by Rob Prugue*
One of the anthems for baby boomers is ‘American Pie’ by Don McLean. Whenever I hear this song, a song so close to my youth, a flood of memories comes back.  Surprisingly, when I was recently asked if I could sing the whole song, I realised I could barely get past the first verse.
Here is a song which I know so intimately, yet when pushed, my knowledge is mostly peripheral. Similarly for many baby boomers, what we know of ‘superannuation’ is a distant reflection of the underlying pension policy.
While Australia’s three pillars superannuation model (made up of the age pension, compulsory superannuation and voluntary savings by individuals) is admittedly recognised as a success, it would be equally wrong to assume that in its current form it has completely immunised future retirees (and tax payers) on pension funding.  Looking forward, we see some challenges looming as demographics and the condition of financial markets differ from when our superannuation system was introduced.
First, it is worthwhile to consider the history of superannuation in Australia. The introduction of compulsory superannuation in the early 1990s has long been lauded as one of the great economic reforms in Australia’s history. There is no doubt that the three pillars model has served Australia well.
However, it should be equally acknowledged that fortunate timing has played a significant role in the system’s success. The default position for most people at the system’s inception was a balanced 60% equities and 40 per cent bonds and since then there has been a tailwind of a 20-year secular bull market where most asset prices rose by CPI+++. While it was sound economic planning, history may have judged it differently if rising asset prices had not boosted many pension plans. Imagine the utterly different outcome had superannuation been introduced at the start of a 20-year deflationary trend.
Regardless, our own market conditions, let alone demographics, are completely different today than when superannuation was legislated.  Markets are more uncertain and with pending fears of asset deflation, leaving many to wonder if asset returns can continue to sustainably surpass inflation. Current asset prices appear to be ‘artificially’ inflated by record low interest rates in almost every country in the world, with many countries now showing government bond yields in negative territory.
How will asset prices respond when global interest rates eventually rise, whether that is in the next five years or ten years? Those close to retirement or in retirement could end up with a lot less to live on, while those that recently joined the superannuation system may become disillusioned as they see negative returns. In addition, the demographics have shifted, putting more strain on the system.
As a function of demographics, large numbers of people are now retiring and receiving their lump sum payment. In many cases, they are opting out of their industry award scheme and moving into an SMSF. According to APRA data, the SMSF sector is now more than 30% of the total Australian superannuation system and growing rapidly.
It should be pointed out that in an SMSF, the retiree is often the trustee, the investor and the custodian. I believe it is worth a further assessment of whether our superannuation system and the SMSF sector in particular, is suitable for the world we face today.
Consider the following:

> SMSFs have much greater leeway in the management of assets than would ever be allowed in an industry fund or retail platform.

> It is not uncommon for an SMSF to have the majority, if not all, of their assets in a term deposit, even though the income generated from this is probably not sufficient for the retiree to live off.

> Some providers are touting investments in property, fully leveraged, exposing retirees to great risk if that asset class corrects.

However, I also consider the debate around SMSF to be one of policy as well as of portfolio allocation. What if SMSFs trustees invest poorly and misallocate?  Would it be a case of Caveat Emptor (buyer beware)? What if this occurred on a large scale and losses were material to the overall pension system?
This Caveat Emptor world runs contrary to the goals of the pension system as it stands. We are aiming to reduce the government burden of retirees, but by moving to an SMSF system, I believe, we are actually putting the risk back on the taxpayer.
The experience of the global financial crisis has taught us that the bigger the debt, the more likely the true underwriter is the tax payer, as we saw in the US and Europe.  Should SMSF returns be inadequate, then it is possible that the tax payer may be forced to step in to cover the extra aged pension costs which will be incurred as a result of SMSF not earning what they could (should) have.  The larger the SMSF sector becomes, the greater the systemic risk.
‘Doomsday’ scenario outcomes may appear an unlikely proposition, but you must remember that the SMSF sector is not overseen by the prudential supervisor, APRA. The remaining two thirds of the Australian system, investing through award schemes or retail platforms, are subject to stringent prudential supervision from APRA with clear rules regarding risk management.
In my view, using super for income in retirement should be the cornerstone of the Australian superannuation system, and there are very generous tax concessions to encourage individuals to move this pension liability away from the tax payer. Yet at the same time, we are allowing SMSF infrastructure and regulation that is more suited for regular savings.
The SMSF market thrives on individuals customising pensions. For the individual that might be fine, but if the main goal is still to ‘immunise’ pension liabilities, the risk is that many SMSF may not be properly immunised.  If poor investment decisions are made in the customisation process, the individual and, in the end, the tax payer may both end up losing.
 
* Rob Prugue is the chief executive of Lazard Asset Management in the Asia Pacific region.