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The current coronavirus crisis has created investment governance challenges for Australia’s superannuation funds – with regard to liquidity requirements – that are relevant to any DC scheme which invests in illiquid assets. It highlights the potential impact of agency issues on decision-making during a crisis environment.

The Australian superannuation system is a fascinating case study monitored by pension experts around the world. The current coronavirus crisis has identified new challenges relevant to other countries with an interest in defined contribution (DC) pension models.

Australia’s circa A$3trillion superannuation system is predominantly DC with a reasonable level of mandatory employer contributions (9.5 per cent of income), high representation, and member choice (of fund and investment strategy).

Assets are managed institutionally (by around 200 registered superannuation entities) or can be self-managed (there are around 600,000 self-managed super funds accounting for more than 25 per cent of assets). Institutional funds vary along multiple dimensions including their financial model (profit-for member or commercially operated), membership focus (some funds focus on a specific cohort of the population such as an industry) and investment strategy, notably the degree of illiquid assets which typically ranges between 0 and 40 per cent.

Prudential regulation of superannuation largely resides with APRA (Australian Prudential Regulatory Authority) while ASIC (Australian Securities & Investments Commission) focuses on consumer protection and accordingly, the behaviour of super fund trustees.

It is important to note that much of APRA’s regulatory model for superannuation funds is principles-based rather than prescriptive. In areas such as liquidity risk management APRA is only prescriptive in saying that a super fund should have a policy which details how liquidity risk is modelled and managed. Much of the detail is left to trustee discretion, and APRA reviews each fund’s policies and assessment and provides feedback to those with weak policies.

The current crisis, a health pandemic which has triggered economic and financial market crises, provides a unique stress test of Australia’s superannuation industry.

The financial market crisis has generated stress events such as volatile and falling equity and credit markets, market liquidity challenges, and a fall in the Australian dollar. These challenges are normal and should be accommodated in stress testing and scenario analysis. The same applies to the behavioural reactions of consumers which has resulted in elevated levels of member switching out of higher risk investment options into cash. All of these issues to date largely sit within stress tests provided by the GFC (Global Financial Crisis).

Every crisis is different and can throw up new stress not considered previously. In this crisis unique issues have emanated from the nature of the health-related economic event, its impact on the economy, and the government policy response. From a plan perspective, isolation strategies resulted in a near-instant unprecedented spike in unemployment, along with a mirror image impact on super fund contributions.

This has impacted some industry sectors, like retail and hospitality, more than others. From a market’s perspective, unlisted assets, notably property and infrastructure (such as airports and toll roads), appear to have been more adversely impacted than in previous crises, with initial markdowns in the order of 7.5 to 10 per cent. And as part of an unparalleled fiscal response the government has allowed economically impacted people to withdraw up to $20,000 from their (preserved) superannuation accounts. Again, the likely impact will be greater on some population cohorts (young to middle-aged, specific industry sectors).

These new stress scenarios have provided a range of investment governance challenges for Australian super funds which are relevant to any DC scheme which invests in illiquid assets.

Much of the media focus in Australia has been on liquidity, strictly the ability to meet cash requirements as they fall due. I don’t expect any liquidity failings of this nature. Rather there are three second order, but equally important issues to focus on.

The first issue is, whether in meeting liquidity requirements, remaining portfolio quality becomes impaired. Impairment could mean many things, with some obvious examples being a portfolio which is well outside its SAA ranges, or a portfolio left with insufficient liquidity to meet a subsequent next possible round of liquidity events. Is there a point at which trustees of super funds need to freeze member redemptions because they would be creating an impaired portfolio for remaining members? The main challenge for some Australian funds will be whether they are now unacceptably overweight unlisted assets, despite recent markdowns.

