Pearls and Irritations

A substantial Productivity Commission report, Superannuation: Assessing Efficiency and Competitiveness, was released this week with submissions due by 13 July 2018. It is an important report that reviews the $2.6 trillion industry with 15 million members and provides sensible reform proposals though the handling of the default allocation to My Super accounts does require further consideration.  

By way of background this is the third stage of the work of the Productivity Commission in examining reforms to the superannuation investment system. The initiation of the process was recommendation 10 of the 2014 Financial System Inquiry Report which proposed the introduction of a formal competition process to allocate new default fund managers to My Super products, in place of the current awards and enterprise agreement based system. This led to the Commonwealth commissioning the Productivity Commission in February 2016 to develop criteria to assess efficiency and effectiveness of the superannuation system (Stage 1) and then to develop alternative models for allocating default fund members to products (Stage 2) and then to the current report (Stage 3) which seeks to identify areas for improvement in the superannuation area in regard to the investment function. The report focusses on defined contribution schemes rather than the defined benefit schemes, which in the main are closed schemes.

The report is written by the Productivity Commission Deputy Chair, Karen Chester, together with Commissioner Angela McRae. Karen has very relevant background in Commonwealth Treasury and in the funds management industry. The report breaks new ground by assessing comparative performance by funds and products against suitable benchmarks that capture the risk-return characteristics of the funds and products as well as undertaking modelling of the cost impact of members having multiple funds and the sequencing risk involved in adverse market changes. This means that the report can draw on extensive data and analysis and not simply make assertions.

For the period 2005 to 2016 it assessed the annual net returns of the various funds and found the following net after tax annual rates of return:

On average retail funds generated returns well below those of not for profit industry funds. It is possible that the retail funds invested in considerably lower risk assets and that explained the lower return rather than relative performance. However, when account was taken of the return relative to the benchmark for each fund it was found that the retail funds performed below their benchmark while not for profit funds were above the relevant benchmark. Of the products that underperformed the benchmark, about 50% were retail funds and one third were industry funds (presumably the balance was corporate and public-sector funds). Putting it in perspective about two thirds of the 14.6million accounts outperformed the benchmark and one third or nearly 5 million, underperformed. Thus, as the report finds, while the system performed well for the majority the challenge is to achieve a better result for all members.

The report identifies two main areas of inefficiency and poor performance: the holding by members of multiple superannuation accounts and the underperformance of a significant number of funds. On the first factor, the holding of multiple accounts, this reflects both paying unnecessary fees and holding unnecessary and multiple life insurance associated with each product. Unnecessary fees were assessed at $690million pa and the additional cost of insurance at $1.9billion per annum. Hence this factor generated excess costs of $2.6billion per annum. The underperformance of funds relative to the benchmarks adds a further $1.3billion in excess costs. Thus, the total annual excess costs are $3.9billion. While it is a large absolute number that should be addressed, to put it in perspective it is about 2.5% of the annual investment return generated in superannuation.

Overall the report finds that despite there being 40,000 superannuation products, the level of competition between funds is not high. Partly this is a function of members and potential members not being fully engaged in the decisions about superannuation, particularly the young who do not see it as relevant to their stage of life. Also, it is a highly technical and complex area with little in the way of clear, easy to understand information of the superannuation funds. On the fund side competition is focussed not on relative performance but on the range of products and administrative services, that is on non-price and performance competition. This is typically   the case in industries with poorly informed or non-expert customers.

The level of inertia and non-involvement of members is highest in the case of those who use the default process whereby they are allocated a superannuation fund. The report finds that the process involved in allocating default funds to persons who elect not to select a specific fund contributes to the underperformance. The process at present is tied into the award and enterprise agreement system whereby the default superannuation scheme is the scheme or schemes referred to in the award and enterprise agreement. Typically, this is a not for profit industry fund. In view of the superior performance of the not for profit funds relative to retail funds, this achieves a better result than simply requiring the person to select a fund at large. About 1.7million member accounts and $62billion in assets are in default My Super products that have underperformed benchmarks, compared with 6 million accounts that have performed well. In dollar terms the cost of being in an underperforming fund means a person who starts work today on the median income would have a balance at retirement 36% less or $375,000 than otherwise.

