2024-11-22 03:10:00
Australia has a seriously big “nest egg”. The Future Fund – our sovereign wealth fund set up in 2006 – now manages about $230 billion.
Specifically, its remit is to “invest for the benefit of future generations of Australians”. That’s long been interpreted as earning the best possible return on investment, without unacceptable risk.
Along with a few other smaller public wealth funds, it’s managed independently, on behalf of the government.
So the government ruffled feathers this week when it announced a new investment mandate which, for the first time, will require it to prioritise specific investments in Australia:
- increasing the supply of residential housing
- supporting the energy transition
- delivering improved infrastructure
These might all seem like reasonable priorities for Australia. But from those who thought this directive was a deviation from the Future Fund’s founding aims, criticisms came thick and fast.
Shadow Treasurer Angus Taylor accused Labor of “raiding Australia’s nest egg” for its own “pet projects”.
Peter Costello, who set up the fund when he was treasurer, said it would undermine the fund’s independence and lead to lower returns.
It’s quite possible, albeit unclear, that requiring the fund to prioritise certain kinds of investments will lead to lower returns.
There’s a more pertinent question. Why can’t the government fund these priority projects through debt rather than by spending sovereign funds?
History of the fund
The Future Fund’s initial purpose was actually to generate an asset pool that could cover government liabilities for future public sector pensions.
When it was established in 2006, the Australian economy was in a golden era of budget surpluses and revenues generated by mining and the China boom.
Details from Bianca De Marchi/AAP
With public debt paid off, there were suddenly questions about the need for a government bond market (used to borrow money).
Australia was also asking whether it should invest its wealth in a new sovereign wealth fund.
The thinking behind the Future Fund was that Australia’s surpluses would not last forever, and a major liability that the government would one day have to face would be defined pension payments to the public service.
A decision was made to build a sovereign wealth fund to fund this liability, and relatedly, a decision to keep the government bond market alive.
The return of government debt
As we now know in hindsight, the global financial crisis brought an end to the era of budget surpluses. That created new questions about the role of the Future Fund.
With government debt rising, it was not obvious that maintaining a separate giant asset like the Future Fund continued to make sense. Why not simply use it to pay down debt?
As always, these questions come down to basic financial engineering.
If, hypothetically, the government was paying 5% interest on its debt, but could generate 6% on Future Fund earnings, it would be better to keep the Future Fund going than to spend it on debt reduction.
The Future Fund now manages assets of around $230 billion. National net debt is forecast at more than $880 billion for 2024–25 and is expected to keep rising.
The government also used this week’s announcement to promise there would be no drawdowns from the fund until at least 2032–33, by which time it’s expected to grow to $380 billion.
Nonetheless, this financial engineering equation will remain a key question for the government.
Jono Searle/AAP
Will the new mandate affect returns?
Currently, the Future Fund’s mandate is to maximise returns, to build the biggest pool possible to fund the government’s future liabilities. Specifically, its mandate currently targets a return of 4–5% per year above the rate of inflation.
Will restricting what the fund can invest in reduce its total returns? It is reasonable to think that any constraint on investment decisions could have some negative impact on returns – and critics have certainly made that case this week.
Jacqui Martin/Shutterstock
The evidence on how mandates such as sustainability requirements affect investment returns is mixed. Analyses have shown that carefully constructed portfolios can perform well, but this is not always the case.
The key questions for the Future Fund become how much money gets allocated to these types of projects and how binding the mandates turn out to be.
Reasonable instructions to focus on green energy investments, housing and similar alternative assets might make sense in a national sense, but in terms of government debt and the purpose of the Future Fund, they muddy the waters.
Should the government just borrow for projects instead?
An alternative to having the Future Fund allocate funding to preferred government priorities would be to have the government simply borrow the money itself and keep the Future Fund assets separate.
If the government is going to support and fund these activities in either event, whether it does so via its debt or its assets doesn’t matter. The government’s net asset position is the same.
Australia is still in the position of having a relatively low national debt position relative to OECD countries, and funding costs are low. As long as we maintain fiscal discipline, this will continue to be the case.
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### The Implications of the Future Fund’s New Mandate
### The Implications of the Future Fund’s New Mandate
The Future Fund, which currently manages approximately $230 billion in assets, plays a crucial role in the Australian government’s financial strategy, especially against the backdrop of rising national net debt—expected to surpass $880 billion in 2024-25. The recent discussions surrounding the fund focus on whether it should be utilized for debt reduction and how its new investment mandate might impact returns.
#### Financial Engineering Considerations
The decision to keep the Future Fund operational hinges on a fundamental financial question: Is it more beneficial to maintain this separate asset or to use it to offset growing government debt? In hypothetical scenarios, if the government incurs a 5% interest rate on its debt while the Future Fund generates a 6% return, it makes more sense financially to retain the fund rather than deplete it for debt repayment. This evaluation of potential returns versus costs is paramount for government financial strategy.
#### Future Fund’s Growth and New Mandate
The government recently assured that there will be no drawdowns from the Future Fund until at least 2032-33. By that time, it’s projected to grow significantly, potentially reaching $380 billion. As the fund continues to accumulate assets, its operations and strategies will be closely scrutinized, particularly concerning its returns on investment.
Currently, the Future Fund’s mandate focuses on maximizing returns, targeting a 4-5% annual gain above inflation. However, the government’s new directive aims to guide investments toward “national priorities,” which may include initiatives such as enhancing housing supply. Critics argue that imposing such constraints could hinder the fund’s ability to generate optimal returns, as limiting investment options often leads to less diversified portfolios and potentially lower yields.
#### The Debate on Investment Constraints
The discourse surrounding the new mandate posits a challenge: Balancing the ethical and social imperatives of investment choices against the fundamental objective of maximizing returns. Critics of the mandate suggest that prioritizing specific sectors could indeed compromise total returns. Nevertheless, some evidence indicates that socially responsible investing does not always result in lower financial performance; different studies yield mixed results on this issue.
#### Conclusion
The question of whether the Future Fund should remain a standalone entity or be leveraged to manage national debt remains central in current financial discussions. Additionally, how the new mandate influences the fund’s overall performance will be critical to observe in the coming years. The government’s approach to financial engineering, the prioritization of national interests, and the pursuit of optimal returns will shape the landscape of Australia’s fiscal policy as it navigates a post-crisis economy.
