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Does Private Equity have a role in superannuation portfolios?

By Dr Kar Mei Tang, the Australian Private Equity and Venture Capital Association

Abstract

This paper looks at whether private equity (PE) has a role to play in meeting retirement savings

needs. In theory, the PE asset class seems well-suited to superannuation investment given its long-

term profile and high returns targets, and can offer diversification to more liquid or volatile asset

classes. This paper looks at the historical evolution of pension allocations to equity, and the empirical

evidence on PE investments in pension funds. The Australian experience is discussed, particularly in

the context of the challenges posed by this asset class in modern superannuation portfolios.

Introduction

This paper looks at whether private equity (PE) has a role to play in meeting retirement savings

needs. In theory, the PE asset class seems well-suited to superannuation investment. PE funds

typically have a ten-year lifespan, and target higher returns than public equity markets by investing

in unlisted companies with strong growth or turnaround potential. The reasoning is that tapping the

much larger pool of investment opportunities in the unlisted market should result in higher risk-

adjusted returns that outperform comparable public market investments over the long term.

Pension allocations to private equity

Investors in PE funds are called Limited Partners (LPs) because, much like shareholders in a

corporation, they are only liable on any debts incurred by the funds to the extent of their

investment.

LPs are mainly pension funds, endowment funds, family offices, and sovereign wealth funds. In the

US, the earliest recorded instance of a public pension investment in PE was in 1981, when the

Oregon state pension fund invested alongside Kohlberg Kravis Roberts & Company to buy the

retailing business Fred Meyer.1

Because PE has traditionally been a high-performing asset class, and because pension funds need to

generate excess returns above the market benchmark in order to meet their members' retirement

funding needs, many pension funds globally have steadily increased their allocations to the asset

class over time. In addition, the high volatility and losses experienced by many pension funds with

high levels of exposure to the listed equity and bond markets during the global financial crisis of

2007-08 saw many pension plans in the US looking at suitable alternative asset classes, to further

diversify and enhance returns to their members.

1 Davidoff, S.M., "Wall St.'s odd couple and their quest to unlock riches", The New York Times, 13 Dec 2011.

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The US GAO reports that 92% of large US defined benefit plans were invested in PE as of 2010. The

average PE allocation of US state pension plans more than doubled from 3.9% in 2001 to 8.2% of

assets in 2011 (Wilshire Consulting, 2012). Allocations were even larger among the biggest pension

funds (those with assets over US$5b), with an average target allocation of 9.7%. The figures are

similar in the UK, and only slightly lower in continental Europe (Figure 1).

In Australia, the typical allocations to PE are much lower. Domestic super funds are estimated to

have $17.6b allocated to PE, constituting only 1.2% of total superannuation assets.2 Of this, $9.3b

(i.e. around half of total allocations to PE) of super monies are committed to domestic PE fund

managers.3

Of the super funds that do invest in PE, we examine 43 super funds ranging from $318m to $52b in

assets under management, for which data is available from Preqin. The average allocation to PE is

5.6% of assets under management. However, this is highly skewed by a single fund with an unusually

large PE allocation. Excluding this outlier brings the average (median) allocation to 4.7% (4.0%) of

assets.

Recent research by Deloitte Access Economics also confirms that the average exposure of local super

funds to PE is much lower compared the US and UK, where some funds invest as much as 50% in PE

(Deloitte Access Economics (2013)).

Figure 1: Average PE allocation (% of assets) of pension plans, by country/region

Sources: Bain Global Private Equity Report 2013, Mercer European Asset Allocation Survey 2012, Preqin, AVCAL analysis. "Large pension plans" are defined as those having >$5b in assets (for US plans), >€2.5b (for UK and European plans), and >AU$2.5b (for Australian plans). Australian data excludes one outlier.

2 Based on superannuation PE allocation data from Preqin, as of 31 May 2013.

3 Australian Bureau of Statistics 5678.0.

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The academic evidence

Do the returns from PE investment adequately compensate for the costs and risks inherent in

investing in this asset class?

Early studies have primarily used Thomson Venture Economics data, and generally find that average

risk-adjusted PE returns perform no better than the public markets (Kaplan and Schoar (2005),

Phalippou and Gottschalg (2009)).

