Australian superannuation funds are now required to disclose a measurement of risk to fund members, with trustees encouraged to use a standardised measurement backed by regulators and industry peak bodies.

The Standard Risk Measure will provide a rating of a fund’s investment option based on the likely number of negative returns this option is predicted to experience over a 20-year period.

The push to require funds to disclose the risk profile of their investment options comes as part of sweeping reforms to Australia’s superannuation system, which include bolstering the governance standards of funds to bring them in line with the banking and insurance industries.

 

World leader?

Two industry organisations, the Association of Superannuation Funds of Australia (ASFA) and the Financial Services Council (FSC) released a standard risk measurement that will be included in funds’ product-disclosure statements.

ASFA claims no other jurisdiction in the world requires funds to disclose a measurement of risk to superannuation members, boasting Australia is leading the world in this type of risk disclosure.

The standard risk measurement was formulated after regulators demanded the industry improve the way it discloses risk to members of Australia’s $1.3-trillion superannuation-fund industry.

The government has agreed to lift the superannuation guarantee from 9 per cent to 12 per cent, but has instigated a series of tough new reforms for the industry.

The increased compulsory contributions are predicted to treble the size of the industry, bringing total assets to more than $3.2 trillion by 2035.

 

The power of comparison

ASFA says the purpose of the risk measurement will be to provide fund members with a way of comparing investment options both within a fund and across other superannuation funds.

Super funds can use another risk measurement, but must explain to regulators why they have chosen to not adopt the industry standard.

In a statement, ASFA says the move to an industry standard for risk measurement was an important indication to government and regulators that the industry could self-regulate.

“While we know the measure is not perfect, it is an improvement on a complete absence of such information,” ASFA stated.

The standard risk measurement divides investment options into seven risk bands, from very low to very high.

If an investment option is forecast to have six or more negative annual returns over any 20-year period, it falls into the highest band. At the other end of the scale, an investment option predicted to have negative annual returns 0.5 times over the same time period would fall into the lowest band.

For an investment option to be labelled conservative, it must only experience a negative annual return less than twice in a 20-year period.

 

Conservative bias preferred

The standardised risk measurement is only one component of risk management, with funds required to disclose to regulators risk-management plans.

These should include consideration of the potential size of negative returns and the chance that while returns may be positive, they may be less than what is required to meet the objectives of fund members.

Funds should also consider what risks are associated with a particular investment strategy, such as market, hedging and liquidity risk.

In outlining the methodology for calculating the risk measurement, ASFA warns that underlying assumptions should be structured to reflect a conservative bias. Trustees are permitted to use alpha assumptions but they should also be conservative.

“Trustees should be cautious of using any assumptions that materially reduce the expectation of negative returns,” ASFA and the FSC advise in a guidance paper for trustees.

A retirement solution that focuses on outcomes and is customised for each participant cannot be met by existing defined-contribution designs, according to Nobel Prize-winning economist, Robert Merton, who advocates a “next-generation DC solution”.

Merton, who is the Massachusetts Institute of Technology Sloan School of Management’s distinguished professor of finance and resident scientist at Dimensional Fund Advisors, says the criteria for a good retirement solution are not met by traditional defined benefit (DB) or defined-contribution (DC) plans.

He says DB plans have their own problems, and are unsustainable because accounting standards and actuarial principles underestimate their cost, while DC plans are not designed to provide core retirement benefits.

Specifically, existing DC plans are not integrated with other retirement assets, require members to make complex financial decisions and focus on the wrong goal – wealth instead of income.

“Income and wealth goals are not the same. If you look at a real annuity in dollar terms it looks very volatile, but the income is guaranteed. If you measure a real annuity in annuity or income terms, then it’s a plotted flat line. It’s the difference between communicating in income and wealth, or dollar, terms. All we’re doing is changing the units. It’s the same as reporting to a client in their currency. This is just a different currency, the annuity units, and you customise for each individual because each has their own risk profile. Under the hood, the whole thing is a laser focus on the goal.”

Merton says a next generation solution should offer robust, scalable low-cost investment strategies, focus on income, not portfolio value or return, and manage the risk of not achieving this.

“The risk to be managed is the risk that the ultimate income goal will not be realised,” he says.

Resources squandered

Merton, whose Nobel Prize in 1997 recognised a new method to determine the value of derivatives, says financial innovation and engineering is required to solve the global problem of funding retirement and produce this next generation of retirement solutions.

