Pension Funds in Australia

Saving for Retirement

Pension Funds in Australia

A Guide to the Australian Market

In this brief guide, we discuss some of the characteristics and peculiarities of the Australian pension fund industry and how this influences the way these funds invest their money.

Pension funds in Australia are referred to as superannuation funds. The term superannuation didn’t always have a positive meaning, as in the 1600s the word ‘superannuate’ meant ‘to be rendered obsolete’.

It wasn’t until the mid-1700s that it gradually took on the meaning of ‘retired on account of old age’. Originally, the word is derived from the Latin superannate, which means ‘more than a year old’ and was used for cattle.

The Origin of Australia’s Pension System

The year 1992 marks the birth of Australia’s modern pension system, which has grown to $2.7 trillion as of March 2020.

That year compulsory superannuation was introduced in Australia under a series of reforms that included the superannuation guarantee, which established mandatory contributions by employers.

Although there are still a number of defined benefit schemes in existence, most of them closed, the 1992 system is a defined contribution scheme, where the employer pays a set rate of an employee’s salary into an individual account and the member bears all of the investment risk.

The employer contribution rate has been 9.5 per cent since 1 July 2014, and was planned to increase gradually from 2021 onwards to 12 per cent in 2025. But further increases are politically sensitive and there is extensive lobbying to keep the contribution rate at the current level.

Contributions receive favourable taxation treatment and are taxed at 15 per cent, which is significantly lower than the net average tax rate of 23.6 per cent workers paid on their income in 2019. For individuals who earn more than $250,000, the contributions tax is set at 30 per cent.

Australia also maintains a means-tested age pension paid for out of general tax revenue.

Superannuation funds did exist before 1992, but they were available to less than half of the working population and had many constraints.

In the 2012 book, A Super History: How Australia’s $1 trillion superannuation industry was made, by Christine St Anne, union organiser Greg Sword narrates how many funds required workers to remain with a company for 35 to 40 years to be eligible for superannuation payments, something that wasn’t realistic even then.

His dissatisfaction with the arrangements led Sword to help establish in 1978 pension fund LUCRF, of which he became the founding Chief Executive Officer.

The seeds for the current system were sown in 1983, when the government reached a deal with trade unions on wage increases. The government would allow wages to be increased by 3 per cent, but in an effort to curb inflation, workers would not be able to spend this 3 per cent, but instead it would be paid out in the form of contributions into a superannuation fund.

Types of Funds

Australian pension funds can be divided into five groups: industry, retail, corporate, public and self-managed super funds.

Although many funds are now open to all workers, industry funds find their origins in catering to specific sections of the workforce and are usually associated with a particular union. They often have union representatives on their boards, under a system called equal representation, where half of trustee directors are appointed by employer representatives and half by member representatives. In more recent years, there have been calls for at least a third of board members to be independent.

The majority of industry funds are set up as non-profit or profit-to-members organisations, enabling them to set competitive fees. They can vary from relatively small funds in terms of assets under management to very large. AustralianSuper is the largest industry fund, as well as the largest pension fund in Australia overall, at $180 billion in assets under management.

Retail funds are commercial pension funds, largely run by banks or wealth management businesses. They often have the benefit of a large army of financial planners, which forms a source of referrals and also provides a sticky client base. Some of the key players are MLC, Colonial First State and BT Financial Group.

Source: APRA/Wikipedia 2019

Corporate funds have been on a sharp decline in Australia as companies have found it increasingly harder to compete with the larger and more sophisticated industry funds. In recent years, many companies, including mining giants BHP Billiton and Rio Tinto, have outsourced their corporate funds or disbanded them altogether.

Public sector funds are for government employees and unlike most pension funds, some employers contribute more than the 9.5 per cent minimum. For example, members of the Australian Public Service receive 15.4 per cent in superannuation contributions.

TCorp, the asset management arm of the state of New South Wales, is one of the larger institutional investors that looks after pensions of public servants. It is the product of the merger of several public organisations, including workers’ compensation schemes, and has more than $110 billion in assets under management.

Finally, self-managed super funds are small funds that can have no more than four members. They are often set up for taxation purposes or by people who have lost faith in the existing system. The average balance is around $1.5 million, but they can be as large as several tens of millions of dollars. Despite their small average size, this sector makes up 30 per cent of all pension assets in Australia.

The Top 10 Largest Superannuation Funds 2020

Top 10 Largest Superannuation Funds

Source: Super fund annual reports

Peer Risk and Asset Allocation

Many superannuation funds in Australia offer members a menu of investment options, but have to choose which one is their default option, called MySuper. Most MySuper products take the shape of a balanced fund, with an asset allocation of between 60 per cent to 75 per cent to growth assets, including equities.

A number of providers have opted to offer life-cycle options, which automatically adjust the asset allocation and have more defensive exposures as the member grows older.

Pension funds in Australia are very sensitive to peer performance and as a result many have similar asset allocation profiles. This is partly because members are able to switch their pension money between funds within 30 days, the so-called ‘Choice’ regime.

But it is also the result of the defined contribution system, where members have their own individual account and see what their investments have done that year, unlike defined benefit funds where assets are pooled and paid out according to actuarial estimates.

More recently, the local prudential regulator, the Australian Prudential Regulation Authority (APRA), has decided to publish a so-called ‘heatmap’ of domestic pension funds. This heatmap compares a fund’s asset allocation to a basket of indices to see if, and how much, a fund adds value and overlays this with investment and administrative fees.

Although it is meant to hold funds to account for both the fees they charge and the level of investment skill they possess, critics have lamented that the heatmap is just another league table, adding to the already strong peer risk as every fund wants to be in the top quarter of the map.

