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1 Introduction and overview
In the early 1990s, Australia took important decisions to require its population to save for retirement, introducing a Superannuation Guarantee Charge, which is currently 9.5% of earnings. As a result, superannuation funds today comprise a significant proportion of Australian personal wealth.1 Their effective management and regulation, the subject of this book, is vital for the well-being of Australian retirees. Unfortunately, the Australian superannuation system exhibits numerous problems including that it currently delivers an income replacement rate for retirees that is among the lowest in the OECD, that it forces fund members to bear risks they are ill-equipped to manage, and that it provides significantly poorer returns on investment than could reasonably have been expected.
In Section 2.1, we consider the design of the Australian system that has led to these outcomes. This begins by evaluating three fundamental policy choices: whether to use a pay-as-you-go (PAYG) or a funded system; whether to allocate pensions on a defined benefit (DB) or a defined contribution (DC) basis; and whether the public or the private sector should manage the funds. For historical and ideological reasons set out in Chapter 3, Australia chose the latter option in each case (funded, DC and privately managed). The outcomes we describe in this book, and much of the relevant literature, suggest that the former would have been a better choice (PAYG, DB and publicly managed).
Empirical estimates presented in Chapter 4 show that, over the last 20 years, the Australian superannuation industry has delivered a return of A$700–900 billion less for its members than it could have if different policy choices had been made.2 The result is that Australia’s superannuation funds, instead of potentially being worth around A$3 trillion, are now only worth around A$2.2 trillion3 (a cumulative shortfall equivalent to about 45% of Australia’s annual Gross Domestic Product (GDP)).4 This shortfall is, in large part, a reflection of the high costs of the superannuation industry that has been created to manage the funds.
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The industry that has emerged in Australia is complex, to an extent that it is imperfectly understood by policymakers and by most members. As Section 2.2 explores, this facilitates rent extraction and works against policy reform. Complexity strengthens the hand of those who seek to manipulate the system for their own benefit, while making it difficult or impossible for regulators and representatives of fund members to ensure that returns are maximised and costs minimised. The more complex the industry, the less likely are members (and trustees on their behalf) to be able to negotiate an acceptable outcome.
International literature highlights how principal-agent and conflict of interest problems abound in financial services, and demonstrates that a high proportion of the potential return to investors from managed funds is routinely extracted by fund managers (and associated intermediaries) through excessive fees and charges. In Australia competitive pressures, governance systems, and legal and regulatory constraints, appear to have been inadequate to curtail rent-seeking behaviour by advisers and managers.5 Competition and choice do not seem to work well enough in this industry to impose the necessary constraints, partly because of a lack of transparency over costs. The high degree of separation between members and those who manage their funds, a result of extensive outsourcing, both increases costs (because all the intermediaries charge a margin) and reduces focus. In addition, individuals in DC schemes face severe longevity and market risks, the management of which (including the provision of fairly priced products) has so far received insufficient attention. In Section 2.3, the reasons why stronger and more effective regulation is therefore needed are discussed.
Other countries, notably the UK, are now following Australia down the path of introducing more individually funded, defined contribution pensions, and reducing reliance on both publicly funded and defined benefit provision while increasing the proportion of funds outsourced to private sector managers. This book highlights the dangers of these changes, and how such moves impose greater risks and welfare losses on retirees, current and future. Although Australia is our primary focus, Section 2.4 includes brief summaries of the policy choices made by a number of other countries. This is partly to inform analysis of the Australian situation, and partly to draw out the lessons that can be learned from the Australian case that may be relevant to other countries as they develop their own pension systems.
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Section 2.5 summarises the challenges Australia now faces. These include that those about to retire will do so with inadequate pensions; high administration and fund management costs; a lack of trust in the industry and its advisers; and the transfer of risks to individuals who are poorly equipped to manage them. Legal and regulatory constraints and guidance provided by a combination of trust law, the Superannuation Industry (Supervision) Act (SIS Act), and the various regulatory agencies in Australia need rationalising and strengthening. Organisation and governance of the system also needs overhaul, and action is required to assist members with the risk management that has been imposed on them. Although large tax concessions have been provided to encourage contributions to superannuation funds, these have been disproportionately available to the rich, while the poorest individuals suffer from paying contributions they cannot afford, while receiving little or no tax benefit. As a result of all these issues, the Australian system can best be described, after 25 years, as still a work-in-progress.
Chapter 3 describes how the Australian system, and the financial industry which supports it, evolved. Australia developed a ‘three pillar’ system, with a means-tested old-age pension enhanced by charitable giving, occupational and public sector schemes, and voluntary savings encouraged by tax incentives. This history is presented in four epochs, with the final one starting with the introduction of the Superannuation Guarantee Charge in 1992. The situation today is that Australia has the highest incidence of poverty, among the old, in the OECD.
