Superannuation Funds: Why Size MattersPublished: October 16, 2012 in Knowledge@Australian School of Business
Making workers invest in their own retirement is rapidly filling the coffers of Australian superannuation funds, but not everyone is benefiting from their increasing size. A paper presented at the Australian School of Business 20th Annual Colloquium of Superannuation Researchers concluded that while industry fund members benefit from having bigger funds, retail fund members do not.
In the paper, Effect of Fund Size on the Performance of Australian Superannuation Funds, James Cummings, a research analyst at the Australian Prudential Regulation Authority (APRA), found there were three ways members could potentially benefit from scale: better gross investment returns, lower investment expenses and lower operating expenses. For industry funds, positive scale economies were evident through all three channels while the impact of scale on the performance of retail funds was mixed. Whatever the reasons, industry funds have outperformed retail funds by about 1.2% a year (after investment fees and tax) over the long term.
Industry funds dominate in the size stakes, representing the top 10 Australian funds by size. Australian Super heads the list at A$45.4 billion, followed by Qsuper (A$35.7 billion), State Super NSW (A$31.4 billion), UniSuper (A$30 billion) and First State Super NSW (A$23.1 billion). The largest retail super fund is AMP Flexible Lifetime with A$18.38 billion under management, in 11th place.
The biggest operator of super funds is the New South Wales government with A$64 billion and four funds, followed by AMP-AXA with 47 products running A$62.5 billion. According to the APRA research, two-fifths of the overall impact of size on the performance of industry or not-for-profit funds is realised in the form of higher gross returns. Larger industry funds have higher allocations to asset classes where they are likely to have a size-related advantage, such as infrastructure, private equity, direct real estate and other alternative investments.
One-quarter of the overall improvement is derived from lower investment expense ratios, which suggests that larger industry funds are able to negotiate more favourable terms with external investment managers. One-third is derived from lower operational expense ratios, suggesting that larger industry funds are able to spread fixed costs associated with administration and IT infrastructure over a larger asset base.
"Based on this evidence, fund members are likely to benefit from further industry consolidation in the not-for-profit sector. The results of this study indicate that the greatest benefits accrue when industry funds grow to a multi-billion dollar size and are not exhausted at the largest Australian fund sizes," says APRA.
Why Retail Funds Don't Measure Up
With retail funds, APRA found that larger retail funds have lower gross returns, which it says may be explained by the structure of many retail funds that operate as platforms. Members of these funds create their own portfolios from a suite of investment products. An implication of this approach is that there is limited opportunity for the fund trustees to optimise the investment allocation, at the whole-of-fund level, to benefit from larger size.
APRA also found there were no economies of scale evident in the investment expenses of retail funds. One explanation is that, because retail funds are more likely to outsource their investment management to related-party fund managers than industry funds, larger retail funds may be forgoing the ability to negotiate more favourable terms on investment management contracts. Larger retail funds were found to benefit from spreading fixed operational costs over a larger asset base, but they didn't realise any reduction in variable costs from administering larger member balances.
"The structure of retail funds, in the sourcing and offering of their investment products, is less conducive to capturing the benefits of scale. Consequently, the merits of industry consolidation are not evident in the retail sector," concludes APRA.
By all accounts, most superannuation fund types - including self-managed superannuation funds, industry funds and retail funds - are only going to get bigger as funds pour in and consolidation continues.
An increase in the superannuation guarantee levy from 9% to 12% will be a major factor behind total assets in the superannuation sector growing to close to one-third larger than Australia's annual GDP by 2019, up from 95% of GDP or A$1.38 trillion now, says research group CoreData Consulting.
In its white paper, Survival of the Fittest, CoreData predicted that by 2020 the number of funds in the Australian superannuation industry would shrink by up to 40%. Presently, there are approximately 362 superannuation funds in Australia, spanning the retail, public, industry and corporate superannuation sectors, a significant drop from about 1700 in 2004. At the same time as fund numbers have reduced, asset levels have ballooned, with the average fund growing to $2.6 billion from $300 million in 2004.
According to CoreData, some commentators believe the "sweet spot" for funds is around A$10 billion to A$15 billion in assets under management. However, many argue that it's not size, but efficiency, that will set apart the successful funds from the rest of the pack.
