Asset allocation is the decision as to what percentage should be invested in income assets (cash, bonds, fixed interest securities etc) or growth assets (shares, property, gold etc). Income assets are more conservative and lower risk whereas growth assets are riskier because the ultimate realisation value of each security is unknown. In addition income assets are normally subject to a higher level of tax, mainly on the interest income, whereas capital gains on growth assets are usually untaxed. In addition New Zealand dividends are rarely taxed as far as investors are concerned.
Few individuals have become wealthy by investing in income assets, wealth is normally generated through growth assets. Income assets are preferred by elderly investors who are risk averse and by individuals who are already wealthy and want to preserve their wealth.
Long-term orientated superannuation funds generally have a strong bias towards growth assets with the New Zealand Superannuation Fund being a good example of this. At the end of October the fund had only 6.4 per cent invested in fixed interest securities with the remaining 93.6 per cent, which includes global equities, New Zealand equities, private equity, property, infrastructure, timber, rural farmland and other private markets, allocated to growth assets.
Australians have less than 25 per cent of their superannuation invested in income assets with the rest in growth assets.
We are far more conservative with 47 per cent of our traditional superannuation funds invested in income assets and 58.2 per cent of KiwiSaver.
The latter figure is not surprising because we have a big bias towards income assets as an amazing 60.5 per cent of non-superannuation managed funds are invested in cash, fixed interest securities and loans and placements.
Our strong preference for fixed interest securities was a godsend as far as unscrupulous finance company promoters were concerned because all they had to do was mention the term "secure debenture" and money came rushing in the door.
One of KiwiSaver's biggest flaws, from a long-term point of view, is the default fund structure.
If individuals don't choose a KiwiSaver scheme then the Inland Revenue will allocate their money to one of the six government-appointed default providers, AMP, ASB, AXA, OnePath, Mercer or Tower. This money is then invested in a conservative investment fund option.
At the end of September, 31 per cent of all KiwiSaver funds were invested in these six conservative funds which had an aggregate 96 per cent of funds allocated to income assets and only 4 per cent to growth securities.
These default funds have performed well in a difficult environment. According to Morningstar they achieved an average return of 4.44 per cent per annum, before tax but after fees, over the first four years of KiwiSaver.
These default KiwiSaver funds have avoided the meltdown in international stock markets but the large allocation to conservative funds has been through chance rather than skill.
A 4.44 per cent pre-tax annual return probably equates to no more than 3.5 per cent a year after tax. No one will become wealthy, or build up a substantial retirement nest egg, on a return of 3.5 per cent a year.
For some unknown reason the Financial Markets Authority is mainly focusing on fees when management fees here are lower than in most countries and when asset allocation and tax considerations will have a much bigger impact on KiwiSaver investment returns.
Choosing the correct asset allocation will be the key driver of investment returns. Thus, is it appropriate that the government - through Inland Revenue - is directing nearly a third of all KiwiSaver money into conservative funds?
Why is the Crown directing money into conservative funds when this approach is inconsistent with the asset allocation of its own New Zealand Superannuation Fund and with most overseas superannuation funds?
KiwiSaver has 1.83 million members of which 1.2 million, or 65.7 per cent, are under 45. Surely one of the priorities is to educate these people about asset allocation instead of shoving them into a conservative default fund?
There are two ways to address the asset allocation issue:
KiwiSaver investors can make their own decision and allocate their money to an income or a growth fund or a combination of the two.
KiwiSavers can allow the investment manager to make the asset allocation on their behalf as well as the individual securities decision. This is normally achieved by investing in a balanced or absolute fund where the manager adjusts the income-growth asset mix depending on market conditions.
The latter approach is popular in Australia although individuals across the Tasman can manage their own superannuation fund whereas KiwiSaver investors must invest through an FMA-registered scheme.
The other important issue is tax and investors are not getting a full and accurate picture when fund performances are quoted before tax, rather than after tax. This is particularly relevant because domestic and overseas investments have different tax treatments and have 46.9 per cent of KiwiSaver funds overseas as well as 65.5 per cent of non-KiwiSaver superannuation funds.
By comparison only 14.9 per cent of all Australian superannuation money is invested overseas.
The important point is that New Zealand investments normally have a lower tax impost and imputation credits are not captured in pre-tax investment returns but they are passed on to investors.
Thus, it is not uncommon to have a growth oriented New Zealand equity fund with an after-tax return higher than the pre-tax figure.
The benefit of this is that investors have a tax credit at the end of the year and this is crystallised through the issue of additional free units to them whereas if there is a tax impost then investors lose a number of units for nil consideration.
This tax issue can have a serious impact on investment returns over the long term but investors cannot see this from the public information available at present.
KiwiSaver has attracted a huge number of investors but the information and transparency regarding fees, performance, asset allocation and tax is inadequate. This makes it difficult for KiwiSaver members to choose the correct fund for them.
KiwiSaver badly needs a Consumer Powerswitch facility. That is the joint venture between Consumer NZ and the Ministry of Consumer Affairs that allows investors to compare electricity companies and to switch from one power company to another.
KiwiSaver will not achieve its full potential until a highly regarded website is established that contains accurate information on fees, asset allocation and the post-tax performance of all registered KiwiSaver schemes.
Brian Gaynor is an executive director of Milford Asset Management and the manager of the Milford Active Growth KiwiSaver Fund. bgaynor@milfordasset.com
