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inputs and outputs to austRaLia’s ASSET ALLOCATION EQuation

participantsn Warren Bird Co-Head, Global Fixed Income & Credit COLONIAL FIRST STATE GLOBAL ASSET MANAGEMENT n Janice Sengupta Executive Director AON SUPERANNUATION n Pauline Vamos Chief Executive Officer ASSOCIATION OF SUPERANNUATION FUNDS OF AUSTRALIA

Moderatorn Laurence Davison Editor KANGANEWS

ECONOMIC INDICATORS

davison economic data points to a weakening in the australian economy. what will the economic outlook mean for asset allocation?n sengupta I can’t forecast what the market will look like in the future, but there is greater fear in the retail market currently; so much so that there has been heightened demand for term deposits. We have secure options, which are heavily oriented towards a diverse fixed income portfolio that offers much better outcomes than term deposits.

Nonetheless, the extreme fear that prevails in the wake of the financial crisis, the distrust that has emerged with regard to managed funds and the attractiveness of having something that is absolutely guaranteed are all factors we will have to be mindful of as we consider asset allocation in the future. The market isn’t going to return to those glorious days of equity bull runs that we enjoyed in the past.

We are looking at a lifecycle approach for our default option, so there is better protection. We will look at asset allocation with a defined benefit mentality – that is, examine the demographics of our membership and adjust our asset allocation accordingly. This is a mass customisation approach, so as a member’s account balance increases and it reaches the point where they can fund a comfortable retirement, we start to take risk off the table. If funds adopt life cycle strategies, there

will be a shift towards more defensive, fixed income assets in the future.

davison over what time period is this shift evolving?n sengupta The real shock came in 2008 and questions emerged at that time. It didn’t take long for the realisation to set in that this financial crisis was different. Concerns have not gone away, but the focus shifts over time: the slowdown in China, the euro crisis and the political wrangling in the US that is affecting appropriate fiscal management. Concern about the global economic environment has been manifest in Australia in an erosion of consumer confidence.

The real question in the current environment is, what is a defensive asset? There is a realisation that sovereign fixed income is not necessarily the place to go, so we need to consider credit and other sectors of fixed income.

davison pauline Vamos, what is the feedback from your members about this structural shift?n VaMos There are a number of structural shifts occurring. There is a very strong move away from peer group measurement towards the importance of an investment strategy that delivers to individual member cohorts according to timing and retirement goals. As we start to move away from peers we will start to get that broader diversification of allocation. That is critical.

articipants in all sectors of the Australian credit market acknowledge

that its main failing is its inability to capture a share of the country’s

vast superannuation pool equivalent to the global standard for credit

allocation. Representatives of each of three key sectors – asset consultancy,

funds management and superannuation – discuss the state of play.

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It is early days, but when I look across all the asset consultants and the major funds the notion of what is a default portfolio is rapidly changing. It was a ‘balanced’ portfolio before – whether that was 70:30 or 50:50 – but we are moving away from that. We will also see more interesting portfolios going forward through the development of MySuper offerings, publication of Australian Prudential Regulation Authority (APRA) league tables and greater focus on the measure of net performance to members.

In some managed fund and choice portfolios we are seeing a move towards term deposits, but that will start to change because more people have higher account balances and they are under advice. Then we have post-retirement, which will have an entirely different asset allocation – the key to these portfolios will be sustainable and non-volatile income streams with the understanding that the underlying assets may be volatile.

davison warren bird, you have been marketing the virtues of credit to clients for a long time. are you getting a different response now?n Bird We’ve had quite a good response for a long time now. I think the main message is to pick up on the point about sovereign risk. It is very easy for governments to over-borrow and hide behind good times. The problem with sovereign bond portfolios in that context is that you are automatically

concentrated. You have several per cent as your benchmark allocation to various countries, so it just reinforces the credit message of diversifying your risk.

