The FSI’s Interim Report acknowledges that superannuation has become a critical part of the economy. As a result, despite the outcomes of the Cooper Review having only recently been completed (as in the creation of MySuper products) or still being worked through (as in measures such as portfolio holdings disclosure), the FSI raises important questions and seeks further information about a number of key superannuation issues including fees, liquidity, retirement income and borrowing. Each of these issues presents distinct policy paths for the FSI to select.
Fees and charges
The FSI is critical of the level of fees paid by superannuation members. It noted that the operating costs of superannuation funds in Australia are among the highest in the OECD and considers that there may be scope for greater efficiencies in the superannuation system.
The debate about fees in superannuation is not a new one, and was a primary theme of the Cooper Review. The result of the previous debate was threefold; the development of a simple “no bells and whistles” MySuper product, the SuperStream measures to reduce back-office administration costs and the new trustee duty to promote the financial interests, in particular, the net returns, of the MySuper members. While the FSI considers it too early to assess whether these reforms will achieve their objectives, it is seeking submissions on the costs, benefits and trade-offs of whether to retain the current arrangements and review the effectiveness of the MySuper regime in due course, or whether to introduce new measures to reduce fees, such as holding “fee auctions” for default fund management.
So, in summary, the fork in the road seems to involve a choice between:
Path 1 - introduce new measures to regulate fees or which are intended to drive them down. This might lead to the adoption of structures where fund trustees look to derive non-fee benefits in order to keep the headline fee rates low. Equally, fund trustees might seek to reduce headline fee rates by increasing charges for specific services and transactions.
Path 2 - would involve a wait and see approach, to allow a proper evaluation to be made of the effectiveness of the MySuper regime in bringing fee levels down.
Liquidity and portability
Another area of concern considered by the FSI was the demand for liquid assets by superannuation funds. For example, liquid assets are needed enable the super fund to make benefit payments and transfer benefits to another fund (or another investment option). However, the level of liquid assets can affect returns. The FSI rejected the idea of a liquidity facility being offered by the Reserve Bank, but is seeking submissions on whether to introduce more flexible portability rules.
Interestingly, the portability rules have already been relaxed in response to the Cooper Review, and it is now possible for funds to offer illiquid investment options so long as there is prior disclosure to investors before they invest. There has only been limited take up of this, however, which suggests that competitive pressures and the difficulty of applying this regime to existing investors in an investment option may be hindering take up of this flexibility.
Path 1 - might therefore be to further relax the standard three day portability rule to allow greater flexibility in determining time frames for benefit rollovers. This may, however, be seen as a backward step given the strenuous efforts and significant costs already made and incurred implementing streamlined rollover processes under the SuperStream reforms, introduced as a result of the Cooper Review.
Path 2 – might be to maintain the current regime, however this could be enhanced by allowing trustees to introduce a non-standard portability timeframe for existing investors on the same basis as for new investors, on an opt out basis. In other words, rather than requiring disclosure before the investor selects an investment option, perhaps the law could be changed to also allow existing investors to be given prior notice of proposed changes to the portability period. This would be on the basis that they could rollover to another investment option if they prefer a more liquid option.
Retirement income reform and longevity risk
The interim report focuses on the fundamental imbalance in the superannuation system: a surprising lack of choice of products tailored for the post-retirement phase.
On reaching retirement, Australians primarily have a choice between two retirement options:
- Account based pensions that allow retirees to select an investment strategy, to draw-down as required (subject to prescribed minimum annual payments) and to make lump sum withdrawals at any time. These products are subject to longevity risk since the account may run out while the investor is still alive; and
- Annuities that address longevity risk by providing guaranteed regular income streams for life but which are less flexible as they typically do not allow for the income payments to be varied or for lump sum withdrawals.
Account-based pensions are currently the overwhelmingly preferred product type (accounting for 94 per cent of current pension assets according to the FSI). The FSI reasons that this dominance is the result of a perceived lack of value provided by annuities, and (perhaps more importantly) because individuals can rely on the age pension to manage longevity risk. In other words, the taxpayer effectively insures against poor financial decisions made by retirees in the post-retirement phase.
The FSI considered the spectrum of possible options to shift behaviour in the direction of longevity-protected products.
Path 1 - at one end of the spectrum - is the option of maintaining the status quo.
Path 2 – of compelling retirees to take some of their benefit as an annuity - is at the other end.
In light of the FSI’s statements, a recommendation in favour of either of these paths seems unlikely. The more likely option is a “middle path” involving the use of the tax system to create appropriate incentives and disincentives or the introduction of default options requiring a portion of the benefit to be applied to purchase annuities on an opt-out basis.
The FSI also points to certain policies as the key barriers to the development of an active market in annuity and other products offering protection against longevity risk. These included the current state of the law, the age pension means test and the requirement for multiple regulatory approvals before offering new products.
Hard on the heels of the FSI, the Government has now also released a Discussion Paper on the Review of Retirement Income Stream Regulation which discusses the main barriers to product innovation in this area and canvasses views on proposals to facilitate the offering of deferred lifetime annuities.
If, as now seems likely, the law will be reformed to provide greater flexibility in the design of retirement income products, this will present significant opportunities for industry.
Borrowing in superannuation
The FSI identifies the use of leverage in superannuation funds as a possible weakness in the current system and is seeking feedback on whether the general prohibition on borrowing should be restored on a prospective basis. If supported, this proposal would remove the current exemption that allows limited recourse borrowing under instalment warrant and like structures.
Maintaining the status quo on this issue seems an unlikely option given the concerns raised by the FSI.
Path 1 – may be to remove the limited recourse borrowing exemption. This option could prompt development of products that achieve gearing by synthetic means as opposed to borrowing.
Path 2 – may be to re-formulate the existing exemption perhaps by introducing leverage limits and removing some of the present complexity. This would be a welcome change, although there will likely be debate about the appropriate limitation.
The FSI also seeks further information on a range of other superannuation-related matters such as the benefits of lifecycle investment, the inclusion of benefit projections on superannuation benefit statements, the prevalence and impact of short-termism in superannuation and the debate about the merits of active vs passive investment management.
There is clearly scope for reforming the law to make it easier for funds to provide benefit projections. It is disappointing that the regulatory regime currently makes this so difficult.
The FSI’s treatment of self-managed superannuation funds (“SMSFs”) has understandably attracted a significant portion of popular attention. The Interim Report questions, for instance, the trend towards SMSFs and comments that poor financial advice may be the source of growth in that sector.