Good cost, bad cost - there is a difference
When assessing any complex product, it is easy to fall into the trap of focusing on a simple measure such as price. A mobile phone plan, for example, may have a ‘cheap’ headline price but will the coverage be wide enough for you to connect whenever you need to and will the call costs result in you paying more in the end than an ‘expensive’ plan?
When you don’t fully understand a product category, the simplest way to choose is often to look for the product with the lowest price. So it is with superannuation. ‘Low fees’ is a common catchcry within the industry and many funds promote themselves largely on that premise. But the pursuit of low fees may ultimately be counterproductive, if the end result is mediocre returns and limited services. Price doesn’t necessarily equate to value.
To politicians, regulators and others pushing the low fees barrow we would say: “Be careful what you wish for”, because you may be doing a disservice to the Australian workforce and ultimately to the national interest.
To those pushing the low fee barrow we would say: “Be careful what you wish for”
Up to a point, higher fees may actually be a ‘good thing’ if they result in better investment outcomes and better member services – especially vital services like education and advice that members need if they are to understand their super and use it to its full potential.
We would contend that there are ‘good’ and ‘bad’ costs in the system, and that the focus needs to be on eliminating the ‘bad’ costs so as to free up more of the total budget to be spent on the ‘good’ costs. But first, we need to separate out the various cost centres in super and identify the different types of fees involved.
First, we need more transparency
Fees and costs are an emotive issue, and there is a high level of confusion and misinformation in most of the public discussion. This is largely because different types of costs are wrongly bundled together, making it difficult for consumers (and sometimes researchers) to identify what they relate to.
While it is tempting, it is seriously misleading and unhelpful to judge funds on the basis of their total costs. Doing so not only hides a lot of valuable information but also ignores the dynamics of the industry. In essence, most of the costs in super relate to three areas – administration, investment and advice (arguably, in some instances this advice component is simply sales commission). Those that don’t are largely one-off transaction or event-based costs and are insignificant in the overall picture.
There are already moves underway to separate product fees from advice fees, and that is a useful first step. This needs to be extended so that product fees are distinctly separated into administration fees and investment fees. That’s because administration and investment fees are different in nature and they affect fund members in different ways. They need to be properly identified, so consumers can understand what they are and make informed decisions based on what services or benefits they are receiving and how much they are prepared to pay for them.
To assess funds fairly, therefore, we need to identify the costs of administration, investment and advice, and our latest fee analysis does just that.
Administration fees are those incurred in running the fund and providing services to members and their employers. In the case of retail funds, they include a profit element. In the not-for-profit sector, they don’t. That largely explains why the not-for-profit industry funds and public sector funds have considerably lower administration fees than the retail funds.
But the profit element isn’t the only reason for the difference. Historically, retail funds have generally provided a greater range of services – and a higher level of service – than their not-for profit counterparts. Those superior services come at a cost, so even leaving aside the profit element it is not surprising that retail funds have charged higher administration fees.
Chart 1 separates out the three main types of costs across three main industry sectors – that is, industry funds, public sector funds and retail funds. We have not included the employer divisions of retail funds because most employer plans have individually negotiated fees which are not made public so meaningful comparisons are difficult.
The chart is based on November 2009 fee data, covers the 10 largest funds in each industry segment, and relates to a member with a $25,000 account balance.
In terms of total cost, retail funds are the most expensive at 2.13%, then industry funds at 1.08% and then public sector funds at 0.80%. If we exclude advice (because this is a separate service a member might choose regardless of the type of fund), the cost of retail funds reduces to 1.62%.
Interestingly, the investment fees of retail funds are slightly lower than industry funds. In practice, when you adjust for the ‘true’ fees of alternative assets (by taking into account the fees of underlying managers), we estimate the difference to be in the 0.10% to 0.15% range.
Industry funds having higher investment fees makes sense when you realise they invest much more in alternative assets, which tend to be much more expensive than traditional asset classes.
