It’s not easy being small

It’s not easy being small

Friday saw the release of our 2014-15 Tria Super Funds Review with hard copies hitting desks this week. One of the themes highlighted is that despite the superannuation industry being very fragmented (the largest market share sits at just 5%), there is a distinct group of very large funds with more than $50b in assets each that are becoming serious contenders on a global scale (to put that size in perspective there are only about 60 ‘jumbo’ pension funds globally with more than $50b in assets, according to Towers Watson).

The big end of town increasingly dominates when it comes to growth. Not only are they already large, the top 6 funds also captured exactly half of the net flows into our large super fund universe. The next 6 captured 30%, leaving the remaining 75 funds to fight it out for the last 20%. That’s not a lot left to go round.

There is something of a snowball effect in which the jumbo super funds effectively now add the scale of an entire medium sized fund each year. Consider the gain in scale of the six biggest entities:

The largest funds are gaining scale at rate which means they are moving further and further away from the rest of the industry.

The advent of such large funds will no doubt fire up the debate on whether economies of scale are being delivered – and if so whether to members, or management and shareholders.

There are a number of potential sources of scale benefits:

• Internalisation of asset management has the biggest potential given that asset management is typically the largest source of costs, but the complexity of implementation means this is only realistic for medium and larger funds. But while internalisation can deliver significant cost savings, it is not yet clear whether members will benefit in net terms – if internal teams significant underperform external managers, members will be worse off despite lower costs.
• Using scale in negotiations with fund managers (as a complement and / or alternative to internalisation); while larger mandates are priced at lower levels, this is already a well-trodden road. And of course the best managers with good track records and capacity constraints have strong bargaining positions.
• Large investments in technology to improve funds’ efficiency (whether back, middle, front-office) can reduce cost structures in their own right. The scale effect of the largest funds also means that large capital investments (which are often largely fixed cost in nature), across technology, investments and product development can be much more easily absorbed by the largest funds as they have much small impact on bps terms. Over the medium term we would expect to see the largest funds making such investments to more efficiently attract, service and retain members – smaller funds will find this difficult or impossible to do, serving to further widen the gap in organic growth rates.

Despite the industry’s poor track record in delivering scale economies to members to date, we are actually optimistic that the largest funds are starting to become more aggressive about doing so, and we expect to see the cost structures of the market leaders falling.

This in turn will increase competitive pressure across the market – something that would be greatly reinforced if impediments to competition (such as the nexus with industrial relations) start to fray, as is widely expected with time.

In any case, the industry has strong incentives beyond competition to take its medicine and attack its cost structure in a disciplined way. As we are now seeing in the life insurance industry, it often pays to make an anticipatory change – even an uncomfortable one – before the regulator feels the need to get involved.