Productivity Commission report into superannuation system bodes well for the future

In brief

Written by Partner Geoff Sanders and Associate Patrick Easton

At first glance, the recent Productivity Commission Draft Report on How to Assess the Competitiveness and Efficiency of the Superannuation System (August 2016) could be dismissed as nothing more than a procedural step along the road to the ultimate goal (as recommended by the FSI) of developing an alternative system of allocating default members to superannuation funds.

After all, the Report reaches no conclusions (and nor was it meant to) on the current efficiency and competitiveness (or otherwise) of the system and, instead, limits itself at its core to doing two things – more clearly defining the goals of the superannuation system and articulating a long, somewhat dry, list of economics-based criteria on which the competitiveness of the system will be judged in the years to come.

However, to dismiss the Report so easily would belie the wealth of detail contained in it and the quality of research undertaken by the Commission. In particular, much of the value of the Report lies in the numerous observations made on the current state of the industry in its weighty 285 pages.

Defining the system objectives and future competitiveness assessment criteria

The ultimate purpose of the Report was for the Commission to develop a set of clear criteria by which it will make an assessment of the superannuation industry in late 2017 which, in turn, is to be used to assist the Commission in the development of possible alternate models for the allocation of default members to superannuation funds.

In undertaking this necessary first step in that process, the Commission does what it does best – using somewhat dry economic theory to articulate the requested criteria in a thorough, systematic and thoughtful manner.

The system objectives

However, before doing so, the Commission sets out what it believes should be seen as the core objectives of the superannuation system – after all, as the point is well made in the Report, there is not much point assessing something unless you are clear what it is that you are assessing it against.

Taking Treasury's proposed overarching system goal of a need to 'provide income in retirement to substitute or supplement the Age Pension' as a starting point, the Commission goes on to articulate five further subsidiary 'system-level' goals of the system:

1. The superannuation system maximises net returns on member contributions and balances over the long term.
2. The superannuation system meets member preferences and needs, in relation to information, products and risk management, over the member's lifetime.
3. The superannuation system provides insurance that meets members' needs at the least cost.
4. The superannuation system complements a stable financial system and does not impede long-term improvements in efficiency.
5. Efficient outcomes for members are driven through a market structure that facilitates competition and with suppliers competing on features that members value.

In our view, the above criteria do a pretty good job of getting to the heart of what the system should be setting itself up to achieve and Treasury could do far worse than to adopt these as the subsidiary criteria contemplated for its proposed legislation enshrining the objectives of superannuation.

The assessment criteria

The Report then sets out the assessment criteria.

These are the tests which the Commission will use in late 2017 to assess how the industry is going in respect of efficiency and competitiveness and, ultimately, will drive whether something potentially radical needs to be done to shake up the industry in future years.

The criteria (for what their worth in isolation at this stage of the process) are:

Competition

1. Is there sufficient member engagement to exert competitive pressure?
2. Are members and member intermediaries able to make informed decisions?
3. Is there low market segmentation along member engagement lines?
4. Do active members and member intermediaries have sufficient countervailing power?
5. Are principal/agent problems being minimised?
6. Is there rivalry among incumbent providers?
7. Is the market contestable?
8. Are there material anti-competitive effects of vertical and horizontal integration?
9. Do funds compete on costs?
10. Are economies of scale utilised and the benefits passed through to members?
11. Do funds compete on relevant non-price dimensions?
12. Is there innovation and quality improvement in the system?
13. Are outcomes improving at the system level?

Efficiency

1. Are net returns maximised over the long term, taking account of member services?
2. Are costs incurred by funds and fees charged to members being minimised taking into account member services?
3. Do all types of funds have opportunities to invest efficiently in upstream capital markets?
4. Is the system effectively managing tax for members, including in transition?
5. Are member preferences and needs being met by:
   • minimising unpaid contributions and lost accounts?
   • funds collecting information to ensure their products are suitable for members?
   • the system providing high-quality information and financial advice to members to help them make decisions?
   • the system providing products and information to help members optimally consume their retirement incomes?
   • member balances being allocated in line with their risk preferences and needs?
6. Is the system using lessons from behavioural finance to design products and 'lean' against well-known biases in how people make decisions?
7. Are trustees acting in the best interests of members?
8. Are there material systemic risks in the superannuation system?
9. Do funds offer insurance products that meet members' needs?
10. Are the costs of insurance being minimised given the type and level of cover?

