Over the last few weeks, two of Australia’s most respected and significant financial management leaders of recent times aired their views on superannuation (ex Treasurer Peter Costello) and inflation (ex RBA Governor Glenn Stevens).
Their respective commentaries were titled “The Uncertain Path of Superannuation Reform” (Costello) and Are we there yet?” (Stevens). Both made significant observations that Australians – particularly self-directed retirees – should reflect upon.
 

Former Federal Treasurer, Peter Costello
 
Costello reviewed the Australian superannuation system and confirmed our views that the system won’t secure the retirement for the overwhelming majority of Australians. Meanwhile Stevens noted that investors are not being adequately compensated for the risk of inflation. When combined, the disparate commentaries suggest that a poorly constructed national retirement scheme will be further tested by the current low yields returned on secure government bond investments.
In this edition of The View we will highlight the key observations of each and draw some conclusions for both investors and retirees.
In his speech to a national conference of superannuation managers, Peter Costello reviewed the short history of superannuation in Australia from its origins in September 1985 when the ALP Government negotiated the ACTU Accord Mark 2. At that time, it was agreed that a 3% wage rise should be paid, not to employees, but into superannuation on their behalf.
The Hawke Government pledged that “Before the expiration of the current parliament, the Government will legislate to establish a national safety net superannuation scheme to which employers will be required to contribute where they have failed to provide cover for their employees under an appropriate scheme.”
Originally, superannuation was to be tax free. Neither the contributions into the fund, nor the earnings of the fund, were to be taxable. The concept was that tax would be paid on pension payments or withdrawals from the pension fund. However, this logical plan, which would have supercharged superannuation assets, was scrapped in 1988 when the Government needed revenue. To quote Costello, “… So it decided to bring forward taxation receipts otherwise not payable until there were end benefits. With few lonely exceptions, Governments have been hiking superannuation taxes ever since.”
Thus thirty years ago – just after the 1987 sharemarket crash – the long-term savings and pension plan of Australia was debased for a short-term government revenue gain.
Costello noted, “In 1973 a National Superannuation Committee of Inquiry was established and in 1976 it reported and recommended a partially contributory, universal pension system with an earnings-related supplement. This was rejected by the then Fraser Government.”
On reflection, Australia’s national superannuation scheme has been created in a piecemeal fashion. It has been tampered with and cobbled together influenced by short-term political or financial needs. There has been precious little long-term vision, and the result will be that it will not meet the needs of the overwhelming majority of Australians. The chance to have a strong national scheme is being lost and there is no political will to admit its shortcomings and to fix it up.
Costello observed that history showed the concept of a national retirement scheme was driven by taxation penalties and incentives. Unfortunately the system was never built with a clear and identifiable aim, and thus an objective measure of success. Indeed the Government’s own analysis, presented by APRA and quoted by the former Treasurer in his speech, paints a disturbing picture.
According to APRA’s Annual Superannuation Bulletin, the average balance in the Age Bracket 60 to 64 (coming up to retirement) in an APRA regulated entity with more than four members as at 30 June 2016 was:-
Male              $148,257
Female          $123,690
These figures would include those who have made voluntary contributions above employer contributions; those who have only received the super guarantee (SG) payments (with no voluntary contributions) would have considerably less.
As Costello noted,“ If you were born in 1956 you could have been in the SG system since age 30 – for 30 years. This is not a system still in infancy. We are now starting to get people who have spent nearly their whole working lives in it. On average (male and female) the balance is $137, 144. Yet life expectancy for males at age 60 is 26.4 years and for females 29.1 years. The SG system will not provide anyone with average life expectancy a retirement income for life, not at a comfortable level and not at all. What the SG system will do, is supplement a person’s Age Pension.”
An interesting observation made by Costello was that the Commission of Audit, which reported in February 2014, noted that around 80% of Australians of pension age are reliant on the Age Pension. It then looked at what would happen if contributions were lifted to 12%. It found that with a 12% SG over the next 40 years, the same number – roughly 80% – would still be on the pension but that more would be on part pension.
That has led both sides of politics agreeing to increase the contribution rates to superannuation as follows:

