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The moral hazard of a national super fund

Former Treasurer and now Chairman of the Future Fund, Peter Costello, regularly entertains the idea that Australia’s sovereign wealth fund could run the ‘wholesale management’ of one mega national super fund. For example, he said in February 2019:

"The Future Fund could be of assistance to a public default fund in working out asset allocation or recommending managers or maybe even having a wholesale role."

Then again in January 2019, he said:

“I’ve never said the Future Fund wants to be a super fund itself, but if the government wants to set up a default (super) agency, we could act as a wholesale fund manager.”

Encouraged by the critical findings of the Financial Services Royal Commission, especially relating to retail superannuation funds, some members of the Morrison government support the idea of a public entity directly accepting default super contributions.

Government purse to the rescue

With Australia’s total pension savings around A$3 trillion, and with government regulators continually vocalising their preference towards further consolidation within super, any one of a number of persistent uncertain investment, liquidity, and operational risks could trigger a moral hazard-like event. No democratically elected government, especially one with an outspoken baby boomer constituency like Australia’s, would ever allow a mega super fund to fail.

Facing the political reality of billions of dollars of retirement savings being lost by a government agency that was supposed to be protecting capital, ‘caveat emptor’ investment theory would be thrown right out the window.

Traditional government responses to rescuing financial institutions would not work under this consolidated mega fund model in an ongoing volatile market. At the moment, if a bank runs into trouble (such as the Bankwest and State Bank bailouts), a takeover by a larger bank is engineered. However, the larger the super assets under management by one provider, the less probable that another one or two unaffected super funds could bail another out given fiduciary responsibilities.

The government would be forced to use a taxpayer-sourced bailout and nationalise the fund, thereby making Paul Keating’s idea of Defined Contribution (DC) obsolete. Under the current DC approach, with superannuation run by the non-public system (including industry funds), performance risk has been passed from the institution to the investor, replacing the old Defined Benefit (DB) system.

The precedent of ‘daiko henjo’, or handing back liabilities

While the collapse of a national super fund is obviously hypothetical, it would be equally wrong to assume that there is no precedence. Japan offers such an example, having an economic circumstance with uncertain market direction, negligible cost of capital (and corresponding anaemic government bond yields), and rapidly ageing demographics. And while the majority of Japanese pension funds are Defined Benefit, the majority of Japanese people retiring (and Japanese corporations funding such a retirement income) find it difficult to operate under the uncertainty of the ‘Three D’s’ - Deficit, Deflation, and Demographics.

CFOs of publicly listed Japanese companies were complaining that while they sustained their business under difficult economic conditions, through fault not of their own, pension liabilities would influence their total debt (and balance sheet) under current international accounting standards.

So nearly 20 years ago, the Japanese government introduced ‘Daiko Henjo’, a Japanese word which loosely translates to ‘hand-over’. Under Daiko Henjo, corporations could take pension liabilities off their books and hand back their pension liabilities to Japanese taxpayers. By implementing Daiko Henjo, Japanese corporations could effectively take their pension liabilities off balance sheet. For this to happen, however, the Japanese government required two things: that the pension fund be fully funded, and that the payout to each employee/retiree be quantifiable.

While there were a few notable exceptions, this free exit was too attractive for Japanese CFOs to pass up. The Japanese government set up GPIF, arguably the largest global pension fund with assets near A$2 trillion. The number of actual corporate pension funds shrank by more than two thirds, and the nationalisation of Japanese pensions has never looked back.

From its peak in 1990, the number of people employed within financial services similarly shrunk by over two thirds, including from institutional funds, brokers, administration, custody and asset consulting. And while the Japanese retail funds market remains robust, it is a shadow of what it once used to be.

Market extremes, strange at the time

While living in Japan, I observed how in the early 2000s, investors could buy a flat in Tokyo, mortgage the purchase at an interest rate of 1.5% and yet access a rental income of 10%! Coming from Australia, the obvious reaction was “How could this be?” Surely this will eventually be arbitraged away.

A decade later, this positive spread has fallen but remains significant. Following 30 years of real asset deflation, investors adapted housing pricing expectations under such extreme market conditions. The income was the compensation required for falling property prices, the complete opposite of Australia where miserable rental yields are the cost of buying into capital gain.

Yes, extreme conditions yield unexpected results. Like cutting interest rates in our demographic world no longer correlates with increased spending. Like negative bond yields in many countries.

In Japan, traditional monetary policy was already ineffective 20 years ago, whereby interest rate cuts were no longer followed by a commensurate rise in consumer spending. With a large population of retirees in Japan, continued cuts in interest rates actually saw a drop in consumer spending as retirement income fell. Sound familiar in Australia now?