The second issue relates to equitable unit pricing. Sharp market falls can create stale pricing challenges for funds with illiquid assets, which remain at a fixed valuation until the next periodic valuation. In a sharp falling market, super fund unit prices are likely overstated and vice versa. In the current crisis a number of funds took the step to conduct out-of-cycle revaluations of their illiquid assets to address this very issue. Prior to these revaluations it appears that balanced option unit prices were overstated by 2-3 per cent, with much greater misplacing for some single sector options such as property.

The final issue is the cost incurred to raise liquidity and maintain portfolio shape. The costs of providing liquidity to one member is borne by all members of a fund. The costs of raising liquidity, even in public markets, can increase significantly in a crisis environment. In Australia transaction spreads can be incorporated into unit prices, but these tend to be fixed not variable.

These issues are complex. There are no prescriptive standards. This places the onus back on super fund trustees to address these difficult questions. For instance: how do you define acceptable portfolio quality? What is a tolerable level of suspected stale pricing (‘suspected’ because one can only estimate the market movement in unlisted assets)? And when does the performance impact of providing liquidity become unreasonable? Having clear policies prior to a market crisis removes the potential impact of agency issues on decision-making during a crisis environment.

These issues also generate reflections on the regulatory model. For complex but important issues such as these, would a more prescriptive regulatory approach be merited? I think so, as it sets a baseline and removes interpretation. It would also provide the regulator with better aggregate information on these issues.

The current crisis has shone a light on some complex second-order issues for DC pension funds and the complicated investment governance challenges they face. Hopefully funds and regulators around the world take the opportunity to consider the issues and reflect on the opportunity to make their retirement systems more robust.

David Bell is executive director of the Conexus Institute

For more stories on Australian superannuation funds visit www.investmentmagazine.com.au

This lecture by professors of economics at the London Business School looks at the science, health policies, economics and macroeconomic policies related to COVID-19.

The economics of a pandemic- the case of COVID-19

ESG data provider, Fair Supply Analytics, has produced technology that maps the impact of COVID-19 on global supply chains, and can be used by investors to measure their investment portfolios exposure to the sectors and countries most effected.

Fair Supply Analytics, which can model issues related to the Sustainable Development Goals and has 30 clients using its modern slavery reporting, has remodelled its multi-regional input output table to measure supply chain disruption due to COVID-19.

Using an industrial mathematical approach, disruptions to the economy and related supply chains to a level of 10 tiers, can be measured at a global scale.

The supply chain data has been collected over the past 10 years – originally for an academic research project looking at environmental assessments – and measures about 99 per cent of global GDP.

About five billion supply chains can be modelled across 189 countries, according to chief technology officer, Arne Gerschke, with 16,000 economic sectors measured over a time series for each year tracking back to 1990.

The model reveals vulnerabilities in global supply chains and can help investors measure those exposures to potential disruptions, says executive director of the tech startup, Kim Randle.

“Using the technology, investors can analyse if they rely on certain economies to function,” she says.

There are a number of examples where there are very limited sources of raw materials, for example coltan used in the electrical components of mobile phones is only found in central Africa.

“Toothpaste has a very strange supply chain. It is manufactured in China but contains whitening pigment from South Africa. A very specific raw material, ilmenite, is used in the pigment and that is only available in Madagascar. If that country gets impacted by COVID-19 that will dry up,” Gershke says.

“Products gain value as they travel through the supply chain and each node or stop in the global supply chain is provided by people. For example turning steel into a car, it’s cheaper to pay for the parts than the final product because you need people to work on the parts. These things come to a grinding halt when an economy shuts down. We can calculate the percent of value generated in each country in the value chain, and how that percent is affected. If the supply chain shows a small contribution from a country then there’s probably an alternative supply chain. But if it is a large contribution from a particular country then there is something unique from that country and the impact could be large.”

Randle says that supply chain transparency has never been more important.

“In times of COVID-19 induced disruptions, the availability of value adds are restricted in many countries due to political measures such as lockdowns or mandatory self-isolation. As a result, essential value-added components such as skilled labour or the availability of capital are limited. This not only disrupts the economy locally, it severely impacts supply chains on a global scale,” she says. “Our new tool provides governments and corporations with the visibility they require to prudently navigate the immense disruptions resulting from COVID-19.”

