Importance of Liabilities to Your Asset Allocation

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1 Importance of Liabilities to Your Asset Allocation

2 Preface Every entity s investment portfolio supports a liability structure Accumulation Superannuation Funds: member account balances Defined Benefit (DB) Pension Plan: defined benefits payable to beneficiaries University/Endowment: funding requirements for the stated objectives of the endowment While the asset side of managing investments is generally robustly modelled, much less attention has been ascribed to liability modelling for Accumulation Funds The Global Financial Crisis was a wake up call in this regard

3 Regulatory Environment Regulatory requirements are increasing as the size and importance of the superannuation sector increases APRA Standard SPS 530 (s.32) states the need for a Liquidity Management Plan approved by the Board for a Fund Guidelines for SPS 530 note the following may be considered: Forecast contributions, forecast benefit payments, benefit structure (pension or lump sum), membership age profile, liquidity stress under adverse market conditions, forecast membership switching, the relative ease of saleability of assets, market events that may result in previously liquid investments becoming illiquid, a proportionate increase in the holding of illiquid assets as the values of liquid assets fall and the potential for cash calls by managers

4 Tools for Liability Modelling In response to these requirements and challenges, Frontier has developed a number of quantitative analytical tools: One tool forecasts Fund cash flows using flexible inputs to allow for scenario testing Another tool predicts member switching behaviour These tools have been applied to analyse fund data Analysis is indicative only as each fund will have different experiences depending on their particular circumstances

5 Cash Flow Model Designed to forecast the Fund/option level cash flows and demographics over 30 years Primary use is to stress-test the impact of events, including legislative changes, aging demographics and fund mergers, on the future cash flows of the Fund Key inputs are cash inflows (contributions, new member rollovers, merger and other rollovers and member switching); cash outflows (due to retirements, other exits and member switching) Most sensitive inputs for cash inflows are salary growth rate and growth in average account balance Most sensitive input for cash outflows is growth in average account balance

6 Super Fund Industry in 10 years Time Projection Net cash flows to halve Cash flows are positive but half the level as a % of assets of today Implications Asset allocation decisions are more difficult to implement, liquidity constraints tighter Pensions fastest growing area of the Fund, but still small Stress on the government budget to fund the growing pension outflows

7 Managing the Future Using Lessons from the Past On average, Funds have experienced a relative decline in net cash flow through time: Net cash flow is significantly less today as a percentage of Fund assets versus the levels observed a decade ago... The membership base has also continued to mature (on average), with older members beginning to build sizeable account balances While pension assets are typically low across the industry today (with retirees overwhelmingly electing to take lump sums), a number of Funds have begun to consider pension retention strategies How are these trends expected to develop into the future? Australian Bureau of Statistics: Projected Demographics

8 Super Fund Industry in 10 years Time Projected Net Cash Flows Breakdown of Net Cash Flows NCF decline to less than half Contributions decline and outflows due to retirement ramp up

9 Super Fund Industry in 20 years Time Projection No net cash flows Cash flow neutral pensions becoming a significant part of the asset base Implications Free cash flow producing assets become a growing focus to service pension needs (both listed and unlisted) Product design critical in attracting and retaining pensioners whilst providing reasonable returns Superannuation as a retirement income asset becomes well established Funds develop a greater understanding of member behaviour

10 Super Fund Industry in 20 years Time Distribution of FUM by Age Proportion of over 55s on the rise Breakdown of Net Cash Flows Contributions continue to decline and retirement outflows continue to ramp up

11 Super Fund Industry in 30 years Time Projection No net cash flows The ability of individual Funds to retain pension members will reduce the impact of projected negative net cash flows Implications Investment returns critical to maintain and grow Funds Pension switching grows with the number of pension members and may prompt introducing fees to reduce excessive switching Pension products proliferate; pricing and features critical to Fund success

12 Super Fund Industry in 30 years Time Sources of Fund Growth Breakdown of Net Cash Flows Fund growth will decline and be driven by investment returns Net cash flows will turn negative

13 Cash Flow Model Key Take Outs Asset Allocation As decisions become more difficult to implement with less capacity for Funds to use cash flow to enact changes, how will your Fund implement DAA going forward? With tighter liquidity constraints, how should your Fund access illiquid assets and how much should be allocated? Asset Mix With a growing focus on free cash flow generating assets (both listed and unlisted) to service pension needs, what are the most appropriate products for your Fund? Product Design Number of retirees will rise significantly over the next 30 years, putting increasing financial pressure on the government pension system The government will inevitably react (via a carrot and/or stick approach) and retirees will increasingly need to rely on their own superannuation pension Can your Fund better service its pensioners?

14 Liquidity Crunch of Yesteryear: Member Switching As the Global Financial Crisis (GFC) hit, Funds started to experience increased switching by members: Switching slowed post this period, but remains elevated for many Funds compared to the pre-gfc period and is triggered by declines in equity markets members remain nervous In a world where Funds face declining net cash flows, switching behaviour becomes an important consideration for liquidity management and product design The elevation in member switching is causing many Funds to think carefully about their liquidity and asset allocation positions today and into the world of tomorrow

15 Member Switching Analytics/Model Frontier designed tools to analyse and predict short-term member switching behaviour Capability to process large Fund datasets on demand % Switchers by State Composition of Switchers (by Type) On demand cross section On demand time series

16 Structural Drivers of Member Switching Large Account Balances More Older Members Other factors include: Members who have switched before Whether the member actively chose to be in the default option Structural factors are specific to each Fund

17 Structural Drivers of Member Switching Gender Higher Wages

18 Cyclical Drivers of Member Switching Returns of Other MIC Options persistence Market Downturns GFC Cyclical factors affect all pools Cyclical factors are often episodic in importance, requiring dynamic factor weights through time

19 Outflows Projections Model (out of sample) Switching Projections Model Inflows Projections Model (out of sample) Bespoke out of sample cash flow predictions

20 Switching - Key Take Outs Switching is Here to Stay Some of the factors driving switching behaviour are growing in significance Others will reappear periodically Fund Composition Matters The demographics of each Fund, the salary profile and MIC menu can all have a significant impact on switching behaviour There is likely to continue to be a wide range of experiences with switching across Funds Switching is at Least Partly Predictable Analysis undertaken by Frontier to date suggests that Funds can successfully predict switching behaviour out to three months in advance Factors in the predictive model appear to work across a number of MIC Options Modelling will never be perfect but this analysis can help Funds better manage liquidity around switching

21 Conclusions Liquidity will become increasingly precious implications for implementation of asset allocation decision and exposure to unlisted assets Free cash flow generation will become increasingly important The range of MIC Options impacts switching behaviour Product design and member interactions will need to advance enormously to meet the challenges of member retention and meeting member requirements in retirement Demographics and a maturing membership base is likely to result in member switching being a growing trend Switching behaviour appears to be partly predictable and can be modelled dynamically, allowing Funds the scope to better manage liquidity requirements