Expanding beyond superannuation without capital

As the superannuation industry grows, more commentators want to see its assets used to support other parts of the economy.  From time to time, people ask for super investments to be used in all sorts of capital-intensive activities, such as helping people to buy a home, or to fund health and aged care late in life.  Last week, it was the turn of some prominent business leaders to ask for long-term loans from funds pointing out that a market for such debt exists in other markets.  There is nothing intrinsically wrong with the suggestion provided the assets fall within a fund’s investment strategy, and pay a reasonable risk-adjusted return.

When mandatory superannuation was legislated 25 years ago, it was necessary to set up very strict rules as to what would be allowable within a superannuation fund.  All superannuation funds, including SMSFs, are subject to the sole purpose test (section 62 of the SIS Act).  This simply means that a fund must meet one or more core purposes, namely they must provide retirement and/or death benefits.  There are a few ancillary purposes too, such as release of benefits on a member’s hardship or disability.

The assets of a superannuation fund must be applied for the core purposes – generally to accrue benefits for retirement and then to manage these benefits during retirement should the member sign up an account-based pension.

Another factor, not well understood, is that all superannuation funds are technically not-for-profit, and the classification of funds between classes such as “retail” and “industry” is functional segmentation.  The retail segment does operate superannuation funds with a commercial motive but the funds themselves don’t make profits.  Rather, the profits are made from margins on the services provided to the fund, including trusteeship, administration, financial advice, investment management and life insurance.

The introduction of FoFA and MySuper has had an impact on the business model for retail default funds and the product pricing has reduced considerably.  While the suppliers of similar services to an industry fund also make profits, they are selected through tenders and are often unrelated parties.

The strict application of the sole purpose test makes it difficult for superannuation funds to diversify their services within the fund.  For example, funds cannot provide banking products to members as this is not a core purpose.  However, they can facilitate lending by providing introductions to their membership.  An example of this is Members Equity Bank.

As the assets of the superannuation industry grow, there will be increased calls to use the assets for other purposes.  Provided the investment strategy is not weakened, the funds will continue to broaden their asset classes in much the same way they have done over the last two decades – think of emerging markets, infrastructure and private equity.

Yet, all superannuation funds want to provide a greater number of services to members, and this is costly.  There is an argument to allow beneficial investment in some entities, even if they don’t always provide a full market return to members.  A good example, is financial advice where the service helps to improve members’ retirement outcomes.  Usually, this diversification means building extra resources in-house, which increases fees for members.  Alternatively, funds can invest externally in software for their planners or in separate advice business.

So, as funds diversify, they can buy or rent the extra services or they can outsource completely to expert businesses, all of which increase member fees. However, there are cases where funds choose to invest in strategic assets which deliver some non-investment benefits for members in a different way.  In a commercial conglomerate, these might be held by a related-party business and the trustees will ensure the service is purchased at a fair price.   With all other funds, the trustees lack the capital to buy these entities so some have purchased them on behalf of the members as private equity investments.  Most of these will provide a commercial return but some could only be justified by including various non-tangible benefits for members.

Many such private equity investments held by funds are large businesses.  For example, First State Super members own State Plus (retirement products and a financial advice business for members/retirees); QSuper members own QInsure (a life company) and QInvest (financial advice).  Members in several funds own shares in IFM and Frontier which are leading businesses in their fields.

As the superannuation industry expands, these types of investments will grow and trustees will occasionally have the dilemma of a non-superannuation business failing to provide a satisfactory investment return.  If it is still delivering some important member benefits, it will be difficult to divest.

None of this was foreshadowed when the SIS Act was prepared and it is time to consider restructuring these investments.  One option is to allow trustees to maintain reserves of (say) 1% of fund assets which can then be invested in strategic assets which provide services to members.  This gives a transparent framework and avoids the conflict of putting capital into assets which might have a lower expected return than other private equity investments.