However, subsequent studies have found that these results are highly sensitive to the choice of data

provider, as shown by Stucke (2011) and Harris, Jenkinson and Kaplan (2012) who find systematic

biases in the Thomson data used in earlier studies.

Gottschalg (2010) finds, using actual transactions data for over 4,000 deals obtained directly from a

large PE fund-of-funds, that PE deals between 1977-2009 delivered on average a positive alpha of

7.1% over public equity investments even after adjusting for timing, sector and leverage effects.

Robinson and Sensoy (2011) also find, using a sample of 542 buyout funds from 1984-2010, that

buyout funds outperform the S&P 500 on a net-of-fee basis by an average of 18% over the fund's

life.

Higson and Stucke (2012) examine over 1,000 funds representing 85% of all capital raised by US

buyout funds, and find that for almost all vintage years since 1980, US buyout funds significantly

outperformed the S&P 500. Fully liquidated funds from 1980-2000 delivered excess returns of about

450 basis points per year. Adding partially liquidated funds up to 2005, excess returns rose to over

800 basis points. They find that over 60% of all funds performed better than the S&P 500.

Phalippou (2012) revisits Phalippou and Gottschalg (2009) using better quality data and finds, using a

sample of 392 funds, that the average buyout fund actually outperforms the S&P 500 by 5.7% p.a.

(although this changes to an underperformance of -3.1% if the public benchmark is changed to small

and value indices, and is levered up).

However, Harris et al (2012) analyse 598 US PE funds and find that the average PE fund beat the S&P

500 by more than 3% p.a., and by 20-27% over the life of the fund. Acharya et al (2013) similarly

finds that the abnormal performance of buyout deals is positive on average, after controlling for

leverage and sector returns.

The industry experience

One of the primary reasons given by LPs for investing in PE is its attractive long-term returns. The

evidence by industry benchmark providers generally affirms this view:

According to Cambridge Associates (C|A), global PE and VC delivered an annualised return of

13.8% (net of fees) over the 30 years up to December 2012, outperforming the MSCI World

Index by 440 basis points and the S&P 500 by 300 basis points.

A 2013 review by Preqin of over 150 pension funds across North America, the UK and Europe

finds that PE was the best performing long-term asset class across the sample, with a median

return of 11.5% over 10 years up to 30 September 2012.

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Mature pension PE programmes often bear the results that demonstrate the value in taking a long-

term view of the asset class. For instance, the California Public Employees’ Retirement System

(CalPERS) – the US’s largest public pension fund – had 14% of its assets in PE in 2012, up from 12.5%

of assets at the end of 2010. As of end-2012, CalPERS' PE programme had an annualised 10-year

return of 6.86% compared to 2.92% on fund's public equity portfolio, and had generated US$23b in

profits since 1990 for its 1.6 million members.4

Many emerging market pension funds are also increasing their exposure to this asset class in an

effort to diversify their sources of returns. In 2012, the National Council for Social Security Fund

(NCSSF), which manages China's RMB850b (US$135b) national social security fund, announced that

it would raise its RMB19.5b PE allocation significantly over the next three years, after PE accounted

for up to 70% of its total return in 2011.5

In 2011, the Montana Public Employees’ Retirement System (MPERS) – which has invested in this

asset class since 1988 – demonstrated to its board members a model of what its pension fund

portfolio would look like without PE.6 If MPERS had allocated each PE drawdown since 1994 to its

domestic stock portfolio instead, the fund would have been US$220.8m poorer by 2010: equivalent

to 7% of the fund's $3b assets under management at the time. This suggests that a public employee

who accumulated $500,000 in her pension over that period would have had only $465,000 if the

fund had not invested in PE, but had invested that allocation in the domestic stock portfolio instead.

This provided a compelling illustration of the long-term benefits of the PE programme where

superior returns were accrued over several economic cycles, not just a selected short-term period of

positive performance.

A similar analysis by the Private Equity Growth Capital Council found that over a ten-year period to

June 2011, a $1 investment by pension funds into PE would have resulted in a return of $2.3,

compared to $1.4, $1.9 and $1.9 for public equity, fixed income and real estate respectively (PEGCC

report, 2012).

The value proposition

Superior returns? The Australian experience

As of December 2012, the C|A Australian PE Index had a 10-year annualized net return of 9.67% in

AUD terms. Over the same period, the S&P/ASX 300 Accumulation Index had an annualised gross

return of 9.05%, aided by significant growth in the resources sector.

