Written by Partner Geoff Sanders and Associate Stephanie Malon
The Financial System Inquiry's final report was blunt in its assessment of the current state of Australia's super system, noting that the 'superannuation system is not operationally efficient due to a lack of strong price-based competition.' The Inquiry's concern with super fees and costs led to one of the most radical recommendations in its final report – that Australia should consider adopting a formal competitive process to allocate new default members to super products, a system which could perhaps have a distinctly Chilean flavour.
Acknowledging that the MySuper reforms were designed to address cost concerns (but that those reforms have not yet had sufficient time to flow through the system), the Inquiry suggested a wait-and-see approach, with the feasibility of implementing a new system for allocating default fund memberships only due to be reassessed in 2020. However, the Inquiry had sufficient doubts as to the effectiveness of MySuper that it recommended the Productivity Commission start work in 2015 on the design of a competitive allocation process for default super contributions in Australia.
This suggestion is certainly food for thought and, whether or not some may see it simply as a shot across the bow of the super industry, is worthy of close consideration – superannuation costs are a fundamental issue that can have a significant impact on income and standard of living in retirement. In this article, we take a closer look at the Chilean approach and whether or not it might be the missing ingredient in Australia's super system.
While many have continued to question the black-and-white nature of the conclusion reached by the Inquiry, the two key factors which led the Inquiry to conclude that cost remains a major issue for the Australian superannuation system were the prior conclusions that:
- when system size is taken into account, Australian super costs are relatively high on a global basis; and
- costs within Australia have not fallen by as much as would be expected as the industry has increased in scale, and preliminary evidence suggests the MySuper reforms will not significantly improve these outcomes.
The Inquiry went on to identify a range of factors which drive these relatively high costs in Australia, including the failure (largely due to lack of engagement) by account holders and employers to put sufficient pressure on funds to lower fees, and the fact that funds tend to differentiate on product features and services rather than price.
Whether or not everyone in the industry agrees with the Inquiry's assessment, it is clear that this is an issue that will not go away quietly. The Inquiry's proposed solution was to recommend the formal assessment of a new, radical competitive process to allocate new default fund members to MySuper products, which appears to be partially modelled on the system adopted in Chile since 2008.
So, what is this Chilean system we keep hearing about and, more importantly, could elements of that system really work in the context of what is already a relatively mature superannuation system in Australia?
The Chilean superannuation system is well regarded internationally, with the 2014 Melbourne Mercer Global Pension Index ranking the Chilean system a respectable 8 out of 25 countries selected as having a developed superannuation system. In its interim report, the Inquiry made special mention of one important feature of the Chilean super system:
…superannuation contributions of all new members are placed in the same default fund. Default fund management is auctioned on the basis of fees, creating stronger competition between funds for default fund status.
Broadly speaking, the Chilean system works as follows:
- every two years, the government conducts a tender for pension funds to become the default fund for new contributing workers;
- tenderers must be approved pension funds and must offer five defined asset allocation options, each set at the same fee;
- the tender is awarded to the fund that offers the lowest fee;
- the winning fund receives all new default accounts opened in the following two years; and
- all existing members of the winning fund also have their fees reduced to this new level.
The Inquiry noted that this system had been effective in achieving significant fee reduction in Chile:
Since these arrangements started, the fees charged by successful bidders in Chile have fallen by 65 per cent, although fees on other funds have not fallen to the same degree.
In fact, the account fee for the default Chilean fund is now around an enviable 0.2 per cent a year – less than one quarter of the Australian average default fee.
Perhaps not surprisingly, the system for allocation of new default accounts mooted in the Inquiry's final report is strikingly similar to the Chilean system in many respects, even if many of the finer details of any new system here in Australia remain unclear – as the Inquiry noted, there are a number of possible variants of this model, for example the approaches adopted in New Zealand and Sweden.
The debate regarding the perceived cost problems in our super system is a complex one. In particular, the relationship between costs and long-term returns has many nuances.
It is possible that the Inquiry's recommendation of a Chilean-style system may have been inspired by a Grattan Institute report, Super sting: how to stop Australians paying too much for superannuation (published early last year) which strongly advocated the adoption of the Chilean system in Australia. An important assumption underlying the Grattan Institute report was that low fees will ultimately produce the best fund performance. In reaching this conclusion, the Grattan Institute cited statistics on the perseverance of short-term performance from 2006 to 2013 which showed that, on average, low-fee funds went on to perform better than funds that previously had high net performance.
However this focus on the perseverance of short-term performance may not tell the full story – does it necessarily mean that the lowest fees are the best guide to future long-term performance, or that other benefits (eg, reduced risk from good quality active asset management) should be sacrificed in the pursuit of low costs? Many argue that the answer to both questions is no.
In addition, it is far from clear what impact a competitive allocation process would have on the substantial product choice currently provided by the Australian superannuation market. Over time, could the process drive a 'race to the bottom' where funds simply aim to offer a relatively homogenous product at the lowest possible cost? The Inquiry recognised that these issues would need to be considered in the design of any competitive process.
Further, as the Inquiry acknowledged, a global cost comparison is difficult and there are some unique features of the Australian system which may contribute to its elevated costs. This, along with the fact that the Australian superannuation system is already relatively mature (and, therefore, many argue, is already operationally efficient in most of the areas in which they can be given the system design) means that we might need to carefully consider which elements of the Australian super system cost structure can be reduced without reducing fund performance.
Nonetheless, the Inquiry and the Grattan Institute raise some important questions which warrant a detailed consideration. It is likely that super cost will be on the regulatory menu for a while to come, whether or not in the form of wholesale Chilean-style reform or ongoing micro reforms.