The major difference is in administration fees. In most cases, administration fees are charged directly to members’ accounts and, in effect, reduce the amount of contribution that is available for investment. Given that, it is in the members’ best interests for these fees to be as low as possible, as long as they are receiving the level of services they require.
This last point is crucial. Some people want a high level of engagement with their fund and are heavy users of a wide range of services. They would put a higher value on those services than someone who is more passive and simply wants a ‘plain vanilla’ experience at the lowest possible cost. So whether a particular product’s fees are high or not is a value judgement, not an absolute fact.
The trend is for convergence
The introduction of member choice of fund in 2005 was the catalyst that changed the competitive nature of the industry. All of a sudden, funds were actively competing to attract and retain members, and administration fees and services became a point of differentiation. In practice, this has meant that the two sides of the industry have converged. Industry funds have improved the range and standard of their services, and as a result their costs have increased. At the same time, retail funds have trimmed their profit margins, as well as becoming more efficient.
Chart 2 shows this convergence of administration fees quite clearly. In the period from June 2005 – just before the introduction of member choice – to November 2009, the average industry fund administration fee has risen from 0.29% to 0.39%. Over the same period, the average retail fund administration fee reduced slightly from 1.03% to 0.96%.
Bear in mind that while retail funds’ fees only fell slightly, the quality of their services improved over the period, especially in key areas such as education, communications and online functionality. So while industry funds have been busy lifting their game, retail funds have been constantly raising the bar. This may not have reduced costs greatly but, in our view, these service enhancements are vital if members are ever going to be properly engaged with their most important financial asset and get the maximum benefit out of it.
Efficiencies that would benefit everyone
Most of the potential for superannuation cost savings is in the administration area. That is not to say that the industry is not already operating efficiently – it is, but further progress is largely constrained by procedural issues that are either related to Government policy or would require Government involvement to overcome.
In terms of the fees paid by the average member, the single biggest factor is the proliferation of multiple accounts. There are about 11 million people in the workforce and about 25 million super accounts. That means the average worker has about 2.5 accounts, and each one is charging them administration fees whether the account is active or not.
If we assume an average administration fee of $1.50 a week, or about $80 a year, the average worker is paying $200 a year in administration fees. If all their super was consolidated in one account, they would be paying $80 a year, a saving of $120. Based on an average total balance of $25,000, that wasted $120 a year is equivalent to almost 0.5% per annum. This would have a material impact on a member’s financial retirement income.
Why do so many people have multiple accounts? Mainly because the process of matching accounts to individuals is so difficult, because the privacy laws don’t allow for Tax File Numbers to be used as identifiers. That is largely why there are estimated to be over 6 million ‘lost’ superannuation accounts, totalling more than $13 billion.
The whole process of rolling over super from one fund to another is difficult and time-consuming, so much so that many people simply give up. In its submission to the Super System Review, BT Financial Group says that, based on its experience, it takes three months on average to consolidate accounts and only six per cent of people who start the process actually complete it. The rest presumably give up in frustration. That is an indictment not of the funds, but of the regulations and unnecessary red tape.
It is in everyone’s interests for members to be able to move money from one fund to another without undue hindrance or delay. According to ASFA, that would require:
- regulated funds being able to rely on each other’s verification of a member’s identity.
- the introduction of industry standard forms and processes.
- funds being required to process rollovers promptly once the member’s identity and other data has been matched.
BT goes further, suggesting that the portability issue is best dealt with by the funds themselves, acting on the member’s authority. Once the member had instructed their fund to find and consolidate other accounts that would be the end of their involvement. The receiving fund would do the rest.
Apart from consolidation of accounts, the major key to efficiency across the board is the elimination of manual processes from the system. Drawing again on BT’s submission, they estimate that operational costs in their retail and employer super products could be reduced by as much as 25% if reforms were introduced that substantially increased the uptake of electronic transactions.
As far as administration costs are concerned, therefore, the focus needs to be on industry-wide reforms to drive out wastage from the system. Alongside that, we believe that impediments should be removed to encourage further consolidation of funds to capture economies of scale. Based on a combination of APRA data and our own research, at June 2008 about 70% of all funds (that is, 357 funds in total, excluding self-managed funds) had assets of less than $1 billion. Most of those were in-house corporate funds and retail funds. About 30% of all funds had assets of less than $100 million.
