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The need for diversification

The need for diversification

Columnist
— 1 minute read
Something of interest to the ATO and APRA, is the trustees' attention to their fund's investment strategy.
The Australian Taxation Office (ATO) recently indicated it intends increasing surveillance of self-managed superannuation funds (SMSF) to ensure they are compliant with superannuation regulations. One factor of interest to the ATO, and indeed the Australian Prudential Regulation Authority (APRA) for APRA-regulated superannuation funds, is the trustees' attention to their fund's investment strategy, one aspect of which is the need for appropriate diversification.

This article looks at the logic behind the need to ensure adequate diversification of a fund's assets. Portfolio theory, developed nearly 50 years ago, tells us that risk and expected return should be optimised across the entire portfolio, not at the level of individual components. Diversification reduces risk and increases the portfolio's expected return per unit of risk. This increases the likelihood actual outcomes will be closer to expectations than alternative strategies with the same expected return that are less diversified. In this sense, diversification provides a 'free-lunch' to investors.

In thinking about the need for SMSFs to diversify, it is useful to remember many current regulations were originally developed some time ago when Australia's superannuation system was quite different. Fifteen years ago defined benefit (DB) retirement schemes were more prevalent. While there are many similarities between DB and the defined contribution (DC) retirement schemes that form the basis of Australia's current superannuation system, there are also some important differences, which can drive differences in the appropriate level of diversification within the fund.

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DB schemes promise members a pension or lump sum payout at retirement that is typically linked to certain employment factors, such as the number of years worked and final salary. These schemes meet their promises through the assets of the fund and future contributions. The employer sponsor is the primary risk bearer in the sense that if the fund has inadequate assets to meet the promises, the employer sponsor is required to make up the shortfall. Hence, for the DB scheme, individual members and the regulator, it makes sense that the scheme remains adequately funded at all times and the fund is adequately diversified, avoiding undue concentration in any investment market or any single asset.

DC superannuation funds, including SMSFs, do not make explicit benefit promises linked to number of years worked and final salary of the member. Rather, these funds accumulate assets that form part of the individual's entire net worth. Most importantly for this article, individuals directly bear the risk of poor investment performance, both in their superannuation fund and with their non-super assets, which together will support the member in retirement. Portfolio theory indicates that risk and expected return should be optimised across the entire portfolio and hence individuals should ensure they are adequately diversified across their total net worth, which includes assets held in the superannuation fund and those held directly.

Does this mean an individual's assets inside the superannuation fund should be fully diversified? Not necessarily. For many individuals, their superannuation fund assets represent only a small portion of their entire net worth. This is true for young people, whose human capital (the value of future wages) typically dominates the value accumulated in superannuation. People whose assets are split between their own home and their superannuation will have a different total portfolio composition to someone with equivalent total net worth, all of which is in superannuation. The portfolio mix of the superannuation assets for these two individuals will be different if risk and expected return is optimised across their total portfolios. People with significant assets, other than the value of their human capital and their own home, face a decision of how much of their financial assets to place into their superannuation fund and how much to hold directly. While superannuation offers attractive tax advantages, access to funds is limited prior to age 55 and hence this decision is a very real one for young people who have good incomes and growing net worth. The manner in which superannuation funds are taxed also makes the asset location decision important. Even if adequate diversification is achieved through holding multiple assets, individuals face decisions as to which assets are best held in the superannuation fund versus which assets are best held in their own name. Tax will be an important driver of this decision.

For all these reasons, finance theory would suggest the benefit of diversifying fund assets is different for DB schemes and DC schemes. There are logical reasons for individuals to structure their superannuation fund very differently when they are the primary risk bearer compared with funds whose defined benefits are sponsored by a third party, their corporate or government employer. It almost goes without saying, the greater the proportion of the individual's net worth held in superannuation, the greater is the benefit to diversification purely within the superannuation fund. In summary, for DB plans, appropriate diversification can be evaluated for the fund on a stand-alone basis. For DC plans, it is the beneficiary's entire net worth that should form the basis for evaluation of appropriate diversification.

 

The need for diversification
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