As lockdowns around the world continue, stockpiles will be used up and certain goods and services will experience shortages due to disrupted supply chains. By measuring the TiVA across the entire supply chain, organisations have the exposure data that they need to begin long term contingency planning as a result of COVID-19.

The coronavirus is an unprecedented test for the United Kingdom’s eight Local Government Pension Scheme asset pools. Set up over the course of the last five years to improve governance and reduce costs across the sector, in the last month the new asset pools have had to navigate unforseseen market turmoil and ensure the resilience of their young structures, processes and relationships.

The London Collective Investment Vehicle, the pooling manager for the pension assets of London’s 32 boroughs or councils has lost around 14-15 per cent off the value of its portfolio for the month following a slight recovery, and chief executive officer Mike O’Donnell says ensuring liquidity and diversification are priorities in the months ahead.

Amid the virus fallout, O’Donnell also remains focused on key areas in CIV’s development. Namely growing assets under management and offering a broader range of investment opportunities for CIV’s client pension funds. So far CIV has £18 billion assets under management across a variety of externally managed funds, but the organisation has the potential to manage £36 billion once client funds re-allocate all their assets to the pool’s management.

“We are half-way there,” says O’Donnell. “Our focus is on increasing our assets under management and ensuring we have the right funds in place for our clients.”

CIV’s part-way progress comes despite the organisation being the first pool out of the starting blocks. CIV was established on a voluntary basis before the government made pooling among its local authority pension funds statutory in 2015.

“I have always been a strong advocate of stronger collaboration. The idea of doing this 32 times over without any collaboration or pooling is just barking. It is for these reasons and the desire for greater collaboration that London local authorities established London CIV, originally on a voluntary basis,” says O’Donnell.

However, creating the right strategic requirements for its diverse 32 London borough clients has been challenging. Although all the funds share hefty allocations to global equity, a mix of passive and active allocations and a fixed income offering, they are also distinct organizations. While other pools typically manage assets for as few as two or up to 12 different pension funds, CIV’s 32 partners makes for a complex brief. “We are significantly over the average,” says O’Donnell.

It means identifying groups of boroughs with the same strategic requirements, and not trying to create a one size fits all. Client funds are also at different stages on their pooling journey. For example, one fund has transferred 80 per cent of its assets, yet another has only transferred its passive allocations, he says.

The right funds

Key to hastening the pooling process is offering the right funds. The London boroughs decide their own strategic asset allocations from a current offering of 14 different funds across equities, multi-assets, fixed income and infrastructure. But O’Donnell says CIV still doesn’t have the full set. One area under development is sustainable investment where CIV is playing “catch up” with O’Donnell referring to a “clear message” from client funds on their climate priorities. CIV is waiting FCA approval to launch an equity exclusion fund, adding to its existing sustainable equity fund based on engagement. Elsewhere the team is in the early stages of planning a renewables fund. “It will offer exposure to standard renewables, but will also consider other potential areas such as investment in battery technologies,” he says.

In an innovative development, it is also planning an impact fund. Working with sister pools the Local Pensions Partnership (LPP) and the London Pensions Fund Authority (LPFA), CIV is planning a new impact fund called the London Fund focused on housing and infrastructure in the capital.

It’s the first time CIV has worked with another pool in an initiative driven by client funds’ enthusiasm for local impact, says O’Donnell.

“Impact investment is probably still quite niche, but we have seen some interest from pension fund committees in focusing investment in local housing and infrastructure, while still maintaining returns.” Reflecting the responsible investment push, CIV has just added a head of responsible investment to its team.

Away from sustainable investment, O’Donnell is also planning an inflation fund to add diversification – all the more pressing in current markets. “Traditional diversification hasn’t worked well recently. In times like these, everything correlates,” he says.

CIV will also look at establishing private debt and property funds, and quicker ways for its client funds to integrate ESG via passive allocations. “Our job is to have the right funds ready for our partners as they become clearer about their longer-term intentions,” he says. However, he has no plans to fill the alternatives allocation although he notes it is a gap in CIV’s offering. “Investments in, for example, hedge funds are a relatively small element of the allocation of partner funds so building out the offering is not something we have in our immediate pipeline.”

No plans to in-house

Nor does he have any plans to bring investment in house. While other pools have set up internal teams and bought management in-house, O’Donnell says London’s borough pension funds have little history of in-house management because their assets under management have been too small at around £1-1.2 billion each. Outsourcing the whole portfolio and buying in expertise and research from external experts will remain the norm. “This is our inheritance,” he says.

It’s turned the focus on other ways to cut costs in line with one of the key rationale’s behind the pooling process. Saving money was relatively easy in the beginning, says O’Donnell. “Around five or six of our funds came on a lift and shift basis whereby CIV took on existing managers and mandates. When we brought them onto our platform, we worked with those managers to negotiate fee reductions.”

However, looking ahead he notes challenges around benchmarking progress on cost saving. “Once we move beyond the original lift and shift transfer of assets from partner funds to the pool, how we demonstrate the achievement of savings can be a challenging question because there is no direct benchmark in terms of fees the individual funds have previously paid. We are planning some further work this year to benchmark the London CIV cost base so that we can continue to show that we are delivering good value for money.”

All 14 funds are single manager funds. On top of this, CIV oversees two significant passive equity mandates run by BlackRock and LGIM in allocations that count towards CIV’s pooling targets. It’s an area CIV is keen to do more. “We are trying to get an extension from the FCA to give us greater ability to be more active in supporting the management of these funds and to offer alternative models to facilitate investments by our partner funds” he says.

More choice

Elsewhere he is keen to ensure partner funds have more of a role in choosing their asset managers, working more closely with them through the selection process. He says it will require CIV being open to new managers, as well as bringing partner funds on board with new investment ideas. “There will be a number of partner funds who are interested in a mandate, but we need to make sure they are ready to invest. It requires being open and transparent and involving partner funds throughout the process.”

Once the core part of the COVID-19 crisis is behind us, leading market participants will continue to engage with the long-term imperative. Major asset owners have asserted their long-term view and the stakeholder approach seems likely to accelerate given the shape and impact of this current crisis.

In practice, especially in a time of uncertainty and disruption, we know that the “long-term” is a place that’s often easy to talk about but harder to operationalise in capital markets that can seem hooked on right now and the next quarter.

The SEC’s guidance this week recognises that forward-looking information can be hard, but is highly valued, particularly during this crisis. But what is true during this crisis is surely true the rest of the time. To understand a company’s value proposition requires a real sense of its ability to innovate and be a source of disruption (not its victim). That requires a rounded view of the forward story and an assessment of key ESG issues and mega-trends.

We think there are a few simple principles to help shape disclosure towards decision-relevant information on long-term strategy that avoids the worst examples of impression management, virtue signaling and boilerplate. CEOs and their teams can engage with these as they experiment with the emerging practice of talking in greater detail about long-term strategy to the capital markets – an imperative now more than ever.

Forward-looking for the long term

We know that corporate disclosure abounds with backward-looking information and much of the forward-looking information that corporations do provide is in-quarter or in-year (across a narrow range of financial metrics). You can’t drive a car if you can only see 10 feet in front of the windshield. Institutional investors have asked for issuers to talk about a period of at least three to five years forward across financial, operational and strategic metrics and milestones (as appropriate to the relevant sector).

Management can signal a long-term outlook by talking about the mega-trends that are going to impact the business and how management assesses the balance of risks and opportunities these present.

If you have a substantial GHG footprint, TCFD is a critical tool for reporting on your alignment with the transition to the low carbon economy – and its inclusion of scenario analysis (which well advised companies should not fear doing and disclosing).

