Over the last three years there has been a growing clamour to increase regulation of superannuation funds. A central element of the proposals, at least under the last two governments, is to replace union trustees at industry superannuation funds with independent trustees. The Productivity Commission is broadly supportive. Both are misguided.
Over $2.3 trillion of superannuation is under management in Australia (about $175,000 for each member of the work force). Most superannuation is managed by industry funds (with their roots in particular industries, with continued union involvement) and retail funds (which sell directly to the public, with greater bank involvement).
There are a lot of industry and retail funds. In 2017 the figure stood at 169. Using the metric of historical returns on managed funds (a measure that is not without problems), they have exhibited widely differing levels of performance. For a business that should exhibit some scale economies —the best outcomes will come from a smallish number of large suppliers — and with such divergent performance, I would expect fewer. So, competition in superannuation is probably not very effective. As testament to this, the number of retail and industry funds has only declined by 11 since 2013; if competition was effective, we would expect the smaller and poorly performing funds to be swallowed up.
For competition to be effective in services like these, customers (i.e. workers who contribute a share of their wages to the funds) must be able to tell the difference between good and bad funds; and, having done so, switch to better funds at low cost.
But can workers tell the good from the bad? What defines a good superannuation fund? For workers in their 20s and 30s, the test of a good fund is the return it will have achieved in 30 to 40 years’ time. Superannuation is the ultimate long-term experience good; you can’t really tell how good it is until it is too late. Current metrics, even metrics such as average return over the last 10 years, leave a lot to be desired. To illustrate, Apple rose from an $8bn value in 2001 to $314bn in 2011; Nokia, in contrast fell from $118bn to $40bn over the same period; and in the middle of that period, there was a GFC.
Even if workers can tell the good from the bad, will they act on it? The very mode of payment of superannuation, deducted from salary and paid automatically into a fund (often a default fund), keeps it out of sight and out of mind. Hardly likely to encourage monitoring, comparison and switching, all core requirements of effective competition.
Why does this lead me to think that greater union involvement can help? First, empirics. In aggregate, the industry funds, characterised by greater reliance on trustees from labour unions, have done better than retail funds using past returns as a metric. Historical returns may not be an ideal measure, but industry funds have another feature that suggests they are superior. Notably and as they frequently advertise, they are low cost and do not profit from the services they provide. In short, a greater share of contributions ends up in the investment pool. I, for one, am yet to be convinced that higher costs and profit making in the retail sector translate into better returns on investment sufficient to close the gap.
There are theoretical considerations that lead in the same direction. Suppose that insiders, the trustees and employees of the funds, can tell how well a fund is performing but that investors cannot (at least not to the same degree). This is a common problem in governance, know to economists as information asymmetry. Suppose also that insiders can tilt the performance of the fund towards certain metrics, say average return over the next 5 years, over which their performance is measured. What will the insider’s do?
Generally, they will perform to meet those metrics. Given that a trustee’s and senior executive’s tenure is typically 5 years or fewer, that will be the typical performance horizon they will address. This creates what is called a principal/agent problem. The principal (the investor) wants to maximize 40-year returns, the agent (trustee or executive) who invests on behalf of the principal wants to maximise the shorter-term return to meet their particular goals. Information asymmetry prevents the principal from finding this out. This problem is not unique to superannuation; the shift towards linking executive pay to share price movements suffers from precisely the same flaw.
So how can we solve, or at least minimize, this problem. We could align the agents and principals by using 40-year future returns to reward the agents, but this is probably impractical. Nevertheless, requiring agents (particularly those under 40) to permanently hold some or all of their own superannuation in the funds they manage might help.
We could introduce more independent trustees. But this may not work. The tenure of the trustees is typically short by the standards of superannuation investment. The independent trustees typically come from the same limited pool, in much the same way as the boards of companies. The lack of diversity in boards (they all come from the ranks other boards and senior executive) is one suggested reason for the dramatic and useless (in an economic sense) escalation in senior executive pay. And since this is investment, independent trustees will very likely have a banking or investment background, and that is not a sector that has covered itself in glory over the last two decades.
Superannuation funds can recognise these risks and commit to certain practices that minimise them. Industry super funds’ commitment to low cost, non-profit and modest pay for their employees is a case in point. It is much harder for the for-profit sector to credibly make such a commitment. Indeed, they may need to do the reverse, link high costs to high pay to secure the ‘star’ investment managers (although I note that there is little evidence that, in aggregate, such ‘star’ investors can beat the market).
And then they can select union trustees from the linked industry. Unions’ interests align with the workers they represent. That alignment is a long-term rather than a short-term as failure to meet workers’ expectations results in the demise or at least diminution of the union. Internally, unions typically adopt democratic means for selection of their officials. Workers have a direct say in who represents them. That translates into performance incentives for unions as trustees in superannuation that extend well beyond the tenure of any one trustee. Closer to my goal of long-term alignment.
Unions are not without their problems. But so too with banks. Both are under scrutiny to weed out their worst practices, and that is to be commended. But eliminating union trustees from superannuation throws away one of the few measures we have for aligning superannuation performance and investor needs for retirement income. The proposed alternatives are not compelling.
10 December 2017