This peer awareness makes it harder for funds to innovate or manage risk in times of crises because, as the great economist John Maynard Keynes said, it is less dangerous “to fail conventionally than to succeed unconventionally”.

But it also ensures a high level of competitiveness between funds, especially as more funds are open to anyone, not just to workers in a particular industry.

In recent years, some funds have vowed to break with tradition and set their own agenda based on their member base. QSuper has been one of the most vocal funds to address peer risk, which has resulted in a higher allocation to fixed income than the average pension fund.
Insourcing Asset Management

Pension funds have grown rapidly since the introduction of mandatory contributions in 1992 and as they have grown, they’ve started to insource asset management functions.

This trend has been partly inspired by some of the large Canadian pension funds, but where those funds insourced the more complex and expensive asset classes of private equity and real estate, Australian funds have favoured domestic equities and fixed income as their first port of call. Local funds take the view that it makes sense to start with asset classes they understand and that are relatively easy to execute. But a 2016 poll by the Investment Innovation Institute [i3] showed the most important driver here was the available talent.

Source: Investment Innovation Institute [i3]

AustralianSuper has been particularly vocal on the benefits of insourcing, citing lower costs and better alignment of interests between the investment team and its members. But many funds also find they have a better grasp on price discovery and deal flow as they are closer to the market than under a fully outsourced model.

Unisuper is a fund that has run internal strategies for many years and has become particularly adept at exploiting short-term market dislocations. The fund’s investment team, led by John Pearce, is known for backing up its views with sizeable allocations.

Questions have been raised about whether funds would have the stomach to fire their own investment teams if performance proves lacklustre, but some funds, including pension fund for the construction and real estate industry Cbus, have addressed these concerns by appointing external advisers to track performance.

Cbus is also unique in that it fully owns a property development company, Cbus Property, which operates independently and, just like any other manager, is given a mandate to fulfil. This company has been running for more than a decade and manages more than $5 billion in investments and developments in the commercial, retail and residential sectors, while it has a further $5 billion of development work underway.

Other funds have refrained from insourcing and have opted to engage in partnerships, not unlike the model spearheaded by the Teacher Retirement System of Texas, which introduced its partnerships program in 2008, giving US$1 billion to four managers and assigning them specific research projects to conduct.

Sunsuper is a good example of a local pension fund adopting this model. It has appointed four fund management firms to run portfolios that are set the same benchmarks as the internal team. In addition, it holds an annual forum with the managers, where they share research and exchange ideas.

More recently, TCorp has also embarked on a partnership model where it seeks to have fewer relationships with managers, but makes use of the broader skill set within these firms. It also has set up partnerships with international peers, including several Canadian funds, co-investing in large infrastructure assets around the world.

Retirement

Retirement is a somewhat underdeveloped segment of the Australian pension industry. As superannuation contributions only became compulsory in 1992, the first cohort of members that have gone through the entire system have only started to retire in the past couple of years. Most existing retirement products are simply tax-adjusted versions of the accumulation products.

In recent years, super funds have started to realise the gap in their product line-up and have begun work on developing comprehensive offerings. The need to develop a retirement product is given impetus by the regulator’s push to develop, what it calls, a comprehensive income product for retirement (CIPR). After setting a framework for the minimum requirements of a default accumulation product, under the MySuper legislation, the regulator cast its eyes on a similar scheme for the retirement phase. But where accumulation products can be relatively generic in nature, since most people are at the start of their career, retirement products are far more complex as individual members will have had very different careers and life paths before they reach this phase.

Super funds, therefore, have expressed a preference for a default platform, which would allow funds to offer a multitude of solutions, including annuities, pooled survival funds and insurance-type solutions, depending on a member’s circumstances.

Yet, in its 2018 Federal Budget, the government introduced the Retirement Income Framework, which contained a retirement income covenant that requires funds to help members reach their retirement income objectives by offering a CIPR.

Superannuation laws already require trustees to formulate, review and give effect to investment, risk management and insurance strategies. The purpose of the covenant is to establish an additional obligation for trustees to formulate a retirement income strategy for their members.

However, the coronavirus pandemic has thrown a spanner in the works and the government has decided to defer the introduction of the retirement income covenant, previously scheduled to commence on 1 July 2020, until a later date.

Yet, the regulator has urged funds not to wait until legislation is finalised, but to continue the development of retirement products, as members need them now.
ESG and Local Economy

Pension funds in Australia have increasingly embraced environmental, social and corporate governance (ESG) considerations as important drivers in investment research, but they haven’t been at the forefront of this development in the way some European pension funds have been.

This can partly be explained by the make-up of the Australian economy. Mining and exploration form a large part of the domestic economy, with resources representing nearly 60 per cent of all export revenues. As such, environmental issues, such as climate change, have become highly politicised discussions, which has led pension funds to tread carefully around these topics.

There is also the discussion around fiduciary duty towards members. In Australia, the government has defined the purpose of its pension system as “to provide an adequate income to ensure all Australians achieve a comfortable standard of living in retirement, supplementing or substituting the Age Pension” in the Superannuation (Objective) Bill 2016.

With this description, the government has defined the primary objective of the pension system purely in financial terms and this has led many pension fund trustees to conclude that all other considerations, including ethical considerations, are secondary to this objective.

But some pension funds see sustainability not just as a moral discussion, but also as resulting in having better investment outcomes, especially over the long term. Joint efforts by regulators globally, under the watchful eye of the International Organization of Securities Commissions, have also caused APRA to urge pension funds to develop assessment frameworks to quantify the impact of climate change on investment portfolios.

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[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.