Stephen Bartholomeusz
Out in the super wash
The Cooper Review of superannuation has been seen largely as focused on improving the efficiency and lowering the cost base of the $1 trillion sector. However, it could lead to more radical changes to the structure of the system.
Last week’s submission to the review from the Investment and Financial Services Association has raised a quite fundamental, and potentially highly political, question for the review. If superannuation funds are financial institutions, should they be subjected to liquidity and capital adequacy regimes analogous to those imposed on banks and other authorised deposit-taking institutions?
That question has been given particular relevance by the financial crisis, which cast a spotlight on some of the issues associated with illiquidity within funds.
It is political because IFSA’s membership is mainly ‘for profit’ funds managers, including the big retail and wholesale-platform operators. The nature of the platforms means they tend to be invested in quite liquid securities or pools of liquid securities. Their arch rivals, the industry funds, tend to have a higher proportion of unlisted and less liquid investments, like unlisted property, infrastructure and hedge fund investments.
Thus the imposition of liquidity standards on the sector would be less of a burden for IFSA’s members than for the industry funds, particularly those with aggressive unlisted investment allocations.
The crisis has highlighted the potential for something akin to a run on funds with large proportions of unlisted assets.
The ability to switch between investment options within a fund, and switch funds under the choice-of-funds regime, combined with the reality that valuations of unlisted assets significantly lag movements in markets for securitised assets, means that fund members can have a compelling reason for fleeing funds that are invested in illiquid assets. In effect, the crisis offered them, after the markets crashed, an extended window to exit at pre-crash values.
That is inequitable because it means that exiting members exacerbate the losses of value of those members who don’t switch options or funds and create a kind of reverse tontine effect.
There is considerable strategic sense in funds owning assets, like infrastructure, that deliver CPI-style returns over the long term, in line with the liability profile of most funds.
However, the inherent illiquidity of those assets in a crisis raises the question of whether there needs to be some offsetting minimum levels of liquidity within the fund to handle a rush of withdrawals or whether the funds should be able to freeze redemptions in their less liquid options in some circumstances to ensure equitable treatment of all their members.
An associated issue is whether or funds should have to offer daily unitised pricing, which minimises the risk that some members can profit at their fellow members’ expense.
Again that would be easier for IFSA members (most of whom would have unitised pricing already) than for some industry funds with significant exposures to unlisted assets that are generally valued only once a year.
Capital requirements would create a different set of issues. While perhaps useful as a buffer against investment and operational risks, they introduce their own layer of inequity – a build up of capital/reserves adversely impacts members who are exiting or will exit the fund in the near term while benefitting younger members because the earnings on the capital boost longer term returns.
If the Cooper Review were to support mandated liquidity requirements there could be beneficial side-effects.
The crisis highlighted the reliance of our banks and companies on overseas credit markets and the shallowness of the domestic market for corporate bonds and securitised credit more generally. It cast a spotlight on the vulnerability the dependence on offshore markets and investors has created.
The banks are already going to have to maintain higher levels of liquid-approved assets as a result of the regulatory response to the lessons of the crisis.
A requirement that superannuation funds with material exposures to unlisted assets also hold a proportion of their assets in government and prime-rated paper could help develop a deeper corporate bond market, might help liquidity in the still-thawing residential mortgage-backed securities market, and might also help create a new market in government-issued infrastructure bonds.
It is a pity that the various reviews of the financial and tax systems are being conducted separately rather than as an holistic inquiry.
The financial system, including the superannuation system, has held up extraordinarily well under the stress-testing provided by the financial crisis, but equally the crisis has exposed some vulnerabilities, weaknesses, and, significantly, some opportunities that might have been easier to realise if a system-wide review had been undertaken.