As soon as you cease to have confidence in a sovereign as a pristine triple-A you are starting to look at credit. The only way to manage credit risk properly is to diversify, so you have a lot of small exposures across lots of names and industries. That message has been quite well received.

davison is the australian dollar credit market a viable alternative to cash or rates-type investment, or do investors need to look overseas for credit?n sengupta It does not necessarily have to be done offshore but the international market is larger. I should point out that we don’t manage money directly – we invest with fund managers and their credit allocation is largely offshore. That is not a requirement on our part, however. They are free to pick securities wherever they find value. Certainly our preference is

to have relatively unconstrained mandates with fund managers and let them pick the best assets. n Bird Australia is just one market – and if you have 20-40 per cent in one country you are concentrated in one interest rate cycle and one economy, whicht is not sufficiently diversified. I have a big issue with the push the industry has at the moment to try to force super funds to invest more in corporate Australia and in corporate bonds in Australia out of a perception that we need to have a big Australian corporate bond market. We don’t.

davison the association of superannuation Funds of australia has established an institutional investor working group. what does the working group hope to achieve?n VaMos With the growth of the industry, its role in the economy and the fact that it is a compulsory system, everyone has an interest in how successful it is in terms of delivering retirement outcomes. We welcome a public debate on super – it is in our collective interest to make it work and grow.

We held a forum earlier this year with Ken Henry, at which he pilloried the industry about sequencing risk and the way assets are allocated. We realised that generally the debate was lopsided and a bit ill-informed. We had all parts of the value chain at the forum, including funds, and from that we produced a discussion paper. The government and the coalition

acknowledge the need to talk about it, so we’ve established a working group to bring institutional investors to the table with all other parts of the value chain.

The investor perspective is very different and often misunderstood, as is the whole superannuation sector. It is a very diverse sector, in terms of the needs of default members, the challenges of choice and the self-managed funds (SMSF) sectors. SMSFs are currently one-third of the A$1.3 trillion sector and could easily grow to 50 per cent. By 2020 the whole super pool could be worth A$5 trillion and the proportion of that in post-retirement will grow. So the allocation to asset classes like fixed interest will form part of the defensive, active and hedging point strategy.

There is also a massive amount of education needed both within and outside the industry. The industry is growing in investment expertise but there is an appetite in funds to develop in-house investment expertise and lessen their reliance on asset consultants, so there is a need to educate funds. This group will provide a way to do that.

“We will look at asset allocation with a defined benefit mentality; that is, examine the demographics of our membership and adjust our asset allocation accordingly. If funds adopt life cycle strategies, there will be a shift towards more defensive fixed income assets in the future.”J a n i c e s e n g u p t a A o n S u p e r A n n u A t I o n

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daVison The last 12 months has seen a revival of direct-to-retail fixed income issuance in Australia. What is the significance of direct retail interest?

VaMos We have talked about risk in the incorrect way. We talk more in terms of risk of negative returns and volatility risk, so the whole focus has been on the portfolio. That is where I think the industry and most financial planners get it wrong – they don’t focus on the individual. The starting point should always be, what is your risk of not getting to your retirement goal? Then we look at how to get there – we need to focus on the end goal. Many don’t talk that way but the conversation is shifting to what asset mix we need to get there.

The key for the super industry is to have the same conversation with cohorts within default funds, so you can deliver their retirement outcomes. That is the big challenge with MySuper and that is why I think the standard default is dead.

Bird Hybrids are marketed and talked about in terms of the yield they offer; not enough attention is paid to risk. Investors don’t get told much about credit risk, because the rating agencies have been scared off being involved in talking about credit

risk to retail because they have been misrepresented.

A single-A credit rating is not a recommendation to invest – it is telling you this thing could go wrong. Within the universe of single-As a certain percentage will go wrong. And yet what we’ve seen is that when that happens, the rating agencies get sued for not giving a security a higher risk rating. But they have actually got it right, because the universe of securities they cover tends to default at the predicted frequency.

Many retail investors don’t understand tail risk. They need to ask, ‘if something goes wrong, how bad could it get?’ The focus of many of my presentations to retail advisers this year has been that hybrids are fine – they have a place in a diversified portfolio – but you have to understand the risks, structures, how subordinated they are, do they have dividend stoppers? This especially applies to bank hybrids.

