Questions over future of Super Fund

By Chris Barton

In their 2008 annual report, the Guardians of New Zealand Superannuation nonchalantly mention their big blunder: "We estimated that the Fund return (after costs, but before tax) would be 8.1 per cent. The actual return was minus 4.92 per cent." As Homer Simpson moments go, a fairly spectacular "Doh!"

That was June 2008. But, as the Guardians point out, in the wider scheme of things an almost 5 per cent loss isn't so bad.

"While disappointing, this year's return came after four years of strong performance results and was within the range of our expectations. Based on our modelling of the Fund's risk and return characteristics, we would expect a performance like this perhaps one in every 15 years."

That's a relief. Except that they're wrong again. Unless manna falls from heaven in the next few months, 2009 is going to be another "one in every 15 years", only much worse. For the first six months of the 2008/9 year, the Fund is showing a return of minus 23.12 per cent. The Guardians had estimated plus 6 per cent. That's a lot of doh!

Getting it wrong like this can be disastrous - in this instance wiping $4.184 billion off the value of the Super Fund in the past 18 months. The fund was designed to help with the burden of paying universal superannuation to the droves of baby boomers who begin retiring in 2010. The concern for the boomers is just what a prolonged recession and continued fund losses will do to the quality of their retirement.

The boom generation could be facing a retirement that's bust.

Never mind. Employer-based superannuation schemes, including the much heralded Kiwisaver, will save the boomers' retirement days. Or maybe not.

Morningstar Research shows that of 376 New Zealand superannuation funds on its database, 275 or 73.13 per cent had negative returns over the year to 30 June 2008. Funds heavy in New Zealand shares fared worst - down 19.19 per cent on average.

Those in world share options weren't great either - down 9.98 per cent on average. Balanced and Growth superannuation funds were minus 5.49 per cent and minus 8.70 per cent, respectively.

The first year of Kiwisaver savings don't look great either. Of 96 KiwiSaver funds on Morningstar's database, 62.5 per cent were showing negative returns for the year to January 31.

In the six months to the end of January, 72.38 per cent were in negative territory. Early days for Kiwisaver, but several years of losses like this could mean a retirement of gloomier boomers.

Thank goodness for property - especially for those prudent boomers entering their retirement mortgage-free. Not so fast. In this big, nasty global recession, virtually every asset class - homes, equities, commodities - has deflated.

Here's former Reserve Bank Governor Dr Don Brash at the beginning of February, with a sobering outlook on property values: "In general, house prices have some way to fall yet. A couple of years

ago I said publicly that they looked to be about 30 per cent overvalued in terms of long term trends. Now we have the correction under way, I guess the call is to estimate how far through it we might be."

Brash's speech, "Confronting The Perfect Storm", goes on to say the bottom for house prices is probably 24 months away and involves at least a 17 per cent tumble. Thanks Don.

So what's a baby boomer, with all three retirement foundations sinking - government superannuation, employer-based superannuation and their home's value - to do?

The short answer might be: hunker down, hold on to cash, get any long term investments into cash-based conservative funds, and look on the bright side of life. But in hunker-down mode, it's hard to ignore even gloomier imaginings.

And words strung together in ways most of us don't understand - "deflationary spiral", "severe economic contraction" and "unanticipated liquidity shocks" - but which definitely don't sound good.

Take arch prophet of doom Nouriel Roubini, professor of economics at NYU's Stern School of Business, and the man who stood in front of a group of economists at the International Monetary Fund in 2006 predicting, to much incredulity, disaster for the global financial system.

A week ago, this is how he described the current predicament: "It is now clear that this is the worst financial crisis since the Great Depression and the worst economic crisis in the last 60 years.

While we are already in a severe and protracted U-shaped recession (as the deluded hope of a short and shallow V-shaped contraction has now evaporated) there is now a rising risk that this crisis will turn into an uglier multi-year L-shaped Japanese style stag-deflation (a deadly combination of stagnation, recession and deflation)."

Who knew recessions form like letters emerging from an alphabet soup?

