(03) 9020 2905PORTFOLIO POINT: Make no mistake – a major super fund could collapse, causing widespread panic. And some fund trustees are exacerbating the risk to members with high levels of illiquid investments.
When a rumour gains a bit of traction, it can be hard to stop. Panic can set in very, very quickly. Reactions can be swift. And a lack of public confidence in an institution can potentially see it collapse with lightning speed.
We’ve seen this happen before – and quite recently – with troubled banks around the world. Queues of customers lined up in Britain at Northern Rock, before it was nationalised, and IndyMac in the US. Both were “rescued” by government institutions following public panic and a “run” on the banks themselves.
But could it happen to an Australian super fund? Could we see so much faith lost in a super fund that members began urgently cashing in? Or for those who can’t gain immediate access, to transfer out to other super funds?
It’s entirely possible, according to Simon Eagleton, senior investment consultant at Mercer. And the potential is exacerbated by those funds that have extremely high levels of illiquid assets, which are largely made up of direct and unlisted property holdings, private equity, infrastructure and hedge funds.
Eagleton calls it a “liquidity mismatch” and he believes it is the single biggest risk now facing the superannuation industry. It was entirely possible, he said, that if a single fund found itself in a liquidity crisis, that the contagion could spread to the entire industry.
The potential issue occurs on three fronts. The first is the problem of members wanting to switch investment options with a fund, which could lead to distortions of asset allocations within the fund for members. The second is that a fund would not be able to pay benefits when they fall due. The third is the potential for mass withdrawals or super transfers.
Australia’s Superannuation Industry (Supervision) Act requires funds to be able to meet member requests within 30 days. But as we saw with the various mortgage and property funds which froze redemptions last year, a run on funds can make it impossible for an orderly sell-down of assets. While lower, the potential exists with funds that have very high allocations to illiquid assets.
“Liquidity mismatch, even within a single fund, has the potential to damage our industry. What I am talking about is that liquidity mismatch creates a systemic risk… and all of us are exposed,” Eagleton told the Asia Pacific Investment Forum this week.
“I hardly need to paint the picture: it is entirely plausible that a single fund finding itself in liquidity stress could lead to a contagion effect engulfing the industry.
“I don’t want to overstate the implications – we are not talking about financial system meltdown, this is not directly analogous to the banking system. But the consequences of a loss of confidence in superannuation could be more widespread use of cash options and lower voluntary contributions, with ultimately lower retirement savings.”
Diagram courtesy of Mercer and Asia Pacific Investment Forum
Eagleton says that the top performing funds had been overweight to illiquid assets. Among the top eight funds, the average holding for illiquid assets was 27%. Of more concern, three of them held more than 36% of their funds in illiquid assets, a figure which would have moved higher with the falls in the listed property and stock markets late last year.
(As a comparison, Eagleton says the average for clients of Mercer, an asset class adviser, is 12%. In total, 85% of its clients have less than 20% in illiquid assets. The industry average weighting to illiquid assets is even more conservative, at 10%.)
According to some industry analysts, the higher exposure by industry funds to unlisted assets has been a key difference in their outperformance when compared to retail funds.
Holding unlisted and direct property, private equity and infrastructure assets have been traditionally useful because their lack of liquidity means there is no daily revaluation of the assets themselves.
(An easier explanation of this is the difference between shares and direct property. Even when property markets are falling, such as now, people can’t see their house price falling on a daily basis because there is no daily measure of the value of residential property. The share market, however, provides pricing by the second.)
Recently, in a related sense, the Australian Prudential Regulatory Authority has warned super funds about what it sees as “unacceptable valuation standards”, including “valuation shopping”, “smoothing returns” to reduce large and small movements in valuations, and a lack of trustee independence in the valuation process. APRA also criticised the frequency of asset valuations, particularly in times of volatility, such as we’ve just been through.
Australia (and the globe) is by no means through the tunnel when it comes to the potential for business collapses. And the sort of crisis of confidence that would occur if a significant Australian super fund collapsed could be devastating.
Eagleton says there are a few possible solutions, the worst, of course, would be government regulation of how super funds invest.
He recommends the industry adopt full public disclosure of liquidity positions and a voluntary code of conduct to reduce liquidity mismatch.
If the super industry fails to act independently, government intervention could be required, as the systemic risks to the industry by a few fund players is significant.
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It’s interesting to note what the Future Fund is doing with its investment mandate, if only because it is a considerable portion of Australia’s superannuation and has the backing of the government.
Bonds have been the go. The Future Fund now has its second biggest shareholding being in bonds, which now make up $11.2 billion of its funds in bonds. This compares to $4.7 billion in Australian equities and $7.9 billion in international equities.
This has the important flow-on of supporting Australian companies, particularly banks, as they try to raise fresh debt.
Bruce Brammall is the principal financial adviser with Castellan Financial Consulting and author of Debt Man Walking.