APRA has expressed concerns over superannuation funds’ ability to maintain their strategic asset allocation (SAA).
With the COVID-19 virus wreaking havoc around the world, causing many thousands of deaths and threatening businesses due to lockdowns and travel restrictions, markets have responded with sharp falls.
This volatility has spooked many members and there is anecdotal evidence that significant numbers are switching to cash, with some funds even seeing more members switching than during the global financial crisis.
On top of that, the Australian government has announced hardship measures that will give pension members early access to part of their funds. It will allow individuals that find themselves in financial stress as a result of the coronavirus to access up to $10,000 of their superannuation this year and a further $10,000 in 2020-21.
This tri-factor of events means pension funds are faced with high liquidity demands.
The situation is such that it has drawn a reaction from the Australian Prudential Regulation Authority (APRA).
APRA has sent out letters to funds to check that they can maintain their strategic asset allocation (SAA) in these turbulent times, a superannuation fund Chief Investment Officer told [i3] Insights.
So why is the regulator worried?
The first problem is one of rebalancing and is best illustrated by an example.
Let’s take a fund with a hypothetical and highly simplified allocation of $100 to equities, unlisted assets (let’s say, property) and bonds.
Let’s start off with the following asset allocation:
● $50 equities
● $30 property (unlisted)
● $20 bonds
If you then have a 40 per cent selloff in the equity markets, you would end up with a portfolio that is now worth $80.
● $30 equities
● $30 property (unlisted)
● $20 bonds
The good news is that you only lost 20 per cent and not 40 per cent, because your portfolio is diversified and only half is in equities.
But the bad news is that if you then want to rebalance and have 50 per cent of your $80 in equities, you need to increase your current $30 in equities to $40. You would have to find $10 from somewhere.
The problem is that you can’t take it out of property, because it is illiquid. So you have to take it out of bonds.
But in doing so, you end up with too little in bonds and too much in property. Your SAA is shot to pieces.
Not to mention that most pension funds would not hold that much in sovereign bonds, but would hold a mixture of credit, high yield assets and emerging market debt. If you were to pull money out of such fixed income assets, you would take a significant hit in the current market conditions, creating further problems in your asset allocation.
The second problem is a higher demand for cash. Members who are switching to cash do not only crystalise their losses, but also the fund’s losses if it doesn’t hold enough cash and is forced to sell assets.
Although on the flip side, it also means they would have to buy fewer equities to get back to their SAA, since they have switched out of the default option.
The third problem, that of the recently announced early access to superannuation, adds another complexity for funds that have a high number of casual workers as members.
Often these funds have a younger membership , which means they have become used to see strong cash flows coming in. If they have relied too much on these cash flows and don’t hold significant buffers, then they might have to sell other assets to come up with the cash.
These funds also tend to have higher allocations to equities, which means the fund will have to find more money to rebalance their portfolios.
The outcome of these three problems will be different for individual funds, depending largely on the makeup and behaviour of their member base. But in the short term it will be all hands on deck.
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.