Institutional Investment - December 12, 2014

Superannuation v2.0: Towards the next generation of pension funds in Australia

Numerous surveys suggest that Australians are not completely satisfied with Superannuation as it exists today. First, fund members tend to think that they will not have enough to retire and second, that investment plan providers are not necessarily acting in their best interest.

In this context, we asked in a recent study supported by AXA Investment Managers whether the recent rapid development of self-managed superannuation funds (SMSFs) may be related to the level of dissatisfaction with the more mainstream types of pension funds (retail, industry and non-profit) especially amongst the relatively more financially literate and wealthier segment of the population. The original attractiveness of SMSFs springs from tax incentives available to wealthy individuals and small business owners. But today it can be argued that if Superannuation funds, especially default option embodied by the MySuper legislation, gave individuals a clearer and more explicit vision of what their pension savings are invested to achieve at the relevant horizon, a number of well-off middle class households would not feel compelled to switch to a “do-it-yourself” version of pension wealth management. This trend may be seen as symptomatic of the difficulty for an industry to demonstrate the benefits of delegation, leading a group of the more active and engaged members to take matters into their own hands.

Developing a reporting standard

While more financial education of individual members is necessary, the objective cannot be one of making each individual member a specialist of long-term pension investment. Moreover, behavioural biases are likely to prevent even the best informed from optimally managing their pension savings. If education can only play a limited role and delegation is necessary, the quality of reporting (i.e. what performance information pension investment solutions providers return to their members) is an essential dimension of the credibility of the pension system as a whole.

Existing reporting requirements leave individuals faced with the problem of computing the contribution of a particular investment option to their pension investment objectives by themselves. The current debate between industry and regulator about the most useful type of reporting will continue so that innovation and learning can take place, while minimising the burden of compliance costs. Part of this effort can come from Superannuation funds themselves and the leadership of major providers is important in this regard.

Regulatory effectiveness and regulatory costs could be optimised by developing a reporting standard of only the most relevant information for fund members. This standard, we argue, can only be developed as part of an iterative dialogue between industry and regulator and pension solutions providers should lead it.

Certifying solutions

As well as transparency and the role of reporting, the ability of a pension system to apply sound governance principles is an important criterion against which it may be judged. Australia has long been in line with most OECD guidelines for fund governance. With the exception of self-managed pension funds, Super funds are structured around trustee arrangements by which there is complete separation between members and trustees, who have fiduciary obligations and take ultimate responsibility for the fund. A further industry-led step in the direction of good governance and transparency is the establishment of a governance body to oversee standards for the industry. To support innovation in the pension investment sector in Australia could be the creation of a certification scheme for retirement solutions compliance with generally accepted / best retirement investment and risk management and governance practices. Such a scheme could be created by the industry to inform the default option selection work of the Fair Work Commission, but also signal service quality to individual investors and employers.

Better information and possibility of choice

Over the past decade, the Super sector has been characterised by both increasing fund sizes, which should lead to scale economies that, in turn, should translate in lower costs for members. At the same time, the presence of a significant number of smaller funds also preserves the possibility of competition.

The premise of recent reforms of Superannuation is that with better information and the possibility of choice, competition can play its role to improve the quality of service and the adequacy of pension investment products. However, increasing competition through member choice has not been associated with a dramatic decrease of costs, and the impact of economies of scale has also been muted. Studies of the relationship between fees and investment performance suggests strongly that Super funds with higher costs do not generate a consistently higher investment return. The literature also finds an inverse relationship between costs and active performance and concludes that higher expenses cannot be justified with claims of more active management aiming, successfully of not, to achieve superior performance, especially in the case of retail funds.

When institutions allowing market participants to compete without restriction on prices or volumes are in place and the expected benefits of competition do not materialise, market mechanisms can be considered to be failing. The Australian Super sector is large and not dominated by any particular provider. Nevertheless, neither choice nor scale appears to have had a marked effect on prices (costs) or the relationship between prices and service quality and adequacy.

Adequate default option

The current problem faced by the average Super fund member, as well as the regulator, is one of identification of the most desirable investment solution. The possibility of choice and the potential for competition have not yet been sufficient conditions to reveal what the advanced service providers could offer.

With perfect information about what investment solutions can be created to achieve a set of long-term objectives, competition between fund members would work as expected: individual members exercise choice and decide which solutions are best suited to their needs e.g. a real consumption/wealth target (liability) to be achieved at different points in their lifecycle while respecting a certain risk budget.

The difficulty arises from the absence of information (i.e. reporting) and point of reference (i.e. certification) for fund members, who cannot discriminate between providers. In this setting, efficient plan providers have an incentive to mimic inefficient providers (moral hazard), make no costly effort to design advanced investment solutions and provide the same products as inefficient providers. What drives up costs in this case is not the absence of competition, but the tendency for all providers to “pool” and behave like the inefficient type of service provider.