Science-based targets will become table-stakes to receive investor support, irrespective of the federal regulatory stance. Capital allocation is also ripe for a robust forward-looking treatment, enabling companies to explain, for example, whether they have the balance sheet resilience to ride out a future crisis. As the COVID-19 period has revealed, flawed short-term thinking around capital distribution and indebtedness can imperil ostensibly successful companies. As ever, past is not prologue; investors need to be able to understand how corporations are thinking through and responding not just to current but emerging risks.

Materiality

Management can use materiality to show how it is thinking through complex current and emerging risks and prioritising such issues in strategy and capital allocation.

A key part of these disclosures are the financially material ESG issues that are the precursors of financial performance. Corporations can use the rigorous framework provided by the Sustainability Accounting Standards Board (SASB) to identify, organise, and disclose on key themes in a way relevant to investors. Corporations should also engage with materiality as a forward-looking concept; seeking to identify not just the issues that are material today, but those issues that may become material potentially impairing profitability and causing license to operate issues (think plastic waste as an issue five years ago and what it looks like today, or indeed pandemic response as zoonotic diseases become more common).

Integrated reporting

As companies get their arms around ESG issues they have to integrate them across their reporting ecosystem. Unfortunately, many companies when they are asked for ESG disclosures seem to hear CSR and start talking about citizenship awards and do-goodery; that is part of a corporation’s story, but only a fractional part.

For a start, issuers can talk about the internal processes they have put in place to oversee and monitor ESG: clear reporting lines to board and management, ESG working groups, collaborations between IRO and CSO, robust and on-going materiality assessments. Demonstrate that the core functions have at least started on the journey; investors don’t expect perfection.

Context

As with any capital markets presentation, the long-term value narrative can’t be a recitation of good news stories. A CEO may want to highlight key initiatives within the business that are aligned with societal expectations, such as the increasing use of electric vehicles. However, to avoid being dismissed as impression management, such initiatives have to be contextualised to help investors assess their significance within the business. What per cent of fleet are EVs? How will that change over time? When will the fleet be all EV? Why has the company prioritised this “green” investment over others? Absent context, such disclosures will always have credibility and usefulness issues.

The existing reporting ecosystem tends to have a relatively short-term focus. Investors are increasingly asking for a greater understanding of a corporation’s long-term value story. Corporations have an opportunity to layer a long-term outlook and a broader set of value themes into their disclosures. This is particularly urgent at a time when the social implications of corporate practices are under renewed scrutiny. This is the start of a journey that will paradigmatically change corporate disclosure over time. More companies need to get started in order to not get left behind.

For further information on these disclosure principles click here

Brian Tomlinson is director of research, Chief Executives for Corporate Purpose

In the space of three months the State of Wisconsin Investment Board has moved its portfolio from “defensive” to “offensive” as it “leans into the opportunities” presented by the coronavirus crisis. CIO and executive director David Villa, and deputy, Rochelle Klaskin spoke to Amanda White about the portfolio and how the large internal team is managing remotely.

In the space of three months, the $110 billion State of Wisconsin Investment Board has moved its portfolio from “defensive” to “offensive” as it “leans into the opportunities” presented by the coronavirus crisis.

In December last year, SWIB’s investment chief and executive director David Villa had a defensive allocation to the portfolio. Villa was worried about the outlook for returns back in October and at that time moved to a significantly underweight position in sovereign bonds in favour of cash.

“I didn’t feel that investors were being compensated for the risk that was being taken by holding different kinds of assets,” he said in an interview with Top1000funds.com. “Today’s posture is much more offensive and aggressive. In terms of fear and greed, the fear factor is very elevated and we are now being compensated.”

But while SWIB’s outlook is more offensive, the approach is still cautious.

“In terms of our budget, we’ve only spent a fraction of it, because we think that it is possible for things to get much worse,” he said. “If there was such a thing as an ‘aggressive budget’ we’ve spent maybe 20 per cent. We are leaning into the opportunities but there is so much uncertainty and volatility that to spend all of our budget things would have to get worse, and there’s a fair chance it could get much worse.”

