Needed financial reforms

While it appears the rest of the world is recovering from the shock of the GFC  Australia should not rest on its laurels.  Many domestic commentators will collectively pat each other on the back and make comments to the effect that we are smarter than the rest of the world. This hubris is misplaced. 

This hubris is evident even in our approach to regulating the financial system post the GFC. While there is still confusion about the cause of the GFC, the readiness to point the finger towards bankers and their bonuses is essentially political in nature. While it is true some of the blame for the credit excesses in the lead up to the GFC can be directed at banks, demand too kindled the fires of boom time. Some of this demand can be related directly back to governments and regulators.

In the 1990’s many Governments reduced debt levels - including Australia. But these same governments forgot to change policies and regulations that force many institutional investors to hold highly rated paper.  Simultaneously, a wave of baby boomers nearing retirement age in the West caused a spike in demand for pension planning. This changing demographic increased demand for quality paper at the same time supply was falling. Thus we finished the millennium with a demographic, regulatory and government distortion to the supply demand curve which moved interest rates to low levels aided and encouraged by an obliging Fed. Luckily for investors who wanted extra return without the extra risk investment banks did indeed step into the void and as they say the rest is history.

The regulatory and trustee requirements that require institutional investor to hold some their portfolios in high-grade paper should be abolished. It was this policy and an outdated asset consulting model that created the negative yield curve forcing investors to look for alternatives such as structured credit. Secondly, policymakers created the rating agencies who in turn rated CDO’s. Recognising their role in rating debt instruments policy makers should get out of the rating game.

In short then the rush to regulate all parts of the finance industry needs to be considered in the context that regulators significantly contributed to the GFC.  That being said, there is room for regulatory improvement.

Superannuation in particular needs serious attention. Current debate centres on fees, not on the liability matching, ie we all contribute to super but there is no requirement for the boards and portfolio managers to provide for a return that will enable us to live out our old age without calling on the Government put (the age pension).

The system that we have in place does rest on its laurels; super funds look over their shoulders at peers lest they stray too far out of the mainstream. In addition there is a prevailing thought that low fees are drivers of investment outcome. This is not true, in a recent study of Australian equity market neutral funds (Zenith Alternatives Research Equity Market Neutral Report 2010) Daniel Liptak demonstrated that low fees have cost investors more in long term compounding than higher cost alternatives.  The result of which is that over the long run - say 10 years - low cost investments tend to significantly provide for poorer returns. 

Table 1 demonstrates this point clearly. The striking and frightening long term under-performance that accumulates to low cost investing (EFT’s or index tracking vehicles) means that there is less chance of positively compound returns. On the other hand high cost investment opportunities tend to protect the downside. While it is true they do suffer losses,  this Table shows that by comparison are not as deep and consequently investors receive the benefits of positive compounding.

Table 1 Returns for major indices Jan 1 2000 to Dec 31 2010

The outcome of an accrued benefit scheme weighted to keeping down costs, ensures at best mediocre returns, and importantly returns that are of no value to superannuates. While defined benefit schemes are quite rightly ridiculed they do provide retirement certainty. Our current system does not. One answer is for superannuation contributions to be raised from 9% to upwards of 15%. This is akin to throwing more money after bad. A better solution would be one which marries the best of the actuarial based model (ie life time pension based on a percentage of average salary) and our compulsory pension savings plan.

With the aging demographics our current superannuation model will limit the future monetary policy options. It will likely see a continual accumulated asset sell-off (in particular housing). This extra supply should be expected to depress asset prices in Australia for the next 20 years as baby boomers retire. The current focus on limiting immigration will further reduce demand for housing assets.

While many individuals in the past have tended to prefer to be cash poor, relying on the old age pension to buy home brand canned food, we are not sure that baby boomers are that way inclined.

Consequently without further refinement and improvement in Superannuation Australian wealth will fall. The large Superannuation pool in Australia provided a buffer during the GFC. It also created an important illusion for millions of Australians that their retirement was being taken care of and thus many individuals did not rush to the doors in panic.   The ramifications of a poorer performing and shrinking pool of wealth will be a system that may not cope with the next extreme market events as easily as it did in 2007/08. Future crises will likely required larger Federal Government spending funded through increasing the deficit.

By addressing the needs of all Australians to have a secure and comfortable old age we also protect the bottom line of the Federal budget.