The presentation of the asset allocation of the Future Fund (“the Fund”) as at 30 June 2017 and its adjusted target rate of return are timely reminders of the difficulties ahead for asset managers and self-directed retirees.
Before reviewing the asset allocation, we should note that the Fund was set up in 2006 to meet the underfunded pension liabilities of retired or retiring Commonwealth public servants. The then government established the Future Fund as part of a broader strategy to improve the government’s long-term financial position. The Fund aimed to finance the largest liability on the government’s balance sheet (as at 2006). Readers may recall that in 2006, the Commonwealth had no net debt whilst the Commonwealth Defined Benefit Scheme was an actuarial assessed superannuation liability. The table below — published by the Australian Treasury in 2006 — discloses the position and outlook.
By 2006, the government had taken a number of decisions to reduce the burgeoning cost of the superannuation liability. These included closing the Parliamentary Contributory Superannuation Scheme to new members of Parliament from 9 October 2004; closing the defined benefit Public Sector Superannuation Scheme to new members from 1 July 2005; and making one-off payments totalling $5 billion to extinguish fully the government’s liabilities relating to the Telstra and Australia Post Superannuation Schemes and various state rail employees.
Shifting public service employees from defined benefit to accumulation schemes reduced the fiscal risks to the government (i.e. the taxpayer) and checked the growth of the superannuation liability arising from civilian public sector employees. The sole remaining defined benefit scheme of any significance still open to new members is the Military Superannuation and Benefits Scheme.
When reporting the Fund’s FY17 returns, the Fund’s chairman Peter Costello noted that the liabilities lay in defined benefit schemes that had been closed for 20 years, but which continued to accumulate liabilities from public servants still working under the scheme. He noted that paying out those liabilities could run until 2085 — depending on the lifespan of eligible members.
In 2006, the Commonwealth actuaries estimated the Commonwealth (i.e. taxpayers’) liability at approximately $100 billion, or 10 per cent of Australia’s 2006 GDP. Therefore something had to be done urgently to secure the servicing of these liabilities. More so because demographic research indicated that fiscal stress would be created by an ageing population that would progressively retire from the tax paying workforce from 2010.
The next chart shows the actuarial estimates of the ballooning liability as more public servants moved into retirement and were paid defined benefit pensions. We note that in 2006, it was forecast that the liability would be about $140 billion and so the target for the Fund’s size was to approximate this amount. To achieve this targeted value, the targeted return (portfolio return target) was set at an average of 5 per cent above inflation.
The good news is that the Fund has met its targets set in 2006, but the bad news is that the Commonwealth actuary underestimated the liability. Today, the 2020 liability is over $200 million and so the government has given the Fund another six years to accumulate enough capital.
Remarkably, the $60 billion actuarial error has passed by the financial and political press with no commentary or assessment. There is no “jumping up and down” by the opposition as many of them are beneficiaries of the Fund. Meanwhile, current Commonwealth defined benefit pensions will continue to be paid from the annual budget with taxpayers paying over $8 billion a year to meet this commitment. At this point, the laudable intention of the Fund — to free future budgets of the burden of making superannuation related payments — has not yet been achieved.
The Future Fund’s asset allocation
Currently, the Fund remains in a quasi "accumulation mode" with no payouts to consolidated Commonwealth revenue to be made until at least 2026. All realised returns and income are left in the Fund to compound as it seeks to match the current actuarial assessment of the unfunded pension liability. The Fund will not make any payouts for at least another eight years because (as noted above) today's asset value of $133 billion represents a significant $66 billion shortfall.
The charts above and the table below present the allocation of the $133 billion Fund as at 30 June 2017. The key features are as follows:
- Equities represent an allocation of 38.5 per cent, with the majority being global;
- Cash is at 21 per cent and is a significant asset class at this point; and
- Alternative investments, many unlisted, are a large element. These include infrastructure, timber, private equity and alternative assets.
The charts suggest that recent yearly portfolio returns have begun to decline and that the outlook is for more of the same. Given the high allocation of funds into offshore assets, the expected returns could be enhanced (or reduced) by the value of the A$. While asset allocation will not be static and will be constantly reviewed, it appears that currently the Fund’s asset advisers are not confident that they can employ significant capital in Australia and generate the targeted return of 4 per cent to 5 per cent above inflation.
The above table does not clearly present the significant offshore exposure currently held across the Fund. Intriguingly, a scan of the Fund’s website does not transparently identify the Fund’s overseas investments. However, there is a hint in the disclosed allocation to the equity asset class. Here we can observe that of the allocation to equities (value of $37 billion), about 75 per cent ($29 billion) is positioned in offshore equity markets. We suspect that across all asset classes, the Fund has less than 30 per cent committed to A$ assets. Having deduced that, we cannot determine the level of hedging undertaken by the Fund or indeed how much of the cash is in foreign currencies.
Arguably, the Fund has a calculated mismatch between the currency exposures of assets and liabilities – the latter being all A$. This suggests that the economic growth opportunity in Australia, clearly superior to much of the developed world, is not available for direct investment. This factor has been commented upon by us over many years. The “growth” investment opportunities are limited in Australia — or they are not offered at attractive values. Australia has and will continue to have too much long-term capital to invest, with too few long-term investment opportunities.
The next table shows that up to 30 June 2017, the Fund has achieved an average annualised return of 7.8 per cent which is above the new target (based on current inflation of 1.9 per cent) of 6.9 per cent. Recently the Treasurer agreed to lower the targeted return to 4 per cent to 5 per cent above inflation (average 4.5 per cent). He did this because the Fund’s asset managers and consultants advised that the outlook for asset returns was difficult with sustained and historically low interest rates taking their toll on investment returns.
What does this mean for self-directed super investors?
While the Fund has some peculiar investment issues given its size ($133 billion), we should not dismiss its views on investment returns. Indeed, we agree that investment returns are likely to remain well below 10 per cent per annum from most asset classes, with the likelihood that capital gains from revaluation are unlikely to be common. Excessively low interest rates can only move in one direction in the medium term. An upward move in interest rates will compress the revaluation of all income assets unless the income flows are indexed or related to growth (ex toll roads, etc.).
We note that the Fund is underweight property in its portfolio. In our view, this is probably caused by its immense size and flags a key issue for self-directed retirees: SMSFs have a growing advantage over large investment funds that simply cannot access attractive properties and yields that are offered in smaller sizes. For instance, a $20-million property with strong tenants is of no investment interest to a $100 billion fund. No one should doubt that there are frequently dis-economies of scale within investment markets.
We suspect that larger funds are driven more to relative returns and away from absolute returns because of their size. While we concede that the Fund has done well over the last 11 years to maintain a focus on absolute return, we believe this will become increasingly difficult as it grows by another 50 per cent in the next nine years. In time, the Fund will likely drift to index-type returns for a fair proportion of its assets.
Index investing certainly suits many large fund managers but it need not be adopted by SMSFs — which can remain nimble and access smaller but more rewarding investment opportunities. It is our view that absolute returns should remain the focus for SMSF investors in their target to meet long-term pension needs.
Outperforming indices with mark to market gains feels and looks good in the short term, but it is the compounding of real cash returns (realised gains and income) that will ultimately provide retirees with financial security and meet their investment objectives.
John Abernethy is chief investment officer at Clime Asset Management. For more detailed stock analysis and investment insights, access our Investing Report here.