Many financial planners have been gobsmacked when I have pointed out that the bank does not have the final say over whether they will call it at maturity – the Australian Prudential Regulation Authority (APRA) does not care about the hybrid investor, it cares about depositors and whether the banks are well capitalised. I don’t expect that

will happen; Westpac Banking Corporation will be fine in five years and call its bond, but if China falls in a hole, Europe blows up and APRA decides Australian banks need to be better capitalised, the banks won’t call those issues. Do investors understand they have these securities for another 20 years unless they can sell them on an exchange?

This is a risk many investors don’t know they have. I shudder to think how they will react if a tail-risk event happens. But you can manage tail risk – that is where managed funds come into their own because we can get diversification the individual investors cannot access.

sengupta Within our Aon Master Trust we have seen a change in behaviour; the investments in our standalone cash and fixed income options have doubled to 8 per cent from 4 per cent since 2009 – this is not counting fixed income exposure through the pre-mixed options. So those who exercise choice on a standalone basis have doubled their investment in cash and fixed income.

When I came to Australia in 1995 I had been living in Canada. I was surprised by the retail fixed income market – at the complex structures offered to retail investors. In Canada there is

easy access to plain-vanilla government bond issues, so the average investor could become familiar with the fixed income market. Such access to safe, simply structured fixed income issues is lacking in this country, which affects the understanding and awareness of fixed income opportunities.

audience question Does fixed income need help through the tax system, given equities are so tax advantaged?

VaMos We are concerned about any tax incentives provided to particular asset classes because of the political volatility in Australia. Tax is important, but strategy comes first. Tax should not drive a diversified portfolio.

Bird Getting franking credits is one of the attractions of hybrid issues. That issue is more pressing for non-super investors. Super carries a lower tax rate and once you are over 60 the tax-free status takes that away when talking about asset allocation in a post-retirement sense.

Outside super if retail did not have to pay as much tax on nominal interest earnings there might be more investment, but the primary thing is to get the strategy right. There would be more fixed income investment if investors understood that liabilities need to be matched.

reading the rETAIL SIgNSRetail fixed income issuance in Australia has soared in 2011 and 2012. The institutional market believes it understands the motivation, but is not convinced about the manner of execution.

“retAIl InveStorS need to ASk, ‘If SomethIng goeS Wrong, hoW bAd could It get?’ the focuS of mAny of my preSentAtIonS to retAIl AdvISerS thIS yeAr hAS been thAt hybrIdS Are fIne – they hAve A plAce In A dIverSIfIed portfolIo – but you hAve to underStAnd the rISkS.”Wa r r e n B i r d c o l o n i a l F i r s t s tat e g l o b a l a s s e t m a n a g e m e n t

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davison there is a perception that allocation changes would immediately spark australia’s credit market. would that really be the case?n VaMos In reality, the overseas market is very attractive because it is so deep and liquid. The Australian market is in competition with offshore markets, and Australian funds’ ability to go offshore is growing. In default funds, allocation to domestic fixed interest is 10 per cent and international fixed interest is 6 per cent. I wouldn’t be surprised if the offshore fixed interest overtakes the Australian allocation over the next few years.n sengupta If we allow fund managers to seek out value where they find it you could argue you don’t need a special carve-out for an Australian fixed income portfolio. The Australian index has about 16 per cent exposure to offshore issuance, so what is Australian fixed interest? If holdings are hedged back to the Australian dollar, the yield is competitive and the credit rating is good, I am indifferent as to whether the bond was issued offshore or domestically. Members in

superannuation funds should also be indifferent to where the issuer is domiciled.n VaMos There is a growing awareness within the industry and within government of the role of super in the economy. In a very simple form we are providing retirement outcomes. The more the industry is a long-term capital provider to encourage the growth and strength of the Australian economy, the better the long-term returns for all Australians. The discussion we are having in Canberra is around how we ensure the pool does its work in the economy. In that sort of discussion the tensions of the different structures of the sector emerge, such as SMSF versus pooled versus choice, and these have a key part in that debate.

