FS Super Volume 12 Issue 02

Volume 12 Issue 02

NO SILVER BULLET Tim Furlan, Russell Investments

Early Release of Super Michael Vrisakis

Impact of COVID-19 on financial services Rahoul Chowdry

TRIS Published by

Buyback performance impacts Post-Royal Commission ethics

Contents

www.fssuper.com.au Volume 12 Issue 02 | 2020

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COVER STORY

NO SILVER BULLET

Tim Furlan

NEWS HIGHLIGHTS

FEATURES

DARWINIAN TIME FOR SUPER

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With COVID-19 rapidly shifting the ground beneath them, only the fittest superannuation funds will survive.

AUSTRALIANSUPER INCREASES INSURANCE PREMIUMS

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Australia’s largest superannuation fund bumped up insurance premiums in May, less than a year on from the last increase.

INDUSTRY FUND SWAPS INSURERS

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An industry fund swapped MLC Life for OnePath as its life insurer in July.

NEVER SAY NEVER TO RBA HELP: FIRST STATE SUPER

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First State Super is confident it does not need specific liquidity support from the RBA, but the fund’s investment chief said the option should remain on the table.

SUPER FUND INTRODUCES NEW FEE

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One of the country’s largest super funds introduced a new fee for retirees.

QUEENSLAND MEGA-FUND MERGER DELAY

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The impending merger of major Queensland superannuation funds QSuper and Sunsuper has been delayed.

FS Super

16 Super will never be the same Alex Dunnin

05 Featurette Few funds immune to ERS

13 Outlook Global equities go viral

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THE JOURNAL OF SUPERANNUATION MANAGEMENT•

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Contents

www.fssuper.com.au Volume 12 Issue 02 | 2020

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Published by a Rainmaker Information company.

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A: Level 7, 55 Clarence Street, Sydney, NSW, 2000, Australia T: +61 2 8234 7500 F: +61 2 8234 7599 W: www.financialstandard.com.au Associate Editor Harrison Worley harrison.worley@financialstandard.com.au Graphic Design & Production Samantha Sherry samantha.sherry@financialstandard.com.au Shauna Milani shauna.milani@financialstandard.com.au Technical Services Elizabeth Thomas elizabeth.thomas@financialstandard.com.au Advertising Stephanie Antonis stephanie.antonis@financialstandard.com.au Director of Media & Publishing Michelle Baltazar michelle.baltazar@financialstandard.com.au Director of Research & Compliance Alex Dunnin alex.dunnin@financialstandard.com.au Managing Director Christopher Page christopher.page@financialstandard.com.au

FS Super

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The Journal of Superannuation Management ISSN 1833-9573

News

DARWINIAN TIME FOR SUPER CBUS READY TO DEPLOY CASH QSUPER WON'T APPEAL LOSS News

AUSTRALIANSUPER INCREASES PREMIUMS MYSUPER BOUNCES BACK TAX RELIEF FOR MERGED FUNDS News

INDUSTRY FUND SWAPS LIFE INSURERS SUPER FUND DELAYS SUCCESSOR FUND TRANSFER SUPER SWITCHING RIFE News

NEVER SAY NEVER TO RBA HELP: FIRST STATE SUPER

SUPERANNUATION STARTUP COMPLETES RAISE ISA REVISES ERS MODELLING News

INDUSTRY FUND INTRODUCES NEW FEE AUSTRALIANSUPER SECURES CORPORATE MANDATE HESTA HIKES COVER News

QUEENSLAND MEGA-FUND MERGER DELAYED INDUSTRY FUND REVALUES UNLISTED ASSETS 60% OF SUPER FUNDS TO GO

All editorial is copyright and may not be reproduced without consent. Opinions expressed in FS Super are not necessarily those of Financial Standard or Rainmaker Information. Financial Standard is a Rawinmaker Information company.

ABN 57 604 552 874

Subscriptions hotline:

1300 884 434 THE JOURNAL OF SUPERANNUATION MANAGEMENT•

For more news and updates, visit www.fssuper.com.au

FS Super

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White papers

www.fssuper.com.au Volume 12 Issue 02 | 2020

WHITE PAPERS

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Administration & Management

IMPACT OF COVID-19 ON THE FINANCIAL SERVICES INDUSTRY

By Rahoul Chowdry, MinterEllison

How has the COVID-19 pandemic impacted the financial services industry in Australia, and what does it mean from macroeconomic, government, regulatory and industry participant viewpoints?

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Ethics & Governance

CORPORATE GOVERNANCE AND ETHICS POST ROYAL COMMISSION

By Phoebe Wynn-Pope and Andrew Lumsden, Corrs Chambers Westgarth

The Royal Commission’s recommendations can be made clearer if an ethical culture consistent with internationally-recognised human rights norms is developed.

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Investment

CURIOUS PERFORMANCE IMPACT OF BUYBACKS

By Raewyn Williams and Joshua Mckenzie, Parametric

Off-market share buybacks are a curious form of Australian corporate action: what rational investor would deliberately elect to sell back shares at a price below market value?

42

Investment

STRUGGLE FOR OIL MARKET SUPREMACY

By Kim Catechis, Martin Currie

The markets have been reacting violently to the sudden weakness in oil prices. Who is most

Administration & Management

COVID-19 AND EARLY ACCESS TO SUPERANNUATION

By Michael Chaaya, Corrs Chambers Westgarth

The government has changed the rules regarding access to superannuation. What exactly changed under these new measures and what considerations should super funds and members now make?

impacted, and what is the state of play?

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Retirement

TRANSITION-TO-RETIREMENT INCOME STREAMS

By Rahul Singh, Challenger

This paper outlines some of the common applications of transition-to-retirement income streams and highlights how they can continue to add strategic value.

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Retirement

LIFETIME INCOME STREAMS: HOW MUCH TO INVEST?

By Michael McLean, Challenger

Though there is no simple answer, this paper focuses on some of the considerations relating to which spouse in a couple should own the lifetime income stream.

22 60

Technology

COMPELLING TRENDS IN DIGITAL PAYMENTS

By Daniel Hill, William Blair

What goes on behind the scenes when a digital payment is made is changing the world. This paper explains why opportunities in the payments industry appear so compelling.

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FS Super

www.fssuper.com.au Volume 12 Issue 02 | 2020

Welcome note

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Alex Dunnin executive director, research & compliance Rainmaker Information

Super will never be the same OVID-19 started out as a health crisis that triggered C an economic, employment and financial crisis. It has led to a full-blown superannuation policy crisis.

Australia’s world-leading superannuation system in the stroke of a pen went from being a 50-year investment for most fund members to an ATM. The Prime Minister then simultaneously jumped the shark and flicked the switch to Vaudeville when he said on national television that super funds should consider investing in distressed businesses if those businesses employed their members.

Super fund fiduciaries, who only a few months ago were lauded by government, regulators and the financial media as investment leaders brave and smart enough to make long term investment decisions that not only benefited their members but were in the national interest, were now being pilloried daily in the national media.

The Commonwealth superannuation minister had by now joined the fray saying super fund trustee boards should have planned for a pandemic. You should have been more imaginative in your scenario stress testing, she said.

At least this rhetoric seemed to calm down when op-eds began appearing in the financial media pleading for assistance for trustee members of SMSFs that may be caught in an income squeeze after the big banks started warning investors they may suspend dividends.

The Parliamentary Standing Committee on Economics, chaired by Tim Wilson MP, meanwhile on March 27 released a statement titled ‘Big four banks public hearings deferred, Super liquidity issues up for scrutiny’.

“In the last round of hearings the superannuation sector dismissed the committee’s concerns about liquidity associated with the structure of their funds. Considering the super funds are now claiming liquidity issues which is inconsistent with the spirit of evidence they had previously submitted, the committee is reserving its right to hold a hearing with APRA, and the superannuation sector in the interests of financial stability,” he said.

He later stunned many when he asked whether an investment by a super fund that doesn’t pay dividends contradicts the sole purpose test.

With this level of policy turbulence, it’s unlikely Australia’s superannuation policy settings will somehow just snap-back after COVID-19 to what they were.

Australia’s superannuation trustees now know they have to plan not just for financial market meltdowns but policy meltdowns too. They need to prepare for governments fundamentally rewriting the law. That is, all legislation is now only temporary.

They have to see into the future to foretell crises that even the World Bank, the United Nations, the Whitehouse, the International Monetary Fund, the Australian government, regulators and biggest banks and companies can’t see.

It’s too early to say how this will impact super fund trustees’ long-term investment strategies. But at the very least it will force them to brutally review long-run liquidity risks. This will coincidentally supercharge their ESG programmes.

Ramping up their liquidity buffers may also force super funds to redesign their default investment choices.

In decades to come trillions of dollars in investment capital could be shifted into low yielding government bonds and cash reserves leading to lower long-run super fund returns.

Age Pension payments will have to increase substantially to make up the shortfall in retirement income streams.

As for the perpetual whinge that governments should stop tinkering with superannuation, that lament is now in the dustbin. Fundamental policy tinkering is now the new normal.

Australia’s superannuation system as we used to know it BC - before Covid-19 - has ceased to exist. fs

The quote

The perpetual whinge that governments should stop tinkering with superannuation is now in the dustbin.

Fundamental policy tinkering is now the new normal.

Alex Dunnin executive director, research & compliance Rainmaker Information

FS Super

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News

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Darwinian time for super Harrison Worley

W QSuper won't appeal loss The $96 billion superannuation fund has decided to not appeal a Federal Court order upholding an AFCA decision but says it creates further obligations for superannuation trustees.

In April, QSuper’s board appealed unsuccessfully to the Federal Court about an AFCA decision asking the fund to refund a member extra premiums, Financial Standard first reported. As a part of its appeal, QSuper had challenged AFCA’s jurisdiction over the matter.

The fund said it had decided not to appeal to the High Court after considering the best interests of its membership.

However, it said it is concerned of extra obligations for superannuation trustees arising from the case.

“QSuper is concerned that the decision creates further obligations on superannuation trustees already compliant with laws regulated by the Australian Securities and Investment Commission (ASIC) and the Australian Prudential Regulatory Authority (APRA),” the fund said.

“With this issue now resolved, QSuper is looking forward to working constructively with AFCA to ensure that member issues are fairly and equitably resolved as quickly as possible,” QSuper chief executive Mike Pennisi said. fs

The quote

I think we will look back at this period as a rather Darwinian one for Australian superannuation in many respects.

ith COVID-19 rapidly shifting the ground beneath them, only the fittest superannuation funds will survive, according to Hostplus’ Paul Watson.

Appearing as part of a virtual panel discussing mergers in super, Hostplus group executive member experience Paul Watson described the current period facing Australia’s superannuation sector as “Darwinian”.

“I think we will look back at this period as a rather Darwinian one for Australian superannuation in many respects,” Watson told the panel.

While Watson is unsure of how many super funds may end up serving Australians over the next decade, he told the panel he has “no doubt” mergers will occur, and at an accelerated rate, as the shift to a member outcome test becomes an important element of determining the health and longevity of funds.

His comments came after VicSuper chief executive Michael Dundon said the focus on mergers is more

prominent given the current economic circumstances.

“I do think the current environment is perhaps accentuating the focus on mergers and merger opportunities,” Dundon said.

“Whether that be what might become a more prolonged economic downturn for Australia, obviously the access of benefits from members and things like increased switching behaviour, are challenges to the competitiveness of individual funds.

“So I think we are likely to see increased merger activity across the landscape, and I think that will challenge boards and management to think about not only the viability of their funds, but also the long-term benefits and value that they provide to members and their fund.”

Tasplan trustee director and executive chair Naomi Edwards agreed, and said the focus would increase on mergers “post-COVID”.

“I definitely think that post-COVID there will be an increased interest in mergers,” Edwards said. fs

Cbus ready to deploy cash Kanika Sood

Cbus investment chief Kristian Fok is turning his focus to the buying opportunities ahead.

The fund’s board devalued its unlisted assets between 8-15% in response to COVID-19, and its March quarter returns stood at 10.54%.

The fund had planned to gradually over 2020 increase its strategic asset allocation to infrastructure and other assets it saw benefiting from lower interest rates. It had made the first part of that change when COVID-19 arrived.

It entered the downturn 6% underweight unlisted assets, after forgoing bidding up on transactions such as Hobart Airport and Victorian Land Titles.

Going forward, Fok is breaking down the buying opportunities as immediate, pipeline investments and the bigger role superannuation could play in the economy.

Fok said the COVID-19 downturn gave Cbus the opportunity to participate in eight equity raises by ASX-listed companies, three of which were new names. It also includes in small companies.

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“We tend to participate where we have existing holdings but also there are a couple of companies where liked the prices,” Fok said.

“We also have a strategy [since nine months] in place where we look at companies with strong fundamentals but also strong stewardship and corporate sustainability alignments where we would like to take longer-term equity holdings in listed sense,” he said.

He also sees direct lending as an immediate opportunity.

“There are a lot of things we have looked at in the past but just because we couldn’t get terms that we felt comfortable with, they didn’t protect the debt investors as well as we would have liked…a number of those opportunities have now come back to us because the players who were looking to fund have fallen away,” Fok said.

In infrastructure, he points to assets that have been identified but haven’t been implemented.

“A good example is the railway from Melbourne Airport to Spencer Street,” he said. fs

FS Super

News

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AustralianSuper increases insurance premiums Jamie Williamson

A Tax relief for merged funds Superannuation funds are set to permanently avoid negative tax outcomes upon merging, after an amendment bill sailed through parliament.

While the FASEA extension stalled during May, the parliament successfully shepherded the government’s Treasury Laws Amendment (2020 Measures No.1) bill through both the House of Representatives and the Senate, ensuring the tax relief granted to merging super funds is now permanent, rather than a temporary measure.

Previously, fund members may have faced a Capital Gains Tax liability when their fund merged.

CGT rollover relief designed to reduce that liability was previously a temporary measure, which was extended several times. The most recent extension was due to expire on July 1.

However as a result of the bill’s passage, Financial Services Council chief executive Sally Loane said the parliament had removed a significant barrier to fund mergers.

“With many merger and consolidation programs underway across the superannuation industry, it is vital that superannuation funds have certainty that existing policy settings will continue,” Loane said.

“This relief has been extended several times, and we are pleased to see the government delivering on its Budget announcement to make this a permanent policy.” fs

FS Super

The numbers

17%

The average increase in TPD cover for AustralianSuper members from May 30.

ustralia’s largest superannuation fund bumped up insurance premiums from May 30, less than a year on from the last increase.

In a communication sent to members, AustralianSuper said the annual review of the fund’s insurance offer was conducted earlier this year and determined the need for premiums to go up.

From May 30 death cover increased by an average of 2.3%; TPD went up by an average of 17%; and income protection now costs, on average, 19.3% more.

“Whilst there is never a good time for an increase in costs we do understand that in the current environment this is difficult news,” the fund said.

“Please be assured that you still only pay for what it costs for us to provide your cover.

“AustralianSuper doesn’t make any profit from the insurance we provide to you.”

The fund said the increase is the

result of “implementing a range of required changes” and an increase in the number of claims made and paid.

“The rise in number of claims paid means that the cost of cover needs to increase,” AustralianSuper said.

The communication to members mentions the fund was able to reduce premiums in May 2018, but premiums were also then increased from 1 June 2019 on the back of the Protecting Your Super reforms by an average of 17% for death, 38% for TPD and 9% for income protection.

The fund also moved to assure members that the increases have nothing to do with COVID-19.

“And whilst the onset of the COVID-19 pandemic and the annual review of insurance costs are not linked, we’d like to assure you AustralianSuper members with active insurance are covered for death, total and permanent disablement and income protection claims resulting from COVID-19,” it said. fs

MySuper bounces back Harrison Worley

While the fallout from the COVID-19 pandemic has demolished the return expectations of investors for the year, new analysis shows MySuper products have managed to turn things around.

Latest Rainmaker research shows MySuper products offered by not-forprofit funds are performing strongly in the wake of COVID-19, with Rainmaker’s SelectingSuper MySuper index recording an average return of 2.2% across April.

The April monthly result is the best since June last year, and shows that despite facing extreme difficulties, MySuper have successfully shielded their members from much of the crisis’ worst impacts.

The results bring the average fall in the MySuper sector to -10% since the onset of the Corona Financial Crisis on 20 February.

Rainmaker’s advance SelectingSuper index is based on an analysis of 20

MySuper products offered by notfor-profit super funds which publish daily unit prices. Products in the index represent $522 billion being around two thirds of the MySuper sector.

Returns across the index ranged from a high of 4.1% to a low of 0%. No MySuper product in the index recorded a negative result for the month.

Overall, rolling 12 month returns for the index are tracking at around -3.2%, the lowest level since August 2009. Financial year to date returns are now averaging -4.8%. However, the results pale in comparison to the troubles suffered during the worst of the GFC, when the MySuper 12-month index dropped all the way to -21% in December 2008.

Rainmaker said the strong April performance is influenced by gains in the ASX of 8.8%, and the positive performance of A-REITs, which posted 13.7%. fs

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Industry fund swaps life insurers Kanika Sood

Super switching rife Eliza Bavin

New data from Colonial First State (CFS) found switches by super members were three times the usual rate in March as Australians moved their super to cash in the midst of the COVID-19 pandemic.

The data found 39% of those that switched their super moved into cash and slightly less moved to growth assets.

The second most popular investment category was Australian shares, with 26% of those who switched moving into equities.

“Switch call volumes peaked on March 23 after the S&P/ASX shed 5.6% to 4546, down 36.5% from its peak just over two months ago,” CFS said.

“The market reaction was in response to news that businesses across the country should prepare to scale down their operations.”

CFS said it experienced the highest number of switches to cash, at 65%, and the lowest percentage of switches by dollars to growth assets (9%) on that day. CFS said while looking to avoid losses caused by the sharp declines in the share market, members who switched to cash at the bottom of the market may have missed out on the gains in the markets in the period after.

Scott Tully, general manager investments at CFS, said: “We recognise the importance of being focused on investing for the long term and we’ve been talking to our members directly about this to help them navigate what are understandably a concerning set of circumstances.” fs

A The quote

We recognise the importance of being focused on investing for the long term and we’ve been talking to our members directly about this to help them navigate what are understandably a concerning set of circumstances.

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n industry fund is moving from MLC Life to OnePath as its life insurer effective July 1 and has notified members of changes to its offering.

Energy Super has chosen OnePath after a rigorous tender process, the fund told members, while notifying them of changes to death and TPD cover.

The change builds from September last year when Energy Super transitioned its income protection from MLC to OnePath.

The fund said costs for some members will go up. There are no changes for defined benefit members.

“Since 1 July 2017, benefits paid to members have been increasing and over the last three years more benefits have been paid to members than premiums collected and paid to the insurer – which is unsustainable,” Energy Super said.

From July 1, the maximum benefit payable for death cover will be $5 million, $3 million for total and permanent disability as well as for terminal illness.

New general cover will cost $0.925 per unit per week for death cover, while weekly general cover for both death and TPD will be $1.459.

These rates are slightly lower for white collar workers or professionals, as $0.740 per week for a unit of death cover, and $1.179 both death and TPD. Members with death and/or TPD cover will no longer be able to elect to continue their insurance under an individual policy if they leave the fund.

While IP had already transitioned to OnePath last year, the terms will be revised from July 1 as the previous agreement comes to an end.

The fund’s IP cover will move to unit-based pricing, with each unit equal to $115.40 per week of cover. fs

Retail super fund delays successor fund transfer A retail superannuation fund has postponed its MySuper transition to a $16.5 billion industry fund citing market uncertainty and volatility arising from COVID-19.

Perpetual’s MySuper product was to transition to CareSuper effective around May 1 as its inflows slowed down significantly during FY19 and five-year performance slipped, Financial Standard first reported March 20.

However, at the end of that month, COVID-19 put a halt to the successor fund transfer plans.

“Due to the market volatility and uncertainty caused by COVID-19, Perpetual Superannuation Limited (the Trustee), has decided to postpone the transfer until later in the calendar year,” Perpetual said in a statement to members.

“This decision was made to protect the superannuation benefits of members from the increased risks of undertaking a transfer in the current market environment.”

A spokesperson confirmed this morning that the trustee has not yet set a new date for transfer.

Perpetual MySuper ranked 21st for one-year returns to June 2019, however it sits in 52nd place over five years. For comparison, CareSuper is ranked 11th over five years, according to Rainmaker data.

Perpetual is not the only trustee to delay a successor fund transfer of late. In March, Tasplan and MTAA Super, who committed to a merger late last year, moved back the date of their merger from 1 October 2020 to 31 March 2021, citing COVID-19.

AMP has also delayed its transfer of corporate client Anglican National Super to the new fund chosen by its board, Mercer, citing COVID-19.

Recently QSuper and Sunsuper delayed their merger saying due diligence was tougher while while staff are working remotely as a result of the COVID-19 pandemic. fs

FS Super

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Advisers fear for Aussies With more Australians needing financial advice than ever before, temporary measures designed to increase access to advice seemed like a good move. But not all agree. Harrison Worley writes. hile backed by major indusW try associations and advocacy bodies, those that actually provide financial advice fear new temporary relief measures offered by ASIC may push Australians towards conflicted advice delivered by the nation’s large superannuation funds.

On April 14 ASIC announced a raft of measures aimed at assisting the industry with providing affordable and timely advice during the COVID-19 crisis, namely the early release of super. As part of this, ASIC issued a temporary no-action position for superannuation trustees to expand the scope of personal advice that can be provided under intra-fund advice.

The other key measure sees the requirement for advisers to issue a Statement of Advice lifted, so long as they provide a Record of Advice and don’t charge more than $300 for the advice.

Here in lies the problem, with advisers concerned Australians may be driven to accessing compromised advice from super funds.

Evalesco Financial Services director Marshall Brentnall says the initiative - taken as a measure designed to accelerate the issuance of information for clients - is “great”, but won’t help with the onboarding of new clients.

“Let’s say someone you know is in financial distress and they want to have access to their superannuation and they’re a new client, we still have to go through the new client process to be able to issue documentation in that area,” Brentnall says.

Brentnall says the cost of setting up a new client - including a 75-minute consultation - would cost him a multiple of the $300 maximum fee advisers are allowed to charge, leaving him to wear the difference.

FS Super

“The reality is the due diligence that you have to do prior to the meeting, within the meeting and then post-meeting… If I’m charging myself out of several hundred dollars-plus, that’s not a very long meeting,” he says.

TWD director Cara Graham agrees, saying even with the temporary measures advisers are still required to abide by the FASEA Code of Ethics.

“It’s not as if that’s [the Code] gone out of the window,” Graham says.

“All the steps in the onboarding process are there to make sure that we’re still understanding their [client’s] situation and making the right decisions for them.

“I think this helps for a very specific purpose…But certainly for the more strategic and full onboarding process, I don’t feel like there is a way to get around that.”

According to Brentnall, the measures appear best suited to the capabilities of large organisations.