The Commission's observations

In many ways, however, the more interesting aspects of the Report are found not in its core outputs (as described above) but rather in the multitude of interesting observations contained in it.

In particular, it is clear that the Commission has spent considerable time in getting to understand the industry at all levels, which we believe ultimately bodes well for a constructive assessment of the state of the industry in due course.

While by no means exhaustive – and, despite its 285-page length, we do recommend a read (in your spare time) of the Report itself – a few of the more interesting observations made in the Report (many of which may well feed into any new default member allocation system designed by the Commission) include the following:

• Net investment returns the key; don't focus on fees and costs alone: There is an acknowledgement in the Report that net returns to members should be at the heart of any assessment of the efficiency and competitiveness of the system and, of course, that fees and costs are a critical part of that assessment. However, and in our view correctly, the Commission is at pains to make the point multiple times that looking at fees and costs in isolation is misguided and recognises the importance of taking a balanced view by looking at 'multiple criteria, weighted by significance'. Interestingly, the Report notes the numerous submissions made to the Commission as to the (often positive) features of the Australian superannuation system that have arguably led to higher than average fees and costs, such as a commitment to active investment management and higher allocation to alternative asset classes as well as the unique structural features of the Australian system (eg, insurance within superannuation, etc).
• Scale is important but not necessarily everything: The Commission appears to broadly accept the proposition that increased scale (in both the system as a whole but also in individual funds) should be a positive in a search for efficiencies. However, in another sign of its encouragingly balanced approach, the Report does seem to indicate that the Commission is far from convinced that scale alone should be a core goal of the system. The Commission argues that it is the benefits of scale that should be assessed and these benefits can be achieved in other ways, including through the use of technology and the use of large service providers (eg, administrators, custodians and investment managers).
• Corporate tenders may provide some guidance: The Report contains an entire chapter devoted to corporate tenders for the provision of superannuation services and suggests that, despite an acknowledgement of a current lack of reliable data, lessons may be learnt by the Commission (with a view, don't forget, to that long-term goal of developing a new default member allocation process) from both the manner in which those tenders are conducted and the outcomes of the tenders (the suggestion being that fee savings are able to be achieved through a successful tender). However, it is interesting to note that the Commission generally appears to take a relatively dim view of the ability of employers to appropriately select a suitable superannuation fund for their employees (a consequence of one of the many, potentially conflicted, 'principal-agent' relationships the Commission notes are present in the system) – certainly something that may well have a significant influence on any alternative default member allocation system the Commission develops.
• Member disengagement shouldn't necessarily be assumed: Interestingly, the Report makes a number of observations that suggest that the Commission's view of member disengagement is not entirely settled. While the Report contains many of the types of statistics we are accustomed to seeing in relation to member disengagement (eg, one in four members don't know their balance; only 43 per cent of males and 22 per cent of females say they understand the concept of a risk-return trade-off; one in ten can't name their superannuation fund etc), it also suggests that the Commission may be swayed by arguments that many 'default' members are in fact in those defaults by active choice and by its scepticism of some other commonly used measures of member disengagement (eg, 'activity-based measures, such as member switching and default rates, are not necessarily a reliable indicator of engagement'). While we may be reading far too much into those comments, some of this might suggest the Commission may place less weight on arguments, given prominence in past reviews of the system, that protection of default members should be at the core of any new default allocation system.
• International comparisons are hard: Finally, and in something that won't come as a surprise to many, the Report briefly looks at similar systems in place in other countries and quickly draws the conclusion that making comparisons across jurisdictions is fraught with difficulties given the huge variation in the nature of each system and the lack of 'apples-for-apples' data. That said, the Commission clearly intends for an element of international comparison to form part of its assessment, with the limitation being that it will need to limit that comparison to 'specific aspects of performance' that can more accurately be compared, including investment management fees and performance against comparable asset classes and the efficiency of specific administration services.