Superannuation policy in Australia has suffered from the ‘stop-go’ effects of a short electoral cycle and the tendency of incoming governments to overturn policies initiated by their predecessors. In the post-war period, the influence of the union movement and its interface with Labor administrations also had a crucial impact. Australian superannuation policy also reflected developments in Europe, the UK and the US, and, in particular, ideological struggles between those who believed in public control and administration, and those who believed in the primacy and efficiency of markets. Section 3.8 describes the reasons why strategy for, and management of, superannuation funds was to a large extent handed over to the private sector, Section 3.9 discusses how the modern legal and regulatory framework evolved, and Section 3.10 sets out how the modern superannuation industry emerged. A timeline of key legislation and events from 1849 to the present is provided in Annex A.
Chapter 4 seeks to benchmark the investment performance of Australian superannuation funds against what might have been possible if different policy choices about the management of the funds had been made. Section 4.3 shows that Australia’s retirees will be considerably poorer than they would have been if their contributions had been held in a single, passively managed fund.6 As noted above, calculations undertaken by the author suggest that in the period from 1996 to 2016, the overall superannuation system achieved substantially less than might have been possible under alternative regimes – after reasonable costs – by between around $700 billion and $900 billion (34–44% of the 2016 funds under management). Section 4.3.8 explores the ‘leakages’ that have led to this shortfall, drawing on Australian and international literature. This benchmarking identifies better performance among smaller corporate funds and poorer performance among the larger Australian retail funds. Public offer (retail) fund types perform least well, while self-managed superannuation schemes (SMSFs) also exhibit below-average returns.
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Section 4.4 compares Australian funds with international counterparts, using detailed cost, performance and financial data at the fund level published by APRA. These data are compared with a sample of 256 pension funds from Canada, the United States and Europe for the period 2004 to 2012. This comparison suggests that, compared with funds in those countries, Australia’s funds performed badly in that period.
Detailed comparison of the Australian and international data also shows proportionately higher administrative costs among the Australian funds.7 Australian funds are less mature, and mostly defined contribution, whereas the international funds are more established and mostly defined benefit. Hence, principal-agent problems may be expected to be more severe in the Australian case, where delegation of responsibility is widespread. There is a strong negative relationship between expenses and performance relative to benchmark. These findings are supported by Australian and international literature, as summarised in Section 4.5. This literature provides additional evidence on the high fees and charges levied by Australian funds, on the poor performance of for-profit funds, on difficulties with governance systems, and on the incidence of higher costs associated with outsourcing.
Chapter 5 draws out some lessons that may be learned from the Australian experience. Section 5.1 explores further the reasons for the relatively poor performance of Australian funds, attributing technical inefficiency to poor principal-agent relationships, weak governance, and lack of transparency. Providing greater choice to members, a major part of the policy response of successive governments, increases costs to an extent that does not seem to be outweighed by its benefits. Various tax-induced choices such as high portfolio allocations to Australian equities and use of expensive advisors may not have been to the overall benefit of members.
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Section 5.2 focuses on the ‘light-handed’ nature of Australian legal and regulatory constraints, attributing this to the prevailing ethos that competition and choice would reduce the need for regulatory intervention. Belief, at the time the system was established, that trust law could be relied on to ensure that trustees, and others, carried out their duties effectively led to the Superannuation Industry (Supervision) Act 1993 (SIS Act) being less prescriptive than it perhaps should have been, a matter to which we return in Chapter 6. The section also notes the division of regulatory responsibility between multiple agencies, and the lack of disclosure of significant elements of cost.
Realisation of the problems the system faces has led to numerous enquiries and attempts at reform, which are summarised in Section 5.3 and elaborated in Annex B. The recent Super System Review has led to the introduction of simpler, standardised products, the Future of Financial Advice (FOFA) reforms have sought to remove the more glaring problems over conflicted advice, and APRA has introduced a series of prudential practice guides. However, the endemic principal-agent and conflict of interest problems remain embedded in the system, consolidation of the industry has reduced competition, the disclosure regime is still imperfect, and fees and charges remain high.
Chapter 6 explores what can be done now to fix the problems outlined above. Section 6.1 sets the challenge of reducing complexity, controlling conflicts of interest and rent-seeking behaviour, and providing greater focus on outcomes for members, thus improving the efficiency of the industry. The list of what needs to be done, presented below, is long, and includes ensuring full and effective disclosure, improving regulatory and governance arrangements, and strengthening legal protections. We also explore a further policy response that has scope to make a greater difference, and suggest the creation of a publicly administered, low-cost alternative to the investment options currently available.
Section 6.2 discusses the extent to which better and more focused regulation is likely to improve the situation. A major problem with the current arrangements is that responsibility for the efficient performance of the sector is divided up between multiple agencies. Creation of a new, or repurposed, agency with a clear responsibility for the sector would be an improvement. Such an agency would need to report directly and on a regular basis to Parliament. It would be responsible for effective development of the disclosure regime, for regular publication of benchmark indicators, and for the identification and policing of conflicts of interest. It would also have a primary duty to promote effective competition. The various forms of regulation that have been made to work in other industries should be adapted to the superannuation context. These could include the introduction of a price cap, at least until effective competition has been established, and the unbundling of insurance provision from the management of superannuation funds.
Section 6.3 explores the extent to which legal constraints could be improved, perhaps through better trust law. We noted above that the SIS Act as originally drafted ...