Because PE investments are drawn down over time rather than at a single point in time, a better

comparison with listed markets would be with the Public Market Equivalent (PME) first proposed by

4 Source: http://www.calpers.ca.gov/index.jsp?bc=/investments/assets/equities/pe/private-equity-review/pe-

perform-review/home.xml# 5 Sources: Preqin and "Asian Pensions & the Road to Alternative Investments" by Citigroup, 2012, p.5.

6 Memo on "Pension Fund PE Investments" in Montana Board of Investments meeting materials, 14 July 2011.

Prospective estimates are based on expected annual arithmetic investment returns for each asset classes as published in the December 2010 Teachers’ Retirement System (TRS) Asset/Liability Study conducted by the Montana Board of Investment’s consultant.

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Kaplan and Schoar (2005) and now increasingly widely used by LPs as a benchmarking metric.7 This

shows Australian PE outperforming a portfolio of index shares (built using an equivalent cash flow

pattern) by 504 basis points even after fees, expenses and carried interest, over the 10 years to

December 2012.

Figure 2: Returns of Australian PE vs the S&P/ASX 300 Index as of 31 December 2012

1 year 3 year 5 year 10 years

C |A Australian PE Index (AUD terms) 6.77 8.19 3.96 9.67

S&P/ASX 300 Acc. Index 19.74 2.8 -1.81 9.05

S&P/ASX 300 Acc. PME 20.12 2.89 0.66 4.17 Source: Cambridge Associates. C|A Australian PE Index returns are net of management fees, expenses, and carried interest.

Despite the relatively young domestic PE industry, a number of local super funds have over time

built up a strong track record of investing in this asset class to meet their investment goals. Not-for-

profit funds (i.e. industry and public sector funds) are particularly strongly represented. The Future

Fund, set up to help to meet the Commonwealth Government's unfunded superannuation liabilities,

has grown its PE allocation from 0.002% of total assets in 2008 to 6.8% in 2013 (still short of its

target allocation of 8%). It explains the reason for this:

"Our private equity strategy is predicated on our view that private equity fulfils two functions within

the Fund’s investment portfolio. The first is to invest in high ‘alpha’ opportunities, where we believe

we can earn a significant premium over similar but more liquid equity investments. Most of these

investments would fall in the buyout or secondaries categories. The second function is to expose the

Fund to investment themes that it cannot readily gain exposure to through other more liquid

investments. In the second category we would include such themes as exposing the portfolio to

innovation (venture), companies in financial difficulty that require capital to undertake financial

restructurings and/or operational turnarounds (distressed opportunities), and funding idiosyncratic

growth within small companies, particularly in sectors or geographies where alternative funding

options are scarce (growth equity)."8

Affirming this investment thesis, Cummings and Ellis (2011) find that not-for-profit Australian super

funds with more illiquid investments recorded higher risk-adjusted returns (which the authors

suggest are the return premium for investing in these illiquid assets) from 2004-2010.

7 The PME is calculated using actual PE cash flows for all funds to see what would have been achieved had one

invested the same cash flow pattern in the listed market index (in this case the S&P/ASX 300 Accumulation index). PE cash inflows are treated as purchases of the index portfolio at that point in time, and PE cash outflows are treated as sales of the index stocks. For example, a PE fund investing $50m in March 1997 and realizing $100m in March 2000 would have generated an annualised IRR of 26%. However, an LP would have been better off investing in the S&P 500 because $50 million in the S&P 500 would have grown to $103.5m over that period. 8 Future Fund Annual Report 2011/12.

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Volatility smoothing

Furthermore, despite some perceptions that PE tends to be a volatile asset class, the evidence

indicates the opposite. The quarterly and annual volatility of the C|A Australia PE Index is markedly

lower than that of the S&P/ASX 300 Index (Figure 3 and Figure 4).9

Figure 3: Quarterly returns of Australian private vs public equity indices

Figure 4: Annual returns of Australian private vs public equity indices

Sources: Cambridge Associates, S&P, AVCAL analysis Sources: Cambridge Associates, S&P, AVCAL analysis

Diversification

A 2012 report by Rice Warner Actuaries indicates that most default funds tend converge to a mix of

70-80% in equities and 20-30% in debt assets, with peer influence appearing to play a role in their

similar asset allocation decisions.