Over the last 10 years, the fastest growing sector of the superannuation industry has been the SMSF sector. While total superannuation industry assets increased 132%, SMSF assets increased 206%. It shows that the 20% of people whom the system does support tend to control their investments and monitor their returns actively. The other 80%, in the main, simply accept whatever happens.
In reviewing our system and leading to his view that the government needs to take greater control over superannuation assets and investments, Costello looked at the Canadian Pension Plan (CPP). He noted that the CPP is very different for it is managed and invested by a Government body, the Canadian Pension Plan Investment Board (CPPIB). CPPIB currently has C$300B in investments. It has economies of scale. It is extremely active in Australia. “It would be one of the most respected investors in the world.”
In an interesting twist for a former Liberal treasurer, Costello (also the Chairman of the Future Fund) declared that he sees a far greater role for a government controlled agency to manage the super for the millions of retail investors who are seemingly not bothered about their long-term retirement needs and thus reliant on the public pension scheme.  He made some pointed comments about default super offerings by industry funds and intimated that many default offerings were constructed with no purpose, nor monitored properly by the beneficiaries.
“Let me say that I believe that, subject to safeguards, people should be able to choose who should manage their superannuation. But the reality in Australia is there is a very large cohort of people that don’t. Their money goes into so-called “default funds” that get allocated to an Industry Fund under an Industrial Award or union agreement, or to a private sector plan by an Employer. With default funds we are dealing with the money of people who make no active choice about where they want their money to go or how it should be invested.
“Instead of the Government arbitrating between Industry Funds and private funds, there is a fair argument that this compulsory payment should be allocated to a national safety net administrator – let us call it the Super Guarantee Agency – a not for profit agency, which could then either set up its own CPPIB-like Investment Board – the SGIA – or contract it out – the Future Fund Management Agency could do it.”
It is our view that “default offerings” by some large funds might not be structured in the best interests of their members. To illustrate the point, we note that recently a large industry superannuation fund suddenly decided to cease the “default offering of life insurance” to young workers. For many years, young workers under 25 years of age, many living at home with parents, had been pushed into life insurance, which they did not need. This led to the depletion of superannuation balances during the formative years that will compound into poorer returns over decades. However, ASIC never questioned this practice even though it had the appearance of a recommendation for a poor product aimed at an unsophisticated retail investor.
While Costello grappled with the likelihood that super will fail to meet the needs of many retirees, it was former RBA Governor Stevens that alerted his readership to the heightened risk of low returns for investors. He noted that returns when measured as compensation for inflation have been crunched. His commentary, presented in a paper for Ellerston Capital titled “Are we there yet?” looked at the current yield returns on bonds after first reviewing the recent history of monetary policy since the GFC. In passing, he made some interesting observations about this long economic recovery.

