Only way is up for Australia’s outsize pension sector

Cerulli Global Edge, November 2013

Australia’s superannuation system already represents one of the largest pension sectors in the world – dramatically bigger than its modest population would suggest. And its proportion of the world pension industry is set to increase still further.

There is one simple reason Australia punches above its weight so dramatically in the pension sector, and that is the Superannuation Guarantee. This was introduced in 1992 and required all employers to put the equivalent of a set proportion of an employee’s wage into a superannuation fund.  The SG started out at a modest 3% before being steadily increased by governments until it reached 9% in 2002. From then on it has provided a classic example of the value of compounding interest over time: no matter what else has been happening in world markets, the SG has provided a relentless flood of new assets to be invested, to grow, and then to be rejuvenated by further mandatory contributions.

On July 1, the SG started to climb for the first time in over a decade. It moved to 9.25% that day, and will steadily increase in slow increments, to 9.5% on July 1 2014, up to 10% a year later, and so on in steady but slight increases until it reaches 12% in 2019.

The Australian government has calculated that these modest increases will add around $500 billion to the existing pool of superannuation savings by 2035, and will increase national savings by 0.4% of GDP over that period. At an individual level, the government says a 30-year old earning average full-time wages will find themselves with an additional $108,000 in retirement savings. And that is off a very high base: A$1.616 trillion in June 2013, according to the Australian Prudential Regulation Authority. Deloitte has projected that the total superannuation pool could reach $6 trillion by 2037, and while other projections tend to come in rather lower, they’re all safely predicting the same direction.

An interesting question follows from this: where will all the money go?

Today, superannuation funds are largely split between four constituent groups: retail (or commercial) funds, industry funds, public sector funds and self-managed super funds. All are increasing in asset terms, particularly as developed world equity markets have started to rebound over the last year, but the longer term trend has been for a relative decline in the proportion of retail and public sector funds, and an increase in industry and self-managed funds.

While all of these groups offer diversified portfolios, there is a tendency for industry funds to put a larger proportion of their assets into alternative asset classes and (although this has dimmed slightly since the financial crisis) less liquid assets, such as infrastructure; and for self-managed super funds to show particular enthusiasm for yield-bearing products, such as hybrid listed debt securities, for example. If these groups continue to get the lion’s share of new flows, and as those flows themselves increase with the rise in the Superannuation Guarantee, then there are questions around where the securities are going to come from for them to invest in.

Wherever they go, it is increasingly clear that the superannuation system in Australia is becoming outsize relative to its domestic capital market. That A$1.616 trillion industry figure is equivalent to the entire national GDP. According to the World Bank, the market capitalization of the whole Australian share market in 2012 was $1.29 trillion (that’s US dollars, but the Australian and US dollar have flirted either side of parity for the last couple of years, although the Aussie dollar is currently weaker).  So it seems certain that more and more assets will have to be invested overseas. It also seems that the typical Australian market bias – pro-equity, less debt – will eventually have to allow for a greater love of bonds.

This has consequences for international asset managers. If Australian super funds do spend more time looking overseas, this has the potential to bring considerable opportunity, both on the debt and the equity side. There is a trend at home for Australian super funds to begin to do the simpler things with in-house teams, both for high grade bonds and for blue chip equities – but only at home. Very few super funds would feel they have the expertise to go it alone with, say, an Asia Pacific equities strategy, or European fixed income. For that, they still need external advice.

Fund managers who can bring alternative assets to Australian super funds are also likely to find a receptive audience, particularly if they do two things: provide true diversification, with limited correlation with other asset classes; and give an opportunity for relatively safety in international markets. Several super funds have been pioneers in infrastructure and private equity in particular, and it is logical for them to look further afield for the right assets.

A separate debate, which local investment bankers have chewed over to distraction, is whether the size of the Australian super fund industry must inevitably one day lead to a more developed local debt market. At the moment, only investment grade borrowers can raise funds domestically, and even then within limitations in scale and tenor; there is absolutely no high yield market here, and anyone who needs it instead has to trek to the USA, either for their public high yield markets, term loan B market or US private placements. There are signs of this improving – BBB rated issuers in Australia can now get funding away at home, and seven-year funding is becoming more commonplace – but it is still a far smaller market than the super industry would suggest. If the market does start to increase in scale and sophistication, this will also bring asset management opportunities.

Still, alongside the increases in the superannuation guarantee, another theme must be kept in mind. The huge baby boom generation of Australians who built all this wealth are starting to retire and draw it out of superannuation again. The government projects that the proportion of Australia’s population aged 65 and over will rise from 13.5% today to around 22.7% by 2050. The most recent Intergenerational Report commissioned by Australia shows that by 2050 there will be 2.7 people of working age for every Australian aged 65 years and over, compared with 5 working aged people in 2010, and 7.5 in 1970.

Demographics like this are part of the reason the government has sought to increase the superannuation guarantee now, because increasingly, just as many people will be starting to take money out of superannuation as new people are starting to put money in.

This, too, has consequences for the asset management industry.

The biggest is this. Australia has perhaps the most sophisticated pension sector in the world: it is robust, professional, and has been endlessly tweaked in order to squeeze the last drop of efficiency from it. But post-retirement, far less has been done. Groups like Challenger and Axa have long argued the need for a more deep and sophisticated annuity sector in Australia, and legislation is working its way through Australia to remove disadvantages to that sort of retirement vehicle. For many managers, this may prove to be the most important part of their business: not just helping to grow investment during an employee’s working life, but finding suitable investment strategies – and underlying assets – to keep that nest-egg in good shape once they have retired.