Cerulli: Australia’s DC pensions sector

Cerulli Asia Pacific Edge, October 2012

Defined contribution funds account for a significant chunk of Australia’s superannuation industry – one of the largest pension fund sectors in the world.

The norm in Australia is that 9% of every individual’s earnings are placed by their employer into a mandatory superannuation fund – a system known as the superannuation guarantee, which is scheduled to climb in an incremental series of increases to a goal of 12%. In most funds, the precise financial outcome is determined by market forces, and not guaranteed or pre-decided; contributions go into an individual’s account in the fund, the assets are invested, and earnings or losses are credited to the member’s accounts minus administration fees and sometimes insurance premiums.  This approach means that most of the industry is what would be considered defined contribution elsewhere in the world, although in Australia the term ‘accumulation fund’ is more common, and some definitions consider superannuation funds to be a hybrid between defined contribution and defined benefit.

Defined benefit funds – in which the member’s outcome is calculated based on a formula, set out in the trust deed, perhaps varying on number of years of service and salary near retirement – do exist in Australia, but they are a small part of the market and shrinking.

Official data shows us that defined contribution funds are dramatically larger than defined benefit; according to the Australian Prudential Regulatory Authority, in 2011 there were A$314 billion in defined contribution funds compared to $22 billion in defined benefit. But actually, the division is still more stark than this. APRA considers a further A$453.3 billion to be hybrid funds demonstrating both defined benefit and defined contribution characteristics, but Cerulli contends they are far more tightly defined in terms of contributions than outcomes, and fit more naturally with the DC camp. The APRA data does not include any funds under its supervision with less than four members, which means that the vast and growing self-managed sector of the industry is omitted; they, too, are very much in the defined contribution mould, with outcomes entirely reliant on market forces.

The delineation is going to continue. Since roughly 1995, the trend has been for an increase in the assets of accumulation or hybrid funds and a decrease in defined benefit. Back in September 1995, defined benefit funds accounted for 19% of the whole superannuation market; by 2004 it was down to 4%, and has continued to slide ever since.

Those defined benefit funds that do remain tend to be public sector funds – anecdotally, about three quarters of them are – and their steady decline reflects the decline in importance of public sector funds themselves (and corporate super funds too) at the expense of retail, industry and self-managed super funds. Ever since the Choice of Super regime came into force in Australia in the mid-2000s, allowing investors a greater degree of choice in where they put their retirement savings, this divide has become still more marked, with industry funds and self-managed super funds – pretty much all of them DC or hybrid – making the biggest gains.

Why? For one thing, the burden on the defined benefit trustee has become too exacting over the years. As elsewhere in the world, a trustee in an Australian defined benefit fund must make sure the fund is able to pay the benefits through actuarial calculations which then set the level of contributions that must come from the employer; the employer then bears the investment, expense and other risks.  As compliance requirements have become steadily more onerous, and the penalties for breaching them more severe, most companies simply have better things to do with their time and have found it more time- and cost-effective to outsource superannuation to commercial or industry fund providers who tend to follow defined-contribution models.

The trajectory for the super fund industry generally is very clear: steadily upwards, reinforced by the mandatory contributions. By March 2012, the Australian super fund industry had A$1.376 trillion under management – well above pre-financial crisis levels. Market reversals can generate temporary declines in the scale of the industry, but they never last, driven by the sheer weight of money coming in.

A closer look at some of the industry leaders illustrates the point that this is, to a large extent, a defined contribution industry. In the top 10 [see top 10 superannuation funds by AUM] eight are hybrids and only two – Colonial First State FirstChoice Superannuation Trust and The Universal Super Scheme – are considered defined contribution under APRA’s definition, but there is very little difference in approach and structure between these and the biggest in the industry, including the AMP Superannaution Savings Trust and the industry fund Australian Super. All the industry funds in the list – Unisuper and Retail Employees Superannuation Trust (REST), for example – are considered hybrids rather than DC, but the fact is these funds involve pre-set inputs for an undetermined output, and are in essence more DC than DB.

There’s no reason, regulatory or tax, for this to change. When it comes to the outcomes in Australia, the norm is to roll one’s superannuation savings into another vehicle entirely, such as an annuity, allocated pension, or some other investment structure compliant with Australia’s complex and onerous tax codes. There are more and more providers who can do both things for you – a super fund while you’re saving, a retirement product when the time comes – and there are efforts to make the movement between the two more seamless. But in the fund accumulation stage itself, the model today is the way things are going to stay.

That’s not to say that there aren’t changes coming to superannuation in Australia – there are, and big ones. The pending arrival of MySuper will drive the creation of simple, low-fee, balanced products which will become the default product for most Australians. But the innovations in this technique are not so much in a shift in model, but in fee structures and the underlying assets that provide the return – for example, ETFs are likely to be an increasingly important part of super funds.

So how do Australian accumulation-style funds look, and does this leave room for greater foreign engagement?

A look at the investment objective chart below shows that equities continue to dominate Australian investment portfolios, but that the proportion has dropped steadily since 2006 at the expense of cash and deposits (a function of the uncertain investment environment over the last five years) and to a lesser extent alternative assets.  Historically, Australians have tended to favour home investments – there was a period of a decade when Australian equities outperformed international equities, in Australian dollar terms, every year – but as the sheer scale of the superannuation industry has grown, it has become impractical to have so much of the asset base invested domestically. This is partly a function of necessity and partly a sense that proper diversification is sensible.

This, then, is where the opportunity for foreign managers remains: giving super funds access to international equities, debt and alternative assets. Specialism is useful: the sort of managers who have typically captured the interest of Australian institutions are names like Walter Scott, the Edinburgh-based boutique, who carry a very clear focus and have something of a cachet of being exclusive. Many international private equity funds – and not just the big ones – have also attracted interest from Australian super funds, while anyone who can provide good exposure to international infrastructure, whose time horizon so closely matches that of a pension fund, will find a receptive audience.

And is there any money in it? With MySuper, a typical super fund fee is going to be just 1%. That doesn’t leave a lot of room to pay a big fee to underlying managers. However, it’s not necessarily as bad as it sounds; it is expected that much of these funds will be made up of passive low-fee assets, with a bigger spend on risk around the edges. That leaves room for global passive managers (Vanguard, State Street and Russell have long been successful in Australia) and for more focused, high-conviction managers chasing smaller ticket sizes for a higher fee. On the plus side, when one has a mandate for a super fund, there’s no further need to worry about distribution; the marketing engine of the top commercial and industry funds is sophisticated and bullish.

Our final chart shows our projections for the superannuation industry over the next five years; it speaks for itself and illustrates why, no matter how tight