In their 2008 annual report, the Guardians of New Zealand Superannuation nonchalantly mention their big blunder: "We estimated that the Fund return (after costs, but before tax) would be 8.1% The actual return was minus 4.92%." As Homer Simpson moments go, a fairly spectacular "Doh!"
That was June 2008. But as the Guardians point out, in the wider scheme of things an almost 5% loss isn't so bad.
"While disappointing, this year's return came after four years of strong performance results and was within the range of our expectations. Based on our modelling of the Fund's risk and return characteristics, we would expect a performance like this perhaps one in every 15 years."
That's a relief. Except they're wrong again. Unless manna falls from heaven in the next few months, 2009 is going to be another "one in every 15 years", only much worse.
For the first six months of the 2008-09 year, the Fund is showing a return of minus 23.12%. The Guardians had estimated plus 6%. That's a lot of doh! Getting it wrong like this can be disastrous - in this instance wiping $4.184 billion off the value of the Super Fund in the past 18 months. The fund was designed to help with the burden of paying universal superannuation to the droves of baby boomers who begin retiring in 2010.
The concern for the boomers is just what a prolonged recession and continued fund losses will do to the quality of their retirement. The boom generation could be facing a retirement that's bust. Never mind. Employer-based superannuation schemes, including the much heralded KiwiSaver, will save the boomers' retirement days. Or maybe not.
Morningstar Research shows that of 376 New Zealand superannuation funds on its database, 275, or 73.13%, had negative returns in the year to June 30, 2008. Funds heavy in New Zealand shares fared worst, down 19.19% on average. Those in world share options weren't great either, down 9.98% on average.
Balanced and growth superannuation funds were minus 5.49% and minus 8.7% respectively.
The first year of KiwiSaver savings don't look great either. Of 96 KiwiSaver funds on Morningstar's database, 62.5% were showing negative returns for the year to January 31. In the six months to the end of January, 72.38% were in negative territory.
Early days for KiwiSaver, but several years of losses like this could mean a retirement of gloomier boomers.
Thank goodness for property; especially for those prudent boomers entering their retirement mortgage-free.
Not so fast. In this big, nasty global recession, virtually every asset class - homes, equities, commodities - has deflated. Here's former Reserve Bank governor Dr Don Brash at the beginning of February, with a sobering outlook on property values: "In general, house prices have some way to fall yet. A couple of years ago I said publicly that they looked to be about 30% overvalued in terms of long-term trends.
Now we have the correction under way, I guess the call is to estimate how far through it we might be."Dr Brash's speech, "Confronting The Perfect Storm", goes on to say the bottom for house prices is probably 24 months away and involves at least a 17% tumble. Thanks Don.
So what's a baby boomer, with all three retirement foundations sinking - government superannuation, employer-based superannuation and their home's value - to do? The short answer might be: hunker down, hold on to cash, get any long-term investments into cash-based conservative funds, and look on the bright side of life.
But in hunker-down mode, it's hard to ignore even gloomier imaginings.
And words strung together in ways most of us don't understand - "deflationary spiral", "severe economic contraction" and "unanticipated liquidity shocks" - but which definitely don't sound good.
Take arch-prophet of doom Nouriel Roubini, professor of economics at NYU's Stern School of Business, and the man who stood in front of a group of economists at the International Monetary Fund in 2006 predicting, to much incredulity, disaster for the global financial system.
Just last month, this is how he described the present predicament: "It is now clear that this is the worst financial crisis since the Great Depression and the worst economic crisis in the last 60 years.
While we are already in a severe and protracted U-shaped recession (as the deluded hope of a short and shallow V-shaped contraction has now evaporated) there is now a rising risk that this crisis will turn into an uglier multi-year L-shaped Japanese-style stag-deflation (a deadly combination of stagnation, recession and deflation)."
Who knew recessions form like letters emerging from an alphabet soup? But Prof Roubini, like an increasing number of commentators, does mention the "D" word - code for it could be worse.
At the moment, most talk of asset-class falls is about 30% to 40%. During the Great Depression, equity values fell 80%, so if it does get really bad, there could be another 40% to 50% decline to go. It's possible to dismiss such excessive doom talk as, well, simply too gloomy to contemplate.
But, returning to the dismal state of our national Super Fund, it is worth asking a few questions about how we got into this mess.
The Guardians tell a familiar story: "The year to June 2008 proved to be a very difficult investment environment A major factor was the emergence of a global 'credit crisis', initially triggered by rising default rates for 'sub-prime' mortgages in the United States. Banks, hedge funds, and other financial institutions became increasingly uncertain about the true market value of a range of complex credit instruments. Interest rates for corporate borrowers increased relative to government rates and obtaining credit became an increasingly difficult proposition for many borrowers."
Yes, we know all that, but why on Earth didn't you, the Guardians of our future, not see this coming? If you, the so-called experts in the field of investing get caught like this, what hope is there for the rest of us? The questions are unsettling because they can, and are, being asked of the private and corporate actors who brought this mess about.
What's becoming abundantly clear is that they, too, didn't understand what they were doing. Many heads of the now myriad failing, or deceased, financial institutions did not grasp the degree of risk and exposure brought about by the dealings of the widely dispersed managers under them. Many investors, including city councils and pension funds, also bought financial instruments without understanding the risks involved.
