How worried should the superannuation industry be by the contents of the Financial System Inquiry’s interim report?
The comments made by David Murray in the interview, the day after the report was published, reveal an entirely unsentimental view of the industry.
The report is critical of the worth of active management, the general level of fees in superannuation and calls into question the worth of franking credits and tax breaks for the highest earners.
Murray also underscored the significant priority to be dedicated to superannuation in his final recommendations in November.
“Superannuation assets are growing so fast in that system, that before we know it, it will be half the system,” he said. “If that is not working well then the financial system is not working well.”
He has also ambitiously called for a greater consensus on superannuation. In his speech to the National Press Club he said: “One of the things that struck us from submissions is the absence of a shared philosophy and set of objectives for superannuation. This is an issue given the size of the sector and its rate of growth.”
Fees
For superannuation, the section relating to fees, dubbed ‘efficiency’, will be the most controversial part of the report. The statements are direct and provocative.
The report states: There is little evidence of strong fee-based competition in the superannuation sector, and operating costs and fees appear high by international standards. This indicates there scope for greater efficiencies in the superannuation system.
It notes the Super System Review finding “that fees had not fallen in line with what could have been expected given the substantial increase in scale”.
And this quote from the Industry Super Australia submission: This increasing level of economies of scale, coupled with technological advancement and efficiency dividends, should have resulted in a notable fall in the level of fees. This has not been the case.
When asked about this, the first thing Murray cites what appears a deeply felt objection to the belief that a reliance on active managers will deliver outperformance over passive managers.
A point many see as ironic, given his history in purchasing Colonial First State in 2000.
“Its pretty clear that the return to alpha is negative after fees, so you have got to be right at the top of the pack finding an alpha manager that is going to make you nicely positive after a higher fee reliably,” he says. “Not everyone is going to be able to do it. So it does not necessarily follow that higher fees are better for everybody. But if people can truly justify that fee level across the system, I would like to see how given the international comparisons.”
The report notes that a 38 basis point reduction in average fees for the entire superannuation sector would deliver a total saving to members, and additional funds to invest, of around $7 billion per annum.
It quotes the Squam Lake Working Group, a group of US academics on this theme: High-fee funds argue that their fees are justified by superior performance. A large body of academic research challenges that argument. On average, high fees are simply a net drain on investors.
The report caveats this point by stating returns also count, but it is clear the burden of proof will lie in showing evidence that an active manager policy does work, rather than evidencing the worth of passive investing.
The report notes the average superannuation fee of 1.12 per cent is too high, but when Murray is asked whether a policy of limiting MySuper to a fee of 1 per cent or less he baulks. “I find it difficult to start putting numbers on this,” he says.
Here his hard words about high fees and inefficiency turn into a defence of choice and the free market.
“In an accumulation system you increasingly want every beneficiary to be able to work their own risk reward position and their own retirement expectations and do what is needed to be done for them. There will be people with different expectations about risk and the different level of fees, but it should even out across the system to an efficient outcome on fees generally and that does not seem to be the case in Australia at the moment.”
The report acknowledges that without any intervention in superannuation MySuper and fund mergers might achieve fee reductions and Murray acknowledges MySuper has added to costs too, “so it is too early to tell if MySuper will be successful,” he says.
Retirement products
One of the most unequivocal parts of the interim report was it declaration of a need for innovation in retirement income.
Australia needs a suitable range of financial products and services to enable a greater number of individuals to manage income and risks in retirement and to help manage the transition from work to retirement.
Many saw this as news the legal and tax based impediments that have restricted the creation and take-up of retirement products would be removed. However, Murray said this should not happen until there was greater consensus on what purpose the superannuation system serves.
He believes changes done without consensus would be open to further change, particularly tax changes.
This would “create political differences and cause continual change and questioning of the system”, he said.
“A commonly accepted purpose and philosophy about that system is a prerequisite to stability in the system, which is a prerequisite to confidence,” he says.
His words will disappoint many who felt there was consensus on the need for urgent action to create a suite of retirement products to meet the needs of the bulge in members entering retirement in the next few years. Though, the release of the Treasury paper acknowledges other forces are at work.
Damaging competition?
One of the more interesting points in the report – though it is not always clearly made – is the proposition that superannuation funds compete to attract and retain members through their product range rather than fees.
It points out that many members lack a full understanding of the impact of high fees, particularly on how it might reduce the amount they have when they retire. It notes only a minority of members are fee sensitive.
Murray explains: “If I have an accumulation balance and I want to receive an outcome that is good for me, I am not interested in my trustee necessarily competing for business with people across the street who might have clients with different expectations. I am interested in the trustee doing a good job for me according to my requirements.”
This would imply he believes the cost of advertising, product development and a large range of investment options are driven by the desire to compete with other funds and are simply driving up fees and detracting from member’s balances.
Tax
For Murray, the purpose of tax incentivising people to save for their retirement is a matter that needs to be reassessed.
He notes its historic rationale as a means of unions agreeing to wage constraint, by being offered deferred income as an alternative.
He says the current system can be justified as a means to increase national investment, as an accumulation system, whose money can be used to provide a retirement income or simply as a one off lump sum at the point of retirement.
He calls into question its purpose for reducing the burden on government to pay for the age pension. “Well has that happened?” he asks and notes that with contributions starting at only 3 per cent, one would not have expected the burden on the age pension to have been fully reduced yet. “It will be some time before people in that part of the structure will have the possibility of a pension that will be an offset to the age pension,” he says.
“It is not easy to resolve until there is common agreement on why it is there. If you can get that done on a bipartisan basis everyone is going to be better off.”
3 day rule
The interim report proposes that the three day portability rule for members be replaced with “a longer maximum time period for a staged transfer of members’ balances between funds, including expanding the regulator’s power to extend the maximum time period to the entire industry in times of stress”.
Some in the industry believe that this will allow funds to invest more in illiquid assets, but Murray denies this is this intention.
“I do not know if that would influence your asset allocation,” he says. “It causes more liquidity stress to sell assets, so it is more of a systemic risk to superannuation funds.”
Leverage
This was perhaps one of the changes least expected from the report, and as a technical point, one that has been misinterpreted when written up in several national media reports.
The FSI interim report states: If allowed to continue, growth in direct leverage by superannuation funds, although embryonic, may create vulnerabilities for the superannuation and financial systems.
The proposal is to rescind the allowance made in 2007 for all APRA regulated superannuation funds to borrow. The report notes borrowing by APRA regulated funds is under $2 million for each quarter over the past year. However, SMSF borrowings have increased from 1.1 per cent of assets in 2008 to 3.7 per cent in 2012.
In speaking to Investment Magazine, Murray said he wants superannuation funds to be immune from any future liquidity crisis that impacts on banks and potentially play a role in helping to support banks in the same way they did in 2009. He points out that this is borrowing for the purpose of investing, not the sort of borrowing that covers short term funding for liquidity purposes. What proposals he has for ending leverage in SMSFs are less clear.