There is also a discussion around the best way to provide long-term capital. We have to overcome the chronic issue of concentration risk because we have so much money in the Australian Securities Exchange – 26 per cent – at the top end. Is there an ability to have corporate bonds at the smaller end? At the moment it is just too expensive for them. We are hoping to find a way to get that diversity.

davison could the infrastructure funding pipeline provide the supply and diversity we need to make the market a more valid option?n Bird It doesn’t provide diversity because it is just one sector. We don’t see infrastructure debt as a separate asset class. We

recognise there are large investors who see it as a separate portfolio, but it is just debt.

Historically, infrastructure debt has been very long-term with all sorts of interesting structural features that aren’t necessarily always good ones from a bond investor’s point of view. You aren’t always paid for the tail risks these investments create so you have to do your homework, treat any security on its merits and include each one as part of a very broadly diversified portfolio.n VaMos I think the whole nature of infrastructure investing will change; the need for the state and federal governments to come together, particularly on greenfields investing, is clear. The message is there but putting that in place is very hard. We are starting to see a desire to invest in infrastructure, particularly in super, because it can give some steady returns, particularly in the post-retirement space, because they are long-term assets. If we can predict the risk and returns with a level of certainty, it can play a key role in any portfolio.

The infrastructure debate has been around for a long time, but the industry has moved on because it has become political. Nothing has been resolved and there is nothing in this sector in Australia today that is investor-ready for super – it is all going overseas. That is why they are looking at smaller projects that can be a direct investment.n sengupta On the surface it seems that as we have a huge need for infrastructure and a massive pool of funds you can just connect the two. But it is not that simple. Part of the challenge is the regulatory environment for superannuation. We have to consider liquidity. In a choice environment we have to be conscious that members can choose which fund they are in and can switch options within a fund. We can afford to have some illiquidity, but we have to manage that prudently.

LIQUIDITY ISSUES

davison certain asset classes, including credit, are by their nature illiquid – will this accentuate the problem?n sengupta Yes, absolutely.n VaMos At the moment there is about A$400 billion in post-retirement; by 2016 there will be A$700 billion and by 2026 A$2 trillion. We have worked hard with the government to start removing some of the regulatory barriers and there will be carrots and sticks in terms of people taking income streams.

“one roadblock is that we don’t have deep expertise across the financial planning industry in post-retirement. there should be a special accreditation, through which planners learn the drivers of retirement as well as the products and what risks need to be mitigated.”p a u l i n e V a M o s A S S o c I A t I o n o f S u p e r A n n u A t I o n f u n d S o f A u S t r A l I A

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People are looking for a steady income stream so the volatility of the underlying asset becomes irrelevant: you are measured on your ability to provide the steady income stream.

In that environment some assets that are not liquid but can provide the income stream will be attractive. That is happening now because the growth in post-retirement is moving quickly.

davison during the financial crisis money was redirected out of already illiquid fixed income funds to rebalance into equities. how have client expectations about what different asset classes should be expected to offer in terms of liquidity been managed?n Bird The main way is to make sure you have defined within the portfolio what the levels of liquidity on certain assets are and you have enough Commonwealth government securities and cash and larger semi governments to make sure you can meet the liquidity needs of your funds.

We were at the heart of the problem with the mortgage trust industry – this was a product suite that was offering liquidity, but the assets weren’t liquid. That worked fine for many years when investments were ‘sticky’, but the chickens came home to roost after 2008 when people wanted to move straight into term deposits.

All you can do is make sure you have the ability to deliver what you say you can and be true to label. I’m not sure all the funds out there have done this. Globally, credit is quite liquid but in Australia it is not. It does seem to me that a few of the Australian bond funds out there are heavily loaded up on illiquid credit. However, I am sure they have some Commonwealth government bonds behind them if they need them.

SYSTEM GROWTH

davison some borrowers say while they are not totally dissatisfied with the australian

fixed income market they are not consistently offered the volume they need. with an ageing population and more consideration of post-retirement, will we meet a critical mass of demand for fixed income product even without a major shift in asset allocation?n sengupta If the pool of money is doubled by 2020 the absolute number of dollars invested in fixed income will double even if we don’t change the asset allocation. If, on top of this, we have an asset allocation shift in response to the ageing population and more demands for life cycle products, the growth in fixed income investments will accelerate.n VaMos Today there are three million people over 65; by 2050 there will be 8.1 million over that age. So 30 per cent of the market will be over 65 compared with 13 per cent today. That is a market with critical mass.

davison what is being done in terms of product innovation to service the market?n VaMos Key developments and issues include the whole design of a default pension – MyPension – as opposed to MySuper; the relationship between the pension and the super pool and what that means, particularly when you look at whether you should spend all of your super money before you get access to the pension; and whether longevity risk insurance should be compulsory.

We all talk about the super pool, but the insurance pool and growth of insurance, particularly around longevity risk, will be enormous and the assets underpinning that type of cover are long-tail, defensive-type assets. That is a very big potential pool that works in harmony with the super system.

Another issue is how we can develop products like annuities. The tax arrangements are a disincentive, but we think they can be changed and there is appetite in Canberra to do that. We are hoping there will be an announcement in the budget next year if there is a surplus.

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When you look at every survey the number one thing people want is to know what money they will receive each week. They want it to last their lifetime and they want access to some sort of pool so if they need money urgently they can get it. They also want to make sure that if they die early they don’t lose their capital. We have the product scope, we have identified the roadblocks in the regulation and we know what the issues will be.n Bird The other main risk on the retirement side is inflation. It is not a problem now but many feel the easy monetary policies that are being applied around the world will end up creating inflation. We need to think about protecting against inflation that may be 15-20 years down the track.

The government, through the Australian Office of Financial Management, has done the right thing in committing to continuing to issue inflation-linked securities as part of the Commonwealth borrowing programme. We need to see more fund managers getting involved in this market.

We need more retail awareness of inflation-linked bonds. The standard response we get from financial planners is, ‘we will invest in one of your diversified funds and you put a bit of inflation-linked product into it’. That is not addressing the issue in the retirement space, where you need that hedge in place for five, 10 or 15 years. We need longer-dated inflation-linked bonds. The real yield won’t be great but you have the security of knowing your capital value and income stream will go up when inflation goes up.n VaMos One of the other roadblocks is that we don’t have deep expertise across the financial planning industry in post-retirement. There should be a special accreditation, through which planners learn the drivers of retirement as well as the products and what risks need to be mitigated. In post-retirement you need a financial planner because it is so individual – it is not something to which you can take a broad default approach. To get the expertise at the time we need it we have to raise standards now.

n sengupta I agree with the comments on the need for education. Advisers think they understand the stock market, but it is a struggle to make bonds sound exciting to financial planners, let alone annuities. As an industry we have been focused on returns – we talk about average returns over 10-20 years, which is a comforting approach. But we need to look at dollar outcomes, which widen over time because of sequencing risk. A lot of education is needed to help people understand how they should be thinking about post-retirement investments.n Bird In the institutional area we are seeing, particularly with insurance companies, a much greater awareness of the need to understand their liabilities and align their assets better. It is very important for retail investors to think in terms of asset and liability matching rather than a set rate of return. They need to think about what they are investing in and why they are putting money aside for the future. People don’t seem to think about what they are doing with their investments in terms of meeting future liabilities and trying to make the assets line up.

Life cycle approaches are helpful in that respect, although I think the traditional life cycle approach means saying to my 23 year-old son ‘you won’t touch your super for 40 years so you should be in equities’. So he goes into an equity fund and then watches it go backwards for a few years and is turned off saving.

The default option for anyone under 30 should be cash and fixed interest so they get used to the fact that it is how much you put in that drives how much you get out. The returns you get on the way are good, but it is your contributions that matter for a young person. We are not doing enough to encourage that understanding.n VaMos That is what is happening in the UK with the National Employment Superannuation Trust. There has been so much work done on mindset and getting people to understand what they need in retirement and contribute over the longer term. Putting young people in cash so they have stability of the investment amount is occurring. •

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