The importance of the superannuation system to the Australian economy and society is evident in the eye-watering agenda of political and regulatory attention over the past decade.
The draft report on competition and efficiency in the superannuation system released by the Productivity Commission is another important contribution to the policy discussion, and also highlights some challenges for financial advisors.
The themes and findings in the draft report are not only of public policy importance, but provide a stark reminder to advisors and money managers of the importance of achieving long term performance and outcomes.
Many of the themes that the Productivity Commission has analysed can also be found in the role of the advisor.
Unintended multiple accounts
There is no doubt that inefficiencies resulting from account-based fees charged to unintended multiple accounts represents low hanging fruit as a means of promoting efficiency - either in public policy or advising a client.
The most basic advice to clients often starts with ensuring that multiple accounts aren’t incurring unnecessary fees.
However, advisors would do well to understand that the likely changes to promote account consolidation may have second order impacts.
The recently announced measures to facilitate account consolidation are a positive step, however care will need to be taken to ensure that the balance and timing thresholds for transferring are appropriate.
Consolidation may also impact the amount of any administration fees charged. Unlike investment related fees, administration fees are usually applied to the number of accounts, in addition to certain activity-based fees.
As fixed costs associated with administration may need to be shared over a smaller account base, the industry will be challenged to find ways of continuing to meet the changing services needs of members efficiently and effectively.
There is a chance that contracting the administration fee base too quickly or significantly will result in increases in in account-based fees or compromise on the services provided.
Advisers may need to keep a close eye on future administration fee changes by superannuation funds, and ensure that comparative fee benchmarking activities are current and robust when comparing options.
Entrenched under performers and alternate default models
Understanding the entrenched underperformance of certain funds or products is a genuine challenge for financial advisors and the industry more generally.
The Commission correctly pointed out that underperformance tends to have a socially regressive effect, with those having better financial interest, aptitude or access to appropriate advice, tending to be able to navigate the complexities of super.
Financial advisors have an important role to play in steering clients towards appropriate and performing funds and products.
The less well-informed are often most exposed to the worst aspects of underperformance. This is not good enough and makes it imperative that the default arrangements for those without advanced financial literacy or access to appropriate financial advice are working efficiently.
While it may be counter-cultural in the advice business, this also means that financial advisors need to take MySuper and default arrangements seriously as viable approaches to providing better retirement outcomes.
The draft report identified that the default segment outperforms the system on average (but not all default funds). The way members are allocated to default products leaves some exposed to the costly risk of being defaulted into an underperforming fund, while others being defaulted into high performing funds.
What this suggests is that the existing standards under MySuper licensing requirements may not be adequate in ensuring that only those funds which are an exemplar of performance qualify as default.
While a strict canon of 10 has been suggested, we might do well to focus on performance standards over an arbitrary limit on the number of performing funds.
Serious caution is also required in promoting greater fund selection for those who have employment arrangements providing superannuation entitlements that are greater than the minimum SG requirements.
Promoting choice in these situations may disrupt the contractual basis of such generous contribution arrangements.
Financial advisors providing comprehensive advice need to have a thorough understanding of the workings of default superannuation arrangements if advice is to genuinely deliver efficiency in the form of better outcomes for clients.
Self-managed superannuation implications
The challenge for efficiency extends to self-managed superannuation funds (SMSFs).
At first glance, SMSF advisors and investors might conclude that the issues of competition and efficiency addressed in the Productivity Commission’s draft report don’t affect SMSFs. Possible policy changes in relation to unintended multiple accounts and alternative default models are less likely to have a significant impact on SMSF trustees or members.
SMSFs are an important part of the superannuation system, and inefficiency in this segment contributes to inefficiency of the system as a whole.
The nature of SMSFs means that competition between SMSFs and other funds is almost a foreign concept. Competition does not appear to be as a driver for efficiency for self-managed superannuation. This makes the role of the advisor in monitoring operational efficiency of paramount importance in the sector.
The challenge of performance without scale is a challenge which both SMSFs and smaller institutional funds share.
The Productivity Commission found that while large SMSFs are broadly competitive with institutional funds, SMSFs with assets valued under $1 million perform significantly worse than institutional funds.
Financial advisors should take heed of these findings, and exercise caution in advising clients to establish an SMSF unless there is confidence that lack of scale is unlikely to contribute to underperformance.
The Productivity Commission also found that the difference between returns from SMSFs with less than $50,000 and those with over $2 million exceeds 10 percentage points a year. Scale inefficiency in the SMSF segment remains of critical systemic importance.
Financial advisors have a greater role to play in safeguarding the effectiveness of the self-management segment of the system.
The underperformance of SMSFs can sometimes be seen as less of a public policy issue. This may be attributable to a perception of individual responsibility which ignores the fiduciary nature of the advisor and trust relationships, and therefore importance to systemic efficiency.
Underperformance of self-managed funds is no less of a policy problem than underperformance of Australian Prudential Regulation Authority (APRA) regulated funds, as any underperformance will contribute to an increased reliance on the age pension.
In this environment, advisors, trustees and SMSF members would do well to reflect on whether the SMSF is also an entrenched under performer, and the subsequent steps that should be taken.
Trustees of MySuper licensed superannuation products are required to make annual declarations that members are not in a position of relative disadvantage due to scale inefficiency. The findings raise the question of whether a similar assessment by advisors and trustees of SMSFs would also benefit members?
At the very least, SMSF advisors and trustees should consider regularly benchmarking and monitoring performance relative to alternatives, including APRA regulated institutional and MySuper licensed products.
And for those of us who consider ourselves as sophisticated advisors or investors...
Sophisticated advisors and choice investors should also take note of the findings of the Productivity Commission, particularly when it comes to entrenched underperformance.
Importantly, the Commission found that most (but not all) underperforming products are in the retail segment.
The retail segment of the system is characterised by menus of thousands of complex financial products and options. While there is a school of thought that we are spoilt for choice, the reality may be closer to being spoiled by choice.
There are behavioural biases such as the IKEA effect and illusion of control which may make more sophisticated and engaged investors more exposed to the risks presented by entrenched underperformance.
The IKEA effect is a general tendency for individuals to place greater value on things that they feel that they have contributed to, and the illusion of control is the belief that outcomes are disproportionately the result of the advice one gives or the decisions one makes.
Financial advisors are not immune from these behavioural biases, and some could argue even more exposed. Being aware of these biases and having robust systems and controls in place to promote greater levels of efficiency focused objectivity is a great place to start.
Advisors and investors exerting a greater level of control over the investments of their fund should take the findings of the Commission as a reminder of the need to regularly monitor, compare and benchmark performance against alternatives.
Jonathan Steffanoni is principal consultant, Legal & Risk with QMV.