Saving for retirement

Lessons from Australia to provide adequate base for living

Across Asia, government-sponsored pension funds are facing the bleak future of being unable to meet their obligations. Increased longevity ― while inherently a good indicator of economic success ― places great stress upon public pension funds, which will face mounting obligations in the decades ahead. Other demographic shifts such as small family sizes also create challenges: fewer children mean the elderly have less family resources to draw upon and the government will have a lower tax base. At the same time, growing wealth and access to a wider range of consumer goods are changing perceptions of an adequate lifestyle.

Given the unstoppable demographic trends, governments are changing legislation to encourage more efficient structures for employer based plans and defined contribution schemes. For example, the Korean government is enabling employers to jointly offer plans that can provide greater efficiencies and hence better outcomes for members.

Background: superannuation system in Australia

Superannuation is a savings vehicle with tax advantages designed to encourage people to provide for an adequate base for living in retirement. In Australia, superannuation is compulsory. A minimum 9 percent (to be increased to 12 percent) of salaries and wages are paid into a registered superannuation fund. Workers can direct their contributions to any one of hundreds of registered, public offer funds under the Choice of Fund regime. Voluntary contributions in addition to the required 9 percent rate can be made, subject to limits based on age. The superannuation industry in Australia reached AUD 1.38 trillion in March 2012, making it one of the largest retirement systems in the world.

The shift from traditional defined benefit funds to defined contribution funds began over 20 years ago in Australia. The industry has become fiercely competitive in terms of investments and features offered as well as cost. The regulatory burden has also increased over the years, with the current Stronger Super reforms presenting a new set of challenges and opportunities. The task of offering security, simplicity and service to members has never been greater. People face a daunting array of choices and Trustees face greater and more onerous responsibilities. As Korea embarks upon regulatory reform, it is illuminating to look at the Australian example to see what the future might hold for Korea and what questions employers, trustees and workers should ask as greater choice emerges in the form of defined contribution plans.

Global investment

Investors in most countries have strong biases toward domestic investments, preferring familiar companies and structures in the local market; for example, purchasing stocks in a home-grown leader or seeking the safety of GICs (guaranteed interest contracts). The same psychology drives behaviour around the world. American investors are biased toward U.S. stocks and bonds, U.K. investors have most of their fixed income invested in gilts, and Australian investors historically had a preference of investing in residential property. Sometimes the “home bias?is reinforced by regulation that limits exposure to offshore investments, especially in the case of retirement funds.

Breaking the psychology of seeking the familiar can be a critical focus in developing the required diversification and opportunity to adequately fund retirement. Many countries have lopsided investment opportunities that miss entire sectors. Australian investors focusing exclusively on Australian shares would likely be concentrated in mining-related companies such as BHP or Rio Tinto and financial services (banks and insurance companies), and would miss out entirely on sectors such as aerospace and global pharmaceuticals. An obvious risk of investing 100 percent domestically is that if the local economy hits a rough patch, the retirement fund will likely suffer commensurately, and this could be a harsh set-back for individuals nearing retirement age. Not even GICs are necessarily safe ― if Korea enters a recession, interest rates would likely decline and future re-investment rates might not be high enough to generate a sufficient nest egg for retirement.

On the other hand, investing offshore introduces other risks such as foreign exchange volatility and greater challenges in monitoring investments. Hence retirement plans should develop a process for seeking appropriate risk mitigation strategies and robust assessment of fund managers, including operational due diligence.

Criteria for selecting funds

Increased regulation and competition in countries such as Australia have resulted in greater resources devoted to selecting funds. Gone are the days of decisions being made on the basis of relationships and a glance at last year’s rate of return. Most superannuation funds in Australia use research to identify fund managers with skill in each asset class. This includes looking for a focus on a coherent philosophy and process, adequately experienced portfolio managers, good risk management systems and a sustainable business model. It is hard for individual investors to gather and analyze this information. This is why you need an expert’s advice when you choose funds. Experts such as investment consultants spend considerable time conducting onsite reviews of managers as part of its extensive quantitative, qualitative and risk analysis of investment strategies.

How much choice is too much?

Competition and choice can have pernicious effects. In the confusion of possibly hundreds of investment options on some superannuation platforms, the member may be paralysed by overwhelming choice and may make investment decisions that are not economically rational. Some of the behaviour observed in member investment choice regimes like Australia’s is for members to make no investment choice and be automatically placed in a fund’s default option, or to choose the default option not with regard to their personal circumstances but on the presumption that the default fund is effectively an investment endorsement by the employer. Investors exercising choice may imprudently concentrate their investments in single, high-risk sector; Outcomes may also suffer from an investor establishing a set-and-forget strategy that is not reviewed as their circumstances change, or at the other extreme from excessive switching based on short-term thinking.

