As investors found out during the global financial crisis and its more recent aftershocks, equities do not always rise in value and the risks of being overexposed to a falling share market are great.
In its latest Pension Markets in Focusreport, the OECD found Australia is out of step with the rest of the developed world with its asset allocation. In most OECD countries bonds – not equity – remain by far the dominant asset class.
The average 50% allocation of total assets to bonds in many European countries suggests an overall conservative stance. Countries out of step include the US, Australia, Finland and Chile, where the portfolio allocations to equities are a significant 40% to 50%.
While many European countries, such as Germany, Norway and Denmark have very high allocations to bonds – at least 45% – Australia has a small allocation of about 11%. "Australia has the mirror image of asset allocation, compared to Europe; our bond allocation is their equity allocation, and our equity allocation is their bond allocation," points out Stephen Nash, the director of strategy and market development at fixed interest broker FIIG Securities.
A direct consequence of the high asset allocation to equities in 2008 to 2010 was the ranking of Australian super funds at the bottom of the OECD pension performance table. The average annual loss over the three years of 2.8% was only marginally better than the worst performer, Estonia. Nash argues that the size of the Australian pension market relative to gross domestic product and the high allocation to equities combine to make it the riskiest pension market in the OECD.
If the pension system failed due to negative capital movements derived from high equity allocations, the Australian government would be forced to intervene and provide a public solution to a problem previously designed to be solved by the private sector, says Nash. The potential problem could be partly solved if Australian superannuation funds invested more heavily in bonds in line with global best practice, he argues. "Equity exposure is worthwhile, but investors can have too much of a good thing, and more debt is needed to balance out higher-risk equities and cushion pension portfolios against low-growth economies."
Nash attributes Australians' obsession with equities in part to the favourable tax arrangements afforded to equity investors but not debt investors. Provided the equities that have been sold are held for more than 12 months, any tax owing on the capital gain receives a 50% discount.
Income earned on cash or fixed-interest investments, including bonds, is taxed at an individual’s marginal tax rate and receives no capital gains tax discount. Investors can receive a further tax boost if the dividends paid by some companies are treated as a tax credit against tax payable on other income.
Nash says a faith among investors – including superannuation funds – that equities will always grow is also partly to blame for the high allocation to Australian equities. "It is a faith that other OECD countries have already questioned," says Nash.
Investors worried about a fund’s allocation to high-risk assets such as equities are free to change their investment choice, notes Hazel Bateman, director of the Centre for Pensions and Superannuation at the University of NSW. Although whether they realise this – or care – is another matter.
"Most Australian super fund members have member investment choice – and we know from the latest annual Australian Prudential Regulatory Authority superannuation statistics that around half of all member assets are in default options, which is generally a balanced fund," says Bateman. The balanced fund option offered by most superannuation funds typically has 60% to 80% invested in growth assets such as shares and property. "People do have the option of choosing a different portfolio allocation. Perhaps there needs to be better communication, education and information provision to fund members so that they can elect to make an investment choice, rather than rely on the default," she says.
One of the biggest arguments among financial advisers for putting people into a balanced option – often well into their retirement years – is longevity and an overall inadequacy of superannuation account balances. A person retiring at 60 could expect to live another 30 years.
Yet the latest Australian Bureau of Statistics figures show that in mid-2007, the median superannuation balance reported by Australian workers was just A$23,698. Even among workers aged 55 to 64, the median balance was just A$71,731. Men average almost twice as much as women, and public servants almost twice as much as those in the private sector.
The mean or average superannuation balance was much higher, but only because some have very large superannuation assets. Only 20% of men and 11% of women said they had A$100,000 or more in their super account.
The figures might be understated, but are consistent with other data showing that most Australians had inadequate super balances, according to Ross Clare, research director for the Association of Superannuation Funds of Australia.
"In 30 years time, they will be substantial, but the harsh reality is that most people don't have a long history of superannuation, and if you're on an average income, it takes a long period for assets to build up," he says.
While the global financial crisis reduced superannuation assets, the deepest losses were borne by those with substantial balances, while the median balance had probably risen a little after several years of high employment, suggests Clare.
Fundamentally, there are two ways to build up superannuation balances – through greater contributions or higher investment earnings. Bateman says that one reason why countries, such as Australia, could see asset allocations of older Australians invested in more risky assets is because superannuation members are not required to annuitise at retirement – and there is no mandatory retirement age. More than 50% of accumulated retirement savings are converted to an account-based pension, rather than an annuity, which provides a guaranteed income for a set period of time, Bateman states.
Account-based pensions continue to be invested in much the same way as superannuation in the accumulation phase. This gives account holders the ability to continue to benefit from any rise in the value of growth assets and live off the income generated. The flipside is it leaves them open to the risk of markets crashing.
"Where there is a one-off decision to annuitise, it makes some sense to phase out of risky assets towards safe assets close to retirement," says Bateman. "In the event of a share market crash prior to retirement, there is no opportunity to recover once you annuitise. However, with an account-based pension, you still have the opportunity to have some of your portfolio in risky assets and recover from the crash. Therefore, I am not surprised that the asset allocations of older Australians are invested in more risky assets than in countries with fixed retirement ages and annuity requirements."
When comparing retirement income arrangements internationally, Bateman observes Australia may have high weightings to risky assets, but a large and growing component of retirement incomes is based on a fully-funded arrangement in the form of the superannuation guarantee, she says. "In many OECD countries, the main component of retirement income is a pay-as-you-go public pension, which is often largely unfunded. Australian retirees may be exposed to market risk, but in many other OECD countries, retirees are exposed to political risk – that is the risk that the government does not pay benefits as promised."