Opinion: NZ Superannuation Fund

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The NZ Herald published a feature article on retirement income savings on February 28. The author was strongly critical of the New Zealand Superannuation Fund's construct and recent performance. In response, Adrian Orr chief executive of the Guardians of New Zealand Superannuation had the following to say:

Friday, March 6th 2009, 12:51PM

The fund is a simple concept. The government has legislated to invest money today to gain a return over the long-term. That return is to be used in the future to smooth the tax burden of the rising cost of superannuation income.

One measure of financial success is whether the returns to the fund over decades are above the cost of government borrowing. This may or may not be the case over any randomly selected day, week, month, or year. In keeping with that we have deliberately and repeatedly highlighted the wide range of year-to-year outcomes we expect over the life-time of the fund, including negative ones. We have used our annual reports to illustrate this.

A government is in a great position to benefit from investing over decades, more so than any individual. It can focus on the long-term and hence make investment decisions not available to many. It has the ability to ride out the tough patches and avoid 'fire sales'. And, it can fund this activity at the cheapest rate and receive the tax on its local investment. The chance of investment success is as good as it can get.

Right now, the earnings prospects for long-term investors have improved significantly. This is great for the Super Fund with the majority of contributions ahead. The global recession has seen asset prices fall and the rewards for accepting investment risk rise to historical levels. History also teaches us that the best time for investment returns is after significant downward corrections.

However, we do not manage the portfolio around expectations of near-term events. Forecasting short-term is near impossible and leads to a lot of cost and lost opportunities. Exactly when a boom or bust will happen, what will trigger it, how it will unfold, and what the investment implications might be can not be forecast with useful precision - otherwise they would not happen. The forecasts the author of the feature article mentioned are long-term returns.

Likewise, putting money only into cash or fixed interest dooms the fund to failure from the outset. The future retirement income liabilities, which follow nominal wages, will outpace the returns. Instead, the fund is invested for the long-term across a very wide range of assets that give us the best chance of buffering rising future retirement income payments.

Diversification is the best means of managing investment risk. Imagine if we only had one asset and it happened to be the worst performing. A diversified portfolio removes that risk. And, we spend a lot of time on investment manager due diligence.

Furthermore, whether a government's operating accounts are in surplus or deficit makes no difference to the investment proposition of the fund. Neither do the returns to the Fund impact on the variability of the government's debt program. The Guardians’ legislation was designed to provide clarity of purpose, operational independence, and transparency. It is recognised internationally for those features.

When I took over two years ago following my role at the Reserve Bank, I inherited a set of investment assets selected to grow and to weather the long-term. These were chosen on a set of investment beliefs. Since then, we have been able to attract and retain world class people, and continue to implement a significant NZ and global investment strategy.

We greatly increased our ability to manage and monitor our risk and liquidity, and invest in market-tracking indices, so that we are cost-effective and can avoid being forced to sell illiquid assets. We have raised the hurdle on our investment managers and let some go, and we have introduced tougher due diligence processes. And, we have deliberately reconsidered our global private equity and property strategies.

Finally, we have benchmarked ourselves against the best in class long-term investing fraternity. They have all experienced the same challenges and remain committed to long-term investing. These are testing times which create the opportunities for long-term investors.

Background Information on the New Zealand Superannuation Fund Investment and Opportunity
There has been much attention recently on the purpose of the New Zealand Superannuation Fund, its investment activities and performance, funding, and whether more should be invested in New Zealand.

As a transparent sovereign wealth fund we welcome debate and wish to provide the following background.

Why do we have the fund?
The fund is a simple concept. Parliament legislated through the New Zealand Superannuation and Retirement Income Act 2001 to invest money today to gain a return over the long-term. That return is to be used in the future to smooth the tax burden of the rising cost of superannuation.

A government is in a good position to benefit from investing over decades, more so than any individual. It can focus on the long-term and hence make investment decisions not available to many. It has the ability to ride out the tough patches and avoid 'fire sales'. And, it can fund this activity at the cheapest rate, as well as receive the tax on its local investment income. The 'hurdle rate' for success is as good as it can get.