An analysis of the growth options of 59 super funds in the Chant West database indicates that the

average returns of the top and bottom quartile funds for the 10-years ending December 2012

differed by only 2.1 percentage points (Figure 5). The best-performing fund in the sample earned

7.6% on an annualised basis over 10 years, while the worst-performing fund earned 5.0%.

The narrow spread of possible returns across the super fund universe suggests that there is currently

little diversity in the standard investment options offered by most funds available to Australian

superannuants, particularly disengaged ones. It is estimated that this cohort likely includes almost all

people under the age of 40 and perhaps half of older Australians, making up more than 75% of all

super members and about half the industry's assets (Rice Warner, 2012). This is one area where

alternative asset classes such as PE can offer diversification benefits and provide an avenue for super

funds to strategically differentiate their offerings to members.

9 This is supported by Blackburn and Augustine (2012) and Schali and Demleitner (2012), who show that not

only have US and European PE outperformed public markets over time, they have done so while experiencing less volatility, as measured by standard deviation. The authors suggest that PE can be a particularly attractive asset class in times of high economic uncertainty.

-25

-20

-15

-10

-5

0

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10

15

2005 Q1 2006 Q1 2007 Q1 2008 Q1 2009 Q1 2010 Q1 2011 Q1 2012 Q1

%

Cambridge Associates AU PE and VC Index Return S&P/ASX 300 index return

-50

-40

-30

-20

-10

0

10

20

30

40

9/30/2001 9/30/2005 9/30/2009

%

Cambridge Associates AU PE and VC Index Return S&P/ASX 300 index return

Volatility of quarterly returns:

PE & VC Index stdev: 4.9% S&P/ASX 300 Index stdev: 8.1% Freq. of positive returns:

PE & VC Index: 71% S&P/ASX 300 Index: 58%

Volatility of annual returns:

PE & VC Index stdev: 14.4% S&P/ASX 300 Index stdev: 17.9% Freq. of positive returns:

PE & VC Index: 75% S&P/ASX 300 Index: 67%

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Figure 5: Spread of superannuation fund returns as of 31 Dec 2012

Sources: Chant West, AVCAL analysis. For the Growth options of 59 superannuation funds.

Challenges for super investors

Superannuation funds as PE investors face particular challenges because they are fiduciaries of their

members' interests, and a regulated industry in their own right. Some of these challenges are

outlined below.

Liquidity

Success in PE requires patience. LPs must remain committed for the lifetime of the fund as PE

investments cannot be redeemed on demand.10 Distributions only flow through when an underlying

investment is exited through a private sale or an IPO.

This illiquidity can pose particular challenges for defined contribution schemes where members'

funds have greater portability. For instance, a PE fund can make a capital call at any time during its

investment period (usually within the first five years of the fund's life, or as defined in the fund's

constituent documents), as suitable deal opportunities arise. LPs have to ensure they have

appropriate provisions to meet these capital calls as they arise.

Superannuation investment managers manage their liquidity risk in several ways, including through

their internal risk management framework, due diligence, and the negotiation of management

agreement terms. For example, most super funds impose internal limits on their allocations to

illiquid assets, such as the Commonwealth Superannuation Scheme (CSS) which limits its target

exposures to private assets (whether equity, debt or real assets) to 25% of the fund.11

The Australian Prudential Regulatory Authority (APRA) acknowledges that while "unlisted assets are

attractive for superannuation funds due to their long-term earnings and smoothed volatility profile",

10

Opportunities for exit via sales of LP commitments to secondaries funds do exist. However, this is a very illiquid market. 11

http://www.css.gov.au/investment-and-performance/investment-options/css-investment-options

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RSE licensees need to carefully consider the liquidity implications of investing in these assets.12

These considerations include assessing the likely impact of the cash flows of these investments on

the fund, ensuring that the liquidity assessment is made at the investment option level (rather than

whole of fund level), and ensuring appropriate stress testing to manage liquidity risk.13

Long-term focus and manager selection

LPs need to consider the tradeoff between PE's relative illiquidity and lack of opportunities for short-

term realisations, against expectations of higher long-term returns and less portfolio volatility.