Clearly Australian funds are far from the point where diseconomies of scale might kick in, says Kevin Liu, a lecturer in actuarial studies at the Australian School of Business. While fund size, investment choice and expenses play a pivotal role in the net return for superannuation fund members, so does the profit orientation of the funds, according to Liu.
A key difference between industry funds and retail funds is that the former are not-for-profit, hence they are able to pass on to members the benefits that come with size, such as reduced fixed costs and more favourable outsourcing arrangements. Growing retail funds may also be able to reduce the same operational costs and investment expenses, but because they are required to distribute return on capital to shareholders, they are more likely to retain the benefits than pass them on to members, Liu says.
Alex Dunnin, director of research at financial services provider Rainmaker Information, has a similar view. "The APRA findings highlight the challenge in the retail sector to demonstrate scale advantages rather than see superannuation just as an opportunity to generate profits," Dunnin says.
Watching for Exceptions
Warren Chant, principal of superannuation consultants Chant West, argues that scale is just one of a number of factors that contribute to performance differentials between funds. "Scale has allowed funds to deliver superior performance over the longer term. Large funds, however, do not always outperform small funds. A fund's decision regarding where to invest is also important," he says.
Chant attributes the long-term outperformance of industry funds over retail funds to industry funds being more prepared to invest in unlisted assets (including alternative assets such as private equity, infrastructure and hedge funds) as well as more actively managing their asset allocation positions. The reason why industry funds are able to invest more in unlisted assets is not to do with scale but because of their more stable memberships and relatively stronger cash flows than retail funds.
Industry fund net contributions represent about 10% of their average net assets, compared with 5% for retail funds. Industry fund inflows are also more stable, with more than 80% coming from compulsory Superannuation Guarantee contributions, compared with about 50% for retail funds.
This helps, in part, to explain why more people don't move from retail funds to industry funds, even though industry funds are better structured to continue to outperform retail funds.
Liu says there are two main reasons why members of under-performing funds are unlikely to move en masse. The first is due to the lack of member engagement. The mandatory nature of Australian superannuation and the increasingly complex retirement savings system implies that many people have limited willingness and knowledge to comprehend and engage with the superannuation system.
"In short, people often don't care or they have inadequate levels of financial literacy to compare funds and to make sensible and informed decisions of where else to invest," says Liu.
Most people do not make active decisions and stick to the default nominated by their employers, even though they are presented with a large number of choices - for example, choice of fund and investment options. Others, who are willing to engage but unable to choose, often rely on someone else, such as a financial adviser, to make decisions on their behalf. The lack of member engagement and heavy reliance on financial intermediaries highlights the deficiency of consumer-driven competition in superannuation.
Liu says the second reason people continue to pour money into under-performing funds, particularly in the retail sector, is due to the supply-driven competition with funds competing to capture distribution networks of financial advisers via incentives. Commission-based incentives motivate advisers to recommend particular products whether or not they are in the best interests of members. The presence of conflicts of interest in financial advice and the lack of capacity for ordinary people to determine the quality of financial advice further contribute to the system's inefficiency.
Up until the introduction of Future of Financial Advice reforms and the banning of commission-based advice, most people who sought advice were more likely to be directed towards a comparatively more expensive retail fund.
A 2007 Rainmaker Information study found that not one of the top 30 financial planning groups had included an industry fund on their "approved product" lists - that is, the set of funds they were authorised to recommend to clients.
"Both reasons tell you the system is inefficient, which drives many of the Cooper Review recommendations, including the introduction of MySuper," says Liu, who is referring to the Super System Review panel chaired by Jeremy Cooper that in 2010 proposed the establishment of no-frills MySuper products by all funds that want to be a default fund nominated by an employer.
Legislation pertaining to MySuper passed through federal parliament last month, establishing a minimum standard for default superannuation investment options. Pauline Vamos, chief executive of the Association of Superannuation Funds of Australia, likens the standard to the "heart tick on food", and says MySuper offers Australian workers a super account with defined fees, no commissions and a highly transparent investment approach.
"All ingredients must be disclosed and products must meet certain standards and be authorised by APRA," Vamos says.
While MySuper should help those super-fund members who are disengaged from their retirement savings, or who don't want to make investment decisions, the onus should always be on fund trustees to generate decent returns for members regardless of scale.
Mergers that centre on the idea of saving costs need also to be mindful that the real goal should always be returns. After all, members cannot retire on a cheap administration fee alone. But they can retire on a sizeable lump sum that was accumulated because of good net returns.