Australian superannuation reform efforts could accelerate industry consolidation

Recommendations from two official inquiries aimed at strengthening Australia's superannuation industry could lead to more aggressive oversight, fewer unnecessary fees and a pickup in industry consolidation.

A Jan. 10 report on the efficiency of Australia's A$2.7 trillion ($1.93 trillion) superannuation industry by the country's Productivity Commission and a Feb. 4 Royal Commission report on financial sector misconduct shared some goals, such as preventing workers from ending up in more than one default option when they change jobs and stiffening the spines of regulators.

Likewise, both reports shone a harsher light on bank-sponsored, for-profit retail super funds than on union-backed, "profit-for-member" industry funds, whether the topic on hand was performance or acting in the best interests of clients.

The Australian Prudential Regulation Authority's latest data, meanwhile, showed combined industry fund assets under management surging 16.4% to A$652.7 billion over the 12 months through Sept. 30, edging out the A$628.1 billion in retail funds, which rose a more modest 6.3%.

For politicians tasked with translating recommendations into legislation, the Royal Commission's calls to prohibit the "hawking" of super products to members, strengthen fund trustees' conflict-of-interest rules and limit the scope for deducting advice fees from member accounts, among others, proved relatively easy to embrace.

Australia's ruling conservative Liberal Party and the opposition Labor Party both quickly pledged to back the Royal Commission's recommendations.

Neither has been as full throated in backing the Productivity Commission, in particular its call for a major overhaul of the system's default mechanism, aimed at supporting a fraction of the more than 11 million Australian workers in default options who, the commission found, find themselves stuck in funds suffering from long-term underperformance.

Other Productivity Commission recommendations garnered broad support, including calls for elevated default fund "outcome tests," steps to spur consolidation of smaller, relatively high-fee funds, and improved data collection to make comparing funds easier.

But the commission's marquee call for a default mechanism built around a "best-in-show" top-10 fund list, chosen by a panel of experts, to improve outcomes for 1.6 million members currently tethered to weak funds, remains a lightning rod.

There's a general sense that the Productivity Commission produced some "really good, deep analysis" of the industry's challenges but then went out on a limb seeking a dramatic overhaul of the system's default mechanism to deal with a small minority of underperforming funds, said David Carruthers, principal consultant and head of member solutions with Melbourne-based investment consultant Frontier Advisors Pty Ltd.

The Productivity Commission did valuable work exposing the extra costs members face from having 10 million "multiple accounts," and the fact that too many underperforming funds manage to retain their status as default options, said Eva Scheerlinck, the CEO of the Australian Institute of Superannuation Trustees, Melbourne.

"Both need to be fixed," and there will be debate over how they're accomplished, said Ms. Scheerlinck. But of the two, underperforming default funds — in a mandatory system where workers contribute 9.5% of their salaries every month — are particularly problematic, she said, noting their potential to undermine trust in the system.

Underperforming funds are a legitimate concern but the Productivity Commission's recommendations seem more focused on picking winners than eliminating those bad performers, noted Martin Fahy, CEO of Sydney-based Association of Superannuation Funds of Australia Ltd.

The commission cited an instance where a predecessor organization to the Fair Work Commission — tasked with pruning weak funds from the list of default options — declined to conduct an independent appraisal of the investment performance of particular funds as evidence that "members' interests were a secondary consideration to questions of standing and history."

But a number of analysts expressed sympathy for the predecessor organization's contention, cited in the Productivity Commission's report, that "performance will vary from time to time and even long-term historical averages may not be a reliable indicator of future performance."

The commission seemed to be on the "optimistic side of the line" when it comes to the challenges of telling good from bad investment managers, said Roger Urwin, London-based global head of investment content with Willis Towers Watson PLC.

Yesterday's underperformance can easily turn into tomorrow's above-average performance, so "you can't just eliminate below-average performers," said Mr. Urwin.

Instead, gatekeepers have to emphasize things like governance and organizational effectiveness because even for the rolling eight-year periods the commission favors, the insights that past performance figures provide will more often than not prove dated, he said.

Another tricky aspect of the commission's "best-in-show" proposal that would be assembling the experts' panel tasked with compiling the shortlist of 10 strong funds. Anyone with sufficient experience and knowledge to do the job well would likely come to the table with some conflicts of interest, predicted Frontier's Mr. Carruthers.

Industry fund officials, meanwhile, differed on how the proposal would impact competition between industry funds and retail funds.

AIST's Ms. Scheerlinck said with industry funds dominating superannuation performance rankings, retail funds would face an uphill battle getting on to that proposed shortlist of 10 funds.

Zachary May, Melbourne-based director of policy with advocacy group Industry Super Australia, said the details of the Productivity Commission's proposed default mechanism structure — such as calling for a 60-day period between a new employee's start date and his or her being put into a default option — leave ample room for bank-backed funds to use their marketing muscle to win new clients.

On the positive side, Willis Towers Watson's Mr. Urwin said, the proposal could be expected to concentrate more money in certain industry funds, which might be net positive overall, given the high costs in the system.

The Productivity Commission report noted that many funds lack scale, with 93 — or roughly half of the superannuation funds regulated by the Australian Prudential Regulation Authority — having less than A$1 billion in assets.

"Everybody would like to see more consolidation in the industry" but even small funds capable of delivering good returns should have the right to compete, said Ms. Scheerlinck.

Both the Royal Commission and the Productivity Commission, meanwhile, called for changes aimed at getting the bodies overseeing superannuation — APRA and the Australian Securities and Investments Commission — to respond more aggressively to industry transgressions, as well as doing more to promote mergers of funds.