“I think the initiative is really designed around supporting major institutions - perhaps superannuation funds - that have either customer service officers or financial planners within them, to rapidly issue documentation to support their existing client,” he says.

With super funds willing to absorb the difference, concerns about the quality of advice provided by super funds has become a central issue.

Super Consumers Australia director Xavier O’Halloran believes it is “pretty clear” there is a disconnect between the quality of advice Australians need and what they end up receiving from super funds, pointing to ASIC’s Report 639 released last December which found

The quote

While they [super funds] have an obligation to act in the best interests of their members, that’s also often interpreted as growing the size of the fund as much as possible and maintaining as much FUM as possible.

Xavier O'Halloran

just 49% of the personal advice provided by 21 super funds was compliant.

SCA is concerned funds will provide Australians with yet more poor advice because of its competing responsibilities: to act both in the best interests of the fund’s members, and the individual seeking advice.

“While they [super funds] have an obligation to act in the best interests of their members, that’s also often interpreted as growing the size of the fund as much as possible and maintaining as much FUM as possible,” O’Halloran says.

Likewise, Graham says ultimately super funds probably don’t want their members to withdraw their funds, adding that not withdrawing - if there are other options - is probably the better choice for many Australians.

However, $59 billion industry super fund Rest rejected the suggestion, pointing out it has been using SCA’s own modelling as a resource to help members make informed decisions and demonstrate the potential impact of the early release measures.

“The Rest Advice team’s remuneration structure does not include bonuses or commissions – there are no incentives to grow or retain funds under management,” a Rest spokesperson told Financial Standard.

“We will continue to do everything we can to support our members in financial distress, including making early release payments to those who are approved by the ATO as quickly as possible.” fs

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www.fssuper.com.au Volume 12 Issue 02 | 2020

Never say never to RBA help: First State Super Harrison Worley

F ISA revises ERS modelling Harrison Worley

Industry Super Australia was forced to revise the modelling underpinning its calculations of the impact of the government’s Early Release Scheme on retirement balances.

An ASIC missive caused the peak body for industry superannuation to reconsider how it calculated the impact of the ERS initiative on retirement balances of super fund members, a response to a Parliamentary Joint Committee on Corporations and Financial Services question on notice revealed.

The regulator revealed it wrote a letter to ISA on April 20, asking about the modelling underpinning industry super’s estimates.

The regulator’s letter told ISA it was concerned the peak body had failed to follow ASIC’s directives on how trustees should communicate the potential long-term impacts of accessing super early, by using different assumptions to those employed by the generic calculator on ISA’s website.

A fortnight after ASIC’s letter landed at ISA, the peak body responded to the corporate regulator, and said that upon review of its calculator it had decided to make changes to the assumptions used in its ERS modelling and the calculators on its website.

However in an interesting twist, ASIC said ISA’s modelling did not use nominal dollars in place of real dollars, contradicting Jeremenko’s evidence. fs

The quote

If we thought the broader system was becoming more challenged around liquidity then it may be that more funds need access to RBA support.

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irst State Super is confident it does not need specific liquidity support from the Reserve Bank, however the fund’s chief investment officer Damian Graham said the uncertain economic future means the option should remain on the table.

Speaking to Financial Standard, Graham said the fund doesn’t feel that it is short of liquidity at the moment, meaning it doesn’t need the RBA’s help.

However, he did say “you never say never” when asked about the prospect of future support, noting the fallout from the pandemic could last for years.

Graham’s comments came as solutions to the super sector’s alleged lack of liquidity made headlines. University of Melbourne professor and Super Consumers Australia director Kevin Davis suggested super funds should consider borrowing from the RBA in an arrangement that we see the fund’s assets used as collateral.

“It’s hard to predict exactly how it will play out over the next two to three years, but we feel very comfortable in our liquidity,” he said.

“But if we thought the broader system was becoming more challenged around liquidity then it may be that more funds need access to RBA support.

“It’s not something that we feel like we’re likely to need, but again I think as a backstop or an option at some point, if it’s something that became relevant then we’d certainly support the RBA doing that.”

Not only does the fund have enough liquidity to deal with the early release scheme, but it’s still looking to take advantage of any opportunities which come its way. Graham said the fund wants to be prepared to pick up additional unlisted assets as they “come back to market”, despite First State having recently repriced its own unlisted assets, like other super funds, out of cycle. fs

Superannuation startup completes equity raise Kanika Sood

A superannuation startup pushed ahead with a retail raise, picking up more than $150,000 from investors.

GigSuper has raised $159,892 to $400,000 from retail investors, in a crowdfunded equity campaign it launched in May. The fund conducted the retail raise through online platform Birchal and set the minimum investment at $250 and the maximum at $10,000. It ran throughout the month and finished on May 28.

It is set to be followed by an institutional raise in June.

GigSuper is about two years old and caters to the subset of self-employed workers, of which it says there are 1.3 million Australians with $88 billion in superannuation savings.

The fund was founded by former IG colleagues Peter Stanhope and Martin Batur, and Branka Injac Misic.

The fund went live at the beginning of the year. in beta phase and has 25 financial members with about $1 million in funds under management.

It was advertising a pre-valuation of $6.02 million, up to $400,000 of which will be allocated to retail investors and $2 million to $3 million will come from an institutional raise in June, as a part of which it will also add board members.

The valuation was decided by GigSuper’s board and is based on its estimate of the addressable market of $88 billion in superannuation savings across 1.3 million workers, instead of current revenue. An institutional raise will soon follow. fs

FS Super

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www.fssuper.com.au Volume 12 Issue 02 | 2020

HESTA hikes cover

Industry fund introduces new fee

Kanika Sood

Eliza Bavin

The $55 billion industry fund hiked the cost of its standard insurance cover for most of its members, with those nearing retirement the worst hit.

HESTA’s standard insurance cover – which eligible members automatically receive upon signing up unless they make a choice – includes two units of income protection (IP) to age 67 and two units of death cover to age 75. It does not include total permanent disability cover (TPD).

From April 30, the cost of IP increased, while the cost of death cover came down.

The net effect spelt an increase in the cost of default cover for most HESTA members.

The only exception is the 67 to 74 age group, whose fee for standard cover became 10% cheaper as it declined from the old $1.16 a week to $1.04 a week.

The 55 to 64 year old bracket saw the highest jump – going from $6.85 in current estimated net insurance fee to $7.70. The rise in net standard insurance cover cost by age groups was: 15-24 years (7.7%), 25 to 34 years (8.5%), 35 to 44 years (9.97%), 45 to 54 years (12.4%), 55 to 64 (13.4%), 65 to 66 years (1.6%) and 67 to 74 years (decline of 10.3%).

The average HESTA member is 42 years old.

“The way that super funds provide insurance cover to members and when their insurance cover must be cancelled has changed as a result of Federal government legislation introduced in 2019. These changes mean that the HESTA insurer has had to review the insurance fee that members pay,” HESTA said in a notice to its members.

HESTA’s group insurance is provided by AIA Australia.

TPD, which is not a part of the standard cover at HESTA, has remained unchanged after the review. fs

O

FS Super

The numbers

0.20%

First State Super's new percentage based fee.

ne of the country’s largest industry funds has introduced a new fee for retirees.

First State Super customers faced changes to the Retirement Income Stream (RIS) and Transition-to-Retirement Income Stream (TRIS) fee structure on 1 April 2020.

In an update to members, the super find annouced it would reduce its administration fee from 0.40% to 0.20% per annum with the $52 per year administration fee remaining and not included in the fee cap.

In addition to dropping the administration fee, the fund introduced a new “management fee” to replace the existing trustee fee for the RIS. “This fee will apply to the premixed investment options and single sector investment options (excluding cash),” the fund said.

“This fee is payable for expenses related to the development of enhanced retirement offerings, retirement specific portfolio management

11

strategies and expenses incurred by the trustee (e.g. fund governance).”

The new fee is 0.15% for pre-mixed options, 0.06% for single-sector options and nil for cash options.

“All other fee and cost components of the investment fee for RIS and TRIS remain the same and will change each year depending on a number of variables, such as the performance of the underlying investments and transaction costs incurred,” the release said.

“To improve how we disclose fees, Investment management costs will now be referred to as Investmentrelated costs. Importantly, there are no changes to how we calculate these costs.”

The move came after AustralianSuper announced it would introduce a new fee called the ‘Administration fee – Protecting your Super’ which sees members pay up to 0.04% of their balance to offset the impact of the recent Protect Your Super reforms. fs

AustralianSuper secures corporate mandate Eliza Bavin

Australia’s largest super fund is the new default superannuation provider for an ASX 200 company with over 1200 employees.

AustralianSuper Select is now the default fund for McMilan Shakespeare Group.

McMilan Shakespeare is the country’s largest single source solution provider of salary packaging, novated leasing, consumer and fleet financing and management services.

AustralianSuper announced the change to McMilan Shakespeare employees at the beginning of the year, noting that employees who are current AustralianSuper members would be transitioned into their

new Select fund in March.

AustralianSuper Select is the fund’s MySuper authorised product and members are automatically invested in the default Balanced option.

In the handout to McMilan Shakespear employees, AustralianSuper said: “While you’re with McMillan Shakespeare Group we’ll apply the better of your individual or category rating to keep insurance costs as low as possible.”

“If you leave McMillan Shakespeare Group you’ll move to AustralianSuper Plan and keep your insurance with us, but the cost of it will change and it’ll be based on your individual work rating.

We’ll write to you if this happens.” fs

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News

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Queensland mega-fund merger delayed Harrison Worley

T 60% of super funds to go Within the next decade, the number of superannuation funds serving Australians will drop by 60%, according to a new KPMG report.

New KPMG research shows the 217 APRA-regulated superannuation funds will shrink to 138 within the next five years, with industry funds reducing at a faster rate than their retail counterparts.

The firm's new Transformation in the Superannuation Industry report claims the 38 industry super funds currently offering a home for Australians' retirement savings will have shrunk to 21 in five years' time. By 2029, just 12 will be left standing.

Conversely, the 118 retail funds currently in operation will have shrunk to 74 within the next half a decade, with 52 still around in 10 years' time, KPMG wrote.

KPMG head of wealth and asset management Linda Elkins said the pressures of COVID-19 would only serve to intensify the increased merger activity of the past year.

"This demonstrates funds are becoming increasingly ambitious in their pursuit of scale, and, for many already large funds, targeting smaller sub-scale funds may not be the best mechanism to achieve a material outcome in regard to scale and its associated benefits," Elkins said. fs

The quote

As you expect, our absolute core focus is helping our members right now.

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he impending merger of major Queensland superannuation funds QSuper and Sunsuper has been delayed.

QSuper has confirmed its planned merger with Sunsuper has been delayed, owing to difficulties in conducting due diligence while staff are working remotely as a result of the COVID-19 pandemic.

According to the fund, the delay was “not unexpected”.

“Due diligence activities regarding our merger with Sunsuper are continuing (although remotely),” QSuper said.

“Like most organisations, COVID-19 is having an impact on the way QSuper works, with many of our employees moving to remote working arrangements.

“We remain fully committed to continuing this work. However, the timelines to complete the due diligence process will be extended. This is not unexpected and ensures that we can balance our members’ needs today and the long-term.”

Members questioned the merger plans in response to an online briefing by chief investment officer Charles Woodhouse earlier this month, asking whether it is appropriate for the fund to consider a merger with its Queensland counterpart given the current circumstances.

“Superannuation is a long-term investment and we think there is long-term value in exploring what benefits can be gained for our members from this merger,” QSuper said.

He said the fund has always been focussed on investing carefully, to improve members with financial security in retirement.

“Our role is to manage both the needs of members today and their needs into the future. As you expect, our absolute core focus is helping our members right now, and no staff have been taken away from any of those core activities; all frontline employees remain dedicated to servicing our members, albeit with a focus on phone and digital rather than face-to-face,” the fund said. fs

Industry fund revalues unlisted assets on pandemic impact Another superannuation fund slashed the value of its unlisted assets, with airports and commercial property taking a hit.

In an investment update to members, Statewide Super said it has done so on the back of advice from external valuers and investment managers.

The fund pointed out its investment managers were also using external valuers.

“Various airports were marked down between 13.5%-15% in the month of March,” Statewide said.

“Most of our unlisted property assets consist of core commercial properties with very low gear-ing and they too were marked down.”

Statewide eased members’ concerns by pointing out that it considers unlisted

property and in-frastructure assets as growth assets, amid recent industry discussions over how they should be most appropriately categorised.

“Since the inception of MySuper (and indeed our merger back then between Statewide and Local Super) we’ve always classified unlisted property and unlisted infrastructure as 100% growth,” Statewide said.

“We’ve also named our default MySuper option simply “MySuper” for the accumulation version and “Growth” for our pension product.

“For most of the time this was deemed to be a little too conservative but in times like this we be-lieve this has placed us well given the recent market dislocation from COVID-19.” fs

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Few funds immune to ERS As the government's ERS initiative kicked into gear, many - including the Minister responsible for superannuation - raised concerns about the need for funds to diversify their memberships. But are those concerns proving unnecessary? Elizabeth McArthur writes. ears super funds with memberF ships concentrated in the industries hit hardest by the COVID-19 shutdown would feel the pain of early release more are proving largely unfounded, with funds of all kinds seeing withdrawals.

While much speculation surrounded how the industry funds with high concentrations of members in sectors like tourism, hospitality and retail would fare, APRA's fund-level data on the super early release scheme showed funds with very diverse membership bases also had significant volumes of early release applications.

Australia's largest fund, AustralianSuper, had paid out $763 million

by May 3 and has hit $1.7 billion since. Sunsuper had paid $784 million by May 3. Hostplus and Rest were not far behind on $661 million and $584 million respectively. Hostplus has since hit $1.2 billion.

AustralianSuper and Sunsuper both have relatively diverse member bases.

It seems the economic pain driving early release is being felt in all corners.

The Australian Bureau of Statistics recently revealed that employment fell by 594,300 people between March and April this year.

A further 600,000 were left underemployed after having their hours cut.

While the numbers for retail funds were slightly more subdued, they were still significant.

Colonial First State had paid out $473 million to members by Friday, May 7, and has since reached $650 million.

CFS general manager product, marketing and remediation Kelly Power said those figures are in line with CFS' expectations.

"CFS supports measures the governFS Super

ment has put in place to help Australians in this time. We are committed to helping our members who are facing uncertainty and hardship," Power said.

The average request for CFS, as with most funds, was well below the $10,000 limit and Power thinks that's a good sign.

"Rather than taking out the full $10,000, it turns out Australians are being very careful and taking out what they really need to," she said.

"The average redemption request has been $7200 which suggests people are using their money for specific debts while trying to preserve their nest egg.”

However, she added that on average members are drawing down about half of their account balance.

This is in line with what Industry Super Australia chief executive Bernie Dean told the House of Representatives standing committee on economics about low balance members accessing early release.

Dean said ISA research had found about 5% of early release claims left account balances at $0 and it expects that number to go up as the scheme continues.

"It's important to understand, the younger you are, the more time you have to repair your superfund," Power said.

"For a lot of people, withdrawing their super is not an academic exercise. People need the money.”

The APRA data showed BT Retirement Wrap had paid out $314 million in early release claims as of May 3. This wrap data encompassed applications across different BT products including BT Super for Life and BT Super.

BT general manager of superannuation Melinda Howes said with 810,000 members and $69 billion in FUM making Retirement Wrap the

The quote

Rather than taking out the full $10,000, it turns out Australians are being very careful and taking out what they really need to.

Kelly Power

ninth biggest fund in the country the applications are not outside expectations.

"BT has a diverse membership, with individual members and employer plans sourced from across the economy," Howes said.

"This is an extremely difficult time for many Australians as the impacts of COVID-19 continue. The volumes are not beyond the levels expected across the industry but they do show just how tough it is for many people right now.”

The data also showed funds catering predominantly to essential services are also seeing withdrawals.

For example, HESTA - the membership of which is comprised of a significant number of healthcare and aged care workers - saw more than $230 million requested in the week to May 3.

By May 31, more than $620 million had left the fund.

Meanwhile, Military Super has seen $55 million in redemptions and Energy Super has so far paid out at least $28 million. fs

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Outlook

www.fssuper.com.au Volume 12 Issue 02 | 2020

Global equities go viral An almost unprecedented worldwide health emergency has sent global equity markets into a tailspin. Investors will recover, but they’ll need cool heads. Harrison Worley writes. efore the COVID-19 crisis came B along, investors were considering how themes such as late cycle market behaviour, central bank policy, and the implications of climate change – among others – would impact their global equity strategies, according to the head of JANA’s global equities research team, Matt Gadsden01.

Investors, with an eye to the future already had their plans well in place.

Alas, nobody can predict the future.

And so, what started as just another news story has quickly morphed into a market-melting global health emergency, leaving those best laid plans in its wake.

So, for those with serious skin in the game – such as superannuation trustees and their members – there’s a myriad of significant considerations to make.

Perhaps most intriguing – and pressing right now – is what to do with global equity allocations, espe-

cially in light of the severe damage doled out to global equity indices.

It isn’t hard to understand why.

According to Rainmaker analysis, almost 35% of AustralianSuper’s mammoth $126.7 billion balanced investment option is invested in global equities.

At $43.9 billion – far heavier than any other asset class – the attraction of global equities to the nation’s largest super fund is clear.

However, are the big funds that concerned?

The $96 billion Queensland government super fund, QSuper doesn’t seem to be.

“Our strategy is based on the long-term. Most of our investors are focused on the long-term,” QSuper chief investment officer Charles Woodhouse 02 says.

The fund famously employs a riskallocation strategy instead of a typical

THE JOURNAL OF SUPERANNUATION MANAGEMENT•

The quote

Opportunities arise in times of crisis and the only way to harness this is through active management.

Matt Gadsden

asset allocation strategy, a decision made in the aftermath of the global financial crisis, which saw member accounts take a hit.

A decade later, it’s prepared for precisely this kind of market phenomenon.

“If you measured us against a traditional strategy, we would have a lot less equities than most,” Woodhouse says.

The QSuper investment boss says that while the fund’s equity allocation has performed “basically down, in-line with [the] market”, its exposure to asset classes with a similar level of expected return – such as long-term bonds – have not only provided protection, but pushed the fund to excel.

“Our long term bonds would be really doing the heavy lifting there to help smooth that ride out for our investors,” he says.

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01: Matt Gadsden

global equities research head JANA

“It [QSuper’s strategy] recognises that there are periods of market volatility, and it helps if we can find diversifying alternatives that we can allocate to which can still generate strong returns over the long term, but can help smooth the ride through these periods of uncertainty, particularly uncertainty around listed equities.”

Despite that, the fund still parks around $18 billion in international equities, which is significantly more than what it puts into local listed equities.

Woodhouse, like others, points to the benefits of diversification.

“We would have lower exposure to Australian shares than most might have. But it’s spread out over a range of different markets,” he says.

“We have a bit of emerging market exposure, but we’re also quite spread out across developed market countries relative to a traditional sort of market cap weighted country exposure.”

Contrasting this, Cbus is more balanced, splitting its equity exposure almost evenly between overseas and Aussie equities. Currently, the fund’s default option allocates around 21% to global equities, while about 5% is dedicated to emerging markets.

In regard to global equities, Cbus deputy chief investment officer Brett Chatfield says the fund’s approach is fully active, incorporating a mixture of fundamental active managers and factor strategies, as well as an internal fundamental strategy. The internal stratFS Super

The quote

Our strategy is based on the long-term.

Most of our investors are focused on the long-term.

Charles Woodhouse

02: Charles Woodhouse

15

03: Lyn Foo

chief investment officer QSuper

egy, which has a strong quality bias, accounts for over 20% of the global equity allocation.

Meanwhile, Cbus global equities senior portfolio manager Lyn Foo 03 says the fund’s internal global team runs two strategies. One is a global equities strategy, while the other is dedicated to the emerging markets.

Foo says the fund’s stock picking is based on a bottom up, concentrated approach.

“We invest in what we deem as the highest quality assets,” she says.

“So those are where we have a high conviction that these companies have very strong competitive advantages, which we think will lead to excess returns on the long term basis, and which operate in attractive industry structures.”

Financial infrastructure assets, she points out, are among the themes currently most interesting for the fund, thanks in part to their scalability, and secular and structural growth drivers.

Companies with a high level of recurring earnings – described by Foo as “sticky, repeatable products” – and barriers to entry such as brand name, distribution and scale capabilities, and product innovation.

“We like exposure to the emerging market middle class. And you get that through a variety of ways,” she says.

Pulled together with a range of factor strategies and external fundamental managers and an objective to outperform the market by around 1.5% per annum on a rolling five year basis, it’s clear the fund’s approach is sophisticated.

“While we didn’t predict this event, the structure of the portfolio is very diversified to help buffer against events such as this,” Cbus head of

global equities senior manager Cbus

asset allocation Tim Ridley says.

The $52 billion fund simply isn’t scrambling amid the market turmoil.

“One thing we are conscious of, is episodes like this typically provide favourable pricing for new investments because there’s so much risk aversion priced into the market,” Ridley says.

While understanding of the sensitivities involved with investing amid a delicate and tragic global health emergency, Cbus recognises its role in managing the investments of its members.

“So that’s one of the things that we are considering on a forward looking basis: at what time does it look to be a good time to be purchasing more global equities?” Ridley adds.

Asked whether sentiment among superannuation funds at the moment is that active global equities managers must shine in this crisis – or find themselves replaced by passive providers – Gadsden agrees. But he does so with a couple of caveats: that the market seeks safety irrelevant of valuations, and that managers are assessed according to respective styles.

“Consistent with greater potential for dispersion for the forward looking prospects of compa-nies, JANA believes that opportunities arise in times of crisis and the only way to harness this is through active management,” Gadsden says.

“While the active versus passive debate will endure, we don’t see it a mutually exclusive consideration; rather we see both as having roles in portfolios depending on investor preferences and portfolio objectives,” Gadsden says.

Whatever the case, there’s value for investors who can see through the panic, and keep a cool head. fs

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NO SILVER BULLET Tim Furlan, Russell Investments

For Russell Investments head of superannuation Tim Furlan, there is no silver bullet for the various challenges facing the superannuation system. But that type of thinking might just be what super is looking for.

Harrison Worley writes.

FS Super

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A

n interesting exercise.

That’s how Russell Investments head of superannuation Tim Furlan characterises his experience with FS Super.

This, because it’s not often he takes a trip down memory lane, he says.

He’s just spent the best part of an hour tracing back over the career that’s led him to overseeing a chunk of Australia’s near $3 trillion in retirement savings.

A clear theme has emerged, and that is the inherent difficulty in shaping superannuation and retirement offerings when everyone’s expectations, dreams and levels of comfort are different.

That said, he isn’t wedded beyond the point of good sense to the beliefs of his particular sect of the superannuation world.

“I think it’s important to have a purpose to what you do,” Furlan says.

