the premier idea sharing and networking event for Australia’s $700 billion not-for-profit superannuation sector. This year CMSF will focus on content that brings you thought leadership and practical insights on topics covering your industry, your members and yourself. The following speakers are already confirmed for 2017:

Arun Abey

Dr Sally Auld

Paul Berney

Jacqui Curtis

Geraldine Davys

Chair, Walsh Bay Partners

Chief Economist and the Head of Fixed Income and FX Strategy for Australia and New Zealand, J.P. Morgan

Managing Partner, mCordis

Chief Operating Officer, Australian Taxation Office

Chief Marketing Officer, iSelect

Saul Eslake

Julie Fedele

Chris Newton

General Manager, Experience Design & Delivery, Retail X Innovation Lab, Bupa

The Hon Michael Kirby AC CMG

Christy Karamzalis

Independent Economist and Vice-Chancellor’s Fellow, University of Tasmania

Industry Head, Financial Services, Google Melbourne

Executive Director, Responsible Investment, IFM Investors

Former Justice of the High Court of Australia

GET IN QUICK AND SAVE UP TO $500. Early bird closes 25 November 2016. Register at aww.aist.asn.au/cmsf

\ ROUNDTABLE

Solving the problems of

LIQUIDITY and

VOL ATILIT Y IN FIXED INCOME

The challenges and risks in fixed income markets, including LIQUIDITY AND VOLATILITY, were discussed at a roundtable hosted by Investment Magazine. Chris Baker principal, Mercer

AT THE ROUNDTABLE, the role of exchange-traded funds (ETFs) in helping address the liquidity challenge and manage risk in fixed income was examined. Investors shared their experiences of using ETFs for short-term trades, tilting in portfolios and transitioning between managers. We live in a new era of fixed income investing, with low yields and increased volatility, coupled with a lack of liquidity. Investors are reacting by being underweight core fixed income, looking further up the risk spectrum and looking at new ways to gain the desired exposures. The roundtable discussed these challenges, and heard that StatePlus and Sunsuper are both underweight core fixed income, and looking to high yield and private debt to generate returns. The impact of Dodd Frank and Basel III is important to highlight, says Bigos. “So the challenge clients are facing is: where to access the liquidity when they want it? Primary market is one source and the issuance is there as borrowers take advantage

NOVEMBER 2016

of low borrowing costs. Just recently we’ve seen increased issuance in investment grade and high yield, but those deals were on average three times oversubscribed,” she says. “We’re conscious of taking more risk, some liquidity risk, in the search for higher returns. That said, we’re not abandoning core fixed interest all together, we need that liquidity,” says Richard Dinham, head of research at StatePlus. For Sunsuper the current environment prompts the question: “why own fixed income?” and portfolio analyst, Andrew Fisher says really the only rationale is that it diversifies equities. “Now when you start to question whether the diversification is going to be there, and the cost, we naturally have less. So we have less fixed income and within fixed income we have less duration,” he says. “We’ve lost confidence that the diversification will continue to behave the way it has in the past.” Craig Vardy, portfolio manager at BlackRock, says tighter regulation is commonly blamed for shrinking dealer

balance sheets and the decline in traditional market-making activity. Lower risk appetite from banks and profitability have been nearly as important as regulation for lower liquidity. “So when you think about liquidity, you’re probably thinking about two main elements. There’s a size element to it, and also a timing element. So how much do you need to trade, and how long have you got to trade that?” he says. “The bid/offer spreads haven’t really changed but the quantity has changed.” David Foodey, co-head of program trading in the Asia Pacific, and co-head of cash execution in Australia at Deutsche Bank, says the bank has tripled the amount of capital it holds and the amount of risk it holds has halved. Ecaterina Bigos, vice president of fixed income product strategy, BlackRock, gave an overview of more than $60bn flows into fixed income ETFs this year, which have gone primarily into exposures such as investment grade, high-yield credit and emerging markets. Morningstar has a lower allocation to

investmentmagazine.com.au

ROUNTABLE \

Ecaterina Bigos vice president of fixed income product strategy, BlackRock

PA R T I C I PA N T S CHRIS BAKER George Lin senior investment manager, CFS

principal, Mercer ECATERINA BIGOS

vice president of fixed income product strategy, BlackRock

fixed income than it might in a “normal” environment, and Brad Bugg, head of multiasset income at Morningstar says cash is the only asset class that can protect capital with 100 per cent certainty. “In terms of breaking down fixed income, we’re probably heavily underweight traditional government bonds. We are starting to take more of a look at the local currency emerging market space. The yields are a lot higher there, and if we are in a slower growth environment around the world, it probably means they’re going to have lower interest rates going forward, so hopefully there’s some potential for diversification as well.” But while the diversification benefits of fixed income may be less, George Lin, senior investment manager at CFS, says he is struggling to find anything that diversifies equities, especially when cost is a consideration. While the argument for diversification may not be as strong, he says the purpose of fixed income will be dictated by the fund’s circumstance

investmentmagazine.com.au

BRAD BUGG

and also include liquidity, or generating return and a bit of income.

head of multi-asset income, Morningstar

FINDING LIQUIDITY

head of research, StatePlus

“It certainly is a challenging environment,” says Chris Baker, principal at Mercer. Importantly, Mercer considers the liquidity aspects, and the defensive nature of fixed income, by splitting up more credit-heavy strategies versus smarter composite style mandates from the core bucket. And while liquidity has been most pronounced in the core bucket, Mercer is also concerned with how liquidity has impacted other buckets. “I guess people are surprised at the liquidity issues in high yield and the market’s really changed over the past few years,” he says.

