More work for superannuation funds to do on costs

Within the Superannuation industry, cost has become a key factor for funds. Legislative reforms now require trustees of MySuper funds to consider whether their scale disadvantages members. This approach of ‘encouraged consolidation’ is premised on the assumption that bigger funds deliver lower costs for members. The focus on costs is important because while investment returns typically have a greater impact on performance for members, costs are controllable and have a cumulative impact on member performance over time. Research shows that the Australian industry is significantly more expensive than many of its international peers and that growth in the size of the industry as a whole has delivered little cost benefit for members. The good news is that research also indicates bigger funds have been consistently cheaper both in Australia and overseas.

In Australia, history shows that at the industry level, costs have remained flat as percentage of industry assets despite asset growth. The period 2005 to 2012 saw significant growth in the industry as funds controlled by Australian Prudential Regulatory Authority (APRA) regulated entities almost doubled, growing at a compound seven percent per annum to $968 billion, excluding self managed ‘DIY’ funds. Over the same period, however, expenses also grew at seven per cent per annum to a total of $6.9 billion. The fastest growing costs were internal management fees at 12 percent per annum, followed by investment management fees, at 10 percent per annum. Across the industry, costs as a percentage of average assets remained relatively static, declining from 78 basis points to 76 basis points,[1]  suggesting that the significant growth in scale at an industry level did not deliver much of a cost reduction.

It’s a different picture, however, when you drill down to the individual fund performance level. The level of consolidation has been dramatic – the number of funds in 2012 was less than one third of the 2004 population. This has meant that big funds have become bigger and that they are also consistently cheaper. Funds with over $20 billion in assets had the lowest costs when expressed as a percentage on assets by a margin of 13 to 22 basis points over the last five years. This cost differential was driven by lower operational costs, rather than investment management costs.

If scale matters for individual funds, then a review of OECD data on pension systems shows that it does not matter for pension systems. Australian operating costs, at 80 basis points on assets over the period 2007 to 2011, were significantly higher than countries with lower asset levels such as Finland (40 basis points), Israel (30 basis points) and Denmark (10 basis points). Operating costs were were also higher in comparison to countries with similar asset levels like Canada (30 basis points) and the Netherlands (15 basis points), and countries with larger asset levels (UK 25 basis points). In other words, there is no relationship between the size of a pension market and its costs.

Clearly, the structure of the various pension systems plays a role in their cost base. The Australian system is predominantly defined contribution and has a relatively lower exposure to fixed interest instruments. The ‘member choice’ regulations in Australia also promote a more fragmented structure than a defined benefit fund which can manage assets as a single pool. But structure cannot explain all variances: Denmark, for example, has a higher percentage of defined contribution assets. Similarly, asset classes do not provide a definitive answer, as both Finland and the Netherlands have a similarly high exposure to listed equities and enjoy lower operating costs.[2]

When comparing the largest Australian funds, with over $20 billion in assets, to some international ‘mega’ pension funds (assets greater than USD 100 billion), the key differentiator was the higher level of operating costs. Analysis examined several of the top 20 pension funds globally including CalPERS (USA 6th), Ontario Teachers (17th), and ATP Denmark (18th) and it highlighted that Australian administration costs are significantly higher than the other large funds globally by between 20-40 basis points as a percentage of average assets.[3]

The move by some funds to insource parts of their investment management function is a departure from the traditional way of doing things, which has historically depended on outsourced investment management.^[4] AustralianSuper, one of the largest APRA regulated funds, is leading this push to ensure that as the fund grows towards $100 billion, its investment management costs can be reduced by around one third. When commenting on their strategy, AustralianSuper refers to a benchmarking analysis undertaken which suggested that a fund of comparable size would have approximately 30 percent of assets managed inhouse.^[5]

Regulatory structures are also encouraging consolidation as a means of reducing cost. As part of the new reforms, fund trustees of default MySuper funds must now consider whether members are disadvantaged by the insufficiency of the assets and/or members of that product.[6] The legislation clearly anticipates that some trustees will conclude such an insufficiency exists and that funds should consolidate with another fund to meet the test.

Operating or administration costs are at the heart of the relative cost competitiveness of bigger funds, as well as the international competitiveness of the Australian model. The Cooper review noted that Australia’s back office pension administration was ‘in urgent need of an upgrade and costs members hundreds of millions of dollars more than it should.’[7] To put that statement into context, the administration costs of funds over $20 billion in assets was 46 basis points or 8 basis points lower than the industry average of 54 basis points. If efficiencies can be generated through fund mergers and automation to reduce overall industry administration costs to the level which the largest funds already enjoy, then it would yield an annual expense reduction of over $650 million – something that would go a long way to the targeted $1 billion per annum in savings identified by Ernst & Young research and relied on by the Australian Treasury in its response to the Cooper Review.[8]

The changes underway in the Australian superannuation industry are significant and have the potential to radically reshape the industry’s cost base. While implementation will be difficult, the premise is sound – and the effectiveness of the legislative and fund-driven initiatives needs evaluation over the coming years to ensure the best result for members is achieved.

Seamus Collins is a senior relationship manager, J.P. Morgan Investor Services, Australia and New Zealand

 

[1] APRA December 2012 Quarterly Statistics