“It’s easy to get involved in the detail of things day to day and not necessarily step back.

“But when you do step back and you go ‘What is the purpose?’ I think the purpose really is about making sure that people are going to have a comfortable retirement.”

That purpose is the one which he works towards every day at Russell, to deliver financial security for people, and he seems passionate about it.

But, that passion takes time to build.

Furlan freely admits superannuation wasn’t on his mind as he pushed through the gruelling study load involved in becoming an actuary, despite the coincidence of starting his Macquarie University degree in

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1992, the year superannuation was guaranteed for all Australians.

Having ruled out a future as a doctor early on - owing to not being great with blood - and “certainly’ not wanting to be a lawyer, Furlan’s enjoyment of mathematics and science led him to actuarial studies, even though he didn’t necessarily have a passion for the areas actuaries worked in at the time.

Looking back on his university experience, Furlan recalls the degree demanding much of his time, a factor which would continue as he chased his professional qualifications.

“I think probably 100 students might have started at Macquarie in the year I started, and maybe 20 or 30 might have graduated at the end of three years with all their exemptions,” he says.

“The pass rate’s always been low. It might have got a little better since I’ve been through, but always hard in terms of not letting a lot of people through. And then you get into the professional qualifications of actuarial studies and the pass rates were about 30% each year.”

Furlan sailed through without much trouble, but points out many who end up qualifying go through subjects several times until they get through.

“There’s a lesson there with both university actuarial and the professional qualifications about just plugging away and being persistent,” he says.

Furlan pushes back against an oft-held myth that succeeding in studying to become an actuary is reserved for the best and brightest.

In his case, it came down to how he attacked the problems before him.

“For me it was not so much the math - the university course is quite mathematical - but it was the ability to switch between the detailed technical side of actuarial studies and the math that we need, and a bit more strategic way of thinking,” Furlan says.

“You had to work out the right way to think about the problem, and then it became a hell of a lot easier and you could work your way through it. It was people that were able to change their way of thinking that got through.”

When the time came to enter the workforce in 1995, Furlan said he hadn’t decided yet that super was the place for him, and kept his options open.

Offered a graduate role by Towers Perrin, Furlan says he started to gain an appreciation for superannuation and why he wanted to work in it.

He recalls early contact with superannuation fund members, and says the experience - difficult to achieve now given the greater regulatory and compliance burden - was akin to being thrown in the deep end.

“Obviously, most of my day was still actuarial calculations, writing and advice. But you did get the opportunity to go and speak to the members and understand what superannuation is all about, delivering for real people,” Furlan says.

It’s this experience that halted a move to other areas actuaries might be involved, such as insurance.

“Often the actuary was thrown in because it was a difficult situation, and you’re able to explain something complicated to people,” Furlan says.

“And so you’ve got the whole range of people - from those that are really appreciative that you’re taking the time and helping them out as much as you can to others that came with a different expectation, or were angry because of what was going on at the time.”

For example, often Furlan’s role was to tell members their defined benefit plan was closed or part of the business they worked for was being sold, impacting their retirement savings, such as when Westpac outsourced its IT business in 2000 to IBM. He says it was always challenging, but for a young actuary, it was rewarding.

Progression at the firm was relatively linear, with graduates steadi-

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The quote

I don’t think any of these things have a silver bullet. The answer for a number of the different questions out there is going to be different for different people.

20

Cover story

ly moving up the ranks as they gained more exposure to the business.

For nine years Furlan climbed that ladder, before deciding to add an MBA to his resumé in 1999.

Again drawing on his ability to shift between different styles of thinking, Furlan notes the MBA exposed him to perspectives not normally covered by actuaries.

“I think it’s important to have broader perspectives,” he says.

“The more different ways that you’ve seen to think about things, the more able you are to develop those models and work your way through a problem.

“Talking to clients, a lot of the clients wanted to talk about business, and going and learning about business was going to help out to have some of those discussions using the right lingo.”

Before long, Furlan became more deeply involved with the local actuarial community, tutoring up-and-comers in the profession at the request of Helen Rowell, then a principal at the firm and president of the Actuaries Institute.

“She pushed me into the International Actuarial Association, representing the Australian profession in the area of accounting for superannuation,” Furlan reveals.

“That didn’t mean a lot when I first did it which was back around 2000, but it became important later in my Towers Perrin career and into Russell when Australia had to adopt international financial reporting standards.”

Now, Furlan holds senior roles in both the local and international peak associations. While he doesn’t have a particular goal to achieve, he says he is focused on making a useful contribution wherever he is.

“That’s how I got into those leadership positions. It’s more that I kind of fell into them because I had something to bring,” he says.

At the time of Towers Perrin’s absorption into Russell in 2004, Furlan was taking care of a portfolio of clients where he was the appointed actuary. While some made the decision to leave when Russell acquired the firm, Furlan stayed, and reaped the benefits.

“I found myself with more of the actuarial responsibilities and a bigger portfolio of clients pretty much straight away after we moved to Russell,” Furlan says.

When Towers Perrin managing director David Solomon retired as the acquisition took place, Furlan was lumped with some large clients.

“Pretty quickly after, I ended up being the manager of the actuarial business in Sydney. As people moved around I was kind of the last person there,” he says.

After a few years the role evolved, seeing Furlan dive into a broader portfolio of superannuation responsibilities for the first time.

When the GFC hit, the firm had to recalibrate. Furlan was asked to step away from the actuarial side of the business and focus on Russell’s investment operations, with a particular emphasis on client engagement.

With most clients sitting in the firm’s master trust, Furlan picked up more responsibilities of the master trust until he was ultimately named leader of Russell’s superannuation business.

“I think I got the title, I’m going to say five or six years ago,” he says.

“But the current position, I’ve had for about two years. There’s been change almost constantly at Russell, but kind of evolutionary change rather than revolutionary change.

He says the business’ relatively flat structure means things evolve, rather than growing according to a hierarchical structure.

“You go to the best person to do stuff at the time when something needs to be done,” he says.

It probably comes as no surprise then that Furlan takes a similar

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philosophical approach to superannuation. That is, there is an option that will suit each member best, and the politics of the system should fall by the wayside when it comes to delivering for members.

Furlan says politics is a hurdle the industry should overcome, but questions whether it can do so.

“Whether we can overcome it [politics] that’s a big question,” Furlan says.

“You look at these debates and you go, ‘Both sides are right’.

“But neither is right. The answer is somewhere in between or has elements of both. Nothing is black and white, everything has shades of grey.”

Furlan says Russell talks extensively about the need to deliver personal results for people, and the result each person is dreaming of is different. There is no one correct solution or answer for the problems and questions facing the industry.

“There’s no magic bullets,” he says.

“Talking about things that I’ve learnt over time in my career, in the things that I’ve done, one of them is that value of perseverance. While I didn’t necessarily have to persevere through the actuarial course, I’ve had to persevere through other things and I absolutely saw people persevere through actuarial. I know the value of perseverance.

“There is no magic bullet to anything. We’re not going to have a magic bullet that’s going to solve the politics, we’re not going to have a magic bullet that’s going to guarantee everyone a fantastic result in retirement.

We’re going to have to work our way through the shades of grey.”

To be clear, Furlan is not calling for the industry to give up on politics.

“They’ve got to do something with the time,” he laughs.

“But I think it's actually going to require investment of time and effort to develop those personal solutions and get members the right solutions. So taking a step back from the politics might be a good first step, but it’s certainly not the only step that’s needed.”

With COVID-19 stepping in, the firm has had to put some plans on the backburner. Once the pandemic comes to an end, Furlan says he would like to have an option available for members to help them get to a better place in their retirement.

He says the fact the firm has been able to work on product developments over the last few years with the amount of additional work to take care of is “really good”.

“There’s been lots of things going on to keep people in the industry busy, so the fact we can devote any time to kind of do anything else I think has been really good,” he says.

Chief among those issues, Furlan says, is the one-size-fits-all nature of super.

He says that whether it’s how much people should contribute or how funds invest - noting recent debates around the suitability of unlisted assets for some super funds – a blanket approach won’t do.

“I think that’s the way forward for the industry, and that’s going to deliver some of the answers to some of the things you might traditionally think of as the big issues,” he says.

“I very much think that personalisation and getting through some of these black and white questions and into some shades of grey is the big issue and where we ought to be going as an industry.”

Furlan is careful to clarify that both sides of super’s most typical arguments are probably right when they go to bat over specific policy issues, but only for a particular group of people.

“Two answers is only one step better than one answer,” he says.

“The reality is there’s a spectrum of people and degrees to which that answer’s right for you versus some of the alternatives.” fs

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Administration & Management:

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COVID-19 and early access to superannuation

25

By Michael Chaaya, Corrs Chambers Westgarth

Impact of COVID-19 on the financial services industry

By Rahoul Chowdry, MinterEllison

22

Administration & Management

www.fssuper.com.au Volume 12 Issue 02 | 2020

CPD Earn CPD hours by completing the assessment quiz for this article via FS Aspire CPD. Worth a read because: The government’s response to the COVID-19 pandemic has included economic stimulus measures to support individuals, households and businesses. This paper outlines temporary measures around early access to superannuation, and looks at what super funds and fund members need to take into account.

Visit www.financialstandard.com.au and click ‘FS Aspire CPD’ in the menu or call 1300 884 434 to gain access to the platform.

COVID-19 and early access to superannuation What it means for superannuation funds and their members

T Michael Chaaya

he coronavirus (COVID-19) pandemic has caused significant disruption across business and society. In response to the economic pressures of the pandemic, the Federal Government has announced a range of stimulus measures to support individuals, households and businesses, including changes to rules regarding access to superannuation. What exactly will change under these new measures and what should superannuation funds and their members consider as they prepare for these changes?

The measures

The Federal Government recently announced measures to address the impacts of COVID-19. The measures were contained in its Coronavirus Economic Response Package Omnibus Bill 2020 (Omnibus Bill) and associated Bills (Associated Bills), which were introduced and passed by the Federal Parliament on March 23 2020. The Omnibus Bill and Associated Bills received Royal Assent swiftly on March 24 2020.

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The response included two specific changes to rules regarding access to superannuation, which we explore in detail in this paper, namely: • temporary early release of superannuation benefits • temporary reduction of superannuation minimum drawdown rates.

1. Temporary early release of superannuation Under the proposed new early release rules, eligible individuals affected by COVID-19 will be able to access up to $20,000 of their superannuation; up to $10,000 in the 2019/20 financial year and up to another $10,000 in the 2020/21 financial year.

The amounts accessed will be treated as non-assessable non-exempt income and therefore are tax free. These payments will not impact any Centrelink or Veterans’ Affairs payments or any other income or means testing. This stands in contrast to existing rules regarding the early release of superannuation.

To be eligible, a person must demonstrate at the time they apply for early release that they are: a) unemployed; or b) eligible to receive any of the following under the Social Security Act 1991:

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i) jobseeker payment ii) parenting payment iii) special benefit; or c) eligible to receive youth allowance under the Social Security Act 1991 (other than on the basis that the person is undertaking full time study or is a new apprentice); or d) eligible to receive farm household allowance under the Farm Household Support Act 2014; or e) on or after 1 January 2020 they were made redundant, or their working hours were reduced by 20% or more (including to zero); or f) for a person who is a sole trader—on or after 1 January 2020 their business was suspended or suffered a reduction in turnover of 20% or more.

How individuals can apply for early access to their super Individuals will be able to apply from mid-April, and must apply through the Australian Taxation Office (ATO), as superannuation funds are not able to accept applications directly.

All applications must be made within six months of the amendments commencing. The provisions are designed to commence the day after the Omnibus Bill received Royal Assent – which means the provisions will be operative from 25 March 2020, and applications must be made by no later than 25 September 2020.

It is proposed that the ATO will make a determination on the application and provide the determination to the individual’s superannuation fund, advising the fund of the amount to be released. Changes made to the operating standards under superannuation legislation then require the fund to release the amount to the member as soon as practicable.

Individuals will be required to apply online to the ATO using the MyGov website (which is already under considerable strain). We understand that the processes for the ATO to receive applications and issue the necessary determinations approving the early release are still being developed and that the online application for the early release benefit will not be available until mid-April 2020.

It is important to note that if a person requests less than $10,000 for either financial year, they cannot then make another request for a release in that financial year.

How should superannuation funds prepare?

The new early release rules will impact superannuation funds from an economic and operational standpoint over the 2019/20 and 2020/21 financial years.

Liquidity risk

The new rules will obviously have the potential to increase the amount of money superannuation funds must release to members. In turn, this will increase liquidity pressure for some funds that are already feeling the effects of the share market downturn owing to COVID-19.

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These liquidity pressures will continue into the 2020/21 financial year, as eligible individuals may make a second application to the ATO for release of an additional $10,000 in the 2020/21 financial year.

Treasury estimates suggest that this reform measure will cost about $27 billion, which equates to approximately 1% of the total superannuation asset pool at present.

According to analysis of APRA data by Rainmaker, in the five years to 2019, a total of 361,000 members took out an average of $8000, totalling $2.9 billion in early release due to severe financial hardship.

The draw down and pressure on liquidity for superannuation funds owing to these emergency reforms will be far greater than the industry has ever experienced. However, it may be a better option than other reforms that were flagged, such as placing a temporary freeze on superannuation guarantee payments.

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The new early release rules will impact super funds from an economic and operational standpoint over the 2019/20 and 2020/21 financial years.

Trust deed operation The new rules create a new compassionate ground for early release within the Superannuation Industry (Supervision) Regulations 1994 (SIS Regulations). Superannuation funds need to ensure that their trust deeds allow for this new ground for early release of funds as directed by the ATO without requiring any additional application or information from the member.

The new operating standard does not apply to amounts that would otherwise be required to be released from defined benefit interests. However, superannuation funds that are able to release amounts from defined benefit interests continue to have the discretion to do so.

Operational challenges Although applications for early release will be made through the ATO, superannuation funds should expect increased communication from their members as they seek to understand the new grounds for release, confirm or change personal details, and check on the progress of their early release payouts. Superannuation funds should ensure that they have adequate FAQs and other resources available for their call centre and customer-facing staff and appropriate processes to be able to handle these claims quickly.

Severe financial hardship claims through existing grounds It can be expected that individuals who do not meet the COVID-19 early release eligibility may still seek early release of their superannuation benefits through a severe financial hardship claim in accordance with items 105 and 205 in Schedule 1 to the SIS Regulations. Superannuation funds should consider whether their existing processes should be adjusted in preparation to manage an increase in the volume of these claims.

Retirement income strategy thwarted Finally, it is worth remembering that approximately 55% of all superannuation accounts in Australia have a

Michael Chaaya, Corrs Chambers Westgarth Michael Chaaya, partner and head of financial services at Corrs Chambers Westgarth, provides regulatory and commercial advice to leading financial services entities.

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CPD Questions Earn CPD hours by completing this quiz via FS Aspire CPD 1. Under the new early access rules, how much are eligible people able to withdraw from their super in the 2019/20 financial year? a) $20,000 b) $10,000 c) $15,000 d) $25,000 2. To be eligible for early access to super, people must demonstrate which of the following at the time of applying under the new rules? a) A person must be eligible for the jobseeker payment b) They were made redundant on/after 1 January 2020 or had working hours reduced by 20% or more c) An individual must demonstrate that they are unemployed d) Any of the above 3. Which of the following is accurate in regard to the new temporary early access to super rules? a) A mounts accessed will be treated as non-assessable, nonexempt income b) Amounts accessed will be treated as assessable income c) Amounts accessed from super will not be tax free d) Amounts accessed will be treated as assessable, exempt income 4. Under the new early release rules, how much are eligible people able to withdraw from their super in the 2020/21 financial year? a) $15,000 b) $10,000 c) Nil d) $25,000

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balance of less than $25,000. If these account holders successfully withdraw $20,000 over two financial years under the proposed early release measures, they will almost effectively wipe out their entire superannuation account balance. Some may view this as flying in the face of Australia’s retirement income strategy. Against the backdrop of the COVID-19 pandemic, others would argue that it’s an economic necessity at present to allow this early access to superannuation measure to take place at any cost.

2. Temporary reduction of super minimum drawdown rates The government is also temporarily reducing superannuation minimum drawdown rates by 50% for account-based pensions and similar products. The reduction in rates will apply for the 2019/20 and 2020/21 financial years.

Age

Default minimum drawdown rates (%)

Under 65

Reduced rates by 50% for the 2019/20 and 2020/21 income years (%)

4

65-74 5

2 2.5

75-79 6

3

80-84 7

3.5

85-89 9

4.5

90-94 11

5.5

95 or more

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This stimulus measure will allow greater flexibility for retirees who are already accessing their superannuation benefits and enable them to draw down less and ride out the COVID-19 storm.

Next steps As outlined, there are a number of considerations for superannuation funds as they prepare for members taking up the early access reforms.

Our financial services team and superannuation specialists are closely monitoring these reforms and the COVID-19 stimulus package in general and can assist during this preparation phase and answer any questions regarding the impact on your business. fs

5. If a person requests to access less than $10,000 in either financial year, they can make another request in that financial year. a) True b) False 6. The government has temporarily reduced the super minimum drawdown rates for account-based pensions. a) True

b) False

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CPD Earn CPD hours by completing the assessment quiz for this article via FS Aspire CPD. Worth a read because: It is clear that the COVID-19 pandemic will have an impact on the broad economy and on the financial services sector for some time. This paper outlines the likely impact of the pandemic from a macroeconomic, regulatory, government and finance industry participant’s perspective.

Visit www.financialstandard.com.au and click ‘FS Aspire CPD’ in the menu or call 1300 884 434 to gain access to the platform.

Impact of COVID-19 on the financial services industry A regulatory and industry participant’s viewpoint

T Rahoul Chowdry

his paper outlines how the COVID-19 pandemic has impacted the financial services industry in Australia to date—what it means from a macroeconomic, government, regulatory and financial services industry participant’s viewpoint.

The pandemic has rapidly developed into the biggest economic crisis in living memory, causing the equity market to crash, business closures, job losses, a lock down of society, and for many, significant decline in earnings and an erosion of their savings. It is already clear that the economic impact will be felt long after the virus has been contained.

The financial services industry in Australia has responded responsibly. Its adoption of a ‘community first’ mindset, helping customers and others deal with the economic fallout through a variety of measures, is not only admirable, but has provided the industry with an opportunity to significantly repair its reputation. And it is an opportunity that appears to have been grasped, at least initially, with both hands. It will

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be important for the industry to sustain its community-minded efforts and at the same time manage the expectations of its shareholders.

That the industry, and the banks in particular, has been able to play the role of ‘crisis shock absorbers’ and ‘crisis backstop’ is due in no small part to having built up ‘unquestionably strong’ capital buffers and healthy liquidity positions mandated by APRA following the prescient recommendations of the Murray Financial System Inquiry of 2014.

Once the ‘here and now’ existential threats have been dealt with, it will be important for organisations to continue to ensure that the risk management, compliance and operational controls frameworks continue not just to operate robustly but potentially anticipate changing threats. While working from home may make the task challenging, financial institutions are demonstrating agility and adapting to the current challenging environment.

It is also encouraging to observe that the industry is not just dealing with the issues of today but is already turning its mind to bending the downward curve back to a narrow U, and the significant op-

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portunities that the recovery will provide. It is already clear that when we emerge, there will be a new normal.

Australia has a well-deserved reputation for rising to a challenge and there is every reason to be optimistic that when the crisis is behind us, the industry will pivot successfully to the new world.

To assist in understanding how COVID-19 continues to impact, this summary—from a macroeconomic, government, regulatory and financial services industry participants’ viewpoint—suggests what the new normal may look like. This snapshot is not designed to be comprehensive; as the landscape evolves, further commentary will be provided.

Macroeconomic situation

Rahoul Chowdry, MinterEllison Rahoul Chowdry is a leading adviser to major banks and financial institutions in Australia and Canada as a partner at MinterEllison.

Rahoul serves on the RBA's Audit Committee and on the board of AMP as chair elect of the Risk Committee.

There is significant uncertainty, however, it is clear that we are in a recession globally and in Australia, and with the global lockdown, economic activity has slowed dramatically and GDP will take a large hit for at least the next two quarters.

Best case scenarios suggest GDP will rebound in the second half of this calendar year, while worst case is the expectation of a rebound in early 2021. Much will depend on how quickly the pandemic can be contained, and the effectiveness of the policy stimulus. It is impossible to be definitive.

The RBA has cut interest rates to a historic low of 0.25%.

It has been buying government bonds to provide liquidity to the market and it appears likely that we will remain in a low interest environment for the foreseeable future.

Unemployment in Australia is likely to reach double digits, with casual workers, and those in the travel and airlines, hospitality, entertainment and retail industries the hardest hit. However, the government has responded strongly and introduced wide-scale fiscal stimulus (outlined below).

There are strong indicators of corporate stress and an increasing number of listed companies are withdrawing earnings guidance. With this comes the expectation of receiverships and insolvencies on a scale not seen in recent years.

The share market has been volatile and mostly in freefall with some limited rallying with volumes down significantly and is expected to remain volatile in the near term. At the time of writing [mid-April 2020], the S&P/ ASX200 is at just over 5000.

Expectations are that house prices will decline before picking up potentially in 2021, with inflation expected to remain materially unchanged.

Capital and liquidity/solvency are critical areas of focus for many companies and market experts believe that the A$ will remain, for the moment, in the low 60s, with the potential for it to drop further before rallying.

Government The government has announced a $320 billion consolidated package of policy, fiscal and balance sheet support to assist businesses and individuals. The details of this are set out in latest COVID-19 government stimulus

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package: support for business. The measures include: • relief for directors of companies from any personal liability for trading while insolvent • the government will provide a guarantee of 50% to SME lenders (with turnover up to $50 million) for new unsecured loans to be used for working capital purposes; maximum total size of loan is $250,000 per borrower • exemption for six months from responsible lending obligations for lenders providing credit to small business customers • the RBA has made available to the banking system a new $90 billion (included in the $320 billion referred to above) funding facility for business lending purposes • to assist small and non-ADIs, the government will provide the Australian Office of Financial Management with $15 billion (included in the $320 billion referred to above) to invest in structured finance markets used by these smaller lenders (ie. direct investment in primary market securitisations and warehousing facilities).

The government has also announced a $130 billion wage subsidy to keep an estimated six million workers in jobs and retain the nation’s productive capacity.

Regulatory environment Specific pandemic planning

In May 2013 APRA released CPG 233 Prudential Practice Guide on Pandemic Planning. The CPG provides useful guidance or reminders in relation to: • pandemic planning governance, structure and timing • the need to review or modify traditional BCP models to incorporate staffing impacts, identifying critical business functions and prioritising resources • stand-alone pandemic plans • on-going communication with other financial institutions, regulators, government • reliance on third-party suppliers • significantly increased usage of electronic transactional and communication channels • modelling the financial impact on assets, liabilities, capital and liquidity and keeping APRA informed of pressure points.