OPPORTUNITY TO PROVIDE LIQUIDITY

RICHARD DINHAM ANDREW FISHER

portfolio analyst, Sunsuper DAVID FOODEY

co-head of program trading, Asia Pacific, and co-head of cash execution in Australia, Deutsche Bank GEORGE LIN

senior investment manager, CFS LEE MA

investment strategist, Willis Towers Watson STEVE STRAIN

transition manager, Mercer CRAIG VARDY

co-head of fixed income, BlackRock

The issue of liquidity was one of interest to the group, and Dinham queried how

NOVEMBER 201 6

\ ROUNDTABLE

Craig Vardy co-head of fixed income, BlackRock

it is possible to provide greater liquidity in an ETF than what is available in the whole underlying market. Bigos explained that the exchange trading element and the ETF design are key differentiators. Fixed income ETFs essentially provide a means to trade bond exposure on exchanges, which are well-established all-to-all trading venues. The additional layer of liquidity provided by the secondary market for ETF shares allows ETF investors to trade shares of the ETF without the need for any transaction in the underlying securities held in the ETFs. But as Bugg pointed out at the roundtable, the industry has been concerned about liquidity in fixed income since 2008/2009. Vardy says the key around managing underlying bond liquidity now is that it can take time to trade positions. “Ask the question of what’s your size, what’s your timeframe in terms of getting in and out. It can be done, it just takes time,” he says. “Changes to the bond market structure have not kept pace with changes to market participants and the overall growth in the number of bonds outstanding. Going forward, it will help to see a reduction in the number of distinct bonds per issuer. We believe this could occur via a greater use of benchmark issues by larger issuers,” Bigos says. According to Bigos, the market dynamics

NOVEMBER 2016

such as issue size and the frequency of issues, of varying maturities complicates matters. When it comes to ETF design in addressing this challenge, ETFs track representative of the universe benchmarks, well diversified across issuers, maturities, ratings and industries. Additionally, liquidity of an ETF is defined through its inclusion rules. For example for the BlackRock high yield ETF a minimum issue size per bond and a minimum amount outstanding per issuer is required before it is included in the index. Another component to consider is portfolio management, and in most cases BlackRock delivers index risk and return with a subset of securities, in doesn’t fully replicate the ETF. “This means, importantly in market distress, or when we’re looking to redeem out of the ETF on client orders, we only have to sell a representative basket of the full portfolio,” Bigos says. “If there’s a bond that is difficult to sell, we’ll just not sell it. We’re not going to be forced sellers into the market,” she says.

HOW DO INSTITUTIONS USE ETFS?

Bigos gave examples of how investors internationally are using ETFs, in particular as overlays to help clients navigate current volatile markets. “One client used ETFs on top of their core asset allocation in order to tilt the duration to the desired level,” she says. “ETFs allow

investors to keep their core over long term, but at the same time be nimble to navigate current markets to tactically position their portfolios over short to medium term.” Steve Strain, transition manager at Mercer, says that when investors are looking to switch to new funds within the same asset class, but have not identified the new manager, they can use ETFs as an interim parking vehicle. “Investors can park the money, and it is safe and flexible and you don’t have to be an expert in the field. It will keep you safe for a while. It can take months to appoint a new manager and we’ve found in the past that managers will be willing to accept the funding through an ETF, and they’d incrementally sell it down into their portfolio at their leisure.” Fisher, who says Sunsuper has used ETFs in transitions, cautioned that if an investor is going to use an ETF in transition then to make sure that transition is not too long, as it can be expensive. Foodey added that if an investor is going straight passive then it is cheaper to go into a passive index fund, especially if an investor has size on their side. But on a short-term basis, ETFs are very practical, he says. “In high yield I don’t think we can do better than an ETF. It’s all about the access, fees, entry and exit costs, and trading volume. It’s probably the easiest place to get volume away in high yield in a relatively short space of time. And we’re more likely to use high yield as a tactical play,” Strain says. Bugg says that Morningstar used iShares Interest Rate Hedged High Yield Bond ETF (HYGH) a hedged high yield bond ETF, earlier in the year when the spreads were out. “We thought they were attractive. We didn’t like the total yield on offer, so we just really wanted to isolate the credit spread. HYGH was a really good option in that environment, and it gave us a couple of months to go and find a manager who could provide a short duration quality option because we don’t want to be running a sort of a passive exposure in high yield over the longer term.” ETFs are not a substitute to active security selection. There is, however, a potential benefit to allocating a portion of a fund to an ETF that offers liquidity and can be traded and repositioned quickly to capture strategic opportunities. Ñ

investmentmagazine.com.au

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NOVEMBER 201 6

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