To illustrate how PE can affect the short and long term returns of super fund portfolios, Figure 6

juxtaposes the net returns from the C|A Australia PE Index (which includes the whole spectrum of PE

fund performances) against the net returns from a sample of super funds, over a range of

investment horizons.

PE's characteristic long-term profile is demonstrated here where, although the C|A Australia PE

Index can underperform a diversified portfolio significantly over shorter horizons, over the longer

term horizons it significantly outperformed the net performance of all super funds in the sample.

Figure 6: Australian PE funds' net returns vs Super Funds' for 1-, 3-, 5- and 10-year horizons ending 31 Dec 2012

Sources: Cambridge Associates, ChantWest, AVCAL analysis. Super funds data for Growth options only. All returns are net of investment fees and tax.

12

APRA Insight Issue 1, 2013, p.22. 13

"Liquidity stress testing for alternative investments", inFinance, Aug 2011.

-4

0

4

8

12

16

%

Accountants Super Growth AMP FD Balanced

AMP RIL Balanced Aon Balanced

Asgard SMA Balanced Auscoal Growth

Aust Catholic Super & Ret Balanced AustralianSuper Balanced

AustSafe Balanced AXA SD Balanced

BT MM Balanced BT Super For Life 1960s Lifestage

BUSS (Q) Balanced Growth CareSuper Balanced

Catholic Super Balanced Catholic Super Mod. Aggressive

CBUS Growth CFS FirstChoice Balanced

CFS FirstChoice Growth Commonwealth Bank Group Super Mix 70

EISS Diversified Equipsuper Balanced Growth

ESSSuper Growth FSS (NSW) Diversified

GESB Super Balanced Growth HESTA Core Pool

HOSTPLUS Balanced Intrust Super Balanced

IOOF MultiMix Balanced Growth JANA Assertive

JANA Moderate Legal Super Growth

LGSS Balanced Growth Maritime Super Balanced

Media Super Balanced Media Super Growth

Mercer Growth Mercer Growth Plus

MLC Growth MLC Horizon 4

MLC Moderate NGS Super Diversified

OnePath OptiMix Balanced Optimum Growth

Plum Pre-Mixed Moderate QSuper Balanced

RecruitmentSuper Growth REI Super Trustee Super Balanced

REST Core REST Diversified

Russell Balanced Russell Balanced Opps

Suncorp Growth Sunsuper Balanced

Sunsuper Growth Tasplan Balanced

Telstra Super Balanced UniSuper Balanced

Vision Super Balanced Growth C|A Private Equity Index

1-yr 3-yr 5-yr 10-yr return return return return

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This outperformance is even more marked when one considers just the top two quartiles of PE funds

managers; that is, when LPs are able to exercise sufficient manager selection skill to invest in the top

two quartiles of the best performing PE funds every vintage year (Figure 7). This illustrates how even

selecting the top 50% of PE fund managers can make a large difference in the net returns achieved

by the LP's PE portfolio. Similarly, consistently poor manager selection will see a corresponding

downward drag on the LP's returns.

Figure 7: Australian top two-quartile PE funds' net returns vs the top two-quartile Super Funds for 1-, 3-, 5- and 10-year horizons ending 31 Dec 2012

Sources: Cambridge Associates, ChantWest, AVCAL analysis. Super funds data for Growth options only. All returns are net of investment fees and tax.

As LPs cannot themselves liquidate their existing commitments to rebalance their PE portfolio on

demand, appropriate manager selection is crucial.14 PE funds tend to exhibit a high degree of

heterogeneity compared to public equities funds. For example, the top half PE funds earned 12% on

an annualised basis over the 10-year horizon to December 2012, while the bottom half PE funds lost

-5%.

This wide spread of possible returns is because a typical PE fund invests in only about half a dozen

companies and then takes an active role in their board of directors and strategic direction over the

next 3-7 years, compared to a typical equities fund which spreads out its investment in much larger

portfolio of listed companies and is generally a relatively passive investor.

14

Except where they are able to sell their existing commitments to a secondary fund/another investor. However, this is a highly illiquid market and such transactions are relatively infrequent.