Australia’s Member Investment Choice environment is a good example of this phenomenon. Despite choice _ or perhaps because of choice _ over 50 percent of assets (and about 80 percent of members) in superannuation funds in Australia remain in the default fund. This is interesting because in the two decades since compulsory superannuation was introduced in Australia, there have been extensive efforts by the government, superannuation industry and the media to educate the public on investments, and the Australian financial planning industry is well developed.

The Australian government is also changing the regulation of default options of retirement funds with by placing greater fiduciary on Trustees. For example, retirement schemes must ensure that members in the new default structures (known as “MySuper?will not be subsidising members in a choice option. The regulatory changes for MySuper are intended to provide better outcomes for members who do not want to make a choice. To this end, some Trustees are introducing “lifecycle?options that vary the asset allocation depending upon demographic characteristics of the member such as age, marital status, time to retirement, etc. Australian default funds typically more than 50 percent of assets allocated to shares and this may not be appropriate for a person nearing retirement and seeking to protect their accumulated savings; lifecycle options will decrease risk by holding more fixed income and cash as retirement nears.

To reduce the burden of choice for plan members, superannuation funds may offer pre-mixed options which are diversified across asset classes. In Australia, most superannuation funds have around five or six pre-mixed options ranging from 100 percent defensive assets (cash and fixed income) to 100 percent growth assets (e.g. equities).

The concentration of money in default options when hundreds of choices are offered also results in unnecessarily high overhead costs. The Aon Hewitt superannuation fund in Australia has kept its investment offering to around 30 options and is reviewing further possibilities to streamline the fund.

Education

Employees making an inappropriate choice may face anxiety and distractions on the job if they are worried about market volatility (if for example, they chose an investment option that presents greater risk than they were expecting). Similarly, employees nearing retirement may face worries if they have been overly cautious and discover belatedly that they have not accumulated enough to retire comfortably. Part of the responsibility of an employer offering a defined contribution plan is to offer website information, brochures, and workshops to assist employees in making their investment choices.

Investment education is particularly important in Korea for defined contribution retirement plans, where employees select their own investments, are relatively new to assessing investment options, and the goals for retirement saving differ from other forms of saving such as for a car or house.

Scale does matter

Australian employers have found the overhead costs, time commitment, and regulatory complexity around their superannuation obligations to be daunting. At both the employer and fund level, scale is desirable in managing the costly and complex range of tasks revolving around governance, operations, investments and member service (including employee education). This trend has underpinned the consolidation of the Australian market into fewer, larger funds: in 2004, there were 1,405 corporate superannuation funds, but by March 2012, the number had shrunk to 123.

The figures below show the Australian superannuation market by category. Corporate funds are stand-alone employer retirement plans; e.g. Qantas runs its own superannuation fund. Industry funds were developed to create scales across employers in a common industry, e.g. workers in hospitality, sugar producers, or meat packers. Public sector funds are government-sponsored funds e.g. for state employees. Small funds may be run by an individual or family for their own use. Retail funds are offered to the general public (individuals as well as companies), for example Aon Hewitt offers a retail fund in Australia.

There is concentration of accounts and assets in retail and industry funds and these are the sections of the Australian superannuation market that are competing on price, as well as features such as insurance and other benefits offered to members.

Lessons from Australia

Korean regulation has limited the consolidation of retirement pension plans until now, but it is changing due to the introduction of multi-employer plans in the new Employee Retirement Benefit Security Act effective from July 26. Sharing structures and providers across employers is expected to generate greater efficiencies, as multi-employer plans will be in a position to negotiate better terms with administrators, custodians and fund managers. This forward-looking initiative provides scope for better outcomes for people saving toward a secure retirement.

The role of investment consulting will become more important as multi-employer plans are developing. For the success of multi-employer plan, there must be an entity that can control and manage all the details about the plan’s governance and investment. Master Trusts are responsible for such tasks in the Australian superannuation system, but this structure does not exist in Korea’s retirement pension system? Retirement pension providers in Korea can provide administration, custodial services and education, but they might have some conflicts of interest regarding selection of investments and pricing arrangements. The Australian experience suggests that a third party such as an investment consultant can be beneficial in establishing an appropriate governance structure for multi-employer plans. Getting the framework right will result in greater efficiency and transparency for Koreans.