But Roubini, like an increasing number of commentators, does mention the "D" word - code for it could be worse. At the moment, most talk of asset class falls is around 30 to 40 per cent. During the Great Depression, equity values fell 80 per cent, so if it does get really bad, there could be another 40 to 50 per cent decline to go.

It's possible to dismiss such excessive doom talk as, well..., simply too gloomy to contemplate. But, returning to the dismal state of our national Super Fund, it is worth asking a few questions about how the hell we got into this mess.

The Guardians tell a, by now, familiar story: "The year to June 2008 proved to be a very difficult investment environment. A major factor was the emergence of a global 'credit crisis', initially triggered by rising default rates for 'sub-prime' mortgages in the United States. Banks, hedge funds, and other financial institutions became increasingly uncertain about the true market value of a range of complex credit instruments.

Interest rates for corporate borrowers increased relative to government rates and obtaining credit became an increasingly difficult proposition for many borrowers."

Yes, we know all that, but why on earth didn't you, the Guardians of our future, not see this coming? If you, the so-called experts in the field of investing get caught like this, what hope is there for the rest of us?

The questions are unsettling because they can, and are, being asked of the private and corporate actors who brought this mess about. What's becoming abundantly clear is that they too didn't understand what they were doing.

Many heads of the now myriad failing, or deceased, financial institutions did not grasp the degree of risk and exposure brought about by the dealings of the widely dispersed managers under them.

Many investors, including city councils and pension funds, also bought financial instruments without understanding the risks involved.

It's true that government agencies around the world failed in their duty to monitor and regulate what was going on. But if the leading executives of financial firms didn't know what was taking place, what chance did the government regulators have?

"I made a mistake in presuming that the self-interests of organisations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms," former chairman of the Federal Reserve of the United States Alan Greenspan told a congressional committee in October. The committee's chairman, Henry Waxman, pressed Greenspan on exactly what he was saying:

"You found that your view of the world, your ideology, was not right, it was not working?" Greenspan agreed: "That's precisely the reason I was shocked because I'd been going for 40 years or so with considerable evidence that it was working exceptionally well."

You may well ask what all this has to do with securing a safe retirement future. The answer is everything. Whether or not this recession signals the final nail in the coffin of libertarian, free market ideology is not the point. What it does signal is that two fundamental tenets of investment - taking a long term view and diversifying risk - have been turned on their head.

The long term view is what the Super Fund does. It's a position that says what goes up must come down and that in investing, if you're prepared to take the rough with the smooth, in the long term everything will be alright. It's a view that says economic cycles are normal. That this recession is just another cycle and, given time, values will increase again.

But what if that's completely wrong? What if this recession is different? What if it is, as radical theorist and author Nassim Taleb claims, an unexpected, rare "black swan" event - a harbinger of a change we've only just begun to appreciate.

Taleb, a specialist in financial derivatives and happy to put his money where his mouth is - reportedly making a multimillion-dollar fortune in 2008 during the global financial meltdown - puts it like this in The Black Swan, published in 2006.

"We have never lived before under the threat of a global collapse. Financial institutions have been merging into a smaller number of very large banks. Almost all banks are interrelated. So the financial ecology is swelling into gigantic, incestuous, bureaucratic banks - when one fails, they all fall." Taleb argues we may be facing chain reactions we've never imagined before. Ripple effects from "the intricate relationships in the system we don't understand".

With that sort of worry in mind, the Weekend Herald asked those looking after the Super Fund what the managers would do to stop losses if the fund continues to bleed money in 2009 as it did in 2008.

'We invest for the long term and take on risk assets within the Fund in the expectation that those will be rewarded over the life of the Fund," says general manager corporate strategy Tim Mitchell. "Risk assets carry the chance that returns can be negative in any given period. We do not anticipate any substantive change to the Fund's strategic asset allocation."

While it sounds as though the fund managers have their heads in the sand amid the carnage, the Guardians briefing to Finance Minister Bill English in December is less business-as-usual.

