Game changer for super – again!

In the dead of night while the foxes were eyeing the hen house, the Productivity Commission (PC) released its draft report on alternate default fund models for superannuation.

The PC starts with the claim that the current superannuation system is inefficient and default members would be much better off with a different structure. This theme is well-argued and there is no doubt that the system could be improved. The key discussion point for government and industry is whether we need such a bold catalyst to drive improvement or whether the industry nudged by regulators can manage incremental enhancements itself.

First, we know we have too many funds but the numbers have been declining over many years, as shown in our Superannuation Market Projections Report. Similarly, there are too many member accounts, but these peaked at 32 million and have declined by three million through account consolidation in the last two years despite a growing population. We also know that fees are too high, yet our Superannuation Fees Analysis to be released next week shows that average fees are now very close to 1%, which was the target set a decade ago by then Minister for Superannuation Nick Sherry.

But is this gradual change enough? No, according to the PC! It wants to set up a system that is structured to provide the best retirement outcomes for members, and claims there are too many inefficiencies in the current industry structure to deliver this today.

The changes

The recommended changes have been structured to minimise disruption to any individual fund or to the industry. The changes do not affect defined benefit members, Choice members (including SMSF trustees) or retirees. While the PC proposes to change the structure of default members, there will be no change to those already in MySuper funds.

• All new members to the superannuation system – about 400,000 youngsters and new migrants each year – will be placed in a default fund as soon as they acquire a TFN (which could occur before they start their first job).
• Once in a default fund, members will stay there unless they elect to choose a fund.  Most members are expected to stay in the initial fund when they change jobs and will do so unless they exercise Choice.
• All MySuper funds will be evaluated and only a small number will be eligible to receive new default members.
• There will be a government website with centralised information on eligible default funds.  This would be used to facilitate new members to making their decision – they will no longer rely on their employer making the choice for them.

The PC has set up four models for consideration. Depending on the model adopted, there would be a very small number of funds eligible to receive new entrants to the super system. Obviously, there would be prestige in being on this shortlist even if the likely number of new members will be small at first. It will be a jewel in advertising to all employees and employers for their super.

The eligible funds under each Model would be limited:

The models

Model 1 – Assisted employee choice

Each new employee would pick a fund from a short list of four to ten high quality funds.  These would be selected via a qualitative assessment process.

One theme in the report is that superannuation for new entrants should be separated from the existing award structure. This implies that the incumbent arbiter for default funds, the Fair Work Commission, is unsuitable. The report goes further and argues that the body responsible would be selected by government and should draw on a range of experts. The PC does not consider ASIC and APRA to be suitable to contribute to this role.

Under this model, there would be a supplementary list of other quality products but they would receive less prominence.

A low-cost “last-resort fund” would be used for those who do not elect a default fund.  Perhaps this could be the Future fund? In theory, this could attract the most members given the past record of member disengagement. However, it would only be a temporary holding fund.

We expect that parents and other family members or friends will be influential in guiding youngsters to pick a fund. Given their advice will not be based on expert knowledge, it is important that any fund on the short-list be completely appropriate.

Model 2 – Assisted employer choice

Under this Model, employers would select a default fund for all their employees.  There would be a long list akin to a MySuper list filtered to eliminate unsuitable funds. The number of approved funds on this list is not stipulated. The report (Table 5.3) lists the criteria amongst which is an emphasis on solid long-term investment performance (measured over periods of at least 5 years).

A short list of quality products would be selected based on investment performance and other product features.  Further, the performance would be constantly monitored to ensure there is no lengthy under-performance. Funds will also need to demonstrate that fund scale is not an impediment to performance.

Employers would probably choose from the short list but they would be free to pick a fund from the long list.  However, there would be stronger rules than currently exist in the provisions of the SIS Act to stop inducement of employers.

Finally, large companies would still be able to negotiate their own terms if they can acquire something better than the short-listed offers.

Model 3 – Multi-criteria tender

Under this Model, a tender would be held centrally to select 5 to 10 funds. Once funds have met minimum criteria for governance and transparency, they will be assessed on multiple characteristics:

• Past performance on net returns and member satisfaction.
• Investment strategy.
• Quality of member services, engagement and intrafund advice.
• Fee levels and transparency.
• Innovation in unspecified areas.

Again, the judge would be a government-appointed selection body which would have to follow pre-determined criteria.

There would then be a performance monitoring and enforcement stage.

Model 4 – Fee-based auction

The most controversial option is for an auction based on fees (combined investment and administration).  One to five products would then be selected.

Although fees would be the key determinant, products would have to meet minimum criteria on investment strategy and other features before qualifying for the auction.

We do not favour this Model as it has the potential to introduce significant systemic risk to the system by reducing the number of providers and potential providers over time who will become too big to fail.

Comments

There is a lot to digest in the 250 page report but super funds will need to assess the four models and they should work out which one they prefer – as one will be recommended to government in the final report.

Some of our observations:

• The current ‘scale test’ relies on trustees to assess the future viability of their fund.  If they have poor prospects, it can be some time before they act.  The proposed models start to do this indirectly.  If small funds stop getting new members, they would need to adopt a successful niche strategy.  Failing this they would decline in size and be forced to merge.
• There will be an annual review of standards to ensure funds maintain their strengths.
• New entrants to the super system can be considered based on their strengths outside MySuper (perhaps in other countries or other financial services).
• There will be immediate savings for members collectively of $150m a year by halting the proliferation of multiple accounts.
• While REST and HOSTPLUS look like being winners as most first jobs are in retail and hospitality, the separation of the decision from unions/awards means that any fund on the short-list could pick up people in their first job.
• Short-listed funds will acquire new default members and they will promote themselves to the young (perhaps through schools where many young people acquire their TFNs before joining the workforce).
• Funds not on the default list will seek Choice members. This could lead to widespread advertising for Choice members. It will be important to tighten the requirements for Choice funds and we note that ASIC will shortly get the power to kill off unsuitable products.
• The adoption of Model 2 would see a return to a system similar to the one that existed prior to the introduction of compulsory superannuation, but with protections for member/employee interests. These protections are not specified and the PC notes that the system would retain an element of principal-agent risk that would need to be controlled by strengthened provisions and powers under the SIS Act.
• The transition for the industry will be relatively slow as existing members do not need to change. However, pace will pick up within a few years as several funds wind up.
• Specialist funds will still be able to woo employers within their industry even if they are not on the short list.
• Retirement products are not subject to this regime.
• When a fund is not retained and replaced by another on the short-list, existing members will not change (unless they then exercise Choice).  This removes the risk of a run on the fund but must leave many members in a sub-optimal position.

Finally, the PC has accepted our proposal (p90) to have a formal framework for fund mergers. This includes more transparency to APRA and members around offers to merge.

Life Insurance

The PC has commented on the lack of a clear purpose for life insurance within superannuation. It noted that life insurance is not regarded as an essential element as it lies outside the Government’s objectives of superannuation. Consequently, the assessment criteria for selecting default funds will not consider the value of life insurance.

Given that group insurance represents 70% of all life insurance premiums, we do regard it as a core element. Life insurance has its problems (and there is an industry working group looking to address these). However, insurance provided through super is cost-effective & provides easy access to insurance for the whole community.

We will review this aspect in more detail when we make our own submission on the draft report.

In summary, there will be a period of consultation and, no doubt, fury from some parts of the industry.