This will require giving up the idea of DC funds aiming for a return of ‘something more’ above a certain target.

“All the resources that are dedicated to that will take away from reaching the goal. You can exchange that for a better chance of success,” he says. “This is not window dressing; it’s very different to the standard way things are done. A dynamic-portfolio strategy cuts out the excess upside possibilities to improve the chances of achieving the desired income target.”

This next-generation DC solution needs to integrate all sources of retirement saving into a tailored dynamic-portfolio strategy based on age, salary, gender, plan accumulation and other retirement-dedicated assets.

It also need to be effective for the member who is not engaged, while providing meaningful information and choices for those who do engage, and allow trustees to control their costs and eliminate balance-sheet risk.

“Engagement is only useful if it helps you get to the goal; we’re not in the entertainment business,” he says. “There is a tendency to clutter in the industry.”

Innovate to be individual

Merton, who among other things was a co-founder of Long Term Capital Management, says these solutions have to be customised for every individual – to be individually managed accounts.

By way of example, he says if person one has 90 per cent of their retirement income in future contributions, and person two has 90 per cent in super and 10 per cent in the contributions of the future, the effect of a downturn will be dramatically different in terms of their overall retirement income.

“If, for example, both of them had 100 per cent of their pension assets in equities, in August 2008 equities were 40 per cent down, person one would only have a 4-per-cent loss on their total retirement assets, but for person two, it would be a 36-per-cent loss,” he says. “You must know the individual information. It’s an important innovation to be individual and not to pool.”

He demonstrates the difference between a managed DC plan and a typical fund allocation of 70 per cent growth and 30 per cent defensive.

The first point is that the managed DC plan allows for an individual’s particular circumstances and the range of fixed-income allocation over time will depend on those circumstances.

Taking one person who is 25 years old and doing Monte Carlo simulations against market conditions throughout a lifecycle produces a range of allocations.

“At, say, age 37 the optimal allocation can range from under 18 per cent to nearly 100 per cent in fixed income, depending on what happens to them and where they are on reaching their goal,” he says.

According to Merton, a “glide path” based on the average of those ranges could be very far from what’s best for the individual depending on what happened to them or is right for their circumstances.

http://www.nobelprize.org/nobel_prizes/economics/laureates/1997/merton-autobio.html/

 

 

 

Reaching-for-yield — the propensity to buy riskier assets in order to achieve higher yields — is believed to be an important factor contributing to the credit cycle.

This Harvard Business School finance working paper analyses this phenomenon in the corporate bond market.

The paper’s authors Bo Becker and Victoria Ivashina show evidence for reaching for yield among insurance companies, the largest institutional holders of corporate bonds.

Insurance companies have capital requirements tied to the credit ratings of their investments.

Conditional on ratings, insurance portfolios are systematically biased toward higher yield, higher CDS bonds.

This behavior appears to be related to the business cycle, being most pronounced during economic expansions.

It is also more pronounced for the insurance firms for which regulatory capital requirements are more binding.

The results hold both at issuance and for trading in the secondary market and are robust to a series of bond and issuer controls, including issuer fixed effects as well as liquidity and duration.

Comparison of the ex-post performance of bonds acquired by insurance companies does not show outperformance, but higher volatility of realized returns.

To read Reaching for Yield in the Bond Market click here

 

 

Encouraging the widespread corporate adoption of a majority-voting standard, promoting diversity on boards and collaborating to improve the way funds report environmental performance are just some of the focuses of the CalSTRS corporate governance team.

Anne Sheehan, CalSTRS’ director of corporate governance, talked exclusively with top1000funds.com about what the key issues are for the self-described “activist investor”.

Sheehan’s team is fresh off the success of its program to encourage more small companies in the Russell 2000 stock market index to adopt a majority-voting standard.

It is a program they plan to continue rolling out in the coming years.

The majority-voting standard requires that a sitting board member receive a majority of the shareholder votes cast in order to continue serving as their representative.

CalSTRS reports that it engaged 95 companies to adopt the standard in the 2012 proxy season. Of these companies, 82 adopted a majority-voting standard.

Sheehan explains that the fund decided to move beyond the typical large-cap companies that make up the S&P 500 to the plethora of smaller companies.

