FSI Final Report – future of default super

The Financial System Inquiry final report is in, and we will discuss its super-related sections over the rest of December.  In proposing some radical but narrow changes, it’s an uneven and underwhelming effort likely to be superceded in importance by the tax white paper.

For a report aiming to improve the efficiency of the overall system, it is not well balanced in the context of a system roughly one third retail, one third SMSF, and one third not-for-profit.

You might have expected a roughly similar examination of each segment.  It hasn’t happened.

Where’s the discussion about vertical integration?  How do you wave away the dominant business model of the retail segment?  The SMSF segment is barely mentioned other than restoring the ban on direct leverage.  If you are serious about industry cost structure, how do ignore a third of the system, particularly when it epitomises fragmentation and loss of scale benefits?  And if you are concerned about super and tax distortions between the wealthy and less well-to-do, you have to give the SMSF segment proportionate attention.

As a result, FSI ends up being mostly about default super.  The FSI has retreated from some of the more extreme positions of the interim report but still concludes that costs can be reduced without any impact on member outcomes, and that its recommendations would improve (non-age pension) member retirement incomes by 25-40%.

How are the FSI’s projected 25-40% gains in retirement income derived?

• ~10% comes from reduced default fees (down 30 bps across the board) via enhanced competition, including the auctioning / tendering of default fund rights, and efficiencies from an individual having a single super account for life.
• ~15-30% comes from a “comprehensive income product for retirement” (CIPR) solution, depicted as a combined account-based pension and a risk / longevity pooling solution.  Interestingly, these gains are derived from a reduction in risk of account depletion, which allows retirees to draw higher levels of income.

In other words, most of the projected gains for members actually come from a new pension design.

If the FSI’s claims for potential fee reductions sound suspiciously familiar, they should – it’s very similar to 33 bps reductions the Super System Review promised for MySuper.  So is this another 30 bps reduction in fees for members?  No, it’s the same 30 bps.  The FSI found no evidence that MySuper had reduced default fees (FoFA was the reason average fees had fallen).  While it recognised that the full benefits are yet to flow, it obviously has doubts that material fee reductions will be the outcome.

What we can say is that gains from reduced fees will mostly come from asset managers – it can’t be any other way as investment costs are typically the majority of default fund costs.  The FSI is sceptical of active asset management and is implicitly telling funds to reduce or internalise it.

Looking at the big default super segments, the industry funds and their stakeholders will be particularly unhappy with the final report.  Part of the prescription for improved efficiency is to remove super from awards and EBAs, and to water down the role of stakeholders (read unions) on fund boards.  That’s despite the FSI’s recognition that award super has delivered the sort of gains from tendering that large corporates have achieved, and which appears to be the goal of its auction / tender model.

The retail segment won’t be delighted where things have landed either.  The FSI unexpectedly endorsed the Productivity Commission’s conclusion that MySuper was not a sufficient standard for default super, and that a quality filter is necessary.  And retailers also have much to lose from an auction / tender system – albeit perhaps more in margins than volumes.

So what does this auction / tender system look like?  It’s sketchy:

• It would apply to new workforce entrants only (although pricing and terms would apply to all default members), with a MySuper product potentially allocated at the same time as a TFN.
• Entrants would be matched to a “successful” fund on criteria including costs, expected future net performance, and past performance.  How funds would be matched to members is not discussed.
• The number of successful funds is not specified other than being described as “significant”.  Presumably that is more than a handful, but less than the number of MySuper products on issue.  Who selects?  Who knows.  Does this end up being much different from the quasi-APLs which will emerge from the Fair Work expert panel process?
• How successful funds are reviewed and replaced in the event of underperformance or other issues receives only a cursory mention.

The strategic threat which an auction / tender system represents to incumbents is uncertain and some way off – while the FSI’s preference, it depends on a conclusion by 2020 that Stronger Super has not worked in delivering system cost reductions.

While there is general support for pension design innovation, there must be doubt about how many of the default super recommendations get implemented, given bipartisan support seems unlikely.   It may suffer the fate of the Henry Review.  That said, FSI puts the super industry on notice to attack its cost structure and evolve its governance model.  Those are good things which will benefit members, and in train already at better funds.  But as with the Super System Review, claims of huge improvements in member outcomes as a result of the FSI’s recommendations should be taken with a large dose of salt.