Don’t assume these things will not happen here

Before anyone wrongly assumes that I am prognosticating the same outcome for Australia, I’m not. What I am flagging, however, is that to write off the threat of a national pension system would be equally naive given our persistent economic and market uncertainties. A government entity accepting default contributions from shop assistants, apprentice bricklayers, coal miners and factory workers would be forced to top up savings in the event of a severe market crisis. We seem to forget the stockmarket receives a 50% crash about once a generation.

Furthermore, with more mega funds capturing economies of scale by moving towards internal manufacturing (whose threat of operational errors are funded by member capital), the risks within super is commensurately rising.

The government should be careful what it wishes for as every action is followed by a set of new reactions.

 

Rob Prugue has over 30 years in funds management, from market regulator to investment analyst and manager, to pension manager, to asset consultant and, most recently, as a CEO of Asia Pacific at Lazard Asset Management. These opinions are his own. Now at the end of his recent sabbatical, Rob would be an ideal resource for any business considering a broad range of investment and planning issues.

 

9 Comments
Justin Wood
February 26, 2020

I couldn't agree more with Rob's main point. While a decentralized DC system with choice, a DIY option and skin in the game has some costs and "inefficiencies" compared with a centralized, taxpayer backed system, the history of DB type schemes has many examples of over promising, some groups gaming the system and wealth transfers from the late entry participants or third parties.

Rob Prugue
February 26, 2020

Very true. And in the US, there is a government insurance company, PBGC, which protected the employees if/when the DB plan failed. Or at least there once was.

DavidJames
February 21, 2020

Rob, you raised an interesting point I have been contemplating recently, albeit from a different angle. It appears economies are becoming less sensitive to interest rate movements. My belief is it is mainly driven by a mix shift in the type of goods we consume: previously manufactured goods were dominant compared to an increasing level of services consumed today. Services are produced by capital light businesses that are less reactive to interest rates. Therefore, bigger rate swings are needed to influence the economy. Now the main part of the economy left that is highly sensitive to IR changes is housing - which is playing out in capital cities now.

You noted demographic shift as a reason interest rates are not as effective as they used to be (in fact it might be perversely counter effective as retirees will spend less when interest rates are cut as their income stream declines). I appreciate this was not the focus of your article, but an interesting topic.

Otherwise good article raising valid points.

RobG
February 20, 2020

Beware former Treasurers touting for business:

Table 2: Future Fund asset allocation


Australian equities 6.8%


Global equities Developed markets 19%


Emerging markets 10.2%


Private equity 14.9%


Property 6.3%


Infrastructure & Timberland 7.0%


Debt securities 8.6%


Alternatives 13.4%


Cash 13.7%


TOTAL $168 billion 

Observations:

- Massive offshore tilt where 100% of their future liabilities are A$'s. Right now look like heroes. A$ gets back to parity where it was not so long ago, they look like dills
- Massive tilt to Private Equity 14.9% plus Alternatives 13.4% - both relatively, opaque and illiquid
- Massive underweight to Aussie equities at 6.8%, so much for backing Australia!

And, by the way, they significantly under performed Aussie and US equities in 2019

Careful what you wish for.

SMSF Trustee
February 27, 2020

OK, this can't go with out comment:

- re the currency impact. Give them some credit for being underweight the A$ in recent years when it's been under pressure and, rather than just assume they'll be stupid and sit there with the same allocation, ask for more information about their hedging policy
- tilt to private equity - again, give them some credit for having an investment team that gets behind the details and understands what the private equity and alternatives managers they use are doing. I'd not be surprised if, being as large as they are, they don't actually have a veto on investments that their managers might make. PE might be opaque to you, but it isn't necessarily opaque to large funds that use the asset class
- ditto with the tilt to alternatives, many of which are fairly well trodden corporate debt relative value funds and the like that are used by many portfolio managers
- as for the underweight to Australian equities, their mandate is not to 'back Australia', it's to generate a return for their Australian investor base, which being government doesn't really benefit from any franking credits
- finally, so what if they underperformed in a couple of equity markets in a one year period? They're genuine long term investors.

I'm not saying that I'd support using the Future Fund and its approach as a 'default' national super fund, but if I reject that proposition it's not for any of the reasons you've put forward

Tom Cottam
February 20, 2020

Keep up the good work, Rob. Excellent article.

Chris S
February 20, 2020

Maybe I'm mis-reading what Rob Prugue is saying, but this comes across more as self-interested by an industry player, rather than an analysis of the value that an alternative wholesale manager could offer.

Graham
February 20, 2020

Hi Chris, that's not Rob's point. He is saying that if a Government agency provided super, it would be expected to bailout investors following a heavy market fall. So the risk is passed back to taxpayers, in contrast to the current system. Rob has no self-serving interest to self serve.

John Flynne
February 20, 2020

When I started my super in 1969 I had to invest 30% in govt securities . I did not complain. Should the Govt require today10% . This would provide a pool of funds for infrastructure investment by the Govt at a cheaper rate than the complicated schemes that do fund infrastructure funding today and then sell it off to the public.

 

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