Less than 10 per cent of companies in the S&P 500 index still maintain a strict plurality standard, by which a nominee can be elected with a single affirmative vote.

More than two-thirds of companies in the Russell 2000 maintain a plurality vote standard.

 

Small cap shift
CalSTRS argues alignment of interest is greater between boards of directors and shareholders when elected under a majority, rather than a plurality, vote standard.

“A couple of our colleagues at other public funds were focusing on those remaining S&P companies so we thought, all right, let’s go to the next tier down, where majority voting is not as prevalent as it is in some of these bigger companies,” Sheehan explains.

The fund decided on which companies to target its engagement efforts by looking at where it had the most influence, both in terms of the size of its holdings as a percentage of total shares outstanding and their total dollar size.

The same screening methodology will be used for its next tranche of companies, with letters set to go out to another 100 companies next week, Sheehan says.

“We will march our way down the Russell 2000,” she says.

A spokesperson for the fund says CalSTRS has approximately  92.5 per cent of its US equity market investments in companies in the Russell 1000 index and 7.5 per cent in companies in the Russell 2000.  With CalSTRS having about $55 billion invested in US equities, this translates to a roughly $4 billion exposure to companies in the Russell 2000.

 

First-time engagement
More than a third of the 95 Russell 2000 companies contacted in the 2012 proxy season adopted majority voting without a proposal being filed.

Sheehan explains that for many companies it is the first time they have had direct engagement with a large active owner like CalSTRS.

“Many of these companies have never received a shareholder proposal, some may have not have heard from a big institutional investor like us, an activist fund,” she says.

“They may have a fund that is a large institutional investor, but it may be a fund that has a different focus.”

As part of its majority voting engagement this proxy season, CalSTRS submitted 61 proposals related to majority voting on corporate boards, with 48 withdrawn after the companies made significant progress towards implementing a majority voting standard.

Of the remaining 13 proposals, nine were passed with more than 75-per-cent average shareholder support, CalSTRS reports.

“If you put this stuff on the proxy, the shareholders are going to support it,” she says.

 

A say on pay
Reflecting on the recent voting season, Sheehan says that the fund is seeing a lot more focus on the directors of companies, with their election no longer the rubber stamp it once was.

“I see much more focus on director votes over the past couple of years than we have in the past,” she says. “I think directors are beginning to understand that they are getting much more of the focus and attention.”

Sheehan observes that companies have become much more responsive to investors, especially in dealing with compensation issues.

The new Say on Pay regulations are one reason Sheehan cites, with companies keen to avoid a failed vote.

CalSTRS sent letters to about 120 companies whose shareholders voted no on compensation and received a 100-per-cent response.

“We have a lot of discussion with companies, including board and compensation-committee members, about their compensation structure. So I have to compliment the companies on being responsive to that because they believe that a failed say-on-pay vote, or even poor showing on their compensation, does not bode well for them in the future.”

“We have seen changes – more can be done – but acknowledgement is the first step.”

Sheehan says that the focus on compensation has generally moved beyond the typical perks and gross-ups that used to be what she describes as “shareholder irritants” to honing in on aligning pay with long-term performance.

 

Duelling with dual-class shares
Corporate board members are also having to turn their minds to who is sitting next to them, with investors such as CalSTRS pushing for more diversity on boards.

In keeping with a broader strategy of collaboration, CalSTRS has teamed up with fellow giant Californian public pension, CalPERS, to take on a leadership role in pushing for greater diversity.

This involved the launch of the 3D database of pre-approved board candidates that emphasises people with fresh ideas and new perspectives. 3D stands for Diverse Director DataSource.

The database project is conducted in partnership with GMI Ratings – an independent provider of global corporate-governance ratings and research – and is, according to the funds, an attempt to provide a market-based solution to the supply and demand issues concerning suitable board candidates.

Sheehan says that as the fund starts to evaluate its most recent proxy-voting season and turn its mind to its strategy leading up to the round of voting next year, the key concerns of majority voting, diversity and the performance of corporations on environmental and sustainability factors remain a priority.

After vocal opposition to News Corp’s dual shareholding, Sheehan says the question of equal shareholder rights for all owners in a company also remains a concern.

The fund has observed that tech companies in particular are favouring dual-class shares, and Sheehan says that has spurred the fund into action.

“We have a concern with dual-class shares, where not all the voting rights are equalised. Some of the companies in Silicon Valley have gone down that path and it is a concern to us,” she says.