"We are already 'institutionalising' lessons learned in this crisis. Those include: the need to ensure appropriate cash buffers to deal with unanticipated liquidity shocks; greater stress-testing of the Fund to assess how the portfolio behaves during period of extreme outcomes."

The Guardians are in "no doubt" that as they stand back and reflect on how events unfolded they "will forge new ways of thinking about the challenges we face".

They say the lessons generated by this crisis will reinforce their motivations to build an organisation "capable of steering the Fund through all weathers." Bravo. Pity that the first rough patch to come their way seems to have flooded the Super Fund's basement.

Mitchell refused to tell the Herald what "new ways of thinking" the fund managers had forged saying it would be discussed in the next annual report. Ditto for what the greater stress testing of the fund had revealed. But he did say they have increased the amount of cash and other "short term liquid instruments" held within the fund.

Mitchell says the Super Fund has also introduced a range of additional metrics to measure and monitor the creditworthiness of its derivative counterparties. Derivatives, so called because they derive their value from something else, a mirror image of an asset, are both a cushion and a gamble - deals that investment companies and banks make to manage the risk of their holdings, while trying to turn a profit at the same time.

They are at the heart of what led to this disaster - mirror images of assets and mirror images of mirror images repeated again and again and traded, not on regulated exchanges like futures commodity contracts, but as private contracts in "dark markets" all over the world.

The problem in trading in mirror images is that when the original image fails, there is nothing in all the mirrors.

Mitchell says to safeguard the derivative swap contracts the Super Fund uses in managing fixed income, equity and commodity exposures, it now has in place "collateral agreements to tightly manage our exposure to the counterparty" - that is the brokers, investment banks, and other securities dealers that serve as the contracting party.

The Super Fund also followed the second rule of investing - diversify. It's the rule of not putting all your eggs in one basket.

It's a good theory, but in this case it didn't work. The diversification of investment, aimed at reducing risk to institutional investors, ended up spreading risk more widely. Investors all over the world, including the Super Fund, found themselves holding mortgage-backed American securities of declining and indeterminate value.

Lehman Brothers Holdings, Freddie Mac, Merrill Lynch, Wachovia, Washington Mutual, American International Group (AIG), Morgan Stanley, Goldman Sachs, and Citigroup are some of the more well-known companies that have either gone bust, been bailed out or suffered catastrophic losses.

The contagion didn't stop in America, spreading to other countries including Britain where once again our Super Fund, diversifying its risk, picked up more poisoned holdings in the Royal Bank of Scotland Group and HBOS PLC. Quite how far this contamination has spread is still not clear. English said on Thursday that he could not rule out the Government's annual top-up payments of $2 billion a year being suspended.

What is clear is our Super Fund, like many other firms in the financial sector, allowed diversification of assets to become a substitute for due diligence on each asset. Bundle enough assets together and you don't need to know much about the assets themselves.

The diversification creed is also endemic in large corporates - the idea being that the more areas you are financially involved in, the more protected you are from loss in any one area.

But as companies like Fonterra demonstrate, the more areas you are involved in, the less you know about them, resulting in unintended consequences - like melamine in your joint venture milk products, dead babies and a subsequent write off of the joint venture investment.

Ditto for the once successful insurance company AIG, brought down by divisions specialising in real estate and exotic derivatives.

Our Super Fund also uses a diversify-and-spread-the-risk mechanism in its management structure. It's run by a board and its investments are made through other fund managers. In theory that might provide the best fund managers in their field, but it also means losing a level of direct control. There's also no public transparency showing which fund managers invested in what, and what return they delivered to the fund.

What's happened to our Super Fund in this unfolding financial crisis is a painful lesson to all investors. Just how its decline impacts on New Zealanders' retirement remains to be seen. But it does highlight several home truths. The long term is murky. Diversification of risk is not as straightforward as it sounds. And above all, it's vital to know who is investing and just what exactly they're investing in.

But it's not all doom and gloom. Amid the carnage there are some rays of hope. In the second part of this investigation we talk to Kiwisaver fund managers who have provided good returns against the odds.

- NZ Herald

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