Australia’s Superannuation System: A $4 Trillion Liquidity Risk

Australia’s superannuation system - managing nearly $4 trillion in assets - stands as a global leader in “defined contribution” pensions. Yet, this pillar of retirement security is under increasing scrutiny for potential liquidity mismanagement, which could undermine member outcomes and pose systemic economic risks during times of market stress. Recent warnings from the Reserve Bank of Australia (RBA) and the International Monetary Fund (IMF) have signalled that greater governance measures are vital to monitor the liquidity risks associated with this rapidly expanding sector.  

The Liquidity Mismatch: A Growing Concern 

Australian super funds are steadily increasing their exposure to illiquid assets, such as private equity and infrastructure, which now comprise over 20% of portfolios on average. While these investments can offer diversification benefits, funds may struggle to convert them into cash during market downturn - creating a liquidity mismatch.  

For instance, during periods of economic uncertainty, members may fear a decline in their portfolio value, and rush to switch investments or withdraw funds. This could force funds to sell assets at unfavourable prices - or, in extreme cases, refuse member requests for portfolio changes - amplifying market volatility and destabilising the wider financial system. 

Systemic Implications 

Having doubled in scale in the past decade, Australia’s super sector now accounts for 25% of total financial system assets with funds holding nearly one-third of domestic bank short-term debt securities.  The RBA has noted that this growing footprint in financial markets heightens risks to financial stability. 

To illustrate, the onset of the Covid pandemic brought with it increased economic uncertainty and subsequent government measures that allowed people early access to their superannuation, namely, the superannuation Early Release Scheme (ERS). As withdrawals surged, funds had two main priorities:  

1. A desire to reduce their exposure to relatively riskier assets during this period of global instability.  

2. A need to meet increased demand for cash, which may have prompted funds to sell assets in order to boost liquidity.  

This resulted in super funds significantly reducing their stock of bank bill holdings to free up cash or to reallocate investments towards safer assets like government bonds. The subsequent increase in the supply of bank debt securities on the market combined with generally low levels of market confidence, pushed down the price of bank securities and increased yields. Banks therefore needed to offer higher interest rates to attract buyers, which increased their funding costs and reverberated throughout the system - raising borrowing costs for the economy as a whole.   

Additionally, super funds' reliance on common benchmarks could further exacerbate this kind of systemic risk. The ASX 200 for example, often serves as a performance yardstick for funds, compelling many to align their portfolios closely with the index to avoid perceived underperformance. This “herding behaviour” heightens the risk of large-scale asset sell offs during market stress, which can drive down asset prices and create a self-reinforcing feedback loop that could destabilise domestic markets. 

Three Key Sources of Liquidity Strain   

Capital Calls on Private Assets 

In some illiquid investments, investors (the super fund) commit to providing a certain amount of money but don’t pay the full amount upfront. Instead, the asset manager issues capital calls when more funds are needed (e.g., to acquire a company or fund a project). 

If multiple capital calls occur simultaneously, or if they coincide with broader financial shocks, super funds might struggle to meet these obligations. To raise the cash required, funds may need to liquidate assets at depressed prices. 

Abrupt Policy Changes  

Regulatory shifts, such as tax reforms or withdrawal rule adjustments, can create unanticipated cash outflows. For example, the ERS required funds to provide liquidity quickly, despite having predominantly invested in illiquid assets. 

Such policy shifts can lead to synchronised selloffs, as multiple funds adjust their positions simultaneously. 

Margin Calls on FX Hedges  

Around 35% of superannuation investments are offshore, making them vulnerable to currency fluctuations (e.g., if the AUD appreciates, the value of overseas investments may decline when converted back into domestic currency, affecting members’ returns).  

To mitigate foreign exchange risk, approximately 40% of these investments are hedged using currency derivatives which often require funds to post collateral as market prices change.  

Liquidity can become an issue if currency movements are sharp or unexpected and the value of the hedge declines. This scenario will likely trigger margin calls - requests for additional collateral to maintain the hedged position - potentially requiring the liquidation of assets and triggering a rapid scramble for cash.  

Policy Challenges: Managing Liquidity Without Stifling Growth 

Addressing the RBA’s 2024 September overview of Australia’s financial health, Treasurer Jim Chalmers emphasized the need for resilient financial institutions. For the super sector, this means striking a balance between managing liquidity and supporting long-term returns. 

The IMF has suggested measures such as: 

• Extending switching timeframes: Allowing funds more time to adjust asset allocations when members switch investment options. 

• Frequent asset revaluation: Ensuring illiquid assets are accurately and regularly valued to reflect changing market sentiments. 

• Enhanced stress testing: Developing robust liquidity management plans that account for extreme scenarios, including large-scale member withdrawals and market downturns. 

The Road Ahead 

It should be noted that Australia’s super industry has structural advantages which may help limit the development of systemic risks, including its long-term investment horizon, limited use of leverage, and a defined contribution structure*.  

However, with growth exceeding that of the wider economy, the IMF, the RBA, and Australia’s Treasury are in accord; proactive policy and sophisticated liquidity planning are more crucial than ever. Especially given our ageing population and the critical role super will play for both members and the economy in the years to come.  

*As opposed to a defined benefit scheme like that of the UK, Australia’s defined contribution scheme means that retirement payouts are not guaranteed. They depend on the amount contributed and the investment performance of members’ individual accounts.