In response to the Draft Productivity Commission Report
The Productivity Commission (PC) recently issued its draft report into superannuation. It offers a blunt approach to a complex issue.
The danger is the PC report may seem to appease thinking from both sides of politics.
The draft report also preferences a number of themes that could create a set of unintended consequences from an unbalanced perspective of how the super system functions in practice rather than theory.
While not government policy, the prospect that some parts of this report could lead to possible future outcomes for super funds should be of concern to policy makers and industry alike.
This article briefly outlines our upcoming reply to the Productivity Commission. We highlight several unintended consequences with some recommendations and proposals. We believe there is scope for sensible alternatives that are far less disruptive to the system that would still meet the expectations of Canberra for a better superannuation outcome.
As we indicated in a previous Editorial, regulators such as APRA see the world as being “complicated” rather than “complex” as would the PC on reflection of their draft report. Misinterpreting this starting point can lead to simplistic solutions to complex problems and underestimating the consequences.
To unscramble 25 years of the superannuation guarantee and our national savings of $2.5 trillion we turn to Systems Theory.
This tells us there are four types of systems:
- Simple: The average age of all people in a specific fund.
- Complicated: The calculation of the date of the highest King tide for a specific point on the coastline or engineering a suspension bridge.
- Complex: A biological ecosystem, social network or financial system.
- Chaos: A system where all levels of control and influence have broken down (eg; Rwanda in the 1990’s, the Australian Senate perhaps...)
It's non-controversial that financial markets are regarded as complex adaptive systems. That means no amount of additional laws or information gathering will allow us to invest with the same confidence that engineers have to design a complicated bridge.
As the superannuation industry largely achieves its outcomes by investing in financial markets, by extension the outcomes of the superannuation system are complex. What this means is that even if you could perfectly understand the structure of the system in July 2018, the system will evolve and change dramatically over the period of a typical working-life. A change that may not be obvious at the start or able to be predicted at the end.
Mention of financial markets, hedge funds, forex rates and stock markets would probably place in the mind of most non-participants the image of an arrogant self-confident trader taking risks with other people’s money and winning or losing large sums of capital. However, we know the reality is quite different. Super fund executives and boards have established a prudent set of long term investment strategies and behaviours, especially in relation to the not-for-profit sector.
Instead of the archetypal fast-twitching trader, our experience has been that the investment professionals who gravitate towards the superannuation system sit at the more prudent end of the spectrum, preferring to leave the higher-risk-higher-return work for others.
As found by the PC, the outperformance of industry funds beyond a fixed cost base validates our view that not-for-profit investment professionals have successfully produced enviable long run returns despite the influences of short-termism that exist elsewhere.
Prudent vs maverick risk
The Productivity Commission has said that many fund ‘mimic’ the strategy of rival funds which they assume is a short-termist approach that ‘is likely to be at the expense of long term returns to members’.
We disagree, and instead propose an alternative view. Rather than a lack of healthy competition driving peer tracking, we believe that the industry as a whole has settled more or less on a broadly prudent asset allocation (for a given level of risk tolerance). In his book, Pension Fund Excellence, Keith Ambachtsheer states:
That is why maverick risk tends to be so important in practice. If there is no obvious way to tell whether you should be more or less aggressive than your competitors, why not match them? It eliminates maverick risk – Keith Ambachtsheer
In other words, Funds that don’t consciously ‘match’ their peer group are liable to suffer what Ambachtsheer refers to as maverick risk.
Should super be commoditised?
A complex system means that there is no one right answer. Although we have noted that superannuation funds have gravitated towards a relatively common prudent asset allocation, there are other significant variations, such as:
- the level of overall risk tolerance set by the default fund,
- the suite of available investment options,
- insurance arrangements negotiated and what additional services are provided by each Fund
These are likely to differ depending on how the fiduciaries and management of the Funds believe they can best meet the needs of their members.
For instance, construction workers are more likely to understand and feel comfortable with an above average level of investments in real estate and infrastructure.
We would argue that funds that tailor their investment, insurance and ancillary services to meet the specific needs of a cohort they understand well are more likely to deliver an outcome nuanced to the expectations of this cohort than would likely be captured by APRA data.
How small is too small?
One of the worrying trends we have noticed recently is for the language used by some to refer to any fund with less than say $5 billion as ‘small’.
In our work as investment governance advisors, we see many fiduciaries that are responsible for the oversight of pools of capital held by charities and other institutions. These fiduciaries may be responsible for overseeing a pool of say $1 million, $10 million or in rarer circumstances $500 million. In an institutional investment setting, we would consider pools of this size as ‘small’. We would not consider a fund that has over 6,000 members and around $2 billion of assets (equating to $300,000 per member) or a fund that has around 84,000 members and around $5 billion of assets (equating to around $60,000 per member) as ‘small’ – as is the case for the AvSuper Fund and for Media Super.
But are regulators on to something in wanting to see larger asset bases? Perhaps they think that doubling the asset size of a fund will halve fixed administration costs. However, our review of actual outcomes does not show this.
According to our analysis of the APRA data, the median operating cost of the all super funds between $1 billion and $5 billion is only 0.1% lower than the operating costs of funds between $5 billion and $10 billion. There was no difference in the percentage operating costs of the $5 - $10 billion group compared to the $10 - $20 billion funds.
We therefore question the underlying desire of the Productivity Commission to see fund mergers and increase the funds under management of Funds in the system assuming they have reached a level that allows them to maintain an institution investment capability.
Is $1b really small change?
We wonder if we can now call Nine Entertainment a 'small company'? It only has a market cap of $2b. Or perhaps Mattell is an SME with a market cap of around A$8b.
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Unintended consequences of the 'Best in Show'
We believe an unintended consequence of the recommended ‘best in show’ is that net-returns would be managed as a priority. To be clear, this would mean that in order for funds to target the top 10 list, they would no longer be able to take prudent ‘middle-of-the-road’ positions with any uncertain risk decisions – but instead ‘swing for the fences’ by taking a single-minded position on one potential outcome. The downside naturally would be worse investment outcomes during periods where actual economic outcomes do not match previously forecasts outcomes.
We are disappointed that the Commission has not taken prudent investment risk management into account in its review to date.
We also believe that combining this error simultaneously with the recommendation for increasing the number of ‘independent’ directors would likely result in appointing directors with aggressive ‘winner takes all’ mindsets as is more common in hedge funds and the for-profit financial sector.
Our paper then continues by detailing our view on good governance, which unlike the Australian Financial Review, we do not believe is the same thing as simply as having a majority of independent directors.
This is a topic we will expand on in a future editorial.