According to superannuation research companies, SuperRatings and Chant West, this high exposure to the stock market has resulted in the average balanced fund returning 4.9% annually over the previous decade and 3.7% over the past five years – significantly less than a capital-guaranteed term annuity. In the past decade gains were recorded in only six years. This means that 60% of the time super investment returns were beating the cash rate, and 40% of the time capital shrunk from losses or inflation.
Partly because of this love affair with shares, the market for longevity products – such as lifetime annuities – to insure against the risk of outliving super savings is massively underdeveloped.This has been the case since 1992 when most Australian superannuation plans became defined contribution rather than defined benefit schemes. Market, inflation and longevity risk were transferred from the super industry to super members.
The upshot is that today people are buying financial products that are unlikely to provide for their retirement. It's a system that's woefully inadequate, particularly given the mandatory nature of the super savings system. The Federal Treasury's 2010 Intergenerational Report shows the proportion of Australia's population aged 65 and over are projected to almost double over the next 40 years, so it's a deficiency that clearly needs to be addressed. Otherwise, longevity risk will cause a premature exhaustion of retirement savings.
Concerns about the ageing population drove the federal government to commission several reports into Australia's A$1.3 trillion national pensions pool and the broader financial services sector. The Super System Review Panel, led by former corporate regulator Jeremy Cooper, released its final report in late June. Cooper's review into the Governance, Efficiency, Structure and Operation of Australia's Superannuation System set the scene for a major super system revamp. Commissions and kickbacks to financial advisers have been banned and big improvements are expected regarding tax and investment choices. Central to the Cooper review is the creation of a low-cost default fund for the 80% of Australian workers who remain unfocussed on the super process. A series of recommendations aim to ensure this scheme is cheaper and simpler. In addition, the government plans to increase compulsory super contributions from 9% to 12%.
Cooper slammed the way risk is identified, analysed, disclosed and managed, placing pressure on fund trustees to lift their games. Currently super fund members are making uninformed decisions about their investment options because funds are often falsely labelled. So-called "balanced" options may be 80% exposed to equities. And most super products and account-based pensions are without a risk rating of any kind.
The Australian Prudential Regulation Authority (APRA) has acknowledged these major problems, saying it's impossible to compare "balanced funds" when a fund may be conservatively invested mostly in bonds or have more than 80% of its money in shares – or anything in between.The authority has also weighed in with a promise to introduce risk-based criteria for classifying investment options such as conservative, balanced and growth funds. It has further charged trustees with clearly stating the expected frequency of negative returns over 20 years.
Moreover, the industry has been told to come up with appropriate risk levels for different investment options and to disclose a standardised measure of the uncertainty or volatility associated with the return. Such reforms have been applauded widely.
According to David Blake, director of Britain's Pensions Institute at Cass Business School, the inability to compare accounts and the lack of risk rating of super products and account-based pensions puts Australia behind the major markets. "It's like the UK 20 years ago," he says. "Not risk-rating products is extremely primitive – and risky – when international standards exist for risk grading."
In light of this, the federal government's response to the Cooper review looks like mere housekeeping when it could be fast-tracking reforms for separate post-retirement investment strategies encompassing not only market risk, but also inflation and longevity risk. After all, Australia already has the fourth highest rate of old-age poverty, according to the International Monetary Fund.
The Cooper Review has not properly dealt with the costly looming problem of longevity risk, says Michael Sherris, a professor of actuarial studies at the Australian School of Business. While the review discusses the all-of-life product market being underdeveloped and the need for industry to develop products that tackle longevity risk, it pays lip service to a critical issue for Australia's financial health."The review hasn't addressed one of the most important issues. It's an empty shell when it comes to providing a default longevity product," Sherris says. Overly focused on regulation, controls and forcing trustees to do the right thing, Cooper's review has little technical detail on developing products to mitigate longevity risk, Sherris says. "There is an assumption that their performance is not up to scratch – that they don't do the right thing by savers."
But Blake believes the Australian model falls down because – unlike the UK – there's no requirement for people to buy an annuity when they retire.
The overall management of retirement assets in Australia is poor due to inadequate risk management during the accumulation stage of super and no longevity risk hedging through annuitisation in retirement, he says."A well-functioning annuity market will become increasingly important in all countries with defined contributions schemes," he says. Blake notes the voluntary purchase of annuities in Australia is miniscule. Only 29 life annuities were sold in 2009 because people are averse to taking an annuity instead of a retirement lump sum.
