Super scale – how much is enough?

Despite consolidation efforts to date, there are still a large number of small to medium size collective super funds. One of the objectives of the Stronger Super reforms is to encourage scale. But how much scale is enough?

All things being equal, funds’ boards generally want to maintain their independence. But they also have an obligation to do the right thing for members. The problem is that they often lack the criteria to decide what to do about scale. Is do-nothing an option? Merge with other small funds? Merge with a bigger fund?

When thinking about criteria, it helps to have the end in mind. From our point of view, the objective should be a situation which allows the delivery of high quality outcomes for members – in terms of investment returns, products and services – at a commercially competitive cost. A fund needs sufficient scale to make that a realistic probability.

There are implications for member numbers and assets. Without enough members, there will not be enough revenue to offer competitive products and services. Without enough assets, it will be hard to gain access to the best and / or lowest cost investment strategies.

– Member numbers is the easier to deal with. As we noted last week, 100,000 members is an important cost milestone (where the fund members are bearing all costs). Costs per member generally escalate rapidly below this figure.

– Asset size is more subjective. Assuming 100,000+ members and a middling average member size of say $25,000 implies an asset size of around $3 billion. However consolidations to date suggest this might be the low side – while Westscheme was about this size, Health Super was much larger at nearly $10 billion, and AGEST is a fast growth fund in between at around $5 billion.

Wherever minimum scale is now, it’s going to keep moving north. As memberships age and become less homogenous, new cost pressures are coming down the pipeline relating to investments (eg the days of the single default are numbered), product development, and particularly advice. None are cheap to implement, and are certainly more affordable when spread over a wider base of members and assets.

Keep in mind that these new costs will be playing out as auto-consolidation is kicking in. Auto-consolidation is the process whereby inactive accounts of less than $1,000 (the intent is to move to $10,000 by the end of 2014) will be automatically rolled into a member’s active account (assuming that both sides of the consolidation can be identified).

Super funds, particularly industry funds, have large numbers of inactive accounts – commonly 30-50% of total member numbers. And with fund revenues being primarily a function of the number of members, the implications for viability are clear. Costs will be rising and revenues will be falling.

This means that a fund with 100,000 members today, or even double that in certain cases, may not be in the safety zone. Given that minimum scale will be a moving and rising target, a fund needs to be looking at a minimum of 100,000 members post auto-consolidation, and perhaps $5 billion in assets, to have some confidence about scale.

Of course there is more than one way of skinning that cat, in addition to outright mergers. Shared services are another model, although in practice this has proved hard to make work. It’s perhaps most prospective in terms of common investment platforms; ie a small fund would cease managing its own portfolio, instead feeding into a pooling structure offered by a large fund, or created by a group of smaller funds. However it could potentially retain its own brand identify, member proposition, and unique products and services.

Scale is not a guarantee of better results. You can make a mess of scaling up, and there are diseconomies of scale such as complexity and people problems. Our view is that members are not automatically better off in a scaled up fund, but there are generally versions of a larger fund which almost certainly deliver better outcomes. It’s defining and executing the right version of scale which is the challenge.