Superannuation funds get back on their feet

The superannuation sector has been hit hard in recent years as funds suffered greatly at the hands of market volatility. Angela Faherty takes a look at what the future holds for the market.

The past few years have been fairly tumultuous for the superannuation industry.

The onset of the global financial crisis coupled with government inquiries in the form of the Cooper and Henry Reviews have turned the industry on its head, with disappointing returns and legislative changes instilling a lack of confidence among investors.

On the back of this, the industry has seen the rapid growth of the self-managed super funds (SMSFs) sector as a growing number of clients look to manage their own super during a time of great market volatility.

Over the last two to three years the investment markets have played a dominant role in superannuation, with the performance of funds clearly reflecting the instability of global stock markets.

Despite the initial downturn and poor performance of recent years, returns have started to bounce back and the general consensus among industry players is that investors can expect positive growth going forward.

“Over the last two and a half to three years the investment markets have played a dominant role in superannuation,” says Mark Delaney, chief investment officer and deputy chief executive officer at Australian Super.

“The onset of the global financial crisis, the fall in share markets and its subsequent rise have affected different asset classes in different ways. This, plus the overlaying regulatory review, has brought a sense of volatility to the investment cycle, which has impacted heavily on superannuation.

“Funds, on average, disappointed investors during the global financial crisis. But, as everyone knows, you should take a long-term view when investing,” says Gerard Doherty, managing director at Fidelity International Australia.

“The Australian market has been a good performer over the long-term. It has been the world’s best performing equities market over the past 109 years to the end of 2009, according to figures from the London Business School, and although the market dropped in 2008 and early 2009, Australian equities returned over 37 per cent last year.”

Despite the strength of the Australian market, Doherty is keen to stress that while positive growth is expected, investors should not expect to see returns at the level previously seen at the height of the economic boom.

“Investors shouldn’t expect 2010 to provide as good a return as last year, but they can expect it to be a return towards the long-term trend. The returns of the local market over the past five years averaged 8.36 per cent, which was well above inflation and ahead of most major developed countries.”

An upward trend in the performance level of funds is certainly where the market is headed, says Sean Hill, national leader, superannuation, at KPMG.

“Over the past year the superannuation industry has been volatile, with markets dropping significantly.

"Last year, March and April saw something of a recovery and, presently, it would be fair to say that the market is still fluctuating, but the trend is that the market on the whole is on the up.

"By the end of the tax year on June 30, 2010, we are expecting double-digit growth for clients. Admittedly, all of them won’t be in that position, but some certainly will be,” he says.

Figures for 2009 certainly show the market has and continues to regain ground.

According to research released by Chant West in December 2009, the median superannuation growth fund witnessed its eighth period of positive growth in November last year, a gain of 10.5 per cent for the calendar year — a welcome relief from the 20 per cent drop in growth levels witnessed during the previous 12 months.

And while the consultancy firm calculated a further 15.7 per cent rise is needed to return to pre-global financial crisis levels, positive returns are indeed likely to continue, albeit on a modest scale.

Doherty agrees that double digit growth is certainly within reach.

“We expect the next 10 years to be positive. Returns in the 10 years after a ‘lost decade’, defined as any 10-year period in which US equity returns are below the rate of inflation, average out at a healthy 11 per cent a year in real terms,” he says.

With heavy emphasis placed on fund performance over the last few years, Russell Mason, head of multi employer consulting and partner at Mercer, says the focus going forward should now be on instilling confidence back into the sector.

“There has been something of a preoccupation with investment returns over the last couple of years and a move into positive territory would be a welcome relief from the turmoil faced by the market in recent years.

"After two years of bad investment returns, funds are starting to pick up and gain momentum in terms of growth, and that is starting to instil confidence in investors again. This can only be a good thing for the market. Confidence is definitely what is needed,” Mason says.

Industry vs retail superannuation funds

Investor confidence has certainly taken a bashing during the last two-year period, particularly as retail master trusts saw their value plummet at the height of the global financial crisis.

In contrast, industry funds were being revered as their performance figures surpassed those seen by retail funds with higher allocations in listed assets.

It is certainly true to say that unlisted assets were the shining stars of the 2008 and 2009 investment period and while unlisted property, infrastructure and shares saw their value fall, their tumble was not as great as those of their listed counterparts.

However, as with most booms, there comes a bust and unlisted asset revaluations from mid 2009 onwards saw the value of industry funds fall towards the end of the year, narrowing the gap between industry fund and master trust performance.

The drag on valuations for unlisted assets sparked industry debate about the value of unlisted assets over the so-called superior cash or listed investment options and calls for greater clarity over revaluation policies.

Questions were also raised about the extent to which some funds exposed themselves to unlisted assets.