Former RBA Governor, Glenn Stevens
 
Importantly, Stevens noted that world growth in this recovery cycle (since the GFC) has been below historic levels. For instance the US economy took 4 years to recover its 2007 GDP level. In Europe, GDP recovery took almost 8 years. From this Stevens posed the question –
So today, a decade after the failure of Northern Rock showed how serious the crisis was becoming, and nine years after the failure of Lehman Brothers saw it erupt into a full scale financial meltdown with potentially catastrophic consequences, the question perhaps is: are we finally there? Are we, at long last, emerging from the shadow of the worst financial crisis since the 1930s? And if so, can we look forward to a resumption of more ‘normal’ times, including more normal settings of monetary policy and more normal long-term interest rates?”
In answering his question, Stevens noted that developed world growth is showing encouraging signs. US employment is good, with the unemployment rate of 4.2% the lowest since 1970 (apart from a very brief period in 2000). In Europe, he sees Germany as booming with the lowest unemployment since the Berlin Wall came down. There are also declines in unemployment in France and Spain –
The IMF upgraded its global forecasts at the spring meeting in April – the first such upgrade for a few years and seems likely to do so again at the Annual meeting this month. How likely is it that this will continue? … At one level, the synchronous nature of the expansion gives it a self-reinforcing characteristic, all other things equal. If everyone is growing now, it makes it easier for them all to keep growing, as incomes expand and create further demand, absent some force which outweighs that dynamic. Both at home and across borders, the circular flow of income, multipliers and so on work to keep an expansion going.”
However Stevens’ biggest concern is this: the economic expansion over the last 100 months (one of the longest growth cycles ever seen in the US) is both long in duration and moderate in pace. Thus far, inflation has remained low and this is unique when compared to economic expansions over the last 100 years. This low inflation cycle has meant that central banks have not been pressured to take contractionary policies (in the manner of the 1960s through to the 1990s). Indeed, to the contrary, they have been unrelentingly expansionary (“remarkably accommodative” is the phrase he uses).
While debt levels across the world are very high, it is the low interest rate cycle that is supporting that debt. It is thus hard to determine what the right or correct level of debt should be in this environment –
One problem in assessing this issue is that no one can be sure what ratio of debt to GDP or income is too high, because what is sustainable depends on interest rates, among other things………….. Of course there is the question of how borrowers will fare once rates rise – an important consideration and one which, all other things equal, will surely see central banks proceed very carefully in their tightening programs over the years ahead………Of course, this discussion begs the question of why interest rates have been so low. To be sure, central banks in major jurisdictions have been undertaking a remarkable experiment, in an effort to do something – anything – to restore growth in aggregate demand and head off deflationary forces.”
So what is causing low interest rates? Is it central banks or is it a low inflation cycle that is correctly represented in bond yields?
“It is difficult to know with any certainty, but the factors behind the very low rates matter a great deal. If the reasons for very low rates in fact owe more to deeper real or structural forces than simply central bank policies (eg global demographics, increased competition, expansion of labour forces in developing countries, technological innovations, etc), then the central banks won’t be able to raise rates very far. But if very low rates are mainly due to the central banks, then as they change course we must expect the whole profile of interest rates to rise quite a bit.”
We believe that current low interest rates across the world are the result of extreme manipulation by Central banks. The low interest rate manipulation has fed into deflation, reinforced by deflationary pressures from Chinese manufactured exports, an aging western world, low energy costs (ex Australia) and the IT revolution.

Could there be a lift in inflation that shocks the world markets?

Stevens noted “…. one of the other things that could cause a financial upset would be a noticeable lift in inflation. Not a break out as in the 1970s, but just enough of a lift to signal that the risk of inflation is something that, once again, needs to be thought about.  And  then “…..None of this is to suggest that inflation is about to return to the ‘bad old days’ of the 1970s. It is just that it is worth thinking about how much – or rather how little – compensation for the risk of inflation investors have been offered in recent years.”
So we sit in a world where it is certain that at some point interest rates will rise – either to meet inflation expectations or to move above inflation and properly compensate investors (savers) as inflation rises. The problem is to determine the length of this perverse interest rate cycle. For how long do we have to be patient and what damage will inflation do – even if it is historically low – if we do not adjust our portfolios to generate a higher yield?
In our view Stevens presents a realistic argument for investors to be patient, but how patient can a retired pensioner be if the government is forcing pension payments at a much higher rate than market interest rates on bank deposits? It appears that pension scales may need to be adjusted to ensure that pension capital is not depleted too quickly over this period.
When both Costello’s and Stevens’ commentaries are considered together the conclusion can be made that Australia’s superannuation system will suffer greatly if interest rates do not rise above inflation. Further, if inflation does return and spooks markets, then risk assets – particularly equities – will be hit hard as PERs fall.
It is clear that many superanuation trustees are chasing excessive returns by taking on excessive risk. It is also clear that many Australians are oblivous to their outlook in retirement. Surely Costello, Stevens and many other former financial leaders, free of the shackles of politics and bureaucracy, can come together to formulate a superannuation policy that will work for the majority of Australians.