SWIB is unusual in the fund does not have an automatic rebalancing process, rather the senior investment team votes every month on the portfolio positions. While it does have limits imposed by the board, they are pretty wide and it’s rare to bump up against them.

“At this moment we are fearless rebalancers,” Villa said. “A lot of return will come from being willing to rebalance without worrying about what might happen. We are also very liquid. Our asset allocation is built around publicly traded securities so we are extremely liquid, and there are deep derivative markets that allow us to rebalance synthetically. Fourteen years ago it would take us eight weeks to rebalance, today it takes us less than 24 hours.”

A rebalancing out of bonds into equities was completed on the last day of March, and SWIB realised the month-to-date recovery in the equity markets the week of April 6. Enhancements to the technology platforms also means the rebalancing process is more precise which also saves on transition costs.

“We don’t try to time the market, instead we focus on fundamentals and valuation, and we stick to policy,” Villa said. “We add active risk when we feel we can be compensated for it.”

Managing remotely

About half of the assets of SWIB are managed inhouse by a team of 80 staff.

“I’m really proud of the team they’ve managed to get things running almost back to normal using remote technology,” Villa said.

A few years ago the fund put in place a business continuity program and it has a cross-functional incident command team of 16 staff that sit under deputy executive director and chief administration officer, Rochelle Klaskin. The plan has been tested and enhanced as a result of two tests last year in the form of a severe snowstorm and a city-wide power outage.

“These were two opportunities to do more than just test, it was a live drill where we had to work remotely for a few days,” Villa said. “But working for a few days is very different to working from home for a very long extended period of time.”

Klaskin said a lot of work was done to prepare the team for working from home since March 12, well ahead of the state government’s instruction. This has included providing them with VPN access, getting more servers and increasing capacity. The team uses Skype for business and Microsoft team to communicate and conduct meetings.

“We are having the same meetings but creating a virtual environment for them,” she said. “Nobody was using Microsoft teams three weeks ago and now that’s the common way to interact. Communication is always important for staff, it’s the number one thing for leaders and managers. At this time when you can’t just run into people in the hallway, it’s even more important. A lot of times you get information from walking around and checking in with each other. You can still to do that remotely but you just need to do it with a lot more intention.”

Villa is pleased with the way the team is working and how the fund’s expansive and new technology infrastructure is holding up, but he’s surprised by some of the more human elements of isolation.

“The one thing unanticipated is the human isolation, everyone getting a bit antsy,” he said. “I think people are walking their dogs a little further and faster than usual. That is a bigger challenge than I thought. I’ve found that I’m reaching out to people I haven’t talked to in a while, and they are reciprocating and reaching out as well. Once or twice a day in between conference calls and reading research, I have one to two interactions with someone who it would be rare I would reach out and talk to. That’s happening on a daily basis. I suspect that’s very common behaviour.”

Impact on investment implementation

Villa said that working remotely had not impacted the implementation of the fund’s strategy “as much as you would think”.

The team can make strategic tilts “at the top of the house” and for a couple of years, the approval process for those kinds of positions has been done using a DocuSign application.

“Even when we are all in the office we use technology to capture the votes remotely,” he said. “So it’s not a big deal to be home and be collaborating and voting using the technology.”

The team is also conducting meetings for ideas and exposure management where managing directors and senior portfolio managers discuss what they are thinking about and what changes they might like to make.

“We had that meeting and had 80 investment professionals on the line,” Villa said. “The chatter was very good, people are used to sharing and were speaking up. We were already in an environment where we were collaborating in a digital environment.”

The next phase of idea generation is to replicate the fund’s widely used whiteboarding practice in a digital environment.

“In the office we have a lot of floor to ceiling whiteboards and do a lot of thinking out loud,” he said. “The next bit of functionality we will be introducing is to provide people the ability to whiteboard in a digital environment.”

SWIB asset allocation