Large superannuation funds are having a conversation about how they can move to offer their members a greater form of liability driven investment (LDI). Broadly LDI is an investment target that is stated and then aimed for, a target sum or a target range of money that will offer members a decent or acceptable income in retirement. The process typically involves the smoothing of returns the closer to target the member’s account balance reaches.
The journey to that destination is largely unchartered for Australian superannuation funds, but the first steps are being taken. Here is a six asset owners, Frontier Advisors and Mercer met with LDI experts Allianz Global Solutions in Melbourne to discuss to what extent superannuation could adopt a liability driven investment model.
Cbus has started sending statements to members that gave projections of their income in retirement, rather than simply state their account balance. The intention is to give members some guidance on their retirement income that allows them to make more informed decisions such as whether they need to increase their contributions or not.
Tim Ridley, investment strategy manager at Cbus, says the idea is to allowing the member to better assess whether their current investment strategy and contributions are likely to produce a suitable retirement outcome. Otherwise, he says, funds would have to make educated guesses about what they are trying to achieve for their membership.
Beyond that many are still weighing up the various approaches to take.
Daniel Craine, head of investment options at AustralianSuper, sees the choices as either putting members into cohorts, where the fund manages the assets in line with a hypothetical liability or like Cbus, providing members with as much information to allow them to make decisions by themselves.
“Is this something that you want the members to choose? Or is this something that we’re able to make a choice for the members?” says Craine.
AustralianSuper is starting from the same problem as Cbus, in that its membership does not realise what their own retirement income liability is.
“When you’ve got a very large number of members, it’s hard to know for each member what their risk profile is, what their income needs are, how long they’re expecting to work, how the age pension fits in and what other assets they may have,” says Craine.
“So it’s very hard to make assumptions about the member base as a whole in terms of what their liability might be.”
Two of the concerns for AustralianSuper are the extra cost of running a liability driven investment scheme and that LDI strategies such as glidepaths may ultimately detract from long term investment performance.
According to JP Crowley, investment consultant at Mercer, this conversation is typical, with funds trying to understand their membership base before they actually try and innovate and bring something to the market.
“Our experience with analysing members with balances as low as $100k is that even at this level, it can help them achieve quite a meaningful difference to their standard of living in retirement,” he says.
For some funds though the answer to their investigation is that liability matched investing is still a long way off.
Paul Kessell, chief investment officer of Kinetic Super, says member balances at his fund are so low that the government age pension is more significant than any liability driven investment plan they could devise. An additional factor with low average balances were many members disengaged from the notion of their balances providing a pension.
On the flip side, George Fishlock, chair of AV Super, says with only 6000 members often with high balances, his fund was able to talk to many members personally. Part of the conversation with members involves Bureau of Statistics figures showing how long people are expected to live. “That drives how much return you are required to achieve to get to the end result,” he says. “People will actually know what their liability is, how long they’ve got to live and you should be structuring the assets that they’ve got in the pension-phase around that.”
He tells how the fund’s experience of offering a DB scheme made LDI easier for DC. “It’s quite easy to translate that across to the DC component, because if it works successfully there, once you’ve got it established, it’s almost difficult to move away from it.”
For Ian Lundy, chief investment officer of the Retirement Benefits Fund, the process would happen gradually. “We can take products further than we actually have and the industry will continue to evolve,” he predicts.
One stumbling block to a full liability driven investment approach to MySuper is that the regulation does not fully allow it, points out Press. “Now that doesn’t mean that we shouldn’t think about it and talk about it, because maybe there is a way through that, but in the current structure where it’s a lump sum structure where it is not an annuitised market, where it is a choice market, where it is all the things that we all know about, then it’s absolutely a theoretical discussion,” she says.
Personal advice
The panel was in general agreement that individual advice to help members determine their liability and then implement a suitable investment strategy was the ideal approach.
The problem with this was pointed out by Danielle Press, chief executive of Equip. “The whole idea that every person is going to see a financial planner is fundamentally flawed, because there are not enough financial planners in the world,” she says.
Michael Sommers, senior consultant at Frontier Advisors, speculates that some slack could be picked up through IT driven advice channels. Along these lines he saw funds’ strategies as needing to become more personalised and envisaged communications to members that would state “you’re not the average person”.
He adds the danger for funds that did not take make progress in this direction was that they risked losing their members to self-managed super funds that did offered tailored liability driven investment advice.