-4

0

4

8

12

16

%

Accountants Super Growth AMP RIL Balanced

Asgard SMA Balanced Auscoal Growth

AustralianSuper Balanced AXA SD Balanced

BT MM Balanced BT Super For Life 1960s Lifestage

BUSS (Q) Balanced Growth CareSuper Balanced

Catholic Super Balanced Catholic Super Mod. Aggressive

CBUS Growth CFS FirstChoice Balanced

CFS FirstChoice Growth Commonwealth Bank Group Super Mix 70

Equipsuper Balanced Growth ESSSuper Growth

FSS (NSW) Diversified GESB Super Balanced Growth

HESTA Core Pool HOSTPLUS Balanced

Intrust Super Balanced IOOF MultiMix Balanced Growth

JANA Assertive JANA Moderate

Maritime Super Balanced MLC Growth

MLC Horizon 4 MLC Moderate

NGS Super Diversified Optimum Growth

Plum Pre-Mixed Moderate QSuper Balanced

RecruitmentSuper Growth REI Super Trustee Super Balanced

REST Core REST Diversified

Russell Balanced Russell Balanced Opps

Suncorp Growth Sunsuper Balanced

Sunsuper Growth Tasplan Balanced

Telstra Super Balanced UniSuper Balanced

Vision Super Balanced Growth C|A Private Equity Index - Upper 2 quartiles

1-yr 3-yr 5-yr 10-yr return return return return

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Fee measurement

The remuneration structures of PE funds are set up to reflect their investment profile. They

constitute the resources and incentives required for the long-term commitment and active

management needed to achieve their higher target returns. For LPs whose primary goal is

minimising management fees, PE will likely not appear to be an attractive low-cost option.

PE management fees can range from 1.5%–2% of total fund commitments. This fee usually remains

steady during the investment period (typically the first five years of a fund’s life), i.e. it is a fixed

dollar fee over this period. During the remaining years, this fee will typically decline according to a

schedule as negotiated and documented in the fund deeds. The fee may decline by a descending

scale of, say, 0.25% per year from the sixth year onwards. Or it may be rebased to 2% of the

remaining capital invested. There is also a performance incentive referred to as the "carried interest"

where the fund's proceeds are split 80/20 between the LP and the PE fund manager if the fund

exceeds the "preferred return" (i.e. outperforms the performance high-water mark agreed upon

beforehand with the LP).

In comparison, listed equity and fixed income managed funds typically charge management fees of

0.7%-2% of the investment balance.15 This differs from the PE fee structure in that the amount of

fees paid will vary with the investment account balance, instead of being fixed based on the

investor's specified investment commitment. The fund manager will get higher fee revenues if the

value of the investment goes up (reducing the net after-fee return to the investor), but risks being

potentially under-resourced through lower fee revenues if the investment does badly. Some

managers also charge additional performance fees. On top of that, the cost of brokerage, accounting

and other fees related to holding direct shares could be an additional 0.5% p.a.16

Given these different fee structures, the calculation of annual management expense ratios will likely

not accurately capture the true cost of PE investment vis-à-vis other asset classes. A true cost

comparison can only be done over the entire lifecycle of the PE fund.

In practice, the cost of a PE programme can be reduced for LPs that have the ability to negotiate

better fee terms and that can exploit economies of scale in their internal management processes

(Dyck and Pomorski (2012), Cummings (2012)).

Balance between low fees and optimal asset allocation

Many experienced LPs generally recognise that access to high-performing fund managers will not be

low-cost. A 2011 report by the US Government Accountability Office on the challenges faced by

pension plans when investing in hedge funds and PE states that, "despite these fee structures,

pension plan officials we contacted cited attaining returns superior to those attained in the stock

market as a reason for investing in hedge funds and PE. One plan official noted that as long as hedge

funds add value net of fees, they found the higher fees acceptable."

15

Source: Australian Investors Association. 16

http://www.moneymanagement.com.au/opinion/investment/benefits-of-managed-funds-warrant-close-analysis

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This is supported by the empirical evidence. Robinson and Sensoy (2013) find that PE managers that

receive higher compensation do earn it in the form of higher gross returns.

PE investment management fees (inclusive of the carried interest of performance fee) as measured

by the MER do typically tend to make up a high proportion of total management fees for LPs. For this

reason, some super trustees and investment managers may not have the appetite to invest in PE as

the implementation is seen to be problematic and difficult relative to the its weight in the overall

portfolio (in Australia, typically around a 4% allocation).

