Don't fault the default
In the best traditions of "nana knows best", the Government is considering changing KiwiSaver to make sure we make the right investment choices. It shouldn't.
Given our tendency to blunder into unsuitable financial relationships, blinded by the coy ankle of a promising return, this might seem a strange view. After all, it's human nature to seek comfort in a great protector when our own frailties seem so obvious.
However, faith can be misplaced. Nana can make mistakes.
The basic idea is that default funds should be reviewed to see whether the system needs a tweak - a sensible move after five years of KiwiSaver. To be fair, the Government has expressed no preferences on what should happen to the default fund system, and its discussion paper published this month is an excellent run-through of the issues.
Default funds exist to ensure those of us who don't choose a particular KiwiSaver option have our money looked after in a sensible way. As of March this year, of 1.9 million people using KiwiSaver, just over a quarter, 447,274, were invested in one of the default funds.
The total assets in the default funds at the time was $2.9 billion.
How those funds are invested clearly affects a lot of people and a lot of money.
The current arrangement involves five default fund providers - AMP/AXA, ASB Bank, Mercer, OnePath and Tower - who are each contracted to run a default fund for seven years.
The scheme requires them to keep fees low and focus the investment strategy on avoiding losses, which means a conservative asset allocation with 75 to 80 per cent of money invested in fixed interest securities, such as bonds, and 15 to 25 per cent in growth assets, such as shares.
In the five years KiwiSaver has been in existence, the default strategies have produced an average annual return of 4.9 per cent, as measured by Morningstar, with returns varying from 3.8 to 5.6 per cent.
Given KiwiSaver's role as retirement savings, five years is a short timescale, so the defaults' performance relative to other investment strategies should be taken with a pinch of salt.
Including salt, the default funds have performed better than moderate, balanced, growth or aggressive fund types on average over the period.
However, investment theory says in the long run the default-type strategy will make a lot less money than less conservative strategies, so it is being argued that anyone in default funds for a long time will retire with a smaller nest egg than they could have.
Those making this argument include Mercer, OnePath owner ANZ, the Capital Markets Development Taskforce and the Savings Working Group.
Among the ideas to solve this apparent problem is changing the default funds so that people are allocated investment strategies according to their age, an approach known as "life-stages" - young people would be put into more equity focused growth funds, old people would be put into cash, and those in between would get a mix.
Thus, if young people don't select their own KiwiSaver, the Government would do their thinking for them and choose them a growth fund by default.
This is a superficially appealing idea, even to fund managers who surely have no self interest in it, but it has several problems. Here are two.
Firstly, it relies on growth assets performing in future much as they have in the past. Secondly, it relies on fund managers delivering superior returns over a long time.
The first assumption is reasonable, but the long-term performance of equities includes periods of considerable volatility. For example, in the 15 years after the 1987 crash there was an extended bear market in New Zealand. For investors whose savings coincide with a period like that, the expected superior returns from equities can be elusive.
Try explaining that to several hundred thousand people in default funds. A "sorry, our modelling said that shouldn't have happened" won't cut much ice.
If the idea of KiwiSaver is to make people do what's good for them, and it turns out not to be good for them, the scheme will lose support and die. That's not a good outcome.
The second assumption is less reasonable. Yes, fund managers who take active positions in the market can produce superior returns, but only a few do so consistently over time. According to Morningstar, the best performing funds over the last 10 years managed annualised returns of about 12 per cent, while the worst managed less than one per cent. What are the chances of getting one of the best running a default fund?
If fund managers get paid X to run a default growth fund, and X+Y to run a non-default growth fund, it's fair bet the best ones won't hang around in default.
Thus, the main selling point of shifting to a life-stages approach for default funds - superior returns - could be difficult to achieve in practice.
Ultimately, the best way to steer savers to the appropriate investment option is to provide every default fund member with the relevant advice. They may or may not choose to take it, but that's still a choice.
Tim Hunter is deputy editor of the Fairfax Business Bureau.
Sunday Star Times