For Reinhold Hafner, managing director of Allianz Global Solutions, an individual approach is the logical conclusion of liability driven investment. “If you look what happens, for example, in the US, it kicked off with plain vanilla target date funds, a pretty simple glide path, but now we are pretty much in the individual space going in that direction, because administration platforms have increasing powers and you can do much more things such as creating transparency about future incomes for example.”
To Hafner much of the debate was academic. “Funds are targeting a certain liability structure even if it is not stated,” he says. “Therefore, what I tend to prefer is to make this explicit.”
These structures might target a lump sum or a retirement income and can have the ability to switch.
“It’s better to make it transparent and have a strategy that targets something that can change. You can build in a switch option, rather than figuring out basically one day before retirement, that you targeted something that might not be what you really want to have.”
How an LDI program works
Part of the investment philosophy of LDI is explained by Hafner as follows: “It’s very beneficial for long-term investors to smooth out volatility, at least the negative part of volatility. That is much more important than achieving the highest return you might get.”
Allianz Global Investors has put downside protection in LDI programs for schemes in Europe, particularly in Germany, where the strategy is popular owing to a culture of conservatism and loss aversion.
For such schemes the asset allocation is often led by the goals of achieving a minimum retirement income for members and an expected retirement income.
He describes how this worked for one client. “We really tried to avoid having talks about what is the right asset allocation, what is a sufficient return, really just focussing on those two numbers instead.” In this case the minimum income became an imperative, with returns above this being a bonus.
“We had a very good experience with that because it turned the attention from talking about asset allocation, the best managers and the best returns to a completely different metric.”
In this case, Allianz were given access to an equity fund, a long duration bond fund and an alternative fund. Each member was given their own glide path using a different composition of these assets.
“If you define, for example, a minimum retirement income, like in a DB scheme, then you know exactly how much liability-matching assets you need at a certain point in time, the rest is in growth,” says Hafner.
An alternative means of achieving a smooth return on investment is by the use of options, though for Hafner this is too much of a drag on expected returns.
Sommer says options would have more appeal in this scenario and he also quizzed how Hafner’s approach would respond to quick market down turns which options would insure against, but dynamic asset allocation could not always protect against.
Hafner acknowledges this was the big advantage of options but it was also why they are so expensive. However, for the long term investor, the small v shapes are not really important. “What is really important is that you protect against large drawdowns,” he says. “Usually, what we do is we rebalance on a monthly basis, which turns out to be sufficient for creating that profile.”
Daniel Craine was not convinced of this strategy. “Any sort of rule based asset allocation algorithm designed to protect against downside risk will – over the course of a cycle – detract from returns. These strategies are replicating a put option and whether you are rebalancing with monthly or daily or whatever frequency, you’re still going to pay the option cost.”
Hafner replied: “Risk management does not only mean avoiding risk or hedging risk, it’s really managing risk and in its true sense can also mean if you have a good path, then you invest your additional risk capital and put it to work and get a high return to compensate for part of the hedging cost you might incur otherwise. So from our experience, we’ve been doing this work for 10 years now, is that for long term investors, you can achieve both.”
The panel had a few objections to the approach Hafner describes. A major one was the peer risk of moving to a liability driven approach which might lead to much lower returns than the average superannuation fund one year and much higher the next.
Press says: “It’s the BBQ conversation that worries me. When they sit around and you’ve got 8 per cent and everybody else has got 14 per cent, that’s probably okay, but when you’ve got zero and everyone else has got 6 per cent, that’s when it’s a real problem.”
She muses that in an ideal world members would be discussing how their income in retirement was fluctuating rather than one year returns.
The closest Equip has got to the LDI approach is to opt for greater downside protection than the average MySuper fund.
JP Crowley says this was a common approach in that funds were starting to think longevity risk and sequencing risk which in the past had not been a part of discussions. Furthermore he reveals that Mercer were seeking to add to this debate by exploring behavioural finance around what people would accept in losses.
A technical point on the purity of an LDI approach was pointed out by Lundy, who says that liabilities fluctuate too and that this was influencing his fund’s investment strategy.
He says RBF’s focus was on future risks to income goals such as spikes in inflation or changes in currency. “We don’t do a full LDI for an individual, but we certainly look at what those risk factors are that we are trying to protect the members against,” he says.
Hafner acknowledged that even in a pure defined benefit scheme, if you take into account longevity risk and other risks that cannot be hatched, it’s not wise to immunise the whole portfolio. Therefore, you need some growth assets and portfolio to match your longevity risk and other risks that cannot be hedged.
He saw it as important for retention.
“You always have to be looking over your shoulder to some extent because your members are looking around,” he says.