Our view is that, in most instances, a fund needs assets of at least $2 billion (unless it outsources via larger investment pools) to capture the economies of scale available in today’s market, and that funds smaller than this should be encouraged to merge. To facilitate this, Government action is required to provide permanent CGT rollover relief on asset transfers and to allow the thousands of ‘legacy’ products that loiter on the industry’s books to be systematically wound up.
Investment costs are not all bad
So far we have concentrated on the ‘bad’ costs in super, which predominantly relate to administration inefficiencies. The other main area of costs is investment fees. While all members incur investment fees, they are less obvious than administration fees because, rather than being a direct charge to their accounts, they come out of their investment returns.
The important point about investment fees is that the level of fees that any individual incurs is generally something they can control. That is because fees depend largely on how the money is allocated – which investment sectors and in what proportions – and almost all funds offer a range of investment options that members can choose from. Each option has a distinct asset allocation and risk/return profile and each carries a different fee. The most conservative options are generally the cheapest, and the higher risk and higher return options the most expensive. Admittedly, most people don’t exercise their choice, opting instead for the fund’s default option, but they could.
Looking again at Chart 1
, we can see that the industry funds’ investment fees are the highest of the three categories. This comes as a surprise to some people, but it shouldn’t. Chant West has regularly reported that industry funds invest a much greater proportion of their assets in unlisted, alternative assets than retail funds do. These investments are more expensive to manage than traditional assets, and so industry funds’ investment costs are relatively high.
Has this been a bad thing? Certainly not if you have been a member of an industry fund during the past ten years. What you care about is the investment return you receive net of fees, and on that score industry funds have served their members very well.
Over the past decade, industry funds as a group have maintained a fairly consistent performance gap of between 1% and 1.5% per annum over their retail fund rivals – and that is after investment fees and tax. More recently that gap has shrunk and then reversed as listed assets have recovered from their GFC-induced slump. But over the longer term we still expect industry funds to outperform, mainly because their strong cashflows and the passive nature of their memberships allow them to take a longer-term view of their investments with less concern about immediate liquidity. And because of the wider spread of their investments, they are also likely to produce less volatile returns.
So again, we see a situation where members are actually better off paying higher investment fees, because by doing so they are likely to end up with a better investment outcome.
Nothing is static in super, of course, and Chart 3
shows the trend in investment fees since the introduction of choice in 2005. The most obvious change is the increase in industry fund investment fees, which have risen by almost 50% over the period. As explained above, this is largely due to them allocating an increasing part of their portfolios to unlisted alternative assets including infrastructure, opportunistic property, hedge funds and private equity, which carry higher fees than traditional shares, bonds and core property.
Retail funds’ investment fees have changed little over the period. If anything they have fallen slightly, which may be attributed to their increasing scale and bargaining power and perhaps also to some trimming of their profit margins. While they have followed industry funds, to some extent, in increasing their allocations to alternative assets, they still tend to prefer liquid (ie listed) securities. While this might result in slightly lower fees, it also deprives them of the illiquidity premium that industry funds are seeking in the returns from their unlisted investments.
We hope that this article demonstrates the folly of assuming that low fees per se is a vital objective, or that a low cost fund is in some sense superior to a higher cost fund. Of course, if two funds produce identical returns and provide identical services then the one with the lower costs is to be preferred, but that simply doesn’t happen in the real world.
The best service the industry can perform for consumers is to be open and honest in disclosing fees and to make it easy to understand which fees relate to which service – administration, investment or advice. And the best service the Government and its agents can perform is to allow free competition to operate and – above all – to remove the obvious roadblocks that prevent the superannuation system from being more efficient than it already is.
The issues raised in this article, together with other matters relating to the operation and efficiency of the Australian superannuation system, are dealt with in more detail in Chant West’s submission to the Super System Review (the ‘Cooper Review’) which is available in our Research Papers.
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