Tuesday 02 December 2014 by Legacy

What lessons can SMSFs gain from global pension asset allocations?

This article analyses the differences in pension asset allocations around the world.  Australians are drawn to, and over exposed to, shares, which are the highest risk assets

It discusses the differences between Australian allocations and other OECD countries and how this information can be used when assessing your own portfolio allocation.

Chart 1 below shows the pension fund asset allocation in 2013 for 29 OECD countries across four asset classes: shares, bonds (inclusive of short term “bills” (less than one year) and long term “bonds” (over one year”), cash and deposits and other.

Key findings include:

  • The average asset allocation to bonds was 52%, to shares 21%, to cash and deposits 11% and 16% to “other”.
  • The exposure to bonds varies from less than 10% in Australia to more than 65% in Denmark.
  • The exposure to shares also varies considerably, ranging from less than 10% in Korea and Japan to 46% in Australia.
  • The allocation to cash and deposits varies considerably, ranging from almost zero in several countries to 18% in Australia.

Australian superannuation

Self-Managed Super Funds (SMSFs) are uniquely Australian and allow the individual to bear the full responsibility for management of their funds.  SMSFs represent about one third of all superannuation assets. Table 1 shows the asset allocation of these funds as at June 2014, as reported by the Australian Taxation Office.

Australian pension funds have a 9% allocation to bonds (which is by far the lowest of all OECD countries) but SMSFs have even less at just 1%, showing how under-allocated they are to this asset class (although this allocation is likely to be slightly higher by virtue of bond allocations in managed funds). SMSFs also appear to have a higher allocation to cash and term deposits than the OECD pension funds.  One of the reasons for this outcome is likely to be that these members are older and possibly in the pension drawdown phase, as well as there being a lack of access to broader fixed income investments in Australia with cash and term deposits often used as a proxy for low risk, defensive asset allocations.

Also of note is the Melbourne Mercer Global Pension Index which uses a measure that estimates the proportion of pension assets invested in “growth” assets as opposed “defensive” assets (see table 2 below).  Growth investments are made with the objective of achieving a return including capital growth and income above the inflation rate.  The actual returns are related to economic performance and therefore can be more volatile. Growth assets include: shares, property and alternative assets.   Defensive assets are investments made with the objective of achieving more stable returns and include cash and fixed income (i.e. bonds).

As suggested by the data, Australia has the highest proportion invested in growth assets with 68%. Most other countries have between 40% and 60%. The obvious question to ask is whether this relatively high exposure to more volatile growth assets places an unreasonable risk on the provision of adequate and sustainable retirement incomes for Australians over the long term.

Factors affecting asset allocation in Australia

Some of the factors that may drive pension allocation to growth vs defensive assets are:

  • Some countries have a significant level of defined benefit or guaranteed pensions or annuities in payment, which mean the superannuation fund guarantees a certain lump sum or cashflow in retirement. The super fund takes the risk and thus chooses to invest in lower risk, more certain investments that enable it to match assets to liabilities. The most suitable assets for matching liabilities are bonds and other fixed income investments. By contrast, Australia has a very small number of defined benefit funds, most are “defined contribution”, where the investor takes all of the risk.
  • The relative importance of defined benefit schemes has reduced steadily in Australia over recent years so that the assets attributed now represent less than 11% (Annual Superannuation Bulletin, APRA, 2014). These features mean that the pressures to match assets with pension liabilities or to de-risk is largely absent from Australia.
  • The maturity of the pension system affects the profile of the current liabilities. Superannuation and pension systems take decades to mature so that a younger system will have very few pensions in payment and therefore require less bonds and fixed income to support such payments.  By contrast, a mature system will have a much higher proportion of the liabilities for older members and therefore a need for less volatile investments.  The Australian Superannuation Guarantee system commenced in 1992 and the mandatory contribution rate only reached 9% in 2002. This means that most of the liabilities and the associated assets relate to active employees.  However this is starting to change, as baby boomers begin to retire. The Australian SMSF statistics, as detailed in Table 1 above, are more representative of those in or nearing retirement and clearly demonstrate a very small allocation to bonds.
  • It is inevitable that most markets have a home bias in respect of their investments. An example of this outcome can be seen in the UK where major pension funds have a strong investment in index-linked government bonds due to their availability. By contrast, both the Australian index-linked and corporate bond markets are relatively small, thereby limiting the opportunity to invest in domestic fixed income.
  • There is also limited understanding and access to fixed income investments, with minimum investment amounts of $500,000 per bond for much of the Australian bond market still prevalent as recently as 2010. Practically every other OECD jurisdiction has smaller denomination amounts and a general awareness and acceptance of the importance of bonds in an overall investment portfolio.
  • Unlike many OECD countries, the Australian high yield/non-investment grade market is in its infancy and this is typically where SMSF investors are attracted.
  • The dividend imputation system increases the relative attractiveness of Australian shares to bonds. A related outcome is for investors who are seeking regular income (i.e. not capital gains). They may perceive the dividends from, for example, the four major Australian banks to be a good option, regardless of the potential for volatility and the fact that dividends can be cut or even eliminated.

What is an appropriate asset allocation based on your risk profile?

Investors typically differ in their preference for risk and return depending on their age and risk sensitivity. Generally the older and closer to retirement an investor is, the greater need for income and capital stability, and as a consequence, asset allocations should favour cash and bonds over shares.

Portfolios should be constructed or optimised to achieve the highest expected returns for given levels of overall portfolio risk depending on your circumstances. A typical example of such a range in asset allocations is provided below in table 3 and is indicative only.

Note how exposure to riskier “growth” assets such as shares increases as allowable portfolio risk increases (typically before retirement with long term investment horizons) while exposure to defensive securities increases as risk tolerance decreases and more emphasis is placed on generating income and protecting capital.

Conclusion

There is not a single asset allocation for pension/superannuation funds that is right for all members but an old rule of thumb to ‘own your age in defensive assets’ is a good starting point.  Diversification of assets should represent a fundamental feature of all investment strategies. Australian superannuation funds have a very high exposure to shares and other growth assets when compared to many other countries. As the superannuation system matures and there is a shift in funds towards retirees, and the benefits of bonds in a portfolio setting become more understood, it is likely that this exposure will gradually reduce in favour of defensive assets.

The current overall allocation, which provides a high level of exposure to volatile assets, will become less appropriate as the baby boomers retire and begin to draw down their funds. A broader range of assets, including corporate bonds and credit, is likely to provide a better long-term outcome for these investors.