Regulatory response

The regulators have rallied strongly and are taking a constructive approach by providing relief or waivers from certain regulatory requirements. On March 16 2020, the Council of Financial Regulators (APRA, ASIC, RBA and Treasury) issued a statement stating that they would examine how the timing of regulatory initiatives might be adjusted to allow financial institutions to concentrate on their businesses and assist customers.

Subsequently, APRA has announced that the implementation date of APS 110, 112, 113, 115, 116, 117 and 330 will be delayed by 12 months and APRA has temporarily reduced its capital ratio requirements to ensure that banks are well positioned to continue to provide credit.

APRA has also expressed its expectations that banks and

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insurance companies will limit their discretionary capital distributions (including dividends). Clearly this will have a major impact, particularly on retail investors and retirees who rely on franked dividends for their income.

ASIC has announced that it will take no action against public companies with 31 December 2019 balance dates that are unable to hold their AGMs by 31 May 2020, as long as the AGMs are held by 31 July 2020. Subject to the requirements of their own constitutions, companies can hold their AGMs virtually or take a hybrid approach.

ASIC has stated that until at least 30 September 2020 it will: • prioritise serious breaches of the law, significant consumer harm, risk to market integrity and time sensitive matters; it will maintain its enforcement activities • suspend non time-critical matters (such as the Close and Continuous Monitoring Program and Internal Dispute Resolution) • provide waivers from certain regulatory requirements where warranted (e.g. the AGM requirements described above) • work alongside financial institutions to speed up the payment of outstanding remediation to customers.

Industry-wide impact

There are a number of issues that are common to all sectors in the financial services industry. These include: • managing the physical and mental health and welfare of staff • key person risk • reduction in reliability of supply chains, especially cross border • changed dynamics of working at home • significant pressure on infrastructure, telecommunications and electronic transactional channels • increased pressure on cyber security and risk of online fraud • increased pressure on other operational risks • declining financial performance caused by several factors • very low return on free funds and continued margin squeeze • managing liquidity in priority to managing margin • declining access to global capital markets • fall in equity markets leading to a decline in funds under management and lower fees • pressure on credit ratings • limited deal flows.

Although some Financial Services Royal Commission recommendations might be put on the back burner, it is important for institutions to stay the course and ensure that the good work to date is not undone.

The specific impact on each of the sectors is set out below.

Banks The banking industry has responded responsibly and is taking a lead role in helping its customers and the community cope with financial pressures—this provides the

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industry with a major opportunity to accelerate the rehabilitation of its reputation in the community.

The industry, and the majors in particular, are well capitalised and have strong liquidity buffers with these immediate impacts on results: • reduction in interest income from continued margin pressure • reduction in fees and charges • mortgage arrear rates could exceed the 5.4% arrear rate that occurred during the global financial crisis • increased loan loss provisions triggered by rise in unemployment, business failures and fall in property prices • pressure on capital and liquidity except for institutions that are financially robust • increase in cash deposits and fixed income investments as investors flee to safety • pressure on ratings • widening of spreads in the debt markets.

The banks are already undertaking a range of mitigating measures to protect their financials. These include: • deferring non-essential projects, and re-prioritising essential projects • promoting the taking of annual leave, long service leave and unpaid leave by their staff • considering alternative employment models, e.g. parttime, haircuts on remuneration, redeployment of parts of the workforce • cutting costs and eliminating discretionary spend where possible without compromising operational resilience.

Following the example of British banks, New Zealand banks have agreed not to pay any dividends or to redeem any tier-one capital instruments. The measures appear to be designed to ensure banks retain profits they make in New Zealand to support lending to New Zealanders during the crisis.

On 7 April 2020, APRA issued guidance to ADIs and insurers on capital management. APRA’s expectations are that discretionary capital distributions will be limited to maintain capacity to lend and underwrite insurance.

This includes ‘prudent reductions in dividends’.

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It will be important for the industry to sustain its community-minded efforts and at the same time manage the expectations of its shareholders.

Wealth management and superannuation entities The economic crisis is putting particular pressure on wealth management and superannuation entities; some examples are listed below.

• significant losses in member portfolios • fear-based selling / switching to cash • increasing proportion of illiquid or unlisted assets created by withdrawals • potential adverse impact on remaining super fund members caused by declining value of infrequently revalued illiquid assets but artificially high unit prices • important to comply with requirements of APRA’s SPG 530 Investment Governance and SPG 531 Valuation • large volume of member enquiries to the superannuation fund or their financial advisers

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CPD Questions Earn CPD hours by completing this quiz via FS Aspire CPD 1. Which of the following is one of the government’s key responses to the COVID-19 crisis? a) Easing of financial hardship restrictions to enable early release of super for eligible people b) Early access to super for all fund members, regardless of their financial situation c) A tightening of restrictions on early withdrawal of super d) Postponement of super guarantee payments by employers for 10 months 2. In what terms does the author describe the mindset that has been encouraged during the pandemic? a) ‘Family first’ mindset b) ‘Economic resilience’ mindset c) ‘Community first’ mindset d) ‘Survival’ mindset 3. ASIC has stated that, until September 30, it will do which of the following? a) P rovide waivers from certain regulatory requirements b) Suspend non time-critical matters c) Prioritise serious breaches of the law d) All of the above 4. To what does the author attribute the healthy liquidity position of Australian banks? a) The Henry Taxation Review b) The Murray Financial System Inquiry c) The Cooper Review d) The Hayne Royal Commission

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• easing of government restrictions on (limited to $10,000 in each of 2019/20 and 2020/21) hardship-related withdrawals to meet income needs (hardship defined as: made redundant, working hours reduced by 20% or more, or for sole traders and businesses in situations where the business has been suspended or where turnover has declined by 20% or more) • major impact on pension benefits of retirees, potentially exacerbated if redemptions are suspended.

There are also strong arguments put forward for and against the provision by the RBA for liquidity to support pandemic-related withdrawals.

Life and general insurance companies The particular ways in which the crisis is impacting insurance companies includes the following: • decline in revenue from reduced business activity • reduced profitability caused by downward pressure in equity markets, interest rates, and management fees • re-assessment of IBNR related claims reserves caused by crisis related delays in claims reporting and general uncertainty • pressure on life product profitability • increase in health, travel and business interruption claims • the obligations under, the effectiveness of, and the impact of ‘force majeure’ clauses • increase in credit-related claims • loss recognition testing might require review and be performed more frequently • drop off in the use of face-to-face channels • pressure on solvency tests • fast-tracking claims processes • adoption of a supporting-the-community mindset • reduction in dividends (refer above under ‘Banks’).

Periodic updates on developments in the industry, together with insights on what they mean for entities, their directors and management, will need to be provided. fs

5. As long as AGMs are held by 31 July 2020, ASIC will not take action against companies with December 2019 balance dates. a) True b) False 6. ASIC stated that it does not expect banks and insurance companies to limit their discretionary capital distributions, including dividends. a) True

b) False

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Ethics & Governance:

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Corporate governance and

ethics post Royal Commission

By Phoebe Wynn-Pope and Andrew Lumsden, Corrs Chambers Westgarth

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CPD Earn CPD hours by completing the assessment quiz for this article via FS Aspire CPD. Worth a read because: The Hayne Royal Commission found that many organisations had failed to meet community standards and expectations. This paper argues that the Commission’s recommendations can be made clearer and ‘organisation ready’ if an ethical culture is developed that is consistent with internationally-recognised human rights norms.

Visit www.financialstandard.com.au and click ‘FS Aspire CPD’ in the menu or call 1300 884 434 to gain access to the platform.

Corporate governance and ethics post-Royal Commission Could a human rights approach be the answer?

I

Phoebe Wynn-Pope and Andrew Lumsden

n February 2019, the Final Report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (Final Report), led by the Hon Kenneth Hayne AC QC, was published. Shortly thereafter, the government published its response, highlighting the actions it will take in respect of all the recommendations.

Since that time, much has been written on the Final Report (and the preceding Interim Report) findings that a number of boards had failed to ensure ethical outcomes for their organisations and customers. Largely driven by its terms of reference, the Royal Commission found that many of the organisations they were called upon to investigate had failed to meet ‘community standards and expectations’.

We suggest that the Royal Commission’s recommendations can be made clearer and ‘organisation ready’ if the ethical culture is developed that is consistent with internationally-recognised human rights norms.

Because they are based in international law, human rights provide an ethical lens that can transcend national and cultural boundaries. They put peoples’ basic human rights at the centre of decision-making and can be used to assess and address any unintended harm. They remove the subjective element from ethics and replace it with internationally-agreed standards ready to be incorporated into thoughtful governance and corporate decision-making

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processes. This type of ethical framework should also help organisations attract and retain customers and employees. Using such a human rights model can help build valuable social capital.

What does a human rights approach entail?

A human rights-based approach to governance design asks an organisation to consider their business conduct and practices against the legitimate rights of stakeholders and the obligations of the organisation to respect all human rights, including such rights as the right to privacy, to freedom of expression, the right to work and have an adequate standard of living, and the right to be free from discrimination.

A human rights approach says that where individuals may be directly affected by decisions, an organisation will consider the legal, regulatory, moral and actual rights of those involved and, where practicable, include affected persons in the decision-making process through communication and consultation—an organisation taking such an approach will not only ask the question ‘can we?’ but ‘should we?’

In 2011, the Human Rights Council unanimously endorsed the UN Guiding Principles on Business and Human Rights (UNGPs).

These principles establish guidance for businesses to respect human rights and take steps to assess, identify, mitigate and prevent adverse human rights impacts.

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The UNGPs have gained significant traction around the world. They have been incorporated into OECD guidelines for multinational enterprises and referenced in other global guidelines and national legislation—21 states, including the United Kingdom, the United States and Germany, have developed National Action Plans on Business and Human Rights, and Australia has referenced the UNGPs in the Draft Guidance to the Modern Slavery Act 2018.

Further, nearly 10,000 organisations across the world have joined the UN Global Compact, meaning they have formally committed to reporting on their progress on human rights, environmental rights, labour rights and anti-corruption on an annual basis. Human rights are also increasingly being referenced in relation to global efforts to address issues like modern slavery in supply chains. However, embedding human rights considerations into decision-making at every level is key to ensuring the framework is effective.

In a 2017 paper, The Role of Social Capital,1 the authors suggest that an organisation can build valuable social capital by being seen to self-regulate beyond governmental controls. This demonstrates to consumers that the organisation is ‘ethical’. Further, a number of studies2 have linked high levels of ethical behaviour to higher profits, with one even showing that customers are willing to pay a slight premium for a product created by a company with high social capital.

A human rights-based approach to governance can help develop a corporate culture that considers all stakeholders affected by a particular corporate decision. It means a governance policy that includes a commitment to treating people with respect, dignity, fairness and equality, to help them obtain or maintain basic human rights standards of individual safety, security, health and welfare.3 In the language of the Royal Commission, a human rights-based model recognises the “differences between a short-term and a longer-term view of prospects and events”. As the Final Report says, “the longer the period of reference, the more likely it is that the interests of shareholders, customers, employees and all associated with any corporation will be seen as converging on the corporation's continued long-term financial advantage”.

A human rights-based approach to governance is also a model that finds support in the recent Brickworks Decision,4 in which the Federal Court supported a view that allowed directors considerable scope to consider the long-term interests of the corporation.

Overlaying directors’ duties Directors must exercise their powers and discharge their duties in good faith, in the best interests of the corporation and for a proper purpose. It is the corporation that is the focus of their duties, but that is not the end of the matter.

This is because the interest of the corporation can intersect with the interests of stakeholders (including shareholders).5 Accordingly, directors may need to take into account

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human rights matters. This is especially true of the current environment. Increasingly, directors are being required to steward their organisations through a range of external and internal stakeholders that are looking out for misconduct, not just within their organisations but all the way along their value chains. Any misdeeds, be they deliberate or accidental, will be of great cost to a corporation if their cause is perceived to be based (either in whole or in part) on the absence of an ethical culture in the corporation.

The duty of care and diligence obliges a director to obtain knowledge and sufficiently place themselves in a position to guide and monitor management of the organisation. In the Centro Case 6 this was described as a ‘core, irreducible requirement’. Directors must become familiar with the fundamentals of the business in which their organisation is engaged, and are under a continuing obligation to keep informed about their organisation’s activities and ‘the effect that a changing economy may have on [its] business’. The Final Report redefines this duty to be: “… consideration of more than the financial returns that will be available to shareholders in any particular period. Financial returns to shareholders (or ‘value’ to shareholders) will always be an important consideration, but it is not the only matter to be considered.”

What is certain is that no current director can ignore the possible impact on their organisation of poor corporate culture and its reputational consequences. While it will never be a complete solution in and of itself, directors who: • consider and adopt a human rights framework; and • act (or decline to act) based upon a rational and in formed assessment of the organisation’s best interests, may be better placed to use the existence of that governance framework as part of a ‘business judgement defence’, 7 especially where they are making business judgements.

This statutory defence protects management decisions provided (among other things) that the director has informed themselves of the subject matter and rationally believes that the judgement is in the best interests of the corporation. When directors make business judgements about balancing environmental, social and governance-related issues or the approach they take to shareholder and consumer activism, a human rights framework may go some way towards establishing that the board considered a broad suite of social capital issues in reaching their decision.

In addition, human rights make good business sense.

Organisations that integrate human rights considerations into their core business practices can see decisions as justifiable and in the best interests of the organisation because, as the Australian Human Rights Commission sensibly points out, it: • safeguards the organisation’s reputation and brand image • highlights human and environmental risks before technical or investment decisions are made • reduces cost burdens associated with stakeholder

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Phoebe WynnPope, Corrs Chambers Westgarth Phoebe WynnPope, is an accomplished senior executive with over 25 years’ experience in the humanitarian sector. She has worked extensively with government, business, academia and the public to promote human rights.

Andrew Lumsden, Corrs Chambers Westgarth Andrew Lumsden, partner at Corrs, specialises in mergers and acquisitions, securities transactions and corporate governance, advising clients on all aspects of local and crossborder mergers and acquisitions and corporate governance.

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The quote

Because they are based in international law, human rights provide an ethical lens that can transcend national and cultural boundaries.

damage control, labour disputes and security issues • reduces the risk of costly litigation • improves governance.

The Final Report challenges the idea that Australian law requires corporate governance based upon shareholder primacy and shareholder wealth maximisation alone. That said, if thoughtfully implemented, a human rights framework underpinning an organisation’s governance code should meet the Final Report’s recommendation that shareholder interests be considered alongside (not necessarily in priority to) those of other stakeholders.

A human rights framework could provide a valuebased underpinning for directors as they try to balance the interests of a number of different stakeholders whose interests in the organisation, direct or indirect, appear now to form a part of the director’s statutory and fiduciary obligations. This is particularly true when we look at what Commissioner Hayne said about the type of conduct required of Australian corporates.

Human rights in the context of ethical conduct When Commissioner Hayne handed down the Final Report, he found that many organisations they were called upon to investigate failed to meet ‘community standards and expectations’. In particular they had failed to: • obey the law • not mislead or deceive • be fair

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• provide services that are fit for purpose • deliver services with reasonable care and skill • when acting for another, act in the best interests of that other.

The following section explores how these requirements could sit in a human rights-based framework designed to promote a culture of acting lawfully, ethically and responsibly. We also consider how these standards sit with the ASX Corporate Governance Council current Corporate Governance Principles and Recommendations (4th Edition). Relevantly, a listed entity is required to articulate and disclose its values. That might include a governance style statement that incorporated a human rights focus, for example: “Our company will conduct its business with uncompromising integrity. Our reputation for honesty, fair dealing and ethical behaviour is a defining hallmark of our corporate culture. Each of us bears responsibility for nurturing and enhancing that reputation and for upholding our values. Those values include an obligation to respect the human rights of individuals. This means that we will treat people with whom we deal with respect, dignity, fairness and equality, to help them obtain or maintain basic human rights standards of individual safety, security, health and welfare so as to avoid infringing on the human rights of others or preferring the interests of one group, and we will address any adverse human rights impacts with which we are involved.

Our standards of business conduct serve as our guide

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to the ethical and legal obligations we have. These standards govern all our dealings with customers, competitors, suppliers, third-party partners, as well as with employees. This means that among other things we will not make representations or omissions, nor engage in any other practices that are deceptive, misleading, fraudulent or unfair.”

This statement would (see the UNGPs for more information): • be approved at the most senior level of the entity • be informed by relevant internal and/or external expertise • stipulate the entity’s human rights expectations of personnel, business partners and other parties directly linked to its operations, products or services • be publicly available and communicated internally and externally to all personnel, business partners and other relevant parties • be reflected in operational policies and procedures necessary to embed it throughout the business enterprise.

It could (and some might say should)8 also be accompanied by an amendment to the constitution, for example: “In exercising their power to manage and direct the affairs of the Company, directors may have regard to those matters they consider most likely to promote the interests of the Company. In particular, directors may take into account the human rights of individuals with whom the Company interacts.”

We examine Commissioner Hayne’s six key behaviours to meet ‘community standards and expectations’ in more detail below.

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Do not mislead or deceive

If a corporate culture, policies, guidelines, procedures and decision-making processes are based on a fundamental respect for human rights and the human rights of all stakeholders, it is possible to build a culture of transparency and accountability. The importance of this approach can also be seen in the context of the OECD Guidelines for Multinational Enterprises, which require enterprises to ‘not make representations or omissions, nor engage in any other practices, that are deceptive, misleading, fraudulent or unfair’.

The quote

Using such a human rights model can help build valuable social capital.

Be fair

Countless studies10 have shown that humans have a deep aversion to inequity engrained in their psyche. Regardless of the actuality, should something appear to have been ‘unfair’, those adversely affected look for a redress of what they think are ‘wrongs’.

Such an approach is never going to serve the best interests of an organisation that is seen to be behaving unfairly.

A human rights perspective says that the impact of any decision should have been considered from the point of view of all relevant stakeholders. Has the organisation tested the decision to make sure it is not going to unfairly impact one group of stakeholders in preference of another?

In some instances, these decisions can be framed with the help of human rights considerations—for example, limiting the freedom of expression of some people to protect the safety and security of others. Identifying salient human rights risks, or recognising where the adverse impact is greatest, may help business to identify the ‘fair’ decision.

Obey the law

Saying ‘obey the law’ may sound trite, but it is not always that easy. Research conducted at Melbourne Law School found the same prohibition in slightly different forms, with different requirements, different defences and different remedies and penalties in more than 30 pieces of state and federal legislation.

While there are many inadequacies in the way our legislation is crafted,9 the ‘obey the law’ principle requires an organisation to make a simple statement that it will apply the laws that govern it and its relationships with its customers, the community and employees in a purposive way consistent with human rights principles.

Today, the wrong corporate culture can be a basis for liability. The Criminal Code Act 1995 contemplates that culture can be a factor in sentencing decisions. In this context, a human rights focus provides guidance by encouraging decision makers to ask: who is affected by this decision and are they positively or negatively impacted? If they are negatively impacted, is it possible to prevent that impact; if not, should we be continuing with this activity, operation, service or transaction?

If these questions are not considered early in the decision-making process, even where a decision is clearly within the law, there may be a risk to business development, sustainability, brand and reputation.

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Provide services that are fit for purpose and deliver services with reasonable care and skill

These two behaviours can also be seen in the context of the OECD Guidelines for Multinational Enterprises, which state that enterprises should ‘act in accordance with fair business, marketing and advertising practices and should take all reasonable steps to ensure the quality and reliability of the goods and services that they provide’. Putting business decisions through a human rights lens can help to determine what services are fit for purpose. What is the aim of this service? Who will benefit from it? Are there any stakeholders who may be negatively affected?

When acting for another, act in the best interests of that other

Are the human rights of others being respected? Are you having a positive or negative impact on them, and how does that manifest itself in the outcomes brought on by the decisions you are making?

Looking forward The Final Report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry has challenged corporate Australia to rethink the orthodoxy of their corporate governance model. So too

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CPD Questions Earn CPD hours by completing this quiz via FS Aspire CPD 1. The Hayne Commission found that many organisations failed to do which of the following? a) Provide services that are fit for purpose b) Obey the law c) Deliver services with reasonable care and skill d) All of the above 2. According to the commentary, how many organisations have joined the UN Global Compact? a) Almost 100,000 b) Around 50,000 c) Nearly 10,000 d) Close to 200,000 3. Which of the following is cited as one of the Hayne Commission’s findings? a) Many organisations failed to meet community standards and expectations b) Hayne was impressed by how many organisations were meeting high standards and expectations c) Very few organisations failed to meet community standards and expectations d) It was not possible to evaluate how many organisations met with community expectations and standards 4. Which of the following statements reflect the commentary? a) A human rights approach asks ‘can we?’, rather than ‘should we?’ b) A human rights approach not only asks ‘can we?’, but also ‘should we?’ c) A human rights approach looks at moral rights, but not legal rights d) None of the above 5. The Hayne Commission stated that shareholder value is the only matter that directors have a duty to consider. a) True b) False 6. The authors state that a human rights approach can help to build valuable social capital. a) True

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have the new ASX Guidelines, which show that the ASX Governance Council is requiring boards to consider (or reconsider) their own practice to ensure their processes are designed to maintain a sound culture and acknowledge the need to meet community expectations.

Human rights is a well-established ethical framework through which to frame that conversation. Where human rights have been considered in the decision-making process in difficult situations, boards and senior managers may be in a better position to outline what they did to prevent the situation, what they did to detect it and what they decided to do when they found out about it.

Commissioner Hayne is right to highlight the important role of directors and management in embedding an ethical culture. The Final Report suggests that the community expects corporate Australia to foster a culture that promotes good leadership, decision-making and ethical behaviour.

Human rights provides a basis for practical understanding of what is ethical, of what is efficient, honest and fair, of what is the ‘right’ thing to do. For directors and managers, putting a human rights framework in place can help shape a ‘human centred approach’ that address the behaviours that the Commissioner suggests are key to meeting community expectations.11 fs References 1. ‘The role of social capital in corporations: a review’, Harvard Law School Forum on Corporate Governance, 3 June 2017.

2. For example, Ching-Wei Ho, ‘Does practicing CSR make consumers like your shop more?’, International Journal of Environmental Research and Public Health, 14(12), December 2017.

3. Sheehan, K., & Kinley, D., ‘Community expectations: putting people before profit means taking human rights seriously’, 6 November 2018, Sydney Law School Research Paper No. 18/73.

4. RBC Investor Services Australia Nominees Pty Limited v Brickworks Limited [2017] FCA 756.

5. This idea was explored in some detail in Bell Group Ltd (in liq) v Westpac Banking Corporation (No.9) (2008) 39 WAR 1, in the context of the interests of the shareholder and the corporation.

6. Australian Securities and Investments Commission v Healey [2011] FCA 717.

7. Lumsden, Andrew J., ‘The business judgement defence: insights from ASIC v Rich’, 25 March 2010, Companies and Securities Law Journal, vol.

