How I'd fix default super

If you’re someone who has selected your own super fund or set up a Self Managed Super Fund (SMSF), it might surprise you to find out that you’re an exception.

The majority of Aussies just take the fund they’re ‘defaulted’ into by their employer when they start work. These default super funds make up about 80% of all super accounts.

Most people in default super take little to no interest in their fund and they tend not to switch regardless of performance.

Because of this, default super funds don’t face the kind of price-based competition they would in other industries where customers demand value-for-money.

The bank-owned default funds regularly charge too much and don’t migrate clients to better options due to conflicted arrangements. The industry funds waste hundreds of millions on failed projects and avoid backlash because they are protected by the industrial awards system.

Without ‘normal’ competitive forces at play, default funds have too often put the interests of their owners, employees and related parties ahead of their fiduciary duty to members.

Enter the Productivity Commission…

Last year the government asked the Productivity Commission to undertake a 12 month inquiry into the efficiency and competitiveness of the super industry.

The final results were handed down this week. The Commission identified that there are nearly 5 million default super accounts that are poor performers. Yes, five million!

Most of them are retail funds although industry funds make up plenty of the worst performers too. The Commission found “evidence abounds of excessive and unwanted fees in the super system”. This matches up with our own Fat Cat Funds Report and the deep dive we did into excess super fund operating expenses.

According to the Commission, Australians pay over $30 billion each year in super fees including $1.3 billion in excess fees to poor performing funds, $1.9 billion in excess insurance premiums and $690 million in admin fees for multiple super accounts.

That’s a lot of money down the gurgler each year!

The Productivity Commission Recommendations

There are 31 recommendations for government. Many of them are sensible steps to improve the system;

• There should be a ban on all trailing financial adviser commissions,
• There should be open access to performance and fee information for all superannuation funds,
• Life insurance through super should be opt-in for under 25s and inactive accounts; and
• To prevent people having multiple super accounts (and paying multiple fees), employees should only be defaulted in a fund if they’re new to the workforce.

What the Productivity Commission missed

The recommendations do a good job at addressing the worst funds. However what it missed is that even the top funds should be doing much better than they are.

Our Fat Cat Fund research shows 96% of Australians would be better off in a low cost index fund than a typical balanced super fund because of inefficient operations and high-cost active management. This is the single biggest drain on the super system, costing over $17 billion each year.

Professor Nicholas Morris of UNSW made the same discovery about expensive active management which he published in “Management and Regulation of Pension Schemes: Australia – A Cautionary Tale” (Routledge, 2018).

Other regulators around the world are coming to the same conclusion too, most recently the European Securities and Markets Authority (ESMA) who published ‘Performance and costs of retail investment products in the EU’.

The ‘best in show’ idea

The headline policy recommendation is a shortlist of ‘10 expert selected super funds’ for all default money which would replace the hundreds of default funds currently available.

This policy recommendation stands out as a poorly thought-out one, but not for the reasons cited by the industry and retail fund lobby groups who are just trying to protect the ‘free ride’ their funds currently get.

I don’t think the policy goes nearly far enough to protect members and push down costs.

Rather than reduce fees, this policy is likely embed existing high costs, create incentives to ‘game’ the system and lead to lobbying to be selected as one of the ten shortlisted funds.

Here’s how…

Who picks these top 10 funds?

The Commission recommended that the ‘best in show’ shortlist should be judged by an independent panel and reviewed every few years.

There are obvious dangers in giving huge power to a select group of people, who presumably will have experience gained from previous careers in the super industry.

This panel will be subject to extensive lobbying from funds and former colleagues who will want their products to be selected, as well as political pressure.

It is unlikely, for instance, that the big four banks, AMP and IOOF would all be omitted from the list even though they should be based on the practices that were exposed in the Royal Commission.

How funds can cheat to get into the list

There are also some problems with how funds get selected as one of the ‘best in show’ list. The (yet to be decided) selection criteria is likely to preference funds who have been recent top performers.

This is easily gamed, as I explained how in How super funds play the ratings game. Strong recent performance due to taking on more risk is both misleading and mean-reverting.

The funds at the top of the list over one period are not likely to stay there over subsequent periods unless they are also low-cost funds.

How funds can cheat to stay in the list

Once funds have made it into the list they are guaranteed huge inflows each year provided they don’t underperform by too much. This will lead to an incentive to plow money into unlisted assets whose values are more easily ‘managed’ for performance.

They’ll also insource more functions like investment and administration and hire much bigger teams. All of these actions will increase overall costs borne by members, but can be masked by their growing scale.

The ‘best in show’ won’t get fees lower

The report doesn’t go far enough to address the clear fact that low fee funds perform better. Our Fat Cat Funds Report shows 96% of balanced super funds were beaten by an equivalent low-fee index fund after fees and taxes.

That includes all of the best performing industry funds and retail funds! A simple, low-cost indexing strategy achieved top 25% returns in every risk category over five and ten years.

What’s the policy alternative?

We need to reduce investment and operating costs across all funds, rather than promote existing practices and costs which have resulted from a lack of price competition.

Rather than cherry-pick the best of an average bunch, I believe the government should focus on removing conflicts of interest and rent-seeking behaviour altogether.

This can be achieved in one of two ways;

• The creation of an independent and publicly answerable alternative fund (low cost and passively managed) which would be the default for all Australians. Our Fat Cat Fund research shows that such a fund will beat almost all super funds over the long run, including the proposed ‘top 10’. This structure has been successful in other parts of the world. A fabulous example is the Nevada Public Employees’ Retirement System. It passively manages US$41 billion with just one employee. His strategy is to keep costs low and not try beating market which makes it a consistent top performing pension fund.

Or alternatively...

• Implement a public tender process for the right to manage default super via a fee based auction. This would enable the current funds to participate but they’d need to be more efficient to compete and recognise that lower costs benefit their members. According to The Grattan Institute, competitive bidding could bring the cost of managing super down by over 50%, a saving of around $10 billion per year.

Australians need lower cost default super

Access to a safe, low cost and simple default option is essential to help the retirement savings of millions of Australians go further and last longer.

Lower costs are clearly in the best interest of members however any policy to promote this would face strong backlash from thousands of hanger-oners employed by the super industry.

It would take a brave government to rattle the cages of the countries’ biggest rent-seekers, but the broader positive impact of returning billions in excess fees each year would be a game-changer for Australia.