Cracks in the $2.5 trillion superannuation system
Posted on: 15 Jan 2018

Cracks in the $2.5 trillion superannuation system

Do people have any idea of the risks lurking in their superannuation savings?

The issue has surfaced again, after The Australian Financial Review's Sally Patten last week revealed accusations that many super funds are masking the riskiness of their investment strategy.

Super funds have huge leeway in deciding whether they should classify particular investments as being riskier "growth" assets, or more stable "defensive" assets.

Now, in the case of most assets such as stocks, bonds and cash, there's a consensus about whether they should be counted as "growth" or "defensive" assets.

But when it comes to more unconventional assets, such as unlisted property and infrastructure assets, there are huge discrepancies in classification.

The problem is that, faced with a low interest rate environment, some super funds have loaded up with these unlisted investments.

They've taken the view that ultra-safe assets such as Commonwealth government bonds and high-grade corporate bonds don't offer satisfactory returns. So they've switched into higher-yielding, but riskier assets such as unlisted property and infrastructure.

The question then arises whether to classify these investments as "defensive" or "growth" assets. And there are concerns that many funds – particularly those with a heavy exposure to these types of assets – are opting to classify them as "defensive".

According to industry insiders, this is not an accidental administrative oversight. Instead, they say, there are strong incentives for managers of super funds to adopt this approach.

Riskier assets typically generate higher returns than safer investments. This means that by disguising the levels of risk they're taking, super fund managers can appear to be heroes, because they're delivering stronger investment returns while appearing to take relatively little risk.

Indeed, industry insiders say there have been instances where risky mezzanine debt (which pays a high rate of interest because it ranks behind bank debt in terms of repayment) and investments in highly geared infrastructure projects, such as airports and toll roads, have been classified as "defensive" assets by super funds.

It means that an investor in a balanced super fund is unable to properly gauge the risks being taken with their investment.

Someone investing in a balanced fund (which, depending on the research firm, is usually defined as between 60 and 80 per cent of growth assets), could have more than 90 per cent of their super savings invested in riskier assets, without them having the faintest idea of how much risk is being taken.

Needless to say, as the practice spreads, more super funds will be put under pressure to adopt the same tactic of ramping the risk levels in their portfolio, while assuring investors that they're investing in "defensive" assets.

Even worse, there's little downside risk to these managers from adopting this approach.

When equity and property markets do eventually suffer sharp declines, their funds will inevitably suffer heavier losses than less risky funds.

But, every super fund is likely to report losses in a down year, so they can be pretty confident that their comparatively weak performance will be seen as part of a broader pattern.

The under-reporting of risk by super funds, however, isn't the only wrinkle for the country's $2.5 trillion super system. There's also the issue of the potential losses from highly-geared investment properties, particularly now that Sydney property prices are coming under pressure.

Josh Mennon, a lawyer at class action firm Maurice Blackburn, says his firm is receiving a growing number of inquiries from people in mortgage stress.

"Most of the cases that we see are investment properties that people have bought on the assumption that values will rise – they're usually mum and dad investors with one or two investment properties."

But, he said, recent intervention by the Australian Prudential Regulation Authority (APRA) – particularly the tightening of interest-only lending – had put the brakes on new mortgage lending, causing the property market to soften. Last March, APRA instructed banks to limit interest-only loans to 30 per cent of new mortgages.

"That obviously has implications for investors relying on continuing capital growth (like we have seen in recent years) to prop up their investment strategy."

The tighter APRA rules prompted banks to begin a series of out-of-cycle rate hikes aimed at investors, making interest-only loans more expensive than standard principal-and-interest loans, where borrowers progressively repay their mortgages. Banks have also encouraged many borrowers with interest-only loans to switch to principal-and-interest loans.

"Most interest-only loans become principal-and-interest after five years, after which time loans repayments increase dramatically. We are now seeing that transition on a mass scale and that will continue to tip a lot of people over the edge.

"We've seen quite a few people who are facing significant losses because they're being forced to sell their investment property, and sometimes even the family home. It's been a sleeping problem until now because the strong rise in the property market has limited the extent of the losses. But now Sydney house prices are not experiencing the same returns that they were."

Mennon says that after the Future of Financial Advice (FOFA) reforms were introduced in 2013 – which banned financial advisers from receiving commissions on the sale of investment products – many had turned to property and set up real estate arms, where commissions were still permitted.

"We have seen these property spruikers advise people to move all of their superannuation savings into self-managed super funds (SMSFs) and to borrow money to purchase real estate.

"With all the property debt being carried by SMSFs, we're going to see huge losses across SMSFs if Sydney property prices continue to decline."

And the level of borrowings by SMSFs is rising exponentially. Just over three years ago, David Murray's Financial System Inquiry urged Canberra to "restore the general prohibition on direct borrowing by superannuation funds" to prevent the unnecessary build-up in risk, both in the super system and in the broader financial system.

In its final report released in December 2014, the Murray Inquiry noted that super funds were increasingly taking advantage of the provision that allowed them to borrow directly using limited recourse borrowing arrangements (LRBAs).

Indeed, the latest Australian Taxation Office figures show that the total amount that SMSFs have borrowed using these limited recourse loans has continued to soar, rising more than tenfold from $2.5 billion at June 2012, to $28.6 billion by June 2017.

The fact that these loans are limited recourse is designed to ensure that, if the SMSF defaults on a mortgage on one investment property, only that property has to be sold, while the other assets within the fund are protected.

But the Murray Inquiry report highlighted the flawed logic of this approach. It pointed out that because limited recourse loans are riskier, lenders typically charge higher interest rates, and, more ominously, "frequently require personal guarantees from trustees".

That means, "in a scenario where there has been a significant reduction in the valuation of an asset that was purchased using a loan, trustees are likely to sell other assets of the fund to repay a lender, particularly if a personal guarantee is involved".

So a significant decline in property markets could trigger forced sales across the SMSF sector, which manages around $700 billion in assets.

As the Murray Inquiry noted, borrowing, even though the loans are supposedly limited recourse, "magnifies the gains and losses from fluctuations in the prices of assets held in funds and increases the probability of large losses within a fund".

Canberra, however, rejected the Murray Inquiry's proposal to ban SMSFs from borrowing to buy property, with Treasurer Scott Morrison arguing there was insufficient evidence to support an immediate ban on borrowing.

Of course, many SMSFs have been enticed by the banks' generous dividend payments to build up overweight position in bank stocks, and could suffer if bank profits get squeezed by any slide in the property market.

As Maurice Blackburn's Mennon points out, banks and other property lenders could be exposed to hefty compensation claims where the are found to have breached National Consumer Credit Protection (NCCP) Act, which requires them to meet responsible lending standards.

"Under the NCCP Act, credit providers must ensure that the customer is able to meet loan repayments without experiencing financial hardship – that the size of the loan is suitable for a customer's circumstances.

"What that means is that banks have to do some due diligence to make sure that people can repay the loan. In many cases, that hasn't been done properly."

The Australian Securities and Investments Commission (ASIC) has already launched civil proceedings against Westpac for allegedly failing to properly assess whether borrowers could repay their home loans, a claim the bank strongly denies.

Central to ASIC's case is its allegation that Westpac relied on an index – the University of Melbourne's Household Expenditure Measure (HEM) – to determine how much it would lend to would-be borrowers. The regulator alleges Westpac approved loans in circumstances where a "proper assessment" of a borrower's ability to repay, based on their actual spending levels, would have shown a shortfall.

Source: AFR