Australia must hedge its massive pension bet

The pension system in Australia is large - very large - relative to GDP when compared to a range of other OECD countries. Recent OECD data confirms that it also has one of the riskiest asset allocations.

With the distance to the last recession now being over 20 years, it is understandable that investors are now swimming in investment risk as they shoulder a large liability from superannuation. However, continued pension system growth, combined with some informed comment, is set to change things. Greater allocation to fixed income should eventuate as the pension system grows and matures, meaning that the Australian corporate-bond market is now set to thrive, and recent longer issuance by the AOFM should help that growth.

Source: Importance of pension funds relative to the size of the economy in selected OECD countries, 2012, p.11, OECD Pension Markets in Focus, 2013

As the total size of the pension system grows relative to GDP, the greater the possible exposure of the total economy to volatility in the valuation of the underlying asset classes. For example, a 50 per cent decline in equity pricing when a pension system is 5 per cent of annual GDP is much less of an issue than when the pension system is 100 per cent  of GDP. 

In other words, the ratio of the pension system to GDP helps standardize the relative importance of the pension system across various economies, although some variations in methodologies occur across the various economies.

Given that equity risk is the highest of all asset classes as equity holders hold the lowest position in the capital structure of companies, and equity usually ranks last or close to it in the event of bankruptcy, the allocation to equities can be used an indicator of underlying asset-allocation risk.

As the chart below shows, Australia ranks very highly in terms of the riskiness of asset allocation as it has one of the highest allocations to equities of all OECD countries. Higher-risk countries will face more volatility in the valuation of pension assets, when compared to lower risk countries, all else being equal. 

Source: Importance of pension funds relative to the size of the economy in selected OECD countries, 2012, p.19, OECD Pension Markets in Focus, 2013.

Such an allocation to equities is troublesome, as it places the Australian pension system in the high volatility category, as former finance minister Lindsay Tanner observed in The Australian back on April 4 2012, when he argued that "on any measure, your typical Australian superannuation fund is massively overweight equities."

"The thing I found troubling were responses to the very legitimate questions being raised by, in many respects, the ultimate heavyweight crew of Ken Henry, David Murray, Jeremy Cooper and Mark Johnson. All essentially saying that our super fund system is overexposed to equities," he said in an article entitled "Intervene in 'overweight' super: Tanner".

"Comments from people of this stature need to be viewed as a serious thing and should be listened to not just by super funds but by governments and by society more broadly," Tanner said."

Combining the two risks described above reveals how some of the countries in the higher risk to the economy category - say where the pension system is over 60 per cent of GDP - compare in terms of asset allocation risk.

Notice in the chart below how Australia and other Anglo economies are right toward the top of the asset-allocation risk scale. Notice also that as the size of the pension system tends to rise over 100 per cent of GDP, allocations tend to become more conservative -  although there are specific reasons for allocations in some of the larger pension systems, especially in Europe.

 Allocations become more conservative as the risks of failure in asset allocation just become too large, as the pension system overtakes total GDP in size.  

Source: Figures 3 and 8, OECD Pension Markets in Focus, 2013.

If Australian pensions grow further as a percentage of GDP, a moderation in asset-allocation risk seems inevitable - even in the face of opposition from industry players. The central bank's Ken Henry revealed that at the peak of the global financial crisis when Australia's access to world markets was frozen, he convened a meeting of funds managers to discuss what would be required to get them to take greater interest in bank term paper and corporate bonds.

"It was not a very successful meeting. I was told that equity would always outperform debt over any time period relevant to Australia's superannuation fund members," he said in an article entitled Superannuation funds are overweight on shares, warns Henry in The Australian on March 17 2012. 

If risk has to fall as the pension market grows and matures, then what asset class should be bolstered? With one of the lowest allocations to bonds in the OECD, the bond market looks set to benefit from the more conservative asset allocation that should, over time, follow a larger pension system.

Dr Stephen Nash is an author and Cambridge PhD graduate with extensive experience in fixed income markets.