The size of the annual capital contributions into the Fund are determined by a formula in our legislation that ensures the tax smoothing goal of the Fund is met. This funding formula sits on the Treasury's website to ensure transparency.

The fund's assets look large against the current Crown balance sheet. In part this is because the present value of future superannuation payments is not recorded on the other side of the Crown ledger - just as future tax revenues are not. Given that the projected Superannuation payments are funded by future tax revenue, they would dwarf the Fund in today's terms.

Whether a government's operating balance is in surplus or deficit makes no difference to the Fund's purpose. Neither do the Fund's returns impact on the variability of a government's debt programme. The Guardians' legislation is designed to provide clarity of purpose, operational independence, and transparency of performance.

Rising superannuation payments
The government offers a universal retirement income (New Zealand Superannuation) to those 65 years of age and older. This income is paid for out of the general tax revenue of the current workforce. It is 'pay as we go'.

Due to an aging population, the cost of providing New Zealand Superannuation will rise rapidly in the future relative to the size of the economy. People may also live longer and hence receive their superannuation for longer.

The higher the future cost, the higher the future tax burden unless savings are made now. The fund is being built up over time as a buffer fund against this known rise in costs. In 20+ years time the superannuation payments will still be paid by that period's tax revenue. However, the fund's returns will provide a buffer to help smooth this growing tax burden.

To give a sense of scale of the challenge, the Treasury estimates that 3.5% of current GDP is spent on paying current retirement income and that this cost will steadily rise. In 30 years the cost is projected to be nearly 6.5%. The Fund is designed to smooth the cost so that it averages around 4.5% of GDP over the next 30 years. This figure includes the fund's tax payments to the government.

Superannuation payments are a political choice. It is not a legal contract with individuals. No government can bind future governments to today's decisions. The existence of the fund represents a commitment today to smooth the future tax cost of superannuation.

Why is the Fund not invested safely in a bank?
The Fund's underlying aim is to ensure that risk-adjusted investment returns will be ahead of the Government's borrowing costs. The likelihood of this being the case improves with the length of the investment horizon and the more diversified the fund's assets are.

Investing only in cash or fixed interest dooms the fund to failure from the outset. Future retirement income payments, which follow nominal wages, will outpace the returns. Hence the fund will not smooth future tax payments. In simple terms, a farmer who plants only one crop faces a greater risk of failure. If his crop is struck by disease or the price of his crop collapses then the farmer's business will fail.

By investing in growth assets, the returns will accrue over time proportionate to the risks taken. Success necessitates diversification, a long horizon, and the ability to weather risks and ups and downs. Likewise, a farmer with many crops is better placed to grow his business and survive the vagaries of climate and market.

The fund is a long-term fund. By law no capital can be withdrawn until at least 2020. The latest Treasury model is currently pointing to 2027 as the first year draw-downs will occur. The draw-down from the fund can only be used to meet one liability – future retirement income payments. The fund also pays tax to the Crown, which contributes to the consolidated account.

The Guardians' 'strategic asset allocation' is engineered to provide the best chance of meeting these obligations. When I took over as CEO two years ago I inherited a well considered 'risk budget' that measures risk and return across asset classes and investment strategies. Capital is allocated to the asset classes that provide the best expected risk-adjusted return over the horizon that matters for us, 20+ years.

These assets include equity ownership in companies through listed and unlisted markets, as well as property, infrastructure, timber, and commodities. We also have some fixed interest investments. We are globally diversified, we are asset class diversified, and we are diversified by investment style. Expert investment managers of many forms work with us in the various asset classes.

This of course ignores the argument of trying to time and pick the market. We specifically do not try to forecast and manage the portfolio around expectations of near-term events. Mostly this is near impossible and leads to a lot of cost and lost opportunities. Exactly when a boom or bust will happen, what will trigger it, how it will unfold, and what the investment implications might be can not be forecast with useful precision - otherwise they would not happen.