To avoid this pooling equilibrium, market participants can create “sorting devices” or “revelation mechanisms”. In this context, we note that consultants may play an important role in reducing asymmetrical information and that progress in this respect progress should be encouraged. In their role as gatekeepers, consultants can for example challenge providers to improve reporting along lines that would be consistent with state-of-the-art principles for retirement management, and to redesign products to add value. In the end, either individual pension fund members, through the regulator, can request bids for a limited number of pre-defined investment solutions (i.e. the regulated default option) in an auction, or pension plan providers can choose to highlight the different solutions that are available through the kind of reporting standard and certification scheme that we discussed above.

Designing high-quality default options

Whether auctions or certification is used to determine the most adequate default option in DC system, the question of what the optimal default fund should be is extensively discussed in the literature and its conclusions tend to be in contrast with the content of existing investment products.

The question with default options is to determine whether or not they should be standardised and, if necessary, regulated, which amounts to asking if on average the combination of a given set of asset allocation strategies and risk management techniques tends to deliver superior outcomes.

Improving the performance of default options in Superannuation plans could begin with maximising the benefits of diversification both within and between asset classes, to design better performance portfolios to allow more ambitious targets at different levels of risk tolerance. Likewise, better liability-hedging portfolios would reduce the risk of dispersion around the objective at the horizon and allow for a higher allocation to the performance portfolio at a given level of risk tolerance.

Going beyond a static liability-driven approach, dynamic allocation between the performance-seeking portfolio and the liability-hedging portfolio can recognise the time-varying nature of asset and liability risks and advantage of the mean-reversion of asset prices over the investors’ long-term horizon.

Without short-term downside protection included in their investment products, fund members are exposed to drastic losses when risky assets plummet simultaneously, as has been the case in the recent financial crisis. Such insurance can be complex and costly to manage, yet a pension system aiming to rely on individual DC funds should aim to integrate the third pillar of risk management into its default option.

Indeed, the separate management of long-term liability risks (via hedging) and short-term loss aversion (via insurance) allows the investor to optimise risk taking in a dynamic manner over the investment period.

The latest advances in risk and investment management can be used to design a new generation of retirement products that would not only offer better performance and risk control features, but also more risk customisation.

In this context, the definition of advanced lifecycle benchmarks (representing reasonable partitions of the population of members according to investment horizons, short- and long-term risk aversion, etc.) would support the design of adequate default options would support convergence towards better default options within MySuper.

Lifecycle investment benchmarks would promote performance and innovation on this market. Providing information about reference asset allocation, they would be combined with generally accepted investment benchmarks to generate performance figures that could be presented using the standardised reporting framework discussed above, to serve as references for the industry.

Obsolete distinction between “pre” and “post” retirement

Australian retirees are likely to spend several decades of their lives in the “post-retirement” stage and the generation of adequate income to fund their desired level of real consumption over such periods should be integrated in the broader question of individuals’ asset and liability management over their entire life. In effect, the period of retirement has its own stages, characterised by different consumption needs and risks, which would benefit from a lifecycle approach. Crucially, the retirement of one’s human capital i.e. the end of labour income, is the largest but also the most predictable asset allocation shock in one’s lifetime. We argue that an integrated, whole-lifecycle approach can thus improve wealth outcomes if this predictable shock is taken into account.

The choice of horizon at which labour income ceases could conceivably be managed as a variable in a dynamic lifecycle environment. The standardisation of reporting and the provision of planning tools to members could allow the impact of financial, career and lifestyle decisions on retirement preparedness to be simulated, and even accommodate the de-regulation of the pensionable age and members’ increasing freedoms to transition out of the labour force.

Given the high expected inflation of the costs of healthcare and long-term care, savings accumulated until retirement risk being insufficient to cover these predictable expenses for a significant share of members. Neither would a typical life annuity be indexed on healthcare price inflation. It thus follows that a proportion of individuals’ savings should stay optimally exposed to rewarded risk for a much longer period than the official retirement date currently suggests.

Since Australian pensioners are still exposed to investment, inflation or interest rate risk when they retire, and as they face a multi-decade liability/consumption objective with a likely upward slopping profile (a significant proportion of medical costs are incurred in the last years of life), they can still benefit considerably from applying efficient and targeted asset and risk management techniques to their pension savings after they have retired.

The most adequate investment horizon in the Super system could thus be a function of individual member’s life expectancy, not the age from which they cease to receive labour income. Hence, default options under MySuper could be designed to encompass the entire lifecycle of fund members and use several significant investment horizons including the official retirement date (the end of labour income) but also the stochastic horizon implied by life expectancy and longevity risk. The investment and risk management technology described above remain the proper way to address this problem: optimise diversification benefits through the design of efficient building blocks, dynamically manage a combination of performance seeking and liability hedging portfolios to target long-term liabilities/wealth objectives taking into account not only age and risk preferences, but also changing market conditions, and control risk budgets through insurance mechanisms.

This research was produced as part of the "Regulation and Institutional Investment" research chair at EDHEC-Risk Institute, in partnership with AXA Investment Managers.

URL for this document:

Hyperlinks in this document: