- On April 6, 2017
The Productivity Commission’s draft report on Alternative Default Models has recommended a new system of allocating new entrants to the superannuation system. It has suggested we consider a new model for placing new members, mainly young people, entering the workforce. It lists four models to consider and has asked for feedback.
The initial reaction from many in the industry has been to question whether we need a new system; could we not just improve the current structure and make it more efficient? Further, despite the warts in the current system, are the proposed models any better?
The Productivity Commission, following on from recommendations made by the Financial System Inquiry, clearly believes that structural reform is necessary. The report implies that the industry is complacent and survives on a flow of mandatory contributions from unengaged members. It argues that there are a number of inefficient funds and too many members could receive better retirement outcomes.
Are there too many funds? There has been a lot of media commentary about the ‘scale test’ and whether this should be applied (by APRA) to remove inefficient (mainly small) funds from the system. In practice, this does not appear easy to regulate. A trustee board must determine on an annual basis that its MySuper members are not disadvantaged relative to MySuper members in other funds. This determination is made after considering the number of members and the pool of assets held in the fund and signing off that they are not ‘insufficient’ in scale. APRA can consider the sufficiency of scale as part of its prudential oversight but it is one of many factors.
Clearly, scale is a subjective term as is the definition of ‘sufficient’. There is also no doubt that the use of custodians and third-party administrators provides low cost services on transactions, so many small funds have fair administration fees. However, it is in the areas of investments, business strategy and member engagement where scale is needed. Smaller funds can sometimes struggle to compete with the very large ones as they wont always have access to the necessary resources. Some can be nimble and offer a reasonable MySuper product, but they are in danger of falling behind in an increasingly competitive world.
At June 2016, there were 105 products sold by commercial businesses (the Retail segment under APRA’s segmentation). This seems far too many but it also includes many legacy products that will be swept up in coming years. The funds which don’t make profits for shareholders are company, industry and public sector funds. There were 139 of those funds. So, 244 funds in total, most of which are public offer and chasing the same members.
Now, retail funds are not going to merge with competitors but the owners will sell them off if they remain unsuccessful or are unprofitable. However, the not-for-profit funds will need to merge if they are unsustainable on their own. Of the 139 funds in this segment, 71 have less than $1b and another 21 have less than $2 billion. If we regard $2 billion as a minimum size, that means two-thirds of these funds are not viable. Our Superannuation Fees Analysis report suggest that funds above $2 billion have overall fees of at least 10 basis points below smaller funds – and the differential grows with size. Yet, larger funds also will often provide more services, which only serves to exacerbate the relative inefficiency of some small funds.
Some commentators argue a threshold of $2 billion is too low. However, many funds above this level (and possibly a few below) have a niche position in the market. The funds may well provide a specialist service or satisfy a particular need to members. The funds would argue this is a sound strategy provided the members know they are paying a premium for this. The challenge for funds is to maintain this in an increasingly competitive marketplace.
In our annual Superannuation Expense Benchmarking study, we note that the greatest rate of reduction in operating and investment expenses occurs for the first 100,000 members and the first $2 billion of assets. While there are continued scale benefits that are achieved for memberships and asset bases above these levels, the law of diminishing returns applies and the scale benefit, while still significant for larger funds, will reduce accordingly.
We have been involved in several fund mergers, mainly of larger funds. In every case, the pair of funds merging have been pleased with the outcome. The trustees of both funds see the advantages of delivering more services and strengthening their investments and member engagement facilities. Hence, larger funds merge to provide better services for their members even if they are already sustainable.
The overall average fees charged to members are 1.03% – a fall of 23 basis points in 10 years. However, strong asset growth has masked the fact that fees in dollar terms are growing well above the rate of inflation. The complexities of our industry – life insurance, financial advice and retirement strategies – means that funds deliver far more than they did a decade ago. The reality is that larger funds are better able to invest in and ultimately deliver these services.
In our submission to the Productivity Commission, we suggested there be a governance framework for mergers to assist funds to deal with the process competently. We consider that there should be:
- Clear guidelines for funds on how to approach another fund with a merger proposal.
- An obligation for trustees to give genuine consideration to merger proposals in the context of member interests.
- Disclosure by trustees to their members and APRA of all (sensible) merger approaches and the reasons for any decision (accept or reject).
The Commission has made a recommendation that such a framework be established.