We do however consider longer-term strategic tilts to the exposures in our strategic asset allocation. All of our current indicators are to take more risk on at present, not reduce it. This is the traditional challenge of a long-term investor.

At present the investment environment provides significant opportunities for long-term investors. The return premiums for those able to invest are at record levels and the cost of funding is very low, especially for governments.

We make no prediction of when asset prices will rise again, but current pricing represents good investment value historically over the long-term. The investment averaging of a long-term investor is the best means of ensuring success over decades.

Should the fund invest more in New Zealand?
The Guardians are very active investors in New Zealand and proactively search for opportunities. Currently approximately 27% of our assets are in New Zealand. Table 2 highlights our NZ investment proportions by asset class.

As New Zealanders, we want increased investment for New Zealand infrastructure, the closing of any shortfalls in local firms' capital requirements, and the widening and deepening of our capital markets.

We believe these will be a natural outcome of our commercial investment activities in New Zealand. As a professional investment team, the Guardians can also introduce commercial and responsible investment disciplines into some sectors of the economy that are currently less exposed to 'outside' capital.

In some cases New Zealand assets are favourable to their foreign equivalents. For example, local infrastructure assets may provide a better match than global infrastructure assets to nominal wage growth in New Zealand. This approach has the potential to increase our exposure to New Zealand assets, as well as play to our strength of being a long-term, liquid, investor.

Of course, given the small scale of New Zealand, it is important that the Guardians have sufficient time and flexibility to maximise their New Zealand investment exposure, making commercial, prudent decisions. This requires sufficient availability of opportunities across all asset classes. Our potential ability to divest is an important consideration at the time of purchase.

How does the fund monitor its performance?
A key measure of the fund's investment strategy is whether the long-term returns on the investments are ahead of the Government's cost of borrowing. This is measured over decades – not days, weeks, months, or even year-to-year.

The fund is invested across a vast range of assets and geographies in wealth generating assets. This diversification is the best means of achieving our target. To assess how we are getting on we assess our returns against the Government borrowing rate over time - with a focus on 5+ year moving averages. We also monitor our actual portfolio against a low cost passive 'index tracking' alternative.

We deliberately seek returns that involve investment risk and by definition expect volatility on the way. In order to communicate this challenge to the public, at the outset we provided a range over which we expect the fund's returns to move around. This has been published in our annual report.

Our five year performance to date remains within this range. The tough news is that the volatility is high – you have to be prepared to ride out the good and bad times.

What have we done over the last 12 months in the face of the crisis?
The Guardians as an organisation has developed considerably and the lessons of the current financial crisis are invaluable - both in terms of management and Fund stress testing and future investment opportunities.

We have:

• Attracted the global skills necessary to compete for the best investment managers and investments.
• Developed strategies that are now being implemented – in an environment with some exceptional opportunities – in private equity, property, and some other interesting investment classes. Establishing a series of well diversified investment vintages is critical to the success of these strategies.
• Raised the bar for our investment managers and sought passive or synthetic (index tracking) exposures to asset classes where we believe it is more cost-effective.
• Increased our investment manager monitoring and due diligence capacity. Bolstered our capacity to undertake investment in-house, including direct investing, passive equity management, and the implementation of derivatives. This enables us to measure and monitor the most cost-effective, fit for purpose portfolio.
• Met all of our legal and financial obligations in a cost-effective manner, while maintaining our investment allocations.
• Established a risk management framework that allows us to measure and manage the important risks in operating the Fund. New counterparties, limit structures and back-up support, amongst others, have been introduced to ensure we are global best practice.
• Forged new investment relationships with the best globally in various fields. Worked with other sovereign wealth funds in sharing ideas and best practice guidelines. Benchmarked ourselves against the best long-term investment fraternity.

• The Guardians have received international plaudits for clarity of purpose, transparency of operations, and governance and management. We continue to assess significant investment opportunities, and are well positioned to take advantage for the benefit of the future.

  Adrian Orr
  Chief executive officer
  Guardians of New Zealand Superannuation

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