“There is no right answer to the question of how much a fund should invest in unlisted assets. On the one hand they offer diversification and reduced volatility, but on the other hand they are less transparent and generally can’t be sold at short notice,” says Chant West principal Warren Chant.

The inability to sell unlisted assets at short notice is something that has stifled the market recovery in the short term, says Pauline Vamos, chief executive of the Association of Superannuation Funds of Australia (ASFA).

“There are lessons to be learned from the global financial crisis,” she says.

“Before then, growth was driven by structured products with no substance to them, such as mortgages on homes in the US where the underlying asset was no good.

"The difficulty with the global financial crisis was that the reduction of contributions into funds caused cash flows to become stretched and, as a result, funds were forced to sell assets.

"However, the problem was they couldn’t sell unlisted assets, so it exacerbated the problem,” she says.

With revaluations of unlisted asset classes bringing performance figures for industry funds more in line with retail funds, should investors be concerned about how much further returns will fall?

No, says Vamos.

“Unlisted asset valuations will bounce back. It is a good asset class but I do think the drop in performance and the effect of the global financial crisis will bring about a real change to the marketplace when it comes to future investments.

"People need to think more about real capital and real growth in the long term and not solely about high returns and high risk. Funds will need to start looking at new investment opportunities and focus on where there is money,” she says.

Chant agrees, saying funds need to strike a balance between caution and overexposure.

“The liquidity concern is why master trusts have been too wary of unlisted assets, while some industry funds have possibly gone too far in that direction.

"Our view is that the maximum exposure should be no more than 25 per cent or 30 per cent and less than that, maybe 15 per cent, if the fund has a relatively small or negative annual net cash flow,” he says.

Delaney agrees.

“Most balanced plans have a 50 to 60 per cent allocation in listed Australian and global equity markets, with the remaining part of a portfolio having allocations in unlisted assets such as property and infrastructure, with a small proportion, around 10 per cent, in defensive asset classes such as government bonds,” he says.

Delaney also believes further correction in the valuation of unlisted assets is likely, with the gap between the performance of unlisted and listed assets creeping even closer.

“People making a big deal about the gap in performance between industry funds and retail master trusts must realise that it is not sustainable.

"Just as industry funds outperformed in 2008, retail master trusts performed better in 2009, it is a market correction. It is simply the other side of the same coin.

"Performance will be more in line going forward and recent events have taught us a very important lesson in viewing performance over the medium term, especially in an environment that has been very volatile.”

Consolidation and innovation

Perhaps one of the most significant changes to the superannuation industry over the last few years is the growing number of mergers and acquisitions that have occurred in the market. In light of the Cooper Review, this number is likely to increase, with a tightened regulatory environment and volatile financial markets creating a framework where funds need greater support in order to survive.

However, despite the high number of mergers in the last few years, consolidation in the market is not necessarily a detriment to the sector, Chant says.

“The Cooper Review is definitely going to create further consolidation in the market and I think that will be a good thing.

"None of the industry bodies are sticking up their hands in favour of company mergers or encouraging smaller funds to consolidate, so there is no direct pressure as such.

"Plus, there are many smaller funds in the market that perform very well and probably won’t need to merge. I reckon we are in for a 10-year period of gradual and slow consolidation, but there will not be any sense of urgency about merger activity,” he says.

While regulation and the performance of global economies have certainly contributed to consolidation in the sector, it hasn’t been a key driver and it is unlikely to become one, Vamos says.

“Consolidation in the industry has been going on for some time and it is not something firms take lightly.

"Some smaller funds are very efficient and consolidation itself is very expensive, so it needs to be carefully thought out and definitely not jumped into, as it is a slow and difficult process,” she says.

Vamos adds that while the global financial crisis was not a driver of merger activity, it perhaps prompted a move by funds to look for a way to improve efficiencies and reduce costs on the whole.

“Funds are looking at creating better efficiencies such as outsourcing administrative duties and systems, moves that mean they can scale up without consolidating.”

Hill disagrees that the global financial crisis had little effect on market consolidation but says regulatory and legislative changes will certainly be a contributing factor in shaping the market going forward.

“The global financial crisis had some effect on merger activity but I think the Cooper Review will bring market consolidation more into focus, particularly when it comes to the cost and efficiencies of funds. That will definitely be dependant on whether a fund merges.

"Having said that, there is always talk of mergers, particularly at the bigger end of the scale, as seen in the case of Just Print and Media Super.”

While further consolidation is expected in the industry, Doherty says development in product offerings from fund managers is almost a certainty as funds look to grow market share.

“Australia has one of the most competitive funds management industries in the world, and while I expect some further consolidation among distributors and platforms, I also expect an expansion among product offerings from managers.