28(3), 2010.

8. Lumsden, Andrew J. & Fridman, Saul, ‘Corporate social responsibility: the case for a self-regulatory model’, Company & Securities Law Journal, 2007; Sydney Law School Research Paper No. 07/34.

9. For a new model see: ‘Statutory interpretation and the critical role of soft law guidelines in developing a coherent law of remedies in Australia’, in New Directions for Law in Australia, 2017.

10. Fehr, E. & Schmidt, K. M., ‘A theory of fairness, competition, and cooperation’, Quarterly Journal of Economics, vol. 114(3), 1999, pp. 817–868.

11. Peter Kell, Why a Human Centred Approach Matters, ASIC, 2018.

b) False

Visit www.financialstandard.com.au and click ‘FS Aspire CPD’ in the menu or call 1300 884 434 to gain access to the platform.

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Investment:

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The curious performance

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impact of buybacks

By Raewyn Williams and Joshua Mckenzie, Parametric

The struggle for oil market

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By Kim Catechis, Martin Currie

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CPD Earn CPD hours by completing the assessment quiz for this article via FS Aspire CPD. Worth a read because: Much of the discussion and analysis of buybacks is based on performance reports, and a misunderstanding of the performance impact of buybacks can lead to flawed decisions about investment strategies and managers. This paper discusses the need for funds to understand the impact of buyback participation on equity performance reports.

Visit www.financialstandard.com.au and click ‘FS Aspire CPD’ in the menu or call 1300 884 434 to gain access to the platform.

The curious performance impact of buybacks Going backward to go forward

O

Raewyn Williams and Joshua Mckenzie

ff-market share buybacks are a curious form of Australian corporate action: what rational investor would deliberately elect to sell back shares at a price below market value? The answer lies in the after-tax value of the transaction. A superannuation fund investor goes backward in pre-tax terms to go forward in after-tax terms.

It is the investment version of Roald Dahl’s ‘square sweets that look round’ absurdity—it makes perfect sense when you understand it.

This paper addresses the lack of understanding of the precise impact of buyback participation on Australian equity performance reports. Because so much discussion and analysis is based on performance reports, misunderstanding the performance impact of buyback participation could lead to flawed decisions about investment strategies and managers.

Australia’s flurry of buyback activity from 2016 to 2019 provides an opportunity to trace a handful of transactions to show their cumulative impact on equity performance. Superannuation funds might be surprised to find how large the benefits can be. The seven buybacks in our analysis collectively added 28 basis points after tax to an index-weighted strategy and 1% to an active strategy with a 10% high-conviction over-

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weight. But it costs funds in pre-tax performance to reap these benefits, raising the critical question of whether some pre-tax-focused super funds have foregone the opportunity to deliver these wins to members.

Some funds have embraced a quick fix for dealing with the harsh pre-tax impact of buybacks in performance calculations. This fix falls short of a more sustainable solution that aligns investment thinking to the after-tax world of super fund members. The benefits we identify make a wise buyback strategy more than just a ‘nice to have’ for Australian equity portfolios. For decision-makers to execute their strategies properly, performance reporting must capture buyback impacts appropriately, treat participating managers fairly and be well understood by decision-makers.

What is a buyback?

A buyback is a corporate action that occurs when a publicly listed company purchases some of its equity back from shareholders. The company’s motivation is often to remove excess cash—a ‘lazy asset’—from its books and reduce the number of shares on offer, increasing the price of the shares remaining in circulation.

Brokers on the exchange conduct on-market buybacks for the company. For a super fund or manager holding these shares, selling the shares back to the company is no different from selling the shares on-market to

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any other purchaser. There is no special impact of this kind of buyback on performance reporting. This paper focuses on off-market buybacks, which are usually conducted through a tender process. Shareholders are invited to tender an offer to sell some or all of their shares back to the company at a particular price, which the company may accept or reject.

The performance complication is that the shares are bid back to the company at a discount to market value. This is because of the tax-advantaged nature of the buyback, which has been described by Treasury as a legal form of franking credit streaming.1 Tax rules treat buyback sale proceeds partly as a franked dividend, with valuable noncash franking credits attached, and partly as trade proceeds, which often trigger a capital gains tax (CGT) loss. The higher the franked dividend component, the more attractive the buyback becomes from an after-tax point of view for low-rate (accumulation-phase super funds) or zero-rate (pension-phase funds) taxpayers.

When shareholders collectively are keen to accept a buyback offer, the off-market buyback price is often bid at the maximum 14% discount to the market price. Companies can scale back an oversubscribed buyback offer, meaning the number of shares each participating shareholder has tendered into the buyback is reduced in an equal proportion. More attractive buybacks result in more demand, potentially to the point of oversubscription, and a higher chance of being scaled back.

ment (10,000 shares multiplied by $30.40). The 2.44% index weight implies an overall portfolio value of $12,459,016 ($304,000 divided by 2.44%). Our super fund therefore has a choice: • if the fund participates in the buyback, it receives $28.94 per share accepted into the buyback • if the fund doesn’t participate in the buyback, the fund’s entire WOW holding is worth $31.49 per share at buyback close.

Figure 1 compares the pre-tax performance of the WOW holdings in these scenarios.

We see here that an index-tracking fund gives up three basis points in pre-tax performance to participate in the WOW buyback versus not participating. This buyback penalty has more impact than the initial result might suggest. If we expand our analysis beyond passive strategies, the pre-tax penalty for WOW buyback participation increases in line with the fund taking a more active position, which is common among superannuation Australian equity portfolios.

Figure 1. Pre-tax performance impacts of buyback participation decisions Participates

Doesn’t participate

Formula

[(Buyback price – market price) × shares accepted] + (market price × shares not bought back) = pre-tax performance impact:

Market price change × total shares = pre-tax performance impact:

Example

[($28.94 – $31.49) × 1532] + ($31.49

($31.49 – $30.40) × 10,000 = $10,900,

× 8,468) = $6993, or 6 bps

or 9 bps

Pre-tax buyback performance impact A super fund participating in a buyback goes backward in pre-tax terms by selling shares at a discount to market value rather than holding them or selling them on-market at market value.

This can be illustrated by assuming an S&P/ASX 200-tracking strategy held 10,000 shares of Woolworths (WOW) at the time the WOW buyback was announced on 1 April 2019 with the following characteristics: • index weighting: 2.44% • market value on buyback announcement: $30.40 • market value at buyback close: $31.49 • buyback price: $28.94 • buyback price designated as a fully franked dividend: $24.15 (83.45%) • scale-back factor: 84.68% (meaning that if 10,000 shares were tendered into the buyback at the accepted price, only 1,532 were actually bought back).

The stocks are worth a total of $304,000 on buyback announce-

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Source: Parametric. For illustrative purposes. Not a recommendation to buy or sell any security.

Figure 2 shows the buyback performance penalty in portfolioholding scenarios ranging from an index weighting to a 10% highconviction overweight.

The pre-tax penalty increases linearly as the fund’s equity strategy becomes more active and the overweight to WOW rises. The pre-tax performance penalty is nine basis points at a 5% overweight and 15 basis points at a 10% overweight. This one transaction alone demonstrates the importance of understanding the performance impact of buyback participation. We then expand our analysis further to cover seven prominent buyback opportunities that occurred in the Australian share market from 2016 to 2019. Figure

Figure 2. Pre-tax buyback performance penalty in active portfolios 0.00% -0.02% -0.04% -0.06% -0.08% -0.10% -0.12% -0.14% -0.16% -0.18% Source: Parametric, 1 January 2020. For illustrative purposes; simulated portfolios are hypothetical and do not reflect the experience of any investor. Not a recommendation to buy or sell any security.

It is not possible to invest directly in an index.

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Figure 3. Franked dividend percentages and scale-back factors of prominent Australian buybacks

The quote

Misunderstanding the performance impact of buyback participation could lead to flawed decisions about investment strategies and managers.

Stock

Buyback date

Franked dividend %

Woolworths (WOW)

May 2019

83.45% 84.68%

Scale-back factor

Caltex (CTX)

April 2019

91.42% 86.86%

BHP (BHP)

December 2018

98.63% 58.70%

Rio Tinto (RIO)

November 2018

86.45% 58.27%

Metcash (MTS)

August 2018 73.01% 72.32%

Rio Tinto (RIO)

November 2017

85.17% 89.33%

Telstra (TLS)

October 2016

59.82%

84.16%

Source: Parametric, 1 January 2020. References to specific securities are for illustrative purposes only and are not recommendations to purchase or sell such securities. ‘Franked dividend %’ refers to the percentage of the total buyback price designated as a fully franked dividend for tax purposes.

Figure 4. Pre-tax performance penalty of prominent Australian buybacks in active portfolios 0.0% -0.5% -1.0% -1.5% -2.0% -2.5% -3.0% -3.5%

Source: Parametric, 1 January 2020. For illustrative purposes; simulated portfolios are hypothetical and do not reflect the experience of any investor. Not a recommendation to buy or sell any security. It is not possible to invest directly in an index.

Figure 5. After-tax performance impacts of buyback participation decisions

Participates Doesn’t participate

Formula

(Tax rate × grossed-up dividends) + franking credits + (tax rate × CGT loss ) = net tax benefit:

Pre-tax performance impact + net tax benefit = after-tax performance impact:

Example

-(15% × 52,854) + 15,856 + (15% × 12,631) = $9823

$10,900 + $0 = $10,900

Formula

Pre-tax performance impact + net tax benefit = after-tax performance impact:

Example

$6993 + $9823 = $16,816 Performance impact expressed in basis points: $16,816 ÷ $12,459,016 = 14 bps

$10,900 ÷ $12,459,016 = 9 bps

Source: Parametric. For illustrative purposes. Simulated portfolios are hypothetical and do not reflect the experience of any investor. Not a recommendation to buy or sell any security. It is not possible to invest directly in an index.

4 shows that an index-tracking strategy would amass a cumulative pre-tax performance penalty of 78 basis points for participating in the seven buybacks in our analysis. More active strategies would fare worse: A strategy with a 5% overweight to the buyback stocks loses 2%, while a strategy with 10% high-conviction overweight suffers a pre-tax performance drag of over 3% in under three years. The size of this performance impact is noteworthy in the context of volatile beta and scarce alpha. This raises tough questions for funds and managers who crave the after-tax value of buybacks but fear looking worse pre-tax compared with benchmarks and peers. This creates the potential for dysfunctional, value-destroying behaviour if not addressed well.

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After-tax buyback performance impact Pre-tax performance doesn’t show the whole picture. As our notion of going backward to go forward reminds us, the mathematics of buybacks makes sense if the tax benefits more than compensate for the discount to market value. We can expand our perspective of the buyback experience by considering tax impacts and overall after-tax outcomes for super fund investors.

Our after-tax calculations reflect a taxable complying super fund tax profile and adopt a pre-liquidation methodology that captures only realised tax impacts. We assume all buyback share parcels were originally purchased at a cost of 50% of the market value of the shares at buyback close. Telstra (TLS) is the one buyback stock in our analysis that generated a capital gain for tax pur-

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Figure 6. Net tax benefits of buyback participation

FSource: Parametric, 1 January 2020. Performance is hypothetical and is provided for illustrative purposes only. It does not reflect the experience of any investor. Not a recommendation to buy or sell any security.

Figure 7. After-tax performance impacts of buyback participation

0.5% 0.4%

Pretax performance impact

Tax performance impact

After-tax performance impact

0.3% 0.2% 0.1% 0.0% -0.1% -0.2%

Raewyn Williams, Parametric Raewyn Williams, managing director, research, Australia, Parametric, is responsible for setting the Australian research agenda to research and develop new products for the Australian market.

Source: Parametric, 1 January 2020. Performance is hypothetical and is provided for illustrative purposes only. It does not reflect the experience of any investor.

Not a recommendation to buy or sell any security.

poses; we assume half of the gain was long-term, qualifying for the one-third CGT discount concession. We further assume no breaches of the 45-day holding-period rule, which means shareholders are entitled to all franking credits received in the buyback. We assume that the fund can use CGT losses from the buyback in the same performance period to offset otherwise taxable capital gains elsewhere in the portfolio. Fees and transaction costs are ignored to simplify our analysis.

Returning to our hypothetical index-tracking fund holding 10,000 WOW shares, we now expand our pre-tax performance calculations in Figure 1 to add the tax benefit and after-tax performance impact for the portfolio.

Our expanded perspective turns a three-basis-point pretax penalty for participation into a five-basis-point after-tax improvement in investment performance. The tax benefits of WOW buyback participation—$9823, or eight basis points of the portfolio—more than compensate for the pretax performance penalty. Figures 6 and 7 show how this win grows as the fund’s WOW weighting becomes more active.

The tax benefits are mostly driven by the effect of streaming franking credits to buyback participants. They reach as high as 39 basis points on a 10% overweight, easily compensating for the discounted sale proceeds received for the stocks bought back. The overall net result

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vindicates the buyback strategy: the portfolio’s net-of-tax performance improves by as much as 23 basis points on a 10% overweight from this single transaction.

These after-tax performance enhancements multiply as we apply this analysis across our entire buyback sample in Figure 8.

The 78-basis-point pre-tax step backward by our index-tracking fund becomes a 28-basis-point after-tax step forward in under three years. A 2% pre-tax step backward becomes a 64-basis-point after-tax step forward for a 5% overweight to buyback stocks. Our 10% high-conviction overweight to buyback stocks is a good deal for super fund members, taking a 3.22% pre-tax penalty to achieve after-tax returns of 1%.

Thinking differently about buyback performance reporting The numbers deliver a clear message about the true value of buyback opportunities. Is that message enough to drive the right member-centric behaviour and decision-making by super fund equity managers and asset consultants?

Industry dialogue about investment opportunities and decisions made every day by super funds continue to be anchored by pre-tax thinking. One common effect of this is that when funds and their advisers appraise and select

Joshua Mckenzie, Parametric Joshua Mckenzie, analyst, Parametric, is responsible for assisting the managing director of research with the Australian research agenda.

He holds a Bachelor’s Degree in Economics and Finance, University of Wollongong.

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Figure 8. Total after-tax performance impact of buyback sample

FSource: Parametric, 1 January 2020. Performance is hypothetical and is provided for illustrative purposes only. It does not reflect the experience of any investor. Not a recommendation to buy or sell any security.

Australian equity managers—a decision with high stakes for all involved—they always come armed with pre-tax performance histories and rarely with after-tax performance.

The implications of this pre-tax mindset are grave given our demonstration of how funds must go backward by taking a pre-tax penalty to go forward and reap significant net after-tax return benefits.

Our analysis shows that it becomes very difficult for funds to give up anywhere from 78 basis points to 3.22% in pre-tax performance, notwithstanding the significant value to be generated for fund members in doing so. But there is a perverse incentive to reject opportunities that add after-tax value to super fund members in order to preserve the pre-tax performance upon which so much decision-making is based. This is a classic agency risk problem.

There are two ways for the industry to solve this problem: a rarelyused long-term solution that eliminates the agency risk, and a more popular fix that specifically (and only) deals with buyback scenarios.

The long-term fix If the superannuation industry had the opportunity to start again from the ground up, one compelling idea would be to establish after-tax performance as a baseline to reflect the taxable nature of Australian super funds. This would align funds’ investment thinking to the concerns of their most important stakeholders: fund members.2 It adds to the toolkit for equity portfolio managers and strategists to achieve investment objectives and beat benchmarks, including the effective tax assumptions embedded in APRA’s controversial new heat map. It makes it easier for funds to comply with superannuation legislation that explicitly compels an after-tax investment focus.

This solution to the buyback performance problem elegantly extinguishes agency risk concerns. Pre-tax penalties become irrelevant to assessments of manager skill and the health of the equity portfolio. The only useful information is how the strategy has performed net of tax.

Buyback decisions would be relevant to this assessment and accurately captured in performance reports.

A variant of this solution would be to add disclosures around after-tax returns on performance reports in the event of buyback participation.

This allows custodians to flag misleading pictures of pre-tax performance and compel fuller pictures that include after-tax returns.3 Performance

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report readers would need to understand the ‘going backward to go forward’ performance impact of buybacks to draw accurate conclusions.

The quick fix Custodians now accommodate a less ambitious fix to the problematic buyback penalty on pre-tax performance. When the strategy participates in a buyback, the custodian removes the buyback penalty from pre-tax performance reporting. This manual process introduces risks but remains manageable because buybacks are seasonal and sporadic. Using the analysis in Figure 8, each strategy’s pre-tax performance would increase to between 78 basis points and 3.22% over the buyback sample period. To be clear, this deliberately overstates the pre-tax performance of the strategies. However, it removes the perverse incentive for an equity manager to reject a value-accretive buyback opportunity by eliminating the pre-tax buyback penalty.

The attraction of this quick fix is its simplicity. Yet it is important to discuss the shortcomings of this solution, which may be becoming standard industry practice: • What should a report user make of pre-tax performance as reported? Is it a true reflection of performance or inflated to ignore the impact of buyback participation? Does trust in the numbers become linked to whether users know if buybacks occurred in the performance period under review? Does this create a precedent to justify further fudging of performance data? This is reminiscent of the physics thought experiment of ‘Schrödinger’s cat’, forever both dead and alive: is pre-tax performance after this buyback fix now destined to be both true and untrue?

• This fix ensures that managers who participate in buybacks aren’t punished pre-tax. But it doesn’t reward managers who pursue these opportunities to add value. There is no way for a super fund to distinguish between a manager who adds value through buyback participation and a manager who forgoes this opportunity.

This fix simply treats the buyback as if it never occurred.

• As more funds demand after-tax performance reporting, this quick pre-tax fix complicates matters. Should the pre-tax buyback penalty be excised or left in when after-tax reporting is also provided to show the net benefits? If it’s excised because of concerns about how pre-tax performance is used, how can funds ensure that

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after-tax performance doesn’t start with an inflated pre-tax figure and thereby overstates the benefits? This fix treats the symptom but ignores the more fundamental issue that all pre-tax performance reporting is limited and potentially misleading. Strategies can look quite different against benchmarks and competitors when viewed through an after-tax lens. This is especially true of Australian equities, where franking credits are a fruitful source of yield though the impact of CGT and the value of realised losses is often underplayed.

Our view is that this quick fix is a useful short-term solution for super funds as a way to remove any reason to forego valuable buyback participation opportunities. But it should only be a stepping-stone to the long-term solution we outlined: transitioning to an after-tax performance mindset that captures the full buyback story without confusing those making decisions based on performance reports.

Funds without an approach to addressing the pre-tax penalty they would incur for buyback participation should move straight to the long-term solution instead of embracing a quick fix they may need to unwind.

Conclusion Our analysis highlights how the superannuation industry’s pre-tax investment focus does a disservice to its most important stakeholders. With sound underlying mathematics for low-rate taxpayers, it shouldn’t require courage to seize upon buyback opportunities to the tune of 28 basis points in after-tax returns for an index-tracking equity strategy, 64 basis points for a moderately active strategy, or 1% for a high-conviction strategy. Yet for a fund to go forward in after-tax terms means it must first go backward and take a significant hit to pre-tax performance, which is courageous indeed.

The industry’s favoured response to this issue needs to evolve.

Just as buyback participation shouldn’t require courage, it shouldn’t require a manual performance workaround that clouds trust and understanding in the performance numbers produced. Funds can solve this more effectively and sustainably by dealing with the root problem: their reliance on pre-tax performance tells only part of the story and misaligns with the reality that after-tax returns build the retirement savings of super fund members. The litmus test of what’s right for funds doesn’t seem like too much to ask: for managers to be able to pursue buyback participation when they wish; for funds to be free of agency risk concerns around buybacks; for performance reports to be fudge-free and reliably show how buyback opportunities have impacted an equity strategy; and for decision-makers to be able to differentiate portfolios with wise buyback strategies from those without them. fs Notes 1. Kehoe, J and Turner, S.,‘Spike in share buybacks ahead of Labor’s franking credit crackdown,’ Australian Financial Review, 30 November 2018.

2. Bouchey, P., Williams, R. and Li, T., ‘Fool’s Gold? Linking a Tax- Efficient Super Fund Equity Portfolio to Retirement Savings for Members,’ Parametric, January 2018. [www. parametricportfolio.com.au] 3. For an example of after-tax performance reporting and how it can better inform

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CPD Questions Earn CPD hours by completing this quiz via FS Aspire CPD 1. Misunderstanding the performance impact of buybacks could lead to which of the following? a) A potential breach of APRA’s prudential regulations b) A possible breach of ASX governance rules c) Flawed decisions about investment managers and strategies d) None of the above 2. Why would an investor deliberately choose to sell back shares at a price below market value? a) There is both pre-tax and after-tax value to be gained b) There can be after-tax value in the transaction c) There is pre-tax value in the transaction d) They are willing to risk after-tax value for the sake of pre-tax gains 3. Which of the following reflects the commentary in regard to why investors participate in share buybacks? a) A super fund investor goes backward in pre-tax terms to go forward in after-tax terms b) A super fund investor stands to gain in both pre-tax and after-tax terms c) A super fund investor goes forward in pre-tax terms, but backward in after-tax terms d) None of the above 4. For decision-makers to execute their buyback strategies properly, performance reporting must do which of the following? a) Treat participating managers fairly b) Be well understood by decision-makers c) Capture buyback impacts appropriately d) All of the above 5. Off-market share buybacks are usually conducted through a tender process. a) True b) False 6. The analysis highlights how the super industry’s pre-tax investment focus does a disservice to fund members. a) True

b) False

Visit www.financialstandard.com.au and click ‘FS Aspire CPD’ in the menu or call 1300 884 434 to gain access to the platform.

users, see Williams, R., ‘Drip, Drip: The Case for Controlling What You Can Control,’ Parametric, November 2019. [www.parametricportfolio.com.au]

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CPD Earn CPD hours by completing the assessment quiz for this article via FS Aspire CPD. Worth a read because: With investment markets reacting violently to the sudden weakness in the oil price and a fall in global demand, not least because of the COVID-19 pandemic, there is a fight for market share. This paper looks at the geopolitics behind the recent oil price decline and what it may mean for major oil producers, economies and industries.

Visit www.financialstandard.com.au and click ‘FS Aspire CPD’ in the menu or call 1300 884 434 to gain access to the platform.

The struggle for oil market supremacy Supply, demand and geopolitics

T Kim Catechis

Figure 1. The world’s biggest oil producers

he markets have been reacting violently to the sudden weakness in the oil price. As at March 2020, West Texas International (WTI) is down 48% from the level of $61 per barrel, where it started the year. Brent’s fall has been very similar. The reason for this? Surprise. In an industry replete with insider discussion around the internal politics of OPEC, the fallout between Saudi and Russia, and Saudi Aramco’s announcements of increased production as well as discounts caught most market participants cold.

The confrontation is being billed as Saudi versus Russia, but they both want to knock out a common irritant: United States shale oil producers, who they feel have had a free ride while the two heavyweights have taken the pain of price stabilisation.