In contrast, Blake points to the UK pension fund industry – the second largest in the world by value – with assets of about 20% of those held in the US. Yet the UK lifetime annuity market is much larger than in the US – about 500,000 annuities are set up each year. "UK private sector pension schemes are ahead of the world in terms of asset-liability management because of the regulatory requirements to eliminate pension fund deficits and to annuitise pension assets," Blake notes. "Government regulations prohibit companies from walking away from pension promises so they had to become much more efficient in asset-liability management and modelling. Because annuitisation is mandatory, the UK has dealt effectively with any insurance industry's biggest problem – moral hazard – that is, people tend to become careless once they have insurance. An obvious example of this is double-dipping – when people get the lump sum, spend it too quickly and then fall back on the state."
A sensible option is for the Australian government to provide lifetime annuities to get around the credit risk issue, says Sherris. It's a sentiment echoed by Blake, who also suggests the government supplies longevity bonds to help the private sector hedge aggregate risk, a risk that cannot be hedged using any existing financial instruments.The UK government used to sell annuities until 1929 but stopped when the private sector annuity providers complained that they were too cheap, he points out.
Inevitably, there are tough times ahead for the private sector. As people live longer, annuity providers need to buy correspondingly longer maturity bonds from which to make the annuity payments. But few governments issue ultra-long maturity bonds so annuity providers are forced to buy shorter maturity bonds – this means they then face rollover risk as these bonds mature. Annuity providers need to hold additional solvency capital. Deferred annuities in particular are very capital intensive. New solvency rules in the European Union are expected to reduce annuity values by as much as 10% and 20%.
The Trend in the Pool
Blake believes the insurance industry is very good at managing idiosyncratic risk – in particular the uncertainty around the length of individual lifetimes – which allows insurers to price that risk appropriately. They do this by pooling and relying on the law of large numbers to reduce the variability of this risk.Where problems are likely to arise is with aggregate risk – if everyone in the pool lives longer than anticipated. This trend risk cannot be diversified away by pooling. And, the more lives an insurer pools, the bigger the relative impact of trend risk.
Aggregate longevity risk might affect the price and availability of annuities, as well as insurance company solvency.The private sector is unable to hedge this risk effectively without a suitable aggregate hedging instrument, such as longevity bonds, Blake argues. He says if annuity markets do grow, possibly as a result of more governments forcing people to annuitise, then there will be further problems. "First, there is the danger of an unhealthy concentration of risk among a small number of insurance companies," Blake says. "Second, there is insufficient capital in the insurance/reinsurance industry to deal with all the longevity risk in private-sector pension schemes, which is estimated to be about US$23 trillion.The only realistic way of dealing with these problems, at least for accrued pension liabilities, is to pass much of the risk on to the capital markets. Again, governments could help this process by issuing longevity bonds, and earning a longevity risk premium for doing so."
Blake is far from alone in this view.The International Monetary Fund (IMF), the Organisation for Economic Cooperation and Development and the World Economic Forum have all called for governments to improve the annuities market by issuing longevity indexed bonds.The IMF noted: "With regard to longevity risk, which most insurers and pension fund managers describe as unhedgeable, some authorities have considered assuming a limited (but important) portion of longevity exposure, such as extreme longevity risk. In this way, by assuming the tail risk, governments may also increase the capacity of the pension and insurance industries to supply annuity protection to sponsor companies, pension beneficiaries and households, and facilitate the broader development of longevity risk markets."
UK to follow?
Given these comments, Blake finds it odd that the UK is about to get rid of compulsory annuitisation if the new coalition government has its way. He views that as a backward step."Some rich people want to give their pension pot to their kids forgetting the fact that the government offered very generous tax breaks on pension contributions and investment returns in order to provide security in retirement, not to increase the amount that could be inherited," he says.
Blake believes the Australian government proposal to raise pension savings from 3% to 9% – and probably to 12% – is very impressive. He suggests the UK may be using Australia as a model to some extent as it plans to switch to auto-enrolment for the first time in 2012. "Currently, there is no requirement for anyone in the UK to join a private pension scheme – if their company has one, they can join, but it's not compulsory," Blake says. "But from 2012, every worker will have to be auto-enrolled, into either their employer's scheme or into the National Employment Savings Trust (NEST).
"NEST has a very well designed default fund, which uses target date funds. Basically if people plan to retire in 2050, they join the 2050 target date fund, which has a high equity weighting until around 2040 to gain the equity risk premium. Then the fund switches gradually into bonds to avoid a catastrophic fall in the equity market just prior to retirement." In the UK, people can still opt out of super, because government "chickened out" of making it mandatory, Blake says. "It's relying on inertia to keep people in a pension scheme – it's the last stage before compulsion," he says. "If too many people contract out, then compulsion will be the only way to get people to save more for their retirements."