Productivity Commission Superannuation Inquiry report – Two steps forward one step back?

[Opinion]

The release of the final report[1] from the Productivity Commission (PC) on its assessment of the efficiency and competitiveness of the superannuation industry saw significant coverage and comments. The responses were generally positive, however most felt that the final report fell short in one way or another.

The final report contained 31 recommendations and even more findings. These have been discussed in great detail by the likes of ASFA[2], AIST[3], Rice Warner[4] and others[5].  What is quite ironic is that the expectation somehow existed that such an inquiry would be the “silver bullet” to solve all the shortcomings currently inherent in the system.

The industry players should be best placed to develop the structures and mechanism to best serve members[6]. Whether the incentives and metrics align the objectives of these players (including Trustees) with the objectives of the system (‘to provide income in retirement to substitute or supplement the Age Pension’[7]) is another question.

The PC’s final report does however improve on several shortcomings in the current system, two of which are discussed below. Unfortunately, other recommendations – such as the “Best in show” shortlist – have the potential to distort and damage the integrity of the super system.

LIFECYCLE STRATEGIES

The PC challenged the value proposition of life-cycle products in its initial draft report[8]  in May 2018.  It concluded that all life-cycle strategies result in an ‘opportunity cost’, based on the assumption that all life-cycle strategies are the same. In a previous article[9] I challenged this statement and made the case for the value proposition of using next generation life-cycle strategies.  Fortunately, the PC recognised the value of adopting a well-designed life-cycle product and included the following finding in its final report:

 “Well-designed life-cycle products can produce benefits greater than or equivalent to single-strategy balanced products, while better addressing sequencing risk for members.”

In making the case for the use of well-designed life-cycle strategies, I also commented on the heterogeneity amongst members during accumulation as well as retirement, and that a ‘one-size fits all’ approach is indefensible (irrespective of whether it is accumulation or retirement).  Unfortunately, the PC’s latest report only touched on accumulation. It is important to realise that the same rationale for adopting well-designed life-cycle strategies in accumulation is applicable for the retirement phase, even though the PC did not recognise this shortcoming in the current system.  The accumulation finding is at least one step forward…

Next generation life-cycle funds enable the efficient taking of investment risk when it is most desirable to do so.  For example, the funds who have adopted dynamic individualised life-cycles recognise this and have been assigning members to a 100/0 growth strategy where it is appropriate. Life-cycle funds should thus be seen as a risk management tool and not a risk reduction opportunity cost, if designed correctly.

Clearly, poor life-cycle design should be challenged, but it needs to be assessed against the correct objective. Risks change as members age and accumulate more wealth. Some superannuation funds are using these factors in their life-cycle MySuper products.  A ‘life-cycle’ investment strategy approach allows the Trustees to differentiate investment risk levels in this way and empowers the Trustees.

Most superannuation funds sit on rich data sets of member data, which should be used to make better informed decisions and improve strategy setting for members. The PC recognised this as well in their final report:

“There are also good prospects for further personalisation of life-cycle products that will better match them to diverse member needs, which would require funds to collect and use more information on their members.” 

This raises the challenge for the industry that one-size fits all balanced funds are clearly indefensible.

INVESTMENT PERFORMANCE

Doing the right thing for members should come first, based on sound principles. Comparability should be a secondary consideration. The focus on league tables and comparability to date has resulted in unintended consequences and the wrong incentives for the industry. Far too often returns and fees have been considered in isolation, with some funds’ marketing material touting “Highest returns and lowest fees” without the clear distinction to members that these are often not in the same product.

The PC has recognised this shortcoming and focussed the comparisons to “net returns”.

The biggest shortcoming of this is the allowance for risk. Therein remains the challenge for the industry: to develop appropriate, useful metrics despite the complexity involved in quantifying the risks members face.

BEST IN SHOW

Both industry and retail funds, represented by the AIST[10] and the FSC[11], agree that the PC report’s recommendation to create a “Best in show” shortlist missed the mark.

The recommendation called for an independent panel of experts to select a shortlist of 10 top performing funds to assist members in their decision to select a super fund. This is where the waters get muddy. The PC report does not specify the criteria for selecting the shortlist. This is likely to result in similar challenges created by league tables, around what gets measured and celebrated in the industry.  The unintended consequences of creating a shortlist could further exacerbate poor member outcomes. Let me explain.

By creating a shortlist, funds will be incentivised to manage their funds to achieve a spot on the shortlist.  This does not necessary align with managing members’ retirement outcomes.  Unless the criteria are well developed, with proper allowance for risk management, funds could potentially take concentrated bets to gain a spot on the list. There is likely to be no difference between being 11th or 50th on the relative rankings, because irrespective of the relative ranking if a fund is not in the top 10 the fund is unlikely to attract new members.

Fortunately, most industry bodies recognise the shortcomings of such a recommendation, with some dedicating efforts to raise awareness of the unintended consequences. A recent example is a Cuffelinks article[12] calling out “10 reasons the ’10 Best in Show’ is ill-suited”.  The article points out that ‘This year’s winner is often next year’s loser’.  As the intention of the shortlist is to update the names only every four years, the starting point for comparison will play a significant role in influencing which funds will make it onto the initial shortlist and thereafter.

Finally, selecting the panel of “independent experts” will prove as difficult as identifying the selection criteria for the shortlist.  The PC report recommends that the panel consists of non-super experts.  If the current system has its shortcomings with industry experts holding oversight responsibilities and roles, what chance would non-super experts have in performing these roles more effectively?

THE YEAR AHEAD

The PC’s final report is a mixed bag. The industry and its participants could not and should not have hoped for such an inquiry to solve all the current shortcomings.  If we did, it clearly did not meet that expectation. However, it did spark a number of discussions and debates, which will hopefully continue to focus attention on what really matters for members.

The year ahead poses interesting challenges and most likely changes for the superannuation industry with the PC’s recommendations in this report and the Royal Commission’s final report, not to mention the federal election coming up and what changes that might bring with it. Everyone would most likely agree that members’ needs should (from now on at least) be at the heart of everything superannuation professionals do, irrespective of whether any changes become formally mandated or not. It has never been as important to maintain trust in the system as now, and therein lies the challenge and the opportunity for us all. What we do today impact the livelihoods of others in retirement.

References

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