Who is most affected?

There are three ways to look at who is most affected: who produces the most, whose economy is most dependent on oil, and who is most hurt by low oil prices.

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Includes crude oil, shale oil, oil sands, condensates and natural gas liquids.

Source: BP

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The quote

It is a fight for market share, in the face of weakening global demand, not least because of COVID-19.

Oil is important to all the countries shown in Figure 1, but for Saudi Arabia, oil accounts for 77% of exports, so it is absolutely crucial. Russia is a significantly more diversified economy, so although for Moscow oil is important, including refined product, it is 52% of exports.

This is a function of the sanctions regime that was tightened in 2016, when the number was 48%.1 Logically, it also matters who your biggest buyers are.

For Saudi, it is China (17%), Japan (15%) and India (11%). For Russia it is the European Union (52%), China (11%) and the United States (4.5%). Arguably the havoc wreaked by COVID-19 could well be a factor in Chinese buying, although all buyers will naturally be opportunistic short term, taking the Saudi discounts to fill inventories.

In terms of each country’s breakeven price, Saudi still requires $88.6 per barrel2 in order to achieve a fiscal breakeven. Russia has spent a long time readying its sovereign financials and its fiscal breakeven point is commonly estimated at $42/bbl.3

Saudi Arabia—high stakes poker The turbulence was precipitated by Mohammed Bin Salman, known widely as MBS, the anointed heir to King Salman bin Abdulaziz. Having failed to convince Russia to reduce production further, in order to support the oil price, he went off the established patterns of behaviour.

Saudi Aramco announced increased production to 12.3 million barrels per day (an increase of 2.5mbpd, probably out of inventory) and offered discounts of $6 to $8 per barrel for April deliveries, thus causing a collapse in Brent to around $30 per barrel. It is a fight for market share, in the face of weakening global demand, not least because of COVID-19.

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Saudi Aramco’s own disclosed cash flow sensitivities suggest that for every $1 move in the per barrel price of crude, there is a $1.5 billion move in cash flow. In terms of production, every 100,000 barrels per day of additional production equals $1.1 billion of cash flow. So, if we assume an average price of $45 per barrel and production going to 12 mbpd, that will only cover $10 of the per barrel price reduction.

Saudi is the dominant driver of OPEC, as the country with (we have long believed) the deepest reservoirs of crude oil and the biggest swing producer in the world.

It accounts for around 13% of the world’s production.4 However, the Kingdom’s budget statement for 2020 lays out the expectation of a budget deficit of $49 billion or 6.4% of GDP, based on the assumption of a $55 per barrel oil price in this year.5 As a rule of thumb, a $10 per barrel move in the oil price percolates through to a $20 billion swing in the Kingdom’s revenues, so a $30 per barrel implies a deficit closer to 19% of GDP. The Saudi Arabian Monetary Authority has around $500 billion6 so in the worst case, the Kingdom can hold out for three years.

There is an added aggravation—the power struggle within the Saudi royal family. By anointing his son MBS, the King effectively broke with the long-established tradition of consensus, which would have passed the throne on to the next senior, in this case his nephew, the experienced, widely respected ex-Crown Prince Mohammed bin Nayef. This unilateral move, along with MBS’s actions to consolidate power, has upset many in the ruling family, leading to speculation about the eventual succession. The international fallout over the war in Yemen and the murder of dissident Jamal Khashoggi in Istanbul have not been helpful.

Kim Catechis, Martin Currie Kim Catechis is head of investment strategy at Martin Currie, a Legg Mason Company.

Kim joined Martin Currie in 2010 from Scottish Widows Investment Partnership, where he was director of the Asia emerging markets desk.

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The quote

The confrontation is being billed as Saudi versus Russia, but they both want to knock out a common irritant: US shale oil producers.

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This is relevant because at the same time as the change of tactics on oil was being implemented, authorities arrested Prince bin Nayef and the King’s younger brother, Prince Ahmed bin Abdulaziz, on suspicion of working to block MBS’ accession to the throne. The key element here is that there remains a significant faction of wealthy, disenfranchised royals with their own support structures that need to be reconciled, potentially undermining the long-term sustainability of the leadership.

All in all, this situation is coming at a difficult juncture for Saudi, which raises the stakes significantly. Perhaps unsurprisingly, Saudi Aramco shares are below the IPO price for the first time.

Russia needs to win this one Russia has consistently been one of the world’s largest producers of crude oil, accounting for 12% of the world’s production7 and historically has remained fiercely independent of OPEC, in spite of many invitations to join. In a context of sagging oil prices and a vacuum left in the Middle East by the withdrawal of the United States, the Kremlin saw an opportunity and intervened in the Syrian civil war and drew closer to Riyadh, as both saw a common foe in the Islamic forces lining up against the Damascus government.

The Kremlin is well aware of its own vulnerability.

Russia is a predominantly resource-based economy constrained by sanctions, with a large working population that is educated, but not growing. That is why it has built a robust macroeconomic moat around itself. The country has very low external debt (28% of GDP) and its reserves are equal to 1,078% of short-term debt. For reference, the United Kingdom’s reserves are at 3.1% and the United States’ at 2.1%.8

The country’s National Wealth Fund now stands at $125 billion, but the Bank of Russia’s reserves are $570 billion.9 All the indications are that the Kremlin is ready for the fight. The sovereign financials are strong; it is a diversified economy with a population that has earned a reputation of social resilience. And the recently announced proposals to change the constitution in order to allow Putin to remain president until 2036 look to be a signal to MBS—I’m not going anywhere!

US shale oil producers—in a tight spot The revolution in the United States oil industry driven by shale technology has propelled production to world leadership in a few years. The production boom has been enabled by the availability of cheap finance and benefitted from the OPEC/Russian production cuts over the last three years. So it is only natural that they have become an irritant to both the Saudis and the Russians, although no one has explicitly said so yet.

The nature of shale oil production is very different from conventional oil production. Traditionally, fields take a long time to hit peak production and can be carefully managed, to last 30 or 40 years. Once a shale well has been ‘fracked’ (hydraulic fracturing, the technique employed to break the underground rock and enable access to the trapped reserve), the field hits peak production in months, but also depletes rapidly.

From a financial investor standpoint, this is good, because the up-front costs should be swiftly recovered as production soars and thereafter free cashflow drives dividends. That is one of the reasons for the sector’s popularity with investors in the early 2000s. However, CEOs and their management teams are typically incentivised to

Figure 2. Cumulative E&P unsecured debt, secured debt & aggregated debt

Source: Haynes and Boone, LLP Oil Patch Bankruptcy Monitor report, January 2020.

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demonstrate growth, which can only be done by way of drilling more wells. The costs of a well can be $10-$12 million, so this is not a cheap exercise, and the complexity of the local geology can imply the need for many fracking operations in a relatively reduced acreage.

So, in 2014/16, the weakness in the oil price forced many small shale operators out of business, but the sector became more efficient. As an indicator, shale breakeven is now estimated between $48 and $54 per barrel, well below the $80+ of 2014. However, the easy availability of cheap finance has meant that companies have not generally chosen to manage their deposits for free cash flow—rather they have pursued growth. So many investors are unhappy, and it is now a sector with relatively few friends.

In the US corporate bond space, we have a precedent when default rates in high yield energy names hit 20% in 2016; but this time things look worse—many companies are more extended, with even investment grade companies exposed.

Haynes and Boone’s Oil Patch Bankruptcy Monitor (January 2020) demonstrates the scale of ‘hit’ taken already by the sector (Figure 2).

Nearly 200 bankruptcy filings in the four years to end 2019, still leaving a total of over $120 billion of debt outstanding, of which nearly $60 billion is unsecured. The three biggest states affected are Texas ($68 billion), Delaware ($25 billion) and New York ($20 billion).10 The rapid increase in debt levels shown below speaks to the focus on growth rather than returns in the context of cheap debt. If oil prices remain below $45 per barrel for a year, the rate of bankruptcies in the sector will rocket.

What is US shale breakeven?

In terms of fundamentals, each well in each shale region is different, but according to the United States Energy Information Administration, at $30 per barrel, 50% of the technically recoverable resource is uneconomical.11 Maybe this is a report that was being read in Moscow and Riyadh, because it finds that until prices fall below $60 per barrel, the reserve

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elasticity is only 0.5, implying that for every 1% reduction in prices, only 0.5% of the reserves become uneconomical. Below $60, elasticity is greatly increased.

The conclusion is that prices must reach relatively low levels before the volume of reserves begins to shrink in a substantial way.

Borrowing costs were already going up for US shale companies— even before the price war was launched, generally over leveraged companies with minimal or even negative free cash flow are being offered 10% as a cost of financing. Russia is at 2.56% and Saudi at 2.38%. Even the big integrated oil companies with robust balance sheets will be pressured by this potentially ugly trench war.

Collateral damage The OPEC alliance with Russia was always going to be a temporary one and we seem to have reached the end of the road in a less elegant way than we are accustomed to. The rude awakening will probably be felt immediately in the US upstream sector, where the stressed balance sheets finally give out. Longer term, banks that are highly exposed to the sector will get marked down as will the municipal issuers in oil sensitive US states. On a global basis, this will clearly hurt the high-cost producers like the United Kingdom (average lifting cost of $52.5 per barrel).12 In many ways, the rest of the world is now contemplating their good luck or their misfortune, as almost everyone will be impacted.

Mexico is unfortunate, as the benefits of their oil price hedge and the mechanism which allows the government to delay implementation of the new lower prices at the pumps are completely swamped by the negative implications for Pemex. The company lost $18 billion last year and loses around $2 billion in free cashflow for every $10 move in the oil price. The starting point for Pemex is -$9 billion of free cash flow in 2019. A downgrade of the company’s credit rating to high yield would raise the cost of financing and impact the sovereign as well, in spite of Mexico’s status as a net oil importer.

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CPD Questions Earn CPD hours by completing this quiz via FS Aspire CPD 1. In terms of exports, oil is cited as ‘absolutely crucial’ to the economy of which country? a) Saudi Arabia

b) Russia

c) China

d) India

2. What is cited by the author as a possible factor in China’s buying of oil, as at March 2020? a) Political turmoil in the United States b) The economic fallout from Brexit c) Havoc wreaked by the COVID-19 pandemic d) Economic growth in emerging economies 3. How does the author describe the struggle for oil market dominance? a) A confrontation between Saudi Arabia and Russia b) A battle between Russia and the United States c) A struggle between Saudi Arabia and China d) A fight between China and the United States 4. Which countries does the author cite as likely to benefit from the COVID-19-induced downturn? a) United States and Canada b) China, South Korea and Japan c) The United Kingdom d) Columbia and Mexico

Elsewhere, Colombia is dependent on oil and suffers from weak sovereign financials as well as the weight of around 1.5 million Venezuelan refugees and the government’s attempts to integrate thousands of ex-Marxist guerrillas in accordance with the terms of the recent peace deal. The country is clearly in danger of a downgrade.

Beneficiaries Medium term, China is the biggest beneficiary—as the country comes out of the COVID-19 induced downturn, it gets the gift of seriously cheap oil, helping speed the recovery. South Korea, another big importer sharing the economic pain of dealing with COVID-19, and Japan, will potentially join them very soon. For countries such as Turkey and India, both struggling economically and with leaderships that are under pressure, this could be a tremendous boon. If these low oil prices are sustained for a year (and clearly there are many reasons to believe they are not), the world may well be the biggest beneficiary as economic growth falters in the coming months. Short term, refining companies will have a field day. fs [This paper was published by Martin Currie in March 2020.]

Notes 1. World Bank database.

2. IMF Statistics, Statistical Appendix [https://www.imf.org/en/Publications].

3. IMF Article IV Consultation, Report 48549 [https://www.imf.org/en/ Publications].

4. BP Statistical Review of World Energy 2019.

5. KSA Ministry of Finance, Budget 2020.

6. Saudi Monetary Authority Annual Report 2019.

7. BP Statistical Review of World Energy 2019.

8. Martin Currie proprietary country risk framework, World Bank and Central Bank of the Russian Federation 24/01/20.

9. Central Bank of Russia [https://www.cbr.ru/eng].

10.Haynes and Boone, LLP Oil Patch Bankruptcy Monitor Report.

11.US Energy Information Administration, The Price Elasticity of US Shale Oil Reserves.

12.Statista and Rystad Energy.

5. The power struggle within the Saudi Royal family is cited as an added aggravation for Saudi’s oil industry. a) True

b) False

6. Historically, Russia has remained independent of OPEC. a) True

b) False

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Retirement:

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Transition-to-retirement income streams

By Rahul Singh, Challenger

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Lifetime income streams: How much should a client invest?

By Michael McLean, Challenger

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CPD Read Earn CPD hours by completing the assessment quiz for this article via FS Aspire CPD. Worth a read because: With the progressive reduction of the concessional contributions cap since 2007, and the removal of earnings tax exemption on transition-to-retirement income streams (TRIS) from 1 July 2017, some have questioned whether TRIS continue to have merit in financial planning. This paper outlines some strategies and highlights how TRIS can continue to add strategic value.

Visit www.financialstandard.com.au and click ‘FS Aspire CPD’ in the menu or call 1300 884 434 to gain access to the platform.

Transition-to-retirement income streams Are TRISs still worthwhile?

T Rahul Singh

o access their superannuation, an individual needs to meet a condition of release. One of the conditions of release is attaining preservation age, which entitles a person to access their superannuation in the form of an income stream, with a restriction that a maximum of up to 10% of the balance can be accessed as

pension payments.

Such income streams are commonly referred to as transition-toretirement income streams (TRIS). They have been a powerful structure in financial planning since their advent in July 2005. However, with progressive reduction of the concessional contributions cap since 1 July 2007 and with the removal of earnings tax exemption on TRIS from 1 July 2017, many have questioned whether TRIS continue to have merit in financial planning.

This paper outlines some of the common applications of TRIS and highlights that TRIS can continue to add strategic value.

What is a TRIS? A TRIS at its simplest form is an income stream that consists of preserved funds in part or in full. While one can be commenced when

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an individual reaches their preservation age, their TRIS is still preserved unless they meet another condition of release, typically retirement, which entitles them for a full release of their superannuation benefits, including commencing an unrestricted account-based pension or purchasing a lifetime annuity.

Preservation age

Preservation age depends on a person’s date of birth and is gradually increasing to 60 for those born on or after 1 July 1964. People born before 30 June 1962 have already reached their preservation age when they turned age 57.

Table 1. Preservation age Date of birth

Preservation age

Born before 1 July 1962 Already reached preservation age 1 July 1962 to 30 June 1963

58

1 July 1963 to 30 June 1964 59 On or after 1 July 1964

60

Taxation of TRIS payments TRIS payments are taxed to the individual based on the tax compo-

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Table 2. Taxation of TRIS pension payments Tax components Tax-free component

From preservation age and under 60

Taxable component - element taxed

Tax-free Tax-free

The quote

Taxed at marginal tax rate (MTR) with a 15% offset Tax-free

nents of the pension payments.

Where the individual turns 60 in a financial year, pension payments arising from the taxable component received before they turn age 60 are taxed at their marginal tax rate (MTR) with a 15% offset. Pension payments received on or after the day the individual turns 60 are tax-free.

Payment restrictions of a TRIS A TRIS has to pay a minimum of 4% with a maximum limit of 10% of the commencement value. An individual can choose pension payments anywhere between their minimum and maximum payment limit. Where a TRIS is commenced part way through the financial year, the minimum is pro-rated but the maximum is not. If a TRIS is commenced on or after June 1, no payment is required in that financial year.

The payment limit is then re-calculated based on the income stream account balance at the start of each financial year.

Earnings tax exemption From 1 July 2017, a TRIS is no longer considered to be a retirement phase income stream. This means that earnings of a TRIS are taxed at the same rate as accumulation phase—maximum of 15%.

Transfer balance cap As a TRIS is not considered to be a retirement phase income stream, commencement of a TRIS does not give rise to a credit towards an individual’s transfer balance account for the purposes of the transfer balance cap ($1.6 million in 2019/20).

However, once the TRIS is considered to be a retirement phase income stream, the value at that time gives rise to a credit for the purposes of the transfer balance cap.

Note that different rules apply when an owner of a TRIS dies and a death benefit income stream is paid to a beneficiary.

When does a TRIS cease and become a retirement phase income stream?

It is important to understand when a TRIS ceases and events that cause it to be a retirement phase income stream. Once a TRIS ceases and it is considered to be a retirement phase income stream, it no longer has a maximum payment limit of 10%. It is also eligible for earnings tax exemption at that time with a credit for transfer balance cap purposes.

A TRIS ceases when a person: • turns age 65 • meets the retirement condition of release • meets the total and permanent disablement condition of release • meets the terminal medical condition of release

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60 or over

• dies and has nominated a reversionary beneficiary.

A TRIS will move automatically into the retirement phase as soon as the individual reaches age 65. For the other conditions of release listed above, an individual needs to notify and/or apply to their superannuation provider for the TRIS to move into the retirement phase. In these cases, the TRIS will move into the retirement phase at the time the provider is satisfied that a condition of release is met.

A TRIS at its simplest form is an income stream which consists of preserved funds in part or in full.

Proportioning rule While the earnings of a TRIS at the product level or within an SMSF are taxed in the same way as accumulation, it is still considered to be an income stream. Therefore, pension payments are received in the same proportion of tax components as at commencement. Earnings are also applied to the tax components in the same proportion as at commencement. The proportioning rule effectively means that the proportion of tax components backing the TRIS are fixed based on the proportion at commencement.

Strategic applications of TRIS Given that a TRIS enables up to 10% of a client’s superannuation balance to be accessed prior to retirement, financial advisers find many strategical applications of commencing a TRIS. These include simply accessing some of the superannuation savings, using the income stream to accelerate accumulation of retirement savings, replacing lost income when reducing working hours and estate planning considerations, all of which are outlined below.

TRIS income swap strategy A TRIS income swap strategy involves commencing a TRIS while working and using the TRIS pension payments as additional income to allow for salary sacrifice or personal deductible super contributions. This is one of the most popular use of TRIS, enabling an acceleration of retirement savings. Generally, this strategy would be used by a person who is less than 65 years old and who does not meet the retirement condition of release and does not have enough disposable income to maximise their concessional contributions cap.

Example: TRIS income swap strategy

Anjali, aged 60, is working full-time, earning $100,000 per annum. To date, she has not been making voluntary super contributions as she has minimal surplus cashflow. She has a super balance of $200,000.

Table 3 looks at the application of a TRIS income swap strategy and how Anjali can receive identical disposable income but simultaneously also increase her retirement savings.

Rahul Singh, Challenger Rahul Singh is Challenger’s technical services manager and has been in the industry since 2004. Rahul is passionate about supporting advisers to deliver technical solutions to retail clients.

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Table 3. TRIS income swap strategy1

The quote

The efficacy of the income swap strategy is usually reduced the more the individual earns.

No income swap strategy

Income swap strategy

Salary

$100,000

$100,000

Superannuation guarantee

$9500

Salary sacrifice/personal Nil

$9500 $15,500

deductible super contributions Contributions tax

$1425

$37502

TRIS pension payments

Nil

$9403

Taxable income

$100,000

$84,500 3

Tax including Medicare Levy

$25,717

$19,620

Take-home pay

$74,283

$74,283

Net contributions to super

$8075

$21,250 4

Net additional super funds

Not applicable

$37725

A TRIS income swap strategy would typically involve consolidating accumulated savings with the TRIS balance from time to time to maximise the strategy in future years.

Using the TRIS income swap strategy, Anjali was able to increase her retirement savings by $3772 in the first year. Assuming that Anjali retires at age 65, using the income swap strategy over five years could provide a significant boost to her retirement savings.

While the above example highlights the income swap strategy for an employee, similar dynamics exist for a self-employed person, except for the fact that their available concessional contributions cap is not being consumed by super guarantee (SG) contributions.

TRIS income swap strategy based on different levels of income The value of a TRIS income swap strategy differs based on an employee’s income. The higher income they earn, the more the concessional contributions cap ($25,000 in 2019/20) is being consumed by 9.5% SG, which results in a comparatively lower amount that can be voluntarily contributed. Therefore, the efficacy of the income swap strategy usually reduces the more the individual earns.

Table 4 looks at the value of the income swap strategy for individuals aged over 60 in similar circumstances to Anjali where they don’t have enough surplus disposable income and need the TRIS payments to supplement concessional contributions to have the same level of disposable income. Any surplus income due to the 4% minimum payment on the $200,000 TRIS balance is contributed as a non-concessional contribution.

Table 4. Value of TRIS income swap strategy of different levels of income Income

Net additional super funds due to income swap strategy

$75,000 $3629 $100,000 $3772 $125,000 $3543 $150,000 $2580 $200,000 $1920

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What if Anjali was over preservation age but under age 60?

TRIS pension payments were tax-free as Anjali was over age 60. If she was under 60, pension payments consisting of taxable component – element taxed are taxable at her marginal tax rate with a 15% tax offset (as per Table 2). Broadly, taxation of pension payments for someone under age 60 cancels some of the benefit of the TRIS income swap strategy.

However, if Anjali had a significant tax-free component backing the TRIS, then there may still be value in implementing the income swap strategy.

Application of the unused concessional contributions cap Traditionally, the concessional contributions cap has worked on a use-it-or-lose-it basis. However, from 1 July 2018, an individual has been able to accrue unused amounts of the concessional contributions cap for a maximum of five years. The unused amounts can then be used in the following financial years as long as their total super balance at the end of the previous financial year was less than $500,000.

Applying this to Anjali, as she has not been making voluntary contributions to date, her unused concessional contributions cap was $15,500 from 2018/19.

This means that in 2019/20, the amount she can make as voluntary concessional contributions, allowing for SG of $9500, is $31,000 ($15,500 + $15,500). Having a higher voluntary concessional contributions cap to work with could allow for a bigger benefit from the TRIS income swap strategy.

Table 5. TRIS income swap strategy with unused concessional contributions No TRIS income swap strategy

TRIS income swap strategy with unused comcessional contributions from 2018/19

Salary

$100,000

$100,000

Superannuation guarantee

$9500

$9500

Salary sacrifice/personal deductible super contributions

Nil

$31,000

Contributions tax

$1425

$6075

TRIS pension payments

Nil

$19,555

Taxable income

$100,000

$69,000 6

Tax including Medicare Levy

$25,717

$14,272

Take home pay

$74,283

$74,283

Net contributions to super

$8075

$34,425

Net additional super funds

Not applicable

$6,7957

As per the above table, with the ability to salary sacrifice the unused concessional contributions cap from 2018/19, the value of the TRIS income swap strategy to Anjali is much higher compared to just salary sacrificing the difference between the standard concessional contributions cap and SG.

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Using a TRIS to receive up to 10% as pension payments Another popular use of TRIS is to simply access up to 10% of TRIS balance as a pension payment. Commonly, this is used to replace lost income when reducing working hours or provide cashflow for any other desired reason.

Going back to Anjali, she reduces her working hours to four days per week, now earning $80,000 per annum.

With a super balance of $200,000, she can receive up to 10% of her balance to replace the reduced income.

Table 6. Using TRIS to replace reduced income

Full-time hours Part-time hours

Salary

$100,000 $80,000

Tax including Medicare Levy

$25,717

$18,067

TRIS pension payments

Nil

$12,350

Take-home pay

$74,283

$74,283

Using a TRIS for proportioning advantages As mentioned, while a TRIS is not considered to be a retirement phase income stream from a tax perspective and therefore does not receive a tax exemption on earnings, it is still a superannuation income stream. Its classification as a super income stream means that it continues to operate under the proportioning rules in relation to tax components being fixed at commencement. This proportioning rule can also be of benefit for those with estate planning needs.

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She can use the bring-forward rule to make a non-concessional contribution of $300,000 as her total superannuation balance at 30 June 2019 was below $1.4 million and she has not used the bring-forward rules in the last two financial years. She does not need any income from her superannuation as she has existing surplus income.

She is concerned about the superannuation death benefit tax whereby her non-dependent beneficiaries pay up to 17% tax on taxable component.

A consideration is whether the $300,000 contribution is retained in accumulation phase or whether a TRIS can offer any strategical advantage.

If she leaves the funds in accumulation phase, while the initial contribution is added to the tax-free component, any future earnings are added to the taxable component.

If however, a TRIS is started with the $300,000 contribution, then upon commencement, it will consist entirely of tax-free component. As the TRIS tax components are fixed based on proportion at commencement, this means that any future earnings will be added entirely to the taxfree component.

If we assume that the $300,000 contribution delivers a constant return of 5% each year for the next five years, then if Anjali unfortunately dies after five years and a super death benefit is paid to her non-dependent beneficiaries, then starting a TRIS has offered the benefit outline in Table 7.

Table 7. Proportioning rule estate planning advantage of TRIS

Example: proportioning rule

Anjali, aged 60, sold an investment property and wishes to contribute $300,000 as a non-concessional contribution to benefit from the concessional tax rates in superannuation. Her existing super balance is $200,000, consisting entirely of taxable component.

FS Super

After five years

Accumulation phase

TRIS

Tax-free component

$300,000

$354,268

Taxable component

$82,885

Nil

Super death benefit tax

$14,090

Nil

Cumulative pension payments

Nil

$64,239

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One disadvantage of commencing a TRIS is that she will be required to receive at least a minimum payment of 4% until she reaches age 65, which could deplete her TRIS balance as Table 7 shows.

However, she could overcome this hurdle by contributing any excess savings built up outside super when she has non-concessional contribution cap space available in a future year. To maximise tax-free component, upon re-contributing in a future year, she could consolidate her TRIS balance with the re-contributed amount.

Using a TRIS to implement a similar strategy to cash-out and re-contribution strategy The cash-out and re-contribution strategy may be useful from an estate planning perspective when a client is planning to reduce potential super death benefit tax paid by non-dependent beneficiaries.

This strategy may be particularly useful for those who have a balance well in excess of $300,000 so that the conversion of taxable component to tax-free component can be proactively maximised.

Example: TRIS to implement a quasi cash-out and recontribution strategy

Anjali, aged 60, has a super balance of $500,000, consisting entirely of taxable component. She plans to retire at age 65. While she does have a spouse, there is a concern around the tax her non-dependent beneficiaries might pay should they both pass away at the same time. Even where her spouse inherits her super balance, there is a concern that the spouse might not be able to effect a re-contribution strategy in the future (eg. due to either not being able to contribute based on their age and/or re-

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strictions imposed by non-concessional contributions cap).

Anjali commences a TRIS, receives $50,000 (10% of $500,000 commencement balance) as a pension payment and recontributes this to superannuation as a non-concessional contribution. To ensure that recontributed funds remain as tax-free component, she starts a new TRIS with the re-contributed funds. She starts a TRIS with the $50,000 contribution, whereby she would need to receive a pro-rata minimum of 4%. In year two, based on account balances on July 1, she would draw out 10% from her larger, mostly taxable TRIS balance and draw 4% from the smaller, mostly tax-free TRIS and contribute this amount as a non-concessional contribution.

The re-contributed amount from year two would then be consolidated with the smaller TRIS and any increase in accumulation phase (from salary sacrifice, personal deductible contributions and SG) is consolidated with the larger TRIS. This arrangement is repeated until she turns age 65, whereby she meets a condition of release allowing for full release of her super benefits. At this point Anjali could then do a higher re-contribution strategy from the income stream that consists entirely of taxable component, subject to the bring-forward non-concessional contributions cap, at that time.

Using a TRIS to equalise account balances for transfer balance cap purposes The transfer balance cap ($1.6 million in 2019/20) imposes a restriction on the amount of superannuation savings that can be transferred/ retained in retirement phase income streams. Where one member of a couple has a higher super balance that is approaching the transfer

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balance cap, or where the couple have combined balances exceeding the transfer balance cap, a TRIS could assist to proactively equalise their super balances.

super savings from the spouse who has reached pension age to their younger spouse, who hasn’t yet reached qualification age for the age pension.

Example: TRIS to equalise super balances

Example: TRIS for pro-actively maximising age pension

Anjali’s spouse, Raja, aged 60, has a super balance of $2 million. He continues to work as a full-time IT consultant. They both plan to retire at age 65, and with concessional contributions up to the cap as well as estimated earnings of 4.4% (net of taxes and fees), he is projected to have $2.6 million in his super at age 65. Anjali has $500,000 in super.

Assuming the transfer balance cap is indexed to $1.8 million in five years’ time when he retires, if Raja does nothing, he could only transfer $1.8 million into a super income stream (including a lifetime annuity) with the remainder to remain in his accumulation phase or taken as a lump sum. Alternatively, he could do a cash-out and contribution to Anjali’s super account subject to the nonconcessional contributions cap.

A TRIS could assist Raja to proactively equalise super balances before retirement so that the amounts in his taxfree retirement income structures are maximised. Raja commences a TRIS with his super balance and, in an endeavour to equalise super balances as well as convert some of the taxable component to tax-free component, he receives $100,000 pension payment and contributes this to Anjali’s super account.

This is repeated each year so that at retirement Raja has been able to reduce his super balance by $500,000 (ignoring indexation of the non-concessional contributions cap) and at retirement, a higher spouse re-contribution strategy can be carried out within the bringforward non-concessional contributions cap at that time.

The equalisation strategy has also assisted with converting some of his taxable component to tax-free component in Anjali’s account.

Generally, a super trustee is required under superannuation law to identify once each financial year, if an individual has multiple accumulation accounts within the same fund.8 If it is in the best interests of the member, the trustee is then required to consolidate those multiple accounts to one account. As such, it is recommended that wherever an individual has deliberately set up multiple accumulation accounts with distinct tax components, either the trustee is contacted to ensure that consolidation does not occur or, where this is not possible, to avoid any unintended consequences, the re-contribution is made to a different super fund separate to their existing fund.

Using a TRIS for Centrelink sheltering strategy Superannuation in accumulation phase is exempt from Centrelink assessment if the person is under the qualification age for the government age pension (currently age 67 for anyone born on or after 1 January 1957). Another popular strategy to maximise age pension is to cash-out

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Raja aged 60, has accumulated superannuation savings of $1 million. His spouse, Anjali, who is five years younger, is retired and she has no super. Raja plans to retire when he reaches age 67, which is his qualification age for the government age pension. They have no other significant assessable assets and wish to maximise Raja’s pension.

The current age pension assets test disqualification limit for a couple who own their home is $863,500. Assuming in seven years’ time, the disqualification limit is indexed to $1.045 million (based on approximately 2.8% CPI) and Raja’s super savings with contributions (fully using the concessional contributions cap each year until retirement) and earnings (based on 4% net of taxes and fees) increases to approximately $1.48 million, his assessable assets are well in excess of the disqualification limit.

Assuming the non-concessional contributions cap is also indexed to $120,000 on an annual basis in seven years’ time, while Raja could do a cash-out and recontribution of $360,000 using the future non-concessional bring-forward cap, his assessable assets will still be in excess of the disqualification limit ($1.12 million in assessable assets is greater than $1.045 million age pension disqualification limit), which could mean he does not receive the age pension when he turns pension age.

A TRIS could assist in proactively considering the sheltering strategy by using the 10% maximum payments from Raja’s account each financial year until retirement to make a spouse contribution to Anjali’s account each year. Raja could reduce his assessable assets by making a spouse contribution up to the annual non-concessional contributions cap for six years and up to the bring-forward amount in the final year, significantly increasing his age pension entitlements for a five-year period until Anjali reaches age pension age. fs Notes 1. Assumes that employer doesn’t reduce superannuation guarantee (SG) entitlements based on post salary-sacrifice income. It is proposed by the government that from 1 July 2020 an employer can’t use salary sacrifice towards SG obligations and nor can they satisfy their SG obligations on post salary-sacrifice income.

2. $25,000 x 15%.

3. $100,000 – $15,500.

4. $25,000 – $3750.

5. $21,250 – $8075 – $9403.

6. $100,000 – $31,000.

7. $34,425 – $8075 – $19,555.

8. SIS Section 108A does not apply to SMSFs and pooled superannuation trusts, although a similar rule applies in SMSFs where a member can only have one accumulation interest.

This information is provided by Challenger Life Company Limited ABN 44 072 486 938, AFSL 234670, for adviser use only. It is not intended to constitute legal, tax or financial product advice.

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CPD Questions Earn CPD hours by completing this quiz via FS Aspire CPD. 1. From 1 July 2017, what change was made in regard to TRISs? a) A TRIS was considered to be a retirement phase income stream b) An earnings tax exemption was applied to all TRISs c) A TRIS was no longer considered to be a retirement phase income stream d) It was announced that TRISs will be phased out 2. W hen can a TRIS be commenced? a) As soon as an individual has saved a nominated amount in superannuation b) When an individual reaches their preservation age c) As soon as an individual reaches age 50 d) Whenever an individual chooses, as long as they are still working 3. Which of the following is accurate in regard to TRISs? a) A TRIS will move into the retirement phase as soon as an individual is age 65 b) A TRIS is no longer an option for individuals who are over age 60

c) A TRIS will move into the retirement phase as soon as an individual is age 60 d) A TRIS will move into the retirement phase as soon as an individual is age 55 4. A t what point does a TRIS cease? a) W hen a person meets a retirement condition of release b) When a person meets the terminal medical condition of release c) When a person dies and has nominated a reversionary beneficiary d) All of the above

5. O ne of the most popular uses of a TRIS is an income swap strategy. a) True b) False 6. From 1 July 2017, earnings of a TRIS are no longer taxed at the same rate as accumulation phase. a) True b) False

Visit www.financialstandard.com.au and click ‘FS Aspire CPD’ in the menu or call 1300 884 434 to gain access to the platform.

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CPD Earn CPD hours by completing the assessment quiz for this article via FS Aspire CPD. Worth a read because: Ultimately an appropriate amount for a client to invest in a lifetime income stream will depend on a client’s situation and the strategy implemented to achieve their goals. This paper addresses some of the key considerations and strategies relating to how much a client should invest in a lifetime income stream.

Visit www.financialstandard.com.au and click ‘FS Aspire CPD’ in the menu or call 1300 884 434 to gain access to the platform.

Lifetime income streams How much should a client invest in a lifetime income stream?

A Michael McLean

lifetime income stream that includes a lifetime annuity can provide secure, regular income for life, providing clients with peace of mind in retirement regardless of how long they live or how investment markets perform. Once a decision has been made to invest into a lifetime income stream, advisers can consider who owns the income stream for partnered clients and how much to allocate to it.

This paper addresses some of the considerations relating to how much a client should invest in a lifetime income stream.

[How to structure a lifetime income stream, and which spouse should own the lifetime income stream is not covered in this paper. Information regarding Challenger’s Guaranteed Annuity (Liquid Lifetime) options can be found in the Product Disclosure Statement on Challenger’s website; Centrelink/DVA and tax information can be found in the Challenger Lifetime Annuity Technical Guide.]

FS Super

How much to invest in a lifetime income stream?

Ultimately an appropriate amount for a client to invest in a lifetime income stream will depend on a client’s situation and the strategy implemented to achieve their goals. This paper looks at the following three strategies and how much clients can consider investing for each: 1. Layering: securing a guaranteed level of income above the maximum Age Pension 2. Helping non-pensioners to access some Age Pension and the Pensioner Concession Card 3. Helping asset-tested pensioners get more Age Pension.

Rates and thresholds used in the following examples are as at 24 January 2020 unless otherwise stated, and couples are considered non-illness separated for Age Pension purposes.

1. Layering: securing a guaranteed level of income above the maximum Age Pension

For many clients, the full Age Pension is not enough to meet all their essentials. The Association of Super Funds

Michael McLean, Challenger Michael McLean, technical services manager, Challenger.

Michael specialises in superannuation, social security and aged care, and is a CFP member of the FPA.

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The quote

An appropriate amount to invest in a lifetime income stream will depend on a client’s situation and the strategy implemented to achieve their goals.

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of Australia (ASFA) provides modest retirement standards for singles and couples: $27,913 per annum (p.a.) and $40,194 p.a. respectively for the September 2019 quarter, which are both higher than the respective maximum Age Pension amounts.

Table 1. Maximum Age Pension rates

Single Couple

Maximum annual Age Pension rate

$24,268.40

$36,582.00

For those who do not want to live on the full Age Pension only, a strategy to consider is using a lifetime annuity as a layer of guaranteed income on top of the Age Pension.

This means that if a client was ever to run out of assets, they would continue to receive two sources of income: the Age Pension plus their lifetime annuity income.

The amount to invest in a lifetime income stream depends on the level of minimum income a client wants.

The lifetime income stream payment should equal at least the difference between the client’s minimum income target and the full Age Pension rate. For example, if a single client wants $30,000 p.a. minimum income for the rest of their life, then a lifetime income stream that provides $5732 ($30,000 - $24,268) could achieve this.

However, there are a few issues to consider: • While the Age Pension basic rate and pension supplement increase with at least CPI each year, the energy supplement ($14.10 per fortnight for singles and $10.60 per fortnight for members of a couple) does not index. This means that over time the full Age Pension rate may not keep up with inflation.

• Will the client wish to add a buffer into their minimum income level in case they have underestimated their needs?

• If 60% of the first-year annual payment from the lifetime annuity is greater than the first-year Age Pension income test thresholds (currently $4524 for singles and $8008 for couples) and CPI-indexation is selected, then clients might always have assessable income greater than the income test threshold.

Based on these considerations, a slightly higher investment amount into the annuity might help clients to maintain their minimum target income for a longer period of time.

will receive at least $40,616 p.a. (Age Pension $36,582 plus lifetime annuity $4034). This is slightly higher than their $40,000 p.a. goal because their adviser considers planning for the non-indexed Energy Supplement and adding in a buffer.

Ali and Yasemin’s adviser recommends that they invest in Ali’s name with Yasemin as reversionary because: • The surviving spouse will receive minimum income of $28,302 p.a. (full Age Pension $24,268 plus lifetime annuity $4034), enabling them to maximise their guaranteed income for life.

• They receive slightly higher payments compared to investing in Yasemin’s name with Ali as reversionary, which is more important to them than a slightly longer withdrawal period from investing in Yasemin’s name.

2. Non-pensioners: Age Pension and the Pensioner Concession Card

Those not receiving Age Pension due to being above their Age Pension assets test cut-out threshold can invest in a Liquid Lifetime Flexible Income (Immediate) to help reduce their assessable assets.

Table 2. Age Pension disqualifying asset limits

Disqualifying asset limits

Single

Couple

Homeowner

$574,500 $863,500

Non-homeowner

$785,000 $1,074,000

Advisers can use the following formula as a simple guide for how much to invest in a lifetime income stream for clients where only the assets test is considered: (Total assessable assets - disqualifying asset limit) / 40% Note that if a person has assessable assets exactly equal to the disqualifying asset limit, they will not receive any Age Pension. Furthermore, assessable asset amounts can increase or decrease over time as markets change or clients spend/save. Therefore, it could be prudent to invest slightly more to ensure clients receive Age Pension and the Pensioner Concession Card immediately and continue to in the future.

Example: Raj and lsha

Example: Ali and Yasemin

Ali and Yasemin, both age 66, are couple homeowners with $200,000 each in deemed account-based pensions.

After speaking with their adviser, they realise that the full couple Age Pension is not enough to meet their essentials. They are currently spending $55,000 p.a. but would like a minimum $40,000 p.a. for the rest of their life; an extra $3418 above the full couple Age Pension.

Ali and Yasemin’s adviser recommends that they invest $100,000 (25% of their assessable assets) in a Liquid Lifetime Flexible Income (Immediate) with $4034 p.a.1 payments indexed to inflation. This means they

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Homeowner couple Raj, age 68, and lsha, age 67, each have $475,000 in deemed account-based pensions, or $950,000 combined assessable assets. The investment amount in a Liquid Lifetime Flexible Income (Immediate) to reduce their assessable assets to the $863,500 threshold is threshold is: ($950,000 - $863,500) / 40% = $216,250 Raj and lsha’s adviser recommends a $250,000 investment (26.3% of their assessable assets), which will reduce their assessable assets to $850,000. Raj and lsha are

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comfortable with a guaranteed lifetime income stream, and that being $13,500 under their $863,500 disqualifying asset threshold is sufficient for them. This provides them with $2002 Age Pension combined in year one and the Pensioner Concession Card.

Raj and lsha are both in their second marriage and would prefer to keep their assets separate. Their adviser also notes that there are no material Centrelink/DVA benefits from investing in just one of their names. They choose to invest $125,000 each into a Liquid Lifetime Flexible Income (Immediate), with no reversionary, which allows Raj and lsha to choose their own beneficiaries. This strategy provides them with $20,7212 more Age Pension over five years if they spend $60,000 p.a. in today’s dollars, and provides them with the Pensioner Concession Card three years earlier compared with leaving all their funds in account-based pensions.

3. Helping asset-tested pensioners get more Age Pension

Generally, the more that an asset-tested pensioner invests in a Liquid Lifetime Flexible Income (Immediate), the more Age Pension they will receive. They can increase their Age Pension by $3120 in the first year per $100,000 Liquid Lifetime Flexible Income (Immediate) investment. However, a client’s risk profile and diversification needs should be considered, as well as the point at which a pensioner becomes income-tested, as the Age Pension benefit of investing in a lifetime income stream reduces at that point.

Figure 1 provides a guide for these crossover points, showing the points for clients who just have deemed financial assets. For example, couple homeowners are full pensioners up to $324,401, at which point they become income tested and remain so up to $411,500, then they are asset-tested up to $863,500 where they lose Age Pension.

The Challenger Age Pension Illustrator (the Illustrator) can be used to determine where the income and asset crossover points are for each specific client case.

Example: Alex and Alina

Alex and Alina, both age 66, are couple homeowners with $250,000 each in deemed account-based pensions (50/50

risk profile); they want a retirement income of $58,000 p.a.

Their adviser realises that their $500,000 assessable assets are just above the crossover guide for couple homeowners ($411,500). Alex and Alina’s adviser feels that a lifetime income stream could be a good option for them, to both help them receive more Age Pension today and provide them with a guaranteed income source for life.

By using the Illustrator, Alex and Alina’s adviser models their retirement income scenario to see how a Liquid Lifetime Flexible Income (Immediate) might help with their Age Pension. Their adviser changes the investment percentage of the lifetime annuity on the Illustrator to see where Alex and Alina become income-tested.

Alex and Alina’s adviser tests this strategy with half the annuity investment in each spouse’s name with the other as reversionary, so both income streams continue for the rest of the surviving spouse’s life.

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The quote

For those who do not want to live on the full Age Pension only, a strategy to consider is using a lifetime annuity as a layer of guaranteed income on top of the Age Pension.

Table 3. Alex and Alina’s Age Pension increase in year one for different lifetime income stream investment amounts Lifetime income stream % investment

Lifetime income stream $ amount

Age Pension increase in year one

Applicable Age Pension test

20%

$100,000 $3120 Assets

30%

$150,000 $4680 Assets

35%

$175,000 $5460 Assets

39%

$195,000 $6084 Assets

40%

$200,000 $6179 Income

45%

$225,000 $6252 Income

Source: Challenger

By using some trial and error with the lifetime annuity allocation on the Illustrator, Alex and Alina’s adviser finds that a 40% investment, or $200,000, in a lifetime income stream, is the point at which they become income-tested.

Any higher investment does not significantly improve their Age Pension, as Table 3 shows. Their adviser discusses the findings with Alex and Alina, and they decide that a 35% investment would be best for them. This does not give them the highest Age Pension today, but Alex and Alina understand that they are drawing down their assets over time, so expect to become income-tested soon enough.

If they invest $87,500 each in their individual names

Figure 1. Income and asset strategy zones Single homeowner

$185,334

Single non-homeowner

$185,334

$282,000

$574,200 $542,500

$785,000

Couple homeowner

$324,401

$411,500

$863,500

Couple non-homeowner

$324,401

$672,000

$1,074,000

$0

$200,000 Maximum Age Pension

FS Super

$400,000

$600,000

Income test provides lowest entitlement

$800,000

$1,000,000

$1,200,000

$1,400,000

Asset test provides lowest entitlement

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CPD Questions Earn CPD hours by completing this quiz via FS Aspire CPD 1. As stated in the paper, the amount to invest in a lifetime income stream depends on which of the following? a) The level of minimum income a client wants b) The client’s stated life expectancy c) The client’s net worth at age 60 d) The client’s investing experience and skill 2. In the context of income streams, what is a ‘layering’ strategy? a) Using income from investments as a layer of income on top of the Age Pension b) Using income from a reverse mortgage as a layer of income on top of the Age Pension c) Using a lifetime annuity as a layer of income on top of the Age Pension d) None of the above 3. Apart from providing regular income, an adviser might recommend a lifetime income stream for what other reason? a) Managing tax outcomes b) As part of a client’s defensive portfolio c) Estate planning considerations d) All of the above 4. What strategy would enable both spouses’ lifetime income streams to continue for the rest of the surviving spouse’s life? a) A client can nominate their spouse as a full beneficiary in a valid Will b) Invest half the annuity amount in each spouse’s name with the other as reversionary c) Such a strategy is not permitted under the existing rules d) It is not advisable to split an annuity amount into two halves

with each other as reversionary, then over five years they are projected to receive $16,0753 more in Age Pension compared with leaving their money in account-based pensions.

Other strategies Advisers may also use a lifetime income stream for other reasons, including: • Managing tax outcomes—the deductible amount of a non-super lifetime income stream’s regular payment is not assessable for tax purposes.

• Competitive payments as part of a client’s defensive portfolio— some advisers simply use a lifetime income stream as an alternative to cash, term deposits and other defensive assets.

