Why super funds are ready for the baby boomer bulge: Bartholomeusz

The superannuation industry was very quick yesterday to respond to a News Ltd report that retirees could face a freeze on their superannuation accounts because the ageing of the baby boomers could generate negative cashflows for funds. The industry sensitivity is understandable because the issue the report highlighted is a live one for the sector.

Indeed, so live is it that yesterday the Australian Prudential Regulation Authority issued a paper on the most sensitive aspect of it – the risks and returns of illiquid investments.

The newspaper report wasn’t wrong, but did rather exaggerate the issue. It quoted reputable authorities – Towers Watson managing director Andrew Boal, Challenger spokesman Stuart Barton and even the Association of Super Funds’ Pauline Vamos – saying there could have to be some limits or even freezing of funds as the baby boomers hit retirement age and increased the risks of negative cash flows for their funds.

What the report didn’t convey, however, was that the sector is well aware of the implications of the demographic bulge moving through the system and is positioning itself for it. The funds, and APRA, still have five or six years to prepare for the impact of the bulge to start being felt. The news report focused on the more sensationalist starting point for a discussion than on the sophisticated discussion that in some funds has been occurring for more than a decade.

In fact, Boal is delivering an address on the issue at this week’s annual ASFA conference and Vamos issued a press release today noting that the industry and governments had long been aware of the implications of an ageing population for the sector, that the APRA paper showed funds were managing their liquidity risk and also that the majority of superannuants didn’t take a lump sum when they retired but left the bulk of their savings in the super system.

The sensitivity demonstrated by the sector lies in at least two areas. One is that it will undermine confidence in the system – and potentially trigger outflows from the system or flows between funds that wouldn’t otherwise occur – if members think there is even a remote possibility that their funds could be frozen.

The other is that during the height of the financial crisis some funds with disproportionately large exposures to illiquid assets suffered significant outflows and because valuations of illiquid assets considerably lag movements in markets exiting members effectively received artificially higher returns at the expense of continuing members.

The fact that the system allows choice, or switching between funds, does create the potential for “runs” on funds.

Most super fund trustees are conscious of the demographics of their fund and tailor their investment strategies broadly to suit them. A fund with a lot of young members can adopt more aggressive strategies and hold a greater proportion of illiquid assets than one with a large proportion of members nearing retirement and holding large balances.

The APRA research tends to conform that the funds with the most illiquid assets tend to be the large not-for-profits with younger membership profiles and strong cash in-flows. Funds with erratic funds flows and a greater proportion of members approaching preservation age adopt more conservative approaches and hold larger cash balances, it said.

The Cooper Review of the super system put a greater focus on fund liquidity, and the liquidity of underlying assets, and will impose an obligation on funds to include an explicit liquidity management component to their risk management plans.

That, and the experience of the crisis, ought to be reflected in few funds having disproportionately large investments in illiquid asset classes – although those assets can produce enhanced returns to compensate for the risk of illiquidity and therefore have their place in properly constructed portfolios.

The funds do have alternatives other than simply holding more liquid assets. They can develop and promote annuity-style products and will have to do so as part of the My Super reforms. That will help reduce the potential volatility in prospective outflows.

While it might go against the grain for some funds, given that compulsory superannuation has created a system that has known only growth, they could effectively plan an orderly self-liquidation in line with dwindling fund membership and asset bases.

A fund with an ageing membership or with an uncomfortable level of exposure to illiquid assets could merge with a fund with a youthful membership or one with high levels of liquid assets. There have already been examples of both those kinds of mergers.

There are some extreme circumstances where even a fund with a strategy of only investing in usually liquid assets might need to temporarily freeze or ration withdrawals, but other than at the peak of a GFC-type event that should be an extremely remote possibility in any reasonably well-managed fund.

The ageing of the baby boomers shouldn’t place any strain on super fund liquidity. It will impose responsibilities on fund trustees to monitor their funds’ probable long-term liquidity profiles and on APRA to ensure that their plans are sufficiently sophisticated and robust to meet both the foreseeable demographic challenges and the odd unforeseeable external event.

This article first appeared on Business Spectator.