It's true that government agencies around the world failed in their duty to monitor and regulate what was going on. But if the leading executives of financial firms didn't know what was taking place, what chance did the government regulators have
?Even market cheerleaders such as former US Federal Reserve chairman Alan Greenspan are now stepping back from the ideology that says self-interest will ensure money managers manage the money to best effect.
Whether or not this recession signals the final nail in the coffin of libertarian, free-market ideology is not the point. What it does signal is that two fundamental tenets of investment - taking a long-term view and diversifying risk - have been turned on their head.
The long-term view is what the Super Fund does. It's a position that says what goes up must come down and that in investing, if you're prepared to take the rough with the smooth, in the long term everything will be all right. It's a view that says economic cycles are normal; that this recession is just another cycle and, given time, values will increase again.
But what if that's completely wrong? What if this recession is different? What if it is, as radical theorist and author Nassim Taleb claims, an unexpected, rare "black swan" event: a harbinger of a change we've only just begun to appreciate?
Taleb, a specialist in financial derivatives and happy to put his money where his mouth is - he's reported to have made a multimillion-dollar fortune in 2008 during the global financial meltdown - puts it like this in The Black Swan, published in 2006.
"We have never lived before under the threat of a global collapse. Financial institutions have been merging into a smaller number of very large banks. Almost all banks are interrelated. So the financial ecology is swelling into gigantic, incestuous, bureaucratic banks - when one fails, they all fall."
Taleb argues we may be facing chain reactions we've never imagined before. Ripple effects from "the intricate relationships in the system we don't understand".
With that sort of worry in mind, what will the managers looking after the Super Fund do to stop losses if the fund continues to bleed money in 2009 as it did in 2008?
"We invest for the long term and take on risk assets within the Fund in the expectation that those will be rewarded over the life of the Fund," general manager corporate strategy Tim Mitchell says. Risk assets carry the chance that returns can be negative in any given period. We do not anticipate any substantive change to the Fund's strategic asset allocation."
While it sounds as though the fund managers have their heads in the sand amid the carnage, the Guardians' briefing to Finance Minister Bill English in December is less business-as-usual.
"We are already 'institutionalising' lessons learned in this crisis. Those include: the need to ensure appropriate cash buffers to deal with unanticipated liquidity shocks; greater stress-testing of the Fund to assess how the portfolio behaves during [a] period of extreme outcomes."
The Guardians are in "no doubt" that as they stand back and reflect on how events unfolded, they "will forge new ways of thinking about the challenges we face". They say the lessons generated by this crisis will reinforce their motivations to build an organisation "capable of steering the Fund through all weathers". Bravo.
Pity that the first rough patch to come their way seems to have flooded the Super Fund's basement.
Mr Mitchell refused to say what "new ways of thinking" the fund managers had forged, saying the matter would be discussed in the next annual report. Ditto for what the greater stress-testing of the fund had revealed.
But he did say the managers had increased the amount of cash and other "short-term liquid instruments" held within the fund.
Mr Mitchell says the Super Fund has also introduced a range of additional metrics to measure and monitor the creditworthiness of its derivative counterparties. Derivatives, so called because they derive their value from something else, mirror images of assets, are both a cushion and a gamble: deals investment companies and banks make to manage the risk of their holdings, while trying to turn a profit at the same time.
They are at the heart of what led to this disaster: mirror images of assets and mirror images of mirror images repeated again and again and traded, not on regulated exchanges like futures commodity contracts, but as private contracts in "dark markets" all over the world.
The problem in trading in mirror images is that when the original image fails, nothing appears in all the mirrors.
Mr Mitchell says to safeguard the derivative swap contracts the Super Fund uses in managing fixed income, equity and commodity exposures, it now has in place "collateral agreements to tightly manage our exposure to the counterparty" - that is the brokers, investment banks, and other securities dealers that serve as the contracting party.
The Super Fund also follows the second rule of investing: diversify. It's the rule of not putting all your eggs in one basket. It's a good theory, but in this case it didn't work. The diversification of investment, aimed at reducing risk to institutional investors, ended up spreading risk more widely.
Investors all over the world, including the Super Fund, found themselves holding mortgage-backed American securities of declining and indeterminate value.
Lehman Brothers Holdings, Freddie Mac, Merrill Lynch, Wachovia, Washington Mutual, American International Group (AIG), Morgan Stanley, Goldman Sachs, and Citigroup are some of the better-known companies that have either gone bust, been bailed out or suffered catastrophic losses.
What is clear is our Super Fund, like many other firms in the financial sector, allowed diversification of assets to become a substitute for due diligence on each asset. Bundle enough assets together and you don't need to know much about the assets themselves.
As it turned out, they knew very little.
Our Super Fund also uses a diversify and spread-the-risk mechanism in its management structure. It's run by a board and its investments are made through other fund managers. In theory, that might provide the best fund managers in their fields, but it also means losing a level of direct control.
There's also no public transparency showing which fund managers invested in what, and what return they delivered to the fund.
What's happened to our Super Fund in this unfolding financial crisis is a painful lesson to all investors. Just how its decline affects New Zealanders' retirement remains to be seen. But it does highlight several home truths.
The long term is murky. Diversification of risk is not as straightforward as it sounds. And above all, it's vital to know who is investing and just what exactly they're investing in.
- Chris Barton.
