Chris Cuffe spoke recently at the Finsia Leadership Connect dinner, and this is an edited transcript of his speech.
The funds management industry is undergoing consolidation and evolving rapidly, under pressure to provide better service and high returns while cutting costs.
Total Australian superannuation system assets are around $1.7 trillion – spread between self-managed super funds, industry funds and retail funds – that’s around 100% of our GDP. Treasury forecasts suggest that super assets will grow to $8.6 trillion by 2040, which would represent around 200% of GDP. To reach this level, taking inflation into account, it would require a compound growth rate of about 6 to 7% per annum.
In a recent speech, Paul Keating suggested that the superannuation system returns that we’ve achieved to date are not going to be repeated in the future. If you have a system that’s reached 200% of GDP, it’s probably mathematically impossible to have returns of 4–6% above GDP growth. We are likely to see significantly lower returns from our super investments into the future. As Keating points out, perhaps we should be quite satisfied with receiving a long-term return equal to nominal GDP plus 1%.
Assuming investment returns become materially lower than over the past few decades, the level of fees charged to manage assets will come under increasing focus.
I think we will see a material downward trend in fees which are based on a percentage of funds under management (FUM). This is partly because industry funds are moving towards managing funds in-house due to their obvious economies of scale and consequent cost savings. Most big industry funds in Australia are non-profit (or perhaps better termed ‘profit for members’), and they only need to cover the cost of managing money, without trying to incorporate a profit margin. If these funds are growing bigger and need proportionately fewer staff for a given level of FUM, then the fees that a member pays for the management of their money will come down, and I see that as creating downward pressure on the whole industry. Put another way, we see one large segment of the industry that have a fee based on ‘cost recovery’ rather than a set ‘per cent of FUM’.
It is important to also appreciate that most industry funds are now ‘public offer’, open to anyone to invest in, providing head-on competition to for-profit retail funds.
Similarly, SMSFs don’t need a profit margin as they’re managing for themselves. While many trustees of SMSFs may continue to use managed funds, many trustees are happy to directly invest. So there’s downward pressure from this area as well. The SMSFs will continue to proliferate in my view, but possibly at a slower rate if the costs of having their money managed via external superannuation funds continues to come down.
There has been a lot of talk about lower costs arising from mergers and scale benefits with the introduction of MySuper but I’m not completely convinced about that. I’ve always thought that if you took commissions out of products (e.g. with the FoFA reforms) you would see more competition, and you might not need the MySuper reforms in order to get lower cost products as well. Certainly though, one good aspect of MySuper is making the insurance offering compulsory given the apathetic nature of many people.
But in investment management and superannuation generally, there are both economies of scale and diseconomies of scale. For example, in my view it’s very hard to manage an Australian equity portfolio that is larger than $5–6 billion and can still generate alpha, whereas if you’re managing a fixed-interest portfolio, scale is your friend. On the administration side of superannuation, people talk about ‘unlimited scale benefits’. I question that. I think you reach a point where you’ve probably got it to the lowest cost per unit, and from there you plateau or you have diseconomies.
The demise of defined benefits schemes
The demise of defined benefits schemes has been absolutely profound both here and globally, and I contend it has not been a great thing. In the Western World, the accountants forced market movements through the financial statements of the corporates underwriting the schemes. This was untenable for corporates, so DB schemes have been closed and most of the population is now in defined contribution schemes. But the defined contribution system around the world has focused ‘the system’ way too much on short-term investing, which has led to a lot of problems.
UniSuper has the largest open defined benefits scheme in Australia. The scheme used to share the same pool of assets as their accumulation balanced fund. Some years ago, they separated it and invested it differently, investing on the defined benefits side by matching the liabilities to get the right return, without regard to the rest of the market. Interestingly, each year now, the defined benefits scheme significantly outperforms the defined contributions side.
It is hard to unscramble the egg and create defined benefit schemes again, because no employer or government will want to be the underwriter. But I think the right scheme going forward is a hybrid scheme, where you have something that looks like a defined benefit scheme, but without an underwriter. That is, you have a pooling of risk rather than an underwriter of risk. I think Australia would be much better served by something like that. But ironically, that would mean turning the clock right back to the first funds that we had in Australia and many other parts of the world, which came out of life companies; they had reserves and would manage the highs and lows of the markets by smoothing investor returns.
Accumulation phase versus the retirement income phase
Although the baby boomers are now moving into the retirement stage, annuity funds are not very popular (and never really have been in Australia or overseas). I think the reasons are pretty obvious: the returns offered are unattractive because of the need for a profit margin, the need to price uncertainty and also to hold sufficient regulatory capital. There is also the risk that the commercial organisation isn’t going to exist in 20–30 years. There’s a problem with matching assets with liabilities in long-term funds where people need a retirement income for 30 years. You can’t easily buy a 30-year bond in Australia.
I think the Australian Government is extremely well placed to offer an annuity scheme, whether as principal or as guarantor, and could do so offering far superior rates to commercial operators. This is something that Paul Keating also believes in. In an article he wrote in Cuffelinks earlier this year, he said:
“A government-administered, universal, compulsory deferred annuity scheme would be a fully-funded scheme, with the capital provided by the annuitant from a portion of their lump sum superannuation benefit. This would mean that if there was any shortfall in the actual assets set aside and the liability due to the annuitant, the government would fund the gap. However, careful asset management with a long-term horizon should ensure that any such shortfall should, over time, be insignificant.”
To me, this has a lot of appeal and would be a strong encouragement for people to better fund their retirement.
A quick reflection on regulation and risk
Particularly post-GFC, I think the burden of regulation has been excessive and in the super industry we have completely bastardised the term ‘risk’. People use it in so many different ways, and it means different things to different people. What’s happened is that people have looked at the downturn in investment markets and called that ‘risk’, and regulators have wanted to put new rules around it. But you can never find the rules to solve investment risk; it’s just part of the game. After 30 years in investment markets, as I’ve learned more and more, I realise I actually know less and less. As time goes on, you figure out that you can’t get from A to B any quicker in terms of returns or the time it takes to generate these, but you just learn where the landmines are. The learning in investment management is really about doing things the right way.
This transcript originally appeared in Finsia’s INFINANCE magazine, December 2013 edition.