Strong returns from equities market over the past decade have helped many defined benefit funds to narrow the deficit between assets and liabilities and State Super is no exception.

One half of the $35 billion fund’s portfolio is allocated to liquid growth assets, essentially equities. Consequently, liquidity risk is always front of mind for State Super chief investment officer, Gary Gabriel as the pension plan pays out more money each year in retirement benefits than it receives in contributions.

This has forced him to deal with challenges that the bulk of the industry in Australia has yet to face. In contrast to other super funds, the  investment chief runs the risk of being forced to sell assets at lower prices in a downturn so they can  still meet their obligations to their retirees.

The defined benefit fund currently has a funding gap that the New South Wales state government aims to eliminate by 2030 through a combination of modest annual contributions and investment returns.

“This objective requires a high growth investment strategy, tailored to also meet the fund’s liquidity requirements,” adds Gabriel, explaining the fund’s high allocation to equities.

State Super manages three main defined benefit schemes: State Authorities Superannuation Scheme (SASS), State Superannuation Scheme (SSS), Police Superannuation Scheme (PSS).

The funding status varies by scheme and employer, but on average, liabilities are around 69 per cent funded.

The scheme has been cash flow negative since 2004. Benefit payments are running around $5 billion annually whereas employer contributions are about half that amount. The balance is made up of investment returns which were 8.5 per cent for the year to 30 June 2019 and 2.1 per cent for the current year ended 30 September.

SASS is a lump sum hybrid scheme, where members receive a benefit on retirement comprising a multiple of their final salaries, plus their contributions (including investment returns), as a single lump sum. In contrast, SSS and PSS schemes provide members who retire, with a pension for life, calculated also on their final salaries.

In addition to the defined benefit scheme, State Super has a contribution fund which takes total assets to $43 billion.

Gabriel, who has been in the top investment job since February, says liquidity management is fundamental to understanding the fund’s liabilities and the cash flow requirements. Pricing liquidity risk is a big part of his role.

“An unplanned need for liquidity definitely means you are probably not going to realise the best price for the assets or securities and even worse you might have to sell into a falling market,” he says. And, a shock to the system means a sustained loss of capital because the net negative cash flow effectively means you have a diminished ability to recover – we can tolerate volatility but a sustained fall is a concern.”

The other trade-off is where the fund has unplanned liquidity requirements and needs to start drawing into the less liquid parts of the portfolio. Direct liquidation costs are high, he went on to say, but there can be even higher indirect costs as well, such as having to sell into an unfavourable market or not maximising the sale price for the specific asset. “So, there is like a beta and an alpha element to that cost,” he said.

Tactical opportunities

Gabriel, who was previously general manager, portfolio strategy and risk at HESTA, hasn’t made many changes to the portfolio aside from an “extra element” of weather proofing.

He sees few opportunities. “We are not seeing any screaming buys,’ he says. “I don’t think this is an environment where at an asset class level there is either the opportunity or the risk appetite to take meaningfully large active asset allocation positions.”

Just like his peers, he has to work harder to find that extra basis point of value. “You have to question every part of the portfolio and dig deeper into the markets, even though the potential reward for additional risk is relatively modest in the current environment.” Gabriel sees an increasing unclear environment ahead.  Like his counterparts, the investment chief also looks beyond the ongoing strong monetary support for markets and mildly positive economic data to a time when the effects of further policy decisions might have less effect.

Diversification remains key to managing risk in the market – that and continually stress testing the portfolio for any fundamental changes that could move capital markets. “We are careful to plan our liquidity so that it’s a well-managed risk rather than something that can have a very damaging impact.”

State Super has robust hedges against unexpected change. “We have a tail risk hedging program we use on a consistent basis with an allocated budget to spend on risk protection across the portfolio so as to avoid deep draw downs on the portfolio. We simply do not have strong positive cashflow to buy the dip and help recover.”

Additionally, the fund’s policy has a number of clear liquidity requirements beyond just the liquid defensive, or fixed income, allocation of 13 per cent.

The fund currently has 36 per cent allocated to alternatives. About 14 per cent is invested in bank loans, high yield, emerging market debt and absolute returns strategies. The balance is in unlisted real assets and other private markets.

While Europe, UK, and the US are probably the primary areas for higher-yielding illiquid private assets, the portfolio has a “meaningful exposure” to emerging markets as a further source of diversification. “There is still more opportunity in those geographies in the longer term,” he said.

The fund also has about 20 per cent exposure to foreign currency again as a risk management tool as well as a diversifier.

Elizabeth Fry has been a financial journalist for more than 25 years and has written for a number of publications, including CFO, The Financial Times and The Australian Financial Review.
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