Asset allocation in a low interest era
- On 27/07/2016
- asset class, retirement, superannuation
Superannuation funds face critical questions about whether their strategic asset allocations and performance targets remain appropriate for what may be an extended period of more subdued, uncertain and volatile returns in a low interest era.
Are widely used targets for balanced (default) portfolios to exceed CPI by 3% to 4% a year over rolling 10-year periods still achievable, particularly given the funds’ current asset allocations and the investment outlook? Or should funds make fundamental changes to both their asset allocations and their investment targets?
The reality is that many funds are using performance targets for their MySuper strategies that were set pre-GFC. Yet, since then, central banks have stimulated their economies through quantitative easing, creating enormous liquidity and historically-low interest rates. Consequently, the expected investment returns on asset classes and the correlation between classes have changed.
Not-so-great expectations
All real assets are now priced on the assumption that long-term yields will stay low for extended periods. Yields on infrastructure investments have reduced from above 12% to 8% in four years. Some Australian prime CBD property has sold at gross yields below 6%.
Over the past four years, leading asset consultants and other investment professionals surveyed annually by Rice Warner have significantly lowered their median expectations for annual returns over the next 10 years in each of the traditional asset classes, namely Australian and international equities, property, fixed interest and cash. The biggest reductions in long term return expectations since 2012 are, not surprisingly, in fixed interest and cash, as shown in the table.
Alternative asset classes
Our 2016 survey of asset consultant and fund manager expectations shows that alternative assets such as infrastructure, hedge funds and direct property are expected to provide higher long-term returns for a given level of volatility.
Some superannuation funds are aiming to offset lower returns from major asset classes, particularly bonds and cash, through larger exposures to alternative assets including private equity and infrastructure, and using credit as an asset class.
Further, a number of funds are working at extracting greater value from their asset allocations by using internal investment teams to manage some of their portfolios. The intention, in part, is to lower costs and therefore increase real returns.
Given the historically low interest rates, funds are in the somewhat paradoxical position of receiving a higher income from their equity investments, particularly franked Australian equities, than from their fixed interest.
A key component of relatively strong real returns of funds in the past has been their exploiting of the equity risk premium, and the illiquidity premium available on unlisted assets.
In turn, this raises the question for fund asset allocations about whether the equity risk premium still exists in a low interest era. However, the performance of investment markets since the GFC and Rice Warner’s survey of investment expectations shows the equity premium is rising.
Meeting asset allocation challenges
There are highly-practical ways for superannuation funds to meet their asset allocation challenges to keep their real returns as high as possible in a low interest era given their members’ circumstances. Many funds now:
- Better understand and segment their members with the aim of developing asset allocations appropriate to different broad categories of their memberships, their differing needs and differing tolerances to risk.
- Avoid focusing excessively on sequencing risk at the point of retirement when setting asset allocations for older members. Sequencing risk is frequently overstated in product development given retirement is a long-term exercise with retirees requiring sufficient exposure to growth assets.
- Avoid surrendering long-term performance to reduce short term volatility. The fear of paper losses in any financial year tends to reduce long term returns.
- Efficiently manage tax to reflect the tax treatment of members in the accumulation and tax-free pension phase to increase real returns.
One of the objectives of superannuation, as recognised by the Financial System Inquiry, should be to maximise returns net of fees and taxes over a member’s lifetime, including retirement. This is a vital consideration when setting asset allocations in a low interest era.
In coming weeks, INSIGHTS will be looking more closely at different factors now affecting asset allocation decisions.
Changing median return expectations (%)
Source: Rice Warner 2016 survey of asset consultants’/fund managers expected annual returns over 10 years.
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