The report also finds that while there has been some consolidation of funds and some reduction in fees since the last reforms in the superannuation area, nevertheless there are still too many small, underperforming funds. In the case of industry funds, these funds are typically small funds which should merge with larger funds. The report notes a possible link with the issue of governance of superannuation funds whereby there is not sufficient accountability on trustees to ensure the interests of members are paramount. In addition, there is room for improvement in the composition of trustee boards to ensure there is the appropriate range of skills and experience.

At the regulatory level, the conduct regulation arrangements for the superannuation system are said to be confusing with significant overlap in the role of APRA and ASIC which have the potential to reinforce poor accountability.

The report contains twenty-two recommendations, but the key ones directed at improving effective competition and performance are as follows:

1, addressing multiple superannuation accounts and unnecessary costs

The report proposes that a default superannuation account is only created once for new entrants to the workforce with the ATO establishing a centralised-on line service for members, employers and governments. Multiple accounts occur at present as people move between jobs, with a new default superannuation account created each time. It is also proposed that the ATO should be authorised to address the existing problem of multiple accounts. Other recommendations to reduce costs include moving to opt in rather than the current opt out approach for life insurance for members under twenty-five years; ceasing life insurance on inactive accounts; and enhancing the content and coverage of the Insurance in Superannuation code.

2. Reformed approach to allocation of default superannuation funds

The Commission considered a range of options to the current employer/industrial relations based approach, including a fee based tender for default, a multiple criterion based tender and the establishment of a government monopoly default scheme, all of which were rejected as unlikely to improve on the current approach. Instead it proposed that there be an independent expert panel selection of what they refer to as the “best in show” shortlist of products that would be available for new members to choose from. In effect the Fair Work Commission would no longer have the power of administering the process for becoming a default-listed fund in awards.

The model is best described as one of “assisted employee choice” whereby the members are given the information that, based on the principles of behavioural economics, nudges members towards selecting from what are assessed as being the very best products. Members are still free to utilise  the full list of My Super products. If a choice is not made the default would be one of the funds from the list. This approach will assist the 470,000 per annum new members as well as helping existing default members through providing to them information on the “best in the show” selection and allowing them to compare with their existing fund.

3. Enhanced My Super authorisation

The report proposes an elevated set of requirements for My Super Accounts with outcomes test assessment undertaken using independent verification at least every three years of the product against other products in the market and determination of whether the members’ best interest is being promoted. APRA would oversight the outcomes test and have the power to revoke My Super authorisation based on the results of the test or underperformance. Clearly the intention is to place pressure on small and underperforming funds to merge with larger, better performing funds.

4. Enhanced governance of trustee boards

The report proposes that all trustee boards need to undertake an assessment of the skills and experience of the board and identify and address any gaps. In addition, it is proposed that the boards undertake an annual review of board performance and have an external review of performance each three years which is provided to APRA. The report does suggest that there is a need for a critical mass of independent directors, which it suggests would be one third of directors. The latter is not a formal recommendation at this stage but the report does propose that any restrictions on the ability of superannuation funds to appoint independent directors be removed. 

5. Member friendly dashboard for all products

The report recommends that all funds must publish simple, single page product dashboards covering all products, setting out the key information on each product. This is directed, like the “best in the show” list for default funds, at providing members and potential members with clear information on the available choices.

There are also recommendations on an enhanced and clarified role for both APRA and ASIC.

Overall the recommended reforms are sensible and address the problems identified, particularly unnecessarily high costs and low returns on a significant proportion of the default funds. The one recommendation that needs careful consideration and design is the proposed reform of the allocation of default superannuation funds. Certainly, the current system of default industry funds incorporated in the awards and enterprise agreements is not ideal but it has the merit that the industry funds are not for profit and generally have performed well. Hence there is a need for assurance that any changes will deliver significant benefits.

It is not clear that it would be possible to identify a “best in show” list of about 10 funds which are available for consideration by members and become the default funds. These will need to cover the range of members in different financial and lifestyle situations with different risk return preferences. Further, the performance of funds change over time and the overperformer can become an underperformer. The situation can be that the best in show fund becomes a poorly performing fund but the members that have being allocated continue to be members through the default process. These issues need serious consideration before a final decision is made. Nevertheless , the proposal in principle to move to a member assisted approach for fund selection is a good one, subject to its design and execution.

Michael Lambert is a former Secretary of NSW Treasury, a health economist at the Sax Institute and a former board member and Audit and Risk Committee member of both the $45 billion State Superannuation Fund and the $15 billion State Plus, a financial planner and fund manager.

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