Anecdotally, Australian super funds are seen to be at the forefront of the fee debate, and appear to

be more price sensitive than their US and European peers (Superfunds, July 2011, pp 20-21). To a

large extent this has been driven by the Government's recent Future of Financial Advice (FoFA) and

Stronger Super reforms. The former bans conflicted payments given to platforms, distributors and

advisers. The latter requires all large superannuation funds to focus specifically on the costs that

might be incurred in relation to their investments, and includes the introduction of low-cost

MySuper products and increased focus on the public reporting of management expense ratios

(MERs).

Figure 8: Fees by superannuation segment - year to 2011

Sector Segment Operating Investment

management Advice Total Fees1

Wholesale Corporate 0.3 0.47 0.05 0.82

Corporate Super Master Trust (large) 0.25 0.58 0.05 0.88

Industry 0.43 0.66 0.04 1.13

Public Sector 0.22 0.56 0.04 0.82

Retail Corporate Super Master Trust (medium) 0.87 0.71 0.25 1.83

Corporate Super Master Trust (small) 1.04 0.77 0.39 2.2

Personal Superannuation 0.84 0.6 0.43 1.87

Retail Retirement Income 0.62 0.67 0.45 1.74

Retirement Savings Accounts 0.6 1.7 - 2.3

Eligible Rollover Funds 1.95 0.45 - 2.4

Small Funds SMSFs 0.33 0.52 0.15 1

TOTAL 0.45 0.58 0.17 1.2 1. Components may not add up to totals due to rounding Source: Rice Warner Actuaries Superannuation Fees report

The reduction of unnecessary and unproductive fees is imminently desirable. But one concern is that

continued downward pressure on total Investment Management costs could work against members'

long-term interests. One of the key aims of MySuper is to charge trustees with "a specific duty to

deliver value for money as measured by long-term net returns, and to actively consider whether the

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fund has sufficient scale".17 However, achieving this through long-term asset allocation decisions is

much more difficult to quantify than through cost reductions, which are immediately measurable

and hence easier to justify. Anecdotally, there has been consequently been an increased focus on

"low costs" as a powerful marketing theme by funds to attract new members or customers.

It can be seen from Figure 8 that Investment Management costs already tend to be relatively

competitive across the broad spectrum of super funds. By comparison, Operating Fees and Advisory

Fees across different funds exhibit a much higher degree of divergence: suggesting further room for

cost reductions.

Will a continued focus on total fee reduction have a detrimental impact on super funds' ability to

invest appropriately for the long term? At some point, it seems likely that there will be a tradeoff

between low cost and diversification/long-term net returns, and the pressure on total fee

comparisons could ultimately lead super funds away from optimal asset allocation decisions.

Conclusion

The weight of the global evidence suggests that due consideration of PE should be part of the

fiduciary duty of any superannuation fund trustee who needs to consider how to best achieve better

retirement savings outcomes for its members.

It may be argued that the real concern is not whether PE makes it difficult for super funds to manage

their liquidity risks and management expense ratios. With the right framework, these risks can be

successfully managed, as seen by the track record of large global pensions with mature PE

programmes.

The greater concerns should meeting unfunded superannuation liabilities, and planning for how

workers are to fund their retirement in the years ahead. For example, total Commonwealth

unfunded super liabilities stood at $144b as of June 2013: one-tenth the size of the entire super

industry.18 For defined contribution funds, the challenge lies in ensuring that super investment

strategies today can meet their members' future retirement needs without placing increasing

pressure on the age pension system (the cost of which is estimated will rise from 2.7% of GDP today

to 3.9% by 2050 (ASFA White Paper, 2013)).

ASFA also estimates that the number of retired Australians will rise from 13% of the population

today to 22% by 2050. With the ratio of workers to retirees also expected to nearly halve from 5:1

today to 2.7:1 by then, the necessity of ensuring adequately funded superannuation has never been

more important. This, in turn, suggests that super trustees and investment officers need to seriously

consider the empirical evidence on the full range of asset classes available to them – including PE –

as part of their obligations to deliver value to their members.

17

http://strongersuper.treasury.gov.au/content/Content.aspx?doc=publications/government_response/key_points.htm 18

Australian Government, Dept of Finance and Deregulation.

This version: 21 June 2013

13

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14

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PE", GAO-11-901SP, 31 Aug 2011.

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Performance from 1984-2010", Ohio State University Working Paper, July 2011.

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