“Media and tech companies seem to like this strategy and we continue to have discussions around that because we do believe that in the long run, the market does discount that [dual-class share structures].”

Florida’s State Board of Administration (SBA) has appointed Mercer to conduct a broad-ranging review of staff compensation that was initiated and will be overseen by the organisation’s independent investment advisory council.

As part of this review, the investment advisory council (IAC) passed a motion at its recent quarterly meeting to provide annual recommendations to trustees on the executive compensation of about 15 top investment staff.

This includes the heads of various asset classes, as well as Ash Williams, the former hedge-fund executive who holds the powerful dual roles of executive director and chief investment officer at the SBA.

Williams, who advised the council at its meeting last week, voiced his objection to recent moves by some public pension funds in the US to cut back bonuses when funds lost money during market downturns.

 

What Williams said
CalPERS is one such fund that provides discretion to trustees to reduce or eliminate investment-staff performance pay in years of negative performance.

This process came about through a similar review of staff compensation also conducted by Mercer.

Responding to questions from the council, Williams noted that to retain staff it was vital that any bonus structure was maintained, regardless of whether the fund lost money in absolute terms.

“The broad history of compensation at public pension funds, more in the US than anywhere else, has been, unfortunately, one where when times are tough and markets are down, for example, [incentive] programs may be abridged,” he said.

“The argument is that – notwithstanding that your relative performance may be statistically and demonstratively excellent and that you added value by protecting capital in an adverse market – if the absolute return was flat or negative, then there have been situations in other jurisdictions where public funds’ leadership has chosen to simply abridge whatever the agreement has been with the affected employees.”

Williams noted that the IAC would be limited to recommending executive pay, with the final decision resting with trustees.

“I think what we would need to do here is create something with enough institutional dignity and have the communication process be thorough enough on the front end of this so that it is understood in order for this to be a credible and effective program at recruiting and retaining the talent you want. But it has to be honoured, however, at the end of the day the trustees can do what they want.”

Williams has been a long-time advocate for increased pay levels for staff at the SBA, the organisation that as of the end of last year ran more than $149 billion in assets over 30 funds.

His pay packet is reported to be $325,000 a year, with the capacity to earn an additional 8 per cent of this salary – or $26,000 – as a performance bonus.

Williams complained to the council that his pay was one of the reasons why he left the fund after a six-year stint in the early 1990s.

“In the six years I was here in the 1990s, I had one raise and, to be honest with you, that was one of the reasons why I wasn’t here for 12 years,” he told the committee.

Williams says the current arrangements in which the trustees decide on pay of executive staff put them in a “tough spot”.

The pay of executives at the SBA has been the focus of politicians in the state’s legislature, which has been particularly vocal during periods when the funds managed have lost money.

The State Board of Administration’s most recent operating budget reported that the fund spent about $18.3 million on staff salaries and benefits.

 

Managing potential conflicts
The Mercer review will examine the compensation of about 100 staff.

The consultancy will look at comparative pay rates in similar public and private sector organisations as well as whether pay and incentives align with the objectives of the SBA and its stakeholders.

Members of the IAC stressed the need for the 9-person council to take an active oversight role in the review, noting that it should be at arm’s length from staff.

Mercer already acts as a consultant on manager selection and oversight in public markets for the SBA and also recently conducted a review of the effectiveness of the fund’s foreign-exchange-trading processes

While Mercer has conducted similar compensation reviews at the Georgia Division of Investment Services and CalPERS, IAC chair David Grain said the council was looking for a tailored outcome.

“I don’t think one size fits all, the fact that they were successful and had good references from CalPERS and Georgia doesn’t mean that we want the same product that was produced for them,” Grain said.

“Ours is going to end up being unique in my view.”

In its review of compensation at CalPERS, Mercer recommended a simplified system of incentives for investment staff that would increase transparency.

The SBA reports that it last updated its pay grades and ranges in 2006. In 2009, the SBA engaged consultancy McLagan Partners to conduct a review of salary and compensation levels across the organisation.

The New York-based consultant found that the average salary of SBA investment staff was 40 per cent below that of staff at other comparable state pension funds.

In a request-for-quote document sent to potential candidates for the compensation review, the SBA details that “a modest incentive program for certain investment staff has been in place for much of the last decade, but payouts under the program have not been budgeted for several years”.