• Estate planning considerations—nominating an individual beneficiary, either for superannuation or non-super lifetime income streams, does not form part of the estate so can help with estate planning goals. fs Notes 1. Challenger quote 24 January 2020, Liquid Lifetime Flexible Income (Immediate), 66- year-old male owner with 66-year-old female reversionary, CPI indexed payments, no adviser fees.

2. Challenger Age Pension Illustrator 24 January 2020, $60,000 p.a. target income, 50/50 defensive/growth risk profile, account-based pension 3.7% defensive returns before 0.6% defensive investment fee and 7.7% growth return before 0.8% growth investment fee, both before 0.5% platform fee, CPI 2.5%. Liquid Lifetime full CPI payments with no adviser fees.

3. Challenger Age Pension Illustrator 24 January 2020, $58,000 p.a. target income, 50/50 defensive/growth risk profile, account-based pension 3.7% defensive returns before 0.6% defensive investment fee and 7.7% growth return before 0.8% growth investment fee, both before 0.5% platform fee, CPI 2.5%. Liquid Lifetime full CPI payments with no adviser fees.

The information in this update is current as at 18 February 2020 unless otherwise specified and is provided by Challenger Life Company Limited ABN 44 072 486 938, AFSL 234670, the issuer of the Challenger annuities. The information in this update is general information only about our financial products. It is not intended to constitute financial product advice.

5. Those who are above the Age Pension assets test threshold can invest in a lifetime annuity to help reduce their assessable assets. a) True b) False 6. If a person has assessable assets exactly equal to the disqualifying asset limit, they will not receive any Age Pension. a) True

b) False

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Technology:

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Compelling trends in digital payments

By Daniel Hill, William Blair

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Technology

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CPD Read Earn CPD hours by completing the assessment quiz for this article via FS Aspire CPD. Worth a read because: The digital payments industry represents a vast market that continues to expand, particularly as individuals further embrace all things digital in the wake of the COVID-19 pandemic. This paper looks at some compelling trends in the payments industry, and explains how digital transformation provides a worthy opportunity for investors.

Visit www.financialstandard.com.au and click ‘FS Aspire CPD’ in the menu or call 1300 884 434 to gain access to the platform.

Compelling trends in digital payments Why we’re paying close attention to digital payments

C Daniel Hill

onsumers might not spend much time thinking about the series of connections and interactions that take place within a few seconds after they swipe their credit card, click ‘complete purchase’ on a screen, or tap their smartphone on a sensor. But what goes on behind the scenes is changing the world, and is even more important as individuals further embrace all things digital in the wake of the COVID-19 pandemic. But as investors, we believe that digital transformation comprises a compelling opportunity that deserves attention. This paper explains why we believe that opportunities in the payments industry are so compelling.

As active managers, William Blair explores every segment of the

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global economy for ways in which to generate alpha. We are especially attracted to industries that feature sticky revenue, durable growth, healthy profitability, and strong free cash flow.

While we sometimes find these attributes in an obscure corner of the market, occasionally we discover a truly exceptional investment opportunity by looking closely at something that is an integral part of our everyday lives. Such is the case with the global digital payments industry—the multifaceted and complex financial transaction ecosystem that allows individuals around the world to pay for goods and services without using cash.

We will dive into assessing the various components and business models of the payments ecosystem—most notably merchant acquirers (the entities that enable merchants to accept credit cards and other forms of digital payments), issuers (the banks that issue credit and debit cards and the issuer processors that are either internal functions

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within banks or are banks’ external partners), and networks (the ‘pipes’ or ‘rails’ through which all transactions flow, connecting merchants and issuers).

But first, we highlight several aspects of the payments industry that we believe make the investment opportunity particularly compelling for fundamental managers focused on finding sustainable sources of value creation.

Massive addressable market with sustainable growth The digital payments industry represents a truly enormous addressable market that continues to expand due to strong, durable secular tailwinds. Many analysts estimate global B2C digital payments volumes to be more than $30 trillion. Trends driving the growth of the payments industry include the following.

The shift away from cash benefits all segments of the payments industry: The global shift away from using

cash is a rising tide that is lifting all boats within the payments industry. As Figure 1 illustrates, from 201217 the volume of global payments using credit or debit cards (which represent the vast majority of digital, or non-cash, payments) grew at a 6% CAGR, and the percentage of transactions conducted via cards increased from about 34% in 2012 to 42% in 2017.

In addition to the expansion of e-commerce and increased internet access in emerging markets, digital payments volume growth is also supported by in-store retail purchases that increasingly rely on cards and ‘digital wallets’. Other secular trends supporting the growth in digital payments include the penetration of mobile phones globally; a younger, more tech-focused consumer population; online gaming with in-app purchases; growth in domestic and global travel; ride-sharing services; and peer-to-peer payment systems (eg. Venmo).

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E-commerce is one of the strongest drivers of volume growth: E-commerce is driving digital payments volume

growth in two ways: consumers make more purchases because of the convenience of buying online or via mobile apps, and, relative to in-store purchases, a significantly higher percentage of e-commerce transactions is completed using a credit or debit card. While e-commerce benefits all segments of the payments industry, it is especially important for merchant acquirers. When evaluating merchant acquirers, we pay close attention to a company’s exposure to e-commerce, as we believe that it represents one of the most powerful and durable growth drivers in digital payment volumes.

Small and mid-size businesses (SMBs) offer opportunity to add more value: In addition to the growing

volume of transactions, merchant acquirers can drive revenue by providing higher-margin, value-added services. These opportunities are especially prevalent when serving SMBs. Merchant acquirers can bundle ancillary services—such as inventory management software, working capital loans, faster payment receipts, targeted marketing, and loyalty programs— into systems designed to meet the needs of SMBs. International markets provide ample white space:

Digital payments penetration in most international markets trails the levels seen in the United States (US).

This is especially true in emerging markets, providing significant room for volume growth as countries such as India shift to a digital economy.

Governments support digital payments: By and large, governments are supportive of the transition to digital payments because it improves tax collection and reduces the size of the black market economy that depends on cash. Furthermore, governments support efforts to extend banking services to under- or unbanked populations.

Figure 1. Global card purchase volume growth (ex-China, nominal, in trillions, constant currency)

Daniel Hill, William Blair

Source: WEO, World Bank, Nilson, corporate reports, Bernstein estimates, as of 2017.

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Daniel Hill, CFA, is a global equity research analyst at William Blair Investment Management.

He joined the firm in 2005 as an investment accountant. He now covers smallcap financial companies.

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Global industry defined by regional trends While digital payment penetration exceeds 40% globally, it varies significantly across regions and countries. The US is a more mature market with high penetration levels, while usage in Europe varies drastically by country. In emerging markets, penetration is typically low, providing a long runway for growth.

High earnings multiples reflect attractive business models and high expectations

The payments industry has been valued at high multiples in recent years, reflecting durable, growing revenues and profit margins. We believe this is a prime example of how high multiples don’t necessarily equate to high valuation. The following industry attributes support this view: • High-quality, visible, and sticky revenues are the result of stable pricing and persistent growth. Even during the 2008/09 global financial crisis, non-cash payments increased by the mid single digits.

• Profit margins that are already attractive can grow further due to high operating leverage derived from a largely fixed cost base.

Scale is key in the industry. We expect the industry’s overall profit pool to increase, offering attractive returns to shareholders.

• Attractive business models can generate solid free cash flow with low capex requirements supporting dividends, buybacks, M&A, and low-volatility returns.

• Markets have supported these high multiples given the industry’s strong business models and because management teams tend to be conservative when providing guidance regarding future growth expectations.

Disruption concerns may be overstated

Disruption is always a consideration when analysing an industry, and this threat varies significantly across the segments of the payments industry. Incumbent merchant acquirers face a major threat of losing market share to new, technology-enabled providers. With networks, on the other hand, we believe that many investors are overestimating the near- and medium-term disruption risk facing the global duopoly of Visa and MasterCard.

The existing networks are firmly entrenched, efficient, inexpensive, safe, and reliable. In other words, there is nothing overpriced or inefficient about the current system that would make it ripe for disruption. Over the longer term, alternatives such as blockchain, real-time payments, and other models may have the potential to take

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volume from the existing networks, but many of the networks are preparing for this risk and using their powerful balance sheets to invest in alternative systems.

Another reason that near- and medium-term disruption risk across the payments industry is overstated is inertia. The methods individuals use to pay for goods and services tend to be firmly established, and consumer behaviour is often resistant to change. Once people are accustomed to—and trust—their forms of payment, a disrupter would have to offer a truly superior alternative, not just a marginally better approach.

New entrants to the payments ecosystem in recent years have leveraged the existing system rather than attempting to replace it. Even if a superior approach that would bypass the existing system did emerge, adoption would likely be slow.

Technology and data analytics underpin and drive growth

Leading payments companies are using increasingly sophisticated technology to create value—and justify their fees—for merchants and consumers through enhanced fraud prevention, increased acceptance rates (ie. lowering the frequency of rejected transactions), more sophisticated targeted marketing, and improved omni-channel experiences.

Companies across all three segments of the payments ecosystem are using artificial intelligence and machine learning to enhance fraud prevention and detection. This is critical in encouraging trust in non-cash payment methods, which is particularly important for app-based services and other forms of e-commerce. Merchant acquirers are using data analytics to enhance merchants’ ability to conduct targeted marketing campaigns, develop more effective customer loyalty programs, and create a more seamless experience for consumers across in-store, online, and mobile environments. All of this is extremely valuable to merchants in helping to increase sales, driving volume for the payments industry.

A complex ecosystem worth understanding Although digital payment transactions take only seconds to complete, there are different layers and numerous players interacting behind the scenes that make that phenomenon possible.

To appreciate the investment opportunities in this space, it is important to understand the business models involved and how money flows through the system every time consumers swipe a credit card, tap a smartphone at a store, or enter their payment information online.

Figure 2. Analysing the payments revenue model

Source: William Blair. Not intended as investment advice. Forecasts are based on current market conditions and are subject to change.

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Technology

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Three distinct segments—but not silos

The global payments ecosystem consists of three primary components: merchant acquirers, issuers, and networks. While it is useful to think about these three components separately, they are far from being siloed. Many payments companies operate in more than one segment, and there has been a significant blurring of lines in recent years. Payments companies are looking for economies of scale as well as economies of data that can result from having access to data about transactions and consumers generated from more than one segment of the payments chain.

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Figure 4. Comparing MDRs across various payments models

Follow the money: a simplified example

To understand how a transaction flows through the payments system, it is helpful to look at a simplified example, illustrated in Figure 3: 1. A consumer uses her credit card at a store to make a purchase.

2. The merchant acquirer’s software and hardware allow the purchase to be initially accepted.

3. The merchant acquirer sends the transaction to the network, which authorises the transaction and sends it to the issuer.

4. The issuer—either through an internal system or via a thirdparty processor—verifies that the consumer has sufficient credit available.

5. A message is sent back through the network to the merchant acquirer authorising the transaction, and the consumer’s purchase is completed.

Two of the most important concepts in understanding payments business models are the merchant discount rate (MDR) and the take rate. MDR refers to the difference between what the consumer spends and what the merchant ultimately receives, net of the payments providers’ fees. Take rate refers to how the total MDR is divided among the various entities involved in the transaction.

Figure 3. How the money flows: the digital payments ecosystem

Source: William Blair. For illustrative purposes only.

Figure 4 illustrates how MDRs vary significantly, using four common payment methods. Comparing the MDR for a standard transaction in the US using a credit card to the MDR for an Apple Pay transaction, note that the merchant acquirer and network take rates are the same; Apple Pay’s 15 basis points (bps) reduces the issuer’s take rate. With PayPal, the MDR is significantly higher, but merchants that accept PayPal (often smaller vendors) recognise the value PayPal provides in the form of increased acceptance rates and the trust that PayPal has built with consumers. The MDR structure for payments made in China using Alipay is drastically different. Alipay has a significantly lower MDR structure because it bypasses the other players in the ecosystem and because local regulations limit MDRs.

FS Super

Sources: Morgan Stanley, Business Insider, Apple, medium.com, Cantor Fitzgerald Research, as of 2019.

Segment 1: Merchant acquirers

Merchant acquirers serve as the initial gatekeepers in a digital transaction, allowing the merchant to accept various forms of non-cash payments from consumers.

What they do: Merchant acquirers approve or reject merchants’ requests for payment authorisations, based on data obtained from the issuing bank and from the network during processing. The acquirer (independent or bank-owned) deposits funds for approved transactions into merchants’ accounts at regular intervals. Merchant acquirers control a key aspect of the entire payments industry by setting the MDR for each merchant. The top five merchant acquirers have more than 80% market share in the US. How they add value: Merchant acquirers allow merchants to accept various forms of payment, giving their customers flexibility and reducing the friction involved in transactions. Acquirers also absorb merchant credit risk; if a merchant goes out of business before delivering a paid-for service, the acquirer is responsible for refunding money to customers. Newer, tech-savvy merchant acquirers offer value-added services that merchants are willing to pay more for, such as enhanced fraud protection and improved acceptance rates.

These capabilities are especially important for e-commerce. Overall acceptance rates for e-commerce transactions average about 80%, compared to 98% for in-store, card-present transactions, so merchant acquirers that can help online retailers close this gap offer a tremendous value proposition. The development of new value-added services has helped the take rate remain stable or increase slightly by preventing competition from eroding pricing power.

Risks: Competition—and its potential to cause take rates to compress—is by far the greatest risk facing merchant acquirers. The space is already highly fragmented and, thanks to relatively low barriers to entry, many new, tech-enabled entrants are rapidly gaining market share from legacy platforms. This threat is especially acute for less innovative merchant acquirers focused on traditional merchants in developed markets and in-store transactions, as growth is slower in these arenas. Innovative firms can counteract this threat of fee compression by offering more value-added services, and the opportunities to do so are significantly greater in e-commerce and for SMBs. Some US merchant acquirers have become more aggressive in using acquisitions to ‘buy growth’ and reduce competition; there

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have been several recent large-scale acquisitions among merchant acquirers. This may reduce competition risk in the short term, but increased competition will likely drive take rates lower over time.

Separately, unexpected regulation limiting fees could potentially reduce MDRs overall, affecting acquirers’ profitability.

Segment 2: Networks

Networks connect merchant acquirers and issuing banks.

What they do: Networks are the ‘payment rails’ that facilitate frontand back-end transaction processing, set interchange fees (issuers’ take from the MDR), and create and enforce operating rules. They work with merchant acquirers to enable acceptance at more merchants and help issuers gain customers. The largest networks, namely Visa and MasterCard, serve all types of merchants, in all parts of the world.

How they add value: Networks are the most entrenched part of the payments ecosystem and a critical part of the infrastructure. Without networks, card payment authorisation wouldn’t be possible. In addition to providing fast and reliable connectivity, they also provide a layer of fraud detection. Networks are investing in infrastructure to make it easier for consumers to shift payments away from cash. This includes investing in new types of rails to accommodate real-time/instant debit payments, which are seeing increasing demand from consumers and merchants, especially in emerging markets.

Risks: Disruption in the form of alternative payment models that bypass the existing infrastructure—such as blockchain, certain types of digital wallets, or real-time payment systems—potentially pose the greatest long-term threat to networks. While long-term disruption risk shouldn’t be ignored, the threat is likely lower in the short and medium term. Networks are well-resourced (strong balance sheets and massive cash flow generation) and aware of the potential for disruption, so they are actively investing in innovative segments and working with governments and large corporations to develop new solutions.

Furthermore, many of the so-called ‘disruptive’ payment models, such as Apple Pay, are actually beneficial to networks because they use the networks’ existing infrastructure and will likely accelerate the shift to non-cash payments by offering consumers added security and convenience. Looking beyond the next decade, it is conceivable that truly disruptive models that bypass networks could gain momentum, especially in emerging markets. But networks are so well-capitalised and ubiquitous that they will likely find a way to participate in these alternative methods.

Regulatory pressure is always a risk, but it is unlikely that regulators would focus outsized pressure on networks, which have the smallest take rate of any part of the payments ecosystem. Governments generally see the networks as providing a ‘social good’ by building critical infrastructure that enables commerce, brings service to the un-banked, and increases tax revenue by limiting the size of the underground economy.

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work. The processing business is fairly commoditised, highly scalable, and lower-risk, so banks are increasingly turning to third parties to handle their processing as it lowers the bank’s operating expenses.

How they add value: The interchange fee represents the largest share of the MDR because issuers accept consumer credit risk. In the US, issuers use a portion of the fee to support generous loyalty/ incentive programs. The European Union (EU) interchange fees (credit interchange fees are capped at 30 bps, debit interchange fees at 20 bps), so loyalty programs are far less robust in Europe. A recent trend has seen issuer processors merge with merchant acquirers, as the data obtained at both ends can allow the provider to improve acceptance rates for online transactions and reduce fraud risk.

Risks: Because the interchange fee is the largest portion of the MDR, it is natural to assume that it could attract the most scrutiny and pressure from regulators looking to clamp down on the fees consumers pay. Issuer banks in the US and elsewhere could face regulatory action to reduce fees, such as the cap on interchange fees imposed by EU regulators. Separately, hacking and financial penalties associated with violations of consumers’ data privacy rights, including the EU General Data Protection Regulation, are an ongoing concern.

Banks must also think about how to fend off potential disruption from technology companies that are looking to move into banking.

Ranking the business models We believe the shift from cash to non-cash payments presents a compelling, durable growth story for all three of the major components that comprise the payments industry. Nonetheless, business models differ across the three segments outlined. It is critical to understand these differences when seeking to identify the companies that are best positioned to capture this growing profit pool and deliver sustainable value creation for investors. Figure 5 ranks payment business models.

Figure 5. Our ranking of payments business models

Segment 3: Issuers and issuer processors

By assuming credit risk, banks that issue credit cards, as well as debit cards, justify earning the largest portion of the MDR. What they do: Issuers are the banking entities that extend credit to cardholders and house the checking accounts that fund debit cards.

Issuer processors handle incoming requests from the networks, connecting to the bank that approves (or declines) the transaction and sends that decision back to the network. Some banks handle processing in-house, but there is a strong trend toward outsourcing the processing

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Source: William Blair. General attributes and concerns we observed for the business model in each segment (which do not necessarily apply to every company within each segment).

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Networks

The networks, outside of China’s closed system, enjoy what amounts to a global duopoly consisting of two large incumbents and a handful of additional players. They continue to experience organic growth in the low teens, which is quite impressive for a mature industry of massive scale, along with high operating margins (around 55% and more).

Because of the ‘network effect’, margins are likely to increase as the market size increases with the ongoing conversion to non-cash transactions. Firmly entrenched, ubiquitous, and scalable, networks face a very low probability of disruption over the intermediate term.

The large incumbents are looking to stave off long-term disruption by using their ample free cash flow to acquire and invest in new fintech companies or alternative payment systems that have shown promise. Low interest rates, consistent revenue growth, and low-volatility returns have provided support for the high earnings multiples seen for these entities.

Merchant acquirers

Profitability and market share in this segment of the industry depend on scale, the ability to innovate with technology, and the firm’s mix of merchant customers (e-commerce vs brick-and-mortar, and large vs SMB).

In our view, winners are likely to be larger entities that benefit from scale and tech-focused players that can grab market share by offering innovative features. This is a highly competitive segment where firms are likely to experience organic growth ranging from 6% to 30% or more.

Focusing on the type of merchants a merchant acquirer serves is essential. Our ranking of the client types, from most to least attractive: 1. E-commerce/online sales: this customer base offers the highest growth for merchant acquirers, and attractive and growing margins. Success in e-commerce is highly dependent on technology differentiation.

2. SMBs, including integrated payment systems: merchant acquirers that focus on enabling small businesses to accept non-cash payments enjoy a take rate that is three to four times higher than for large business transactions and are forecast to see double-digit top-line growth for the next three to five years. The ability to offer bundled services, including inventory management, lending, and payroll, in addition to payments expands the value proposition.

3. Non-US: lower non-cash penetration outside of the US and certain other developed markets means higher growth potential internationally (generally 13%-plus revenue growth versus 8-plus in the US). The growth opportunity is especially compelling in emerging markets, with large numbers of small merchants and underbanked consumers eager to engage in the digital marketplace.

4. Off-line traditional: this segment of a merchant acquirer’s customer base is highly competitive and typically offers lower growth (mid-single digits). Scale is key to profitability when serving traditional merchants.

Issuer processors

With less opportunity for differentiation and lower growth in mature markets, scale is key to issuer processors. These firms typically enjoy low- to high-single-digit growth that is relatively low risk.

Although the growth story is not as dramatic as some other segments, the trend among banks to outsource noncore functions is a tailwind for issuer processors. Much of the large-scale M&A in the

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US payments industry has come from merchant acquirers combining with issuer processors.

Customer data is a key driver of this trend, as merchant acquirers are looking to support their e-commerce business by combining their data with that of issuer processors to create a more robust offering that can improve acceptance rates for online transactions.

Why active management matters Although the industry comprises distinct components with different services and business models, we expect a continued blurring of lines, as many companies in the industry don’t fit neatly into just one of the segments.

It is becoming increasingly difficult to invest in standalone merchant acquiring, issuer processing, or terminal manufacturing.

There is a good chance a company will have exposure to more than one of those segments, which offers both diversification benefits and potential risks.

Understanding how all of the pieces and players interact is one of the ways our multi-sector, global approach to fundamental research and active management helps us to identify sustainable sources of value creation. As the pools of profitability in the payments industry shift and grow at different rates around the world, we are focused on using multiple lenses to uncover opportunities for our clients. fs

Disclaimer This material is provided for informational purposes only and is not intended as investment advice or a recommendation to buy or sell any particular security or product. References are for illustrative purposes only. William Blair Investment Management is exempt from the requirement to hold an AFSL. It is regulated by the US Securities and Exchange Commission, under laws which differ from Australian laws.

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CPD Questions Earn CPD hours by completing this quiz via FS Aspire CPD. 1. While e-commerce benefits all segments of the payments industry, it is especially important for which of the following? a) Merchant acquirers b) Investors c) Sole traders d) Older consumers

4. W hich of the following is a primary component of the global

2. In terms of generating alpha, industries that feature which of the following are of most interest to the authors? a) Strong, free cash flow b) Durable growth c) Healthy profitability d) All of the above

5. T he merchant discount rate is the difference between what

3. Much of the large-scale M&A in the US payments industry has come from which of the following? a) Networks alone b) Merchant acquirers combining with issuer processors c) Merchant acquirers alone d) Issue processors alone

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payments ecosystem?

a) Issuers b) Networks

c) Merchant acquirers d) All of the above

the consumer spends and what the merchant receives. a) True

b) False

6. It is becoming increasingly easy to invest in standalone merchant acquiring and issuer processing. a) True

b) False

Visit www.financialstandard.com.au and click ‘FS Aspire CPD’ in the menu or call 1300 884 434 to gain access to the platform.

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