"More funds and new players would also be welcome as they provide more competition, which is ultimately good for investors,” he says.

Whether there is scope for new players in an already packed sector is another question. Many think not, but there is certainly a place for product innovation and simplification, particularly in the retirement market, where product offerings in the shape of annuities have traditionally been very expensive and of little value to clients.

“Product development remains a big issue, especially when it comes to longevity risk. Annuities have not been seen as an attractive retirement vehicle, they are expensive and haven’t been popular, mainly for that reason,” Chant says.

“People are also living longer than their life expectancy and are worried about spending all their money before they die. Product innovation needs to address that.”

David Kan, general manager of retirement and investment solutions at ING Australia, agrees. He says that as more baby boomers hit retirement, greater consideration must be placed on the allocation and income phases.

“Surprisingly, despite Australia having one of the most advanced superannuation systems in the world, we seem to be playing catch-up with retirement income products.

"This fact was not lost on the Federal Government’s Henry Review — which labelled the lack of annuity products a ‘structural weakness’ in Australia’s retirement system,” he says.

In a bid to tackle the problems in the annuities market, ING Australia developed a guaranteed lifetime product called MoneyForLife, which was released last October.

The product is the first of its kind in Australia and a hybrid of a lifetime annuity and an allocated pension that provides the investor with a guaranteed income for life.

The product is certainly a step in the right direction, particularly if it gets people to spend their money as opposed to saving in case the funds become exhausted.

Vamos adds that because products have traditionally been unappealing to investors, many have been concerned they may run out of money half way through retirement, and as a result they have refrained from spending. “At the moment, we have retired people who are too scared to spend money because they are worried they won’t have enough to fund their retirement.

But getting them to spend is vital for the economy and the industry as a whole,” Vamos says.

She adds that by 2020, 35 per cent of the population of Australia will be in the post-retirement stage, so product innovation in the next decade is essential.

This is why ASFA has stressed the urgency of product development in this area in its submission to the Cooper and Henry Reviews, she says.

SMSFs

One product that has thrived in recent years is SMSFs, which now accounts for one-third of the market. Industry figures show that assets in SMSFs have doubled in size since 2004 and there are predictions SMSFs will hold more than $900 billion in assets by 2020.

The popularity of SMSFs can be attributed to the fact that they allow the investor to have greater control over the fund, but this has caused something of a divide in the industry, with many calling for the funds to be regulated by the Australian Prudential Regulation Authority in order to provide greater protection for investors, while others want to retain the status quo.

“There are a lot of providers and services in the SMSF arena, and as with any financial product, you need to look at the risks associated with them. It is important to ensure the less sophisticated trustees are protected and that the advisers instructing them are too,” Vamos says.

Poor advice and a lack of understanding of SMSFs are certainly concerns in the industry, Chant says. He thinks the SMSF sector will level out as the take up of SMSFs fall.

“The situation with SMSFs is that a lot of people put way too few assets into their funds because of poor advice, and as a result there are a lot of people in SMSFs who shouldn’t be there.

"However, I think we are likely to see fewer SMSFs than more in the next five years as they are expensive for the lower cap investor in terms of administration,” Chant says.

Craig Jameson, managing director at SuperConcepts, agrees education is vital to the success of SMSFs going forward but thinks the market is likely to continue to grow.

“Concerns relate to the need to ensure that advisers to this part of the market have the necessary skills to provide advice to trustees, and that the enquiries currently being conducted by the Government do not unnecessarily impact on the operation of SMSFs or add to the ongoing uncertainty about superannuation generally,” he says.

The future

Uncertainty in the market is not a sentiment that needs fuelling in the sector, as confidence is already low.

The impact of the global economy on fund performance has shaken the market significantly and it will take some time before things start to get back on a level footing.

“The shock that we all have had will take some time to get over,” says Stewart Brentnall, chief investment officer at ING Australia.

“Debt levels are still high, growth levels have rebounded but are expected to remain modest as interest rates start to rise around the world and governments start to withdraw fiscal stimulus, as they must do at some stage.”

Chant agrees: “Generally speaking, there remains a big concern when it comes to getting back on track. The global financial crisis was caused by banks having too much debt, and this problem still hasn’t gone away.

"There is still a lot of debt in the world and that debt has to be repaid. How it will be repaid is putting a dampener on world sentiment and it is the reason why people are being very cautious about a recovery.”

With this in mind, it seems the superannuation sector is heading for slow but steady growth over the next few years.

Funds have already begun to pick up and investment returns are starting to gain momentum, however, investors are unlikely to experience the levels of returns seen before the global financial crisis.

Nevertheless, improved fund performance, a focus on product development and a government inquiry into the sector mean changes are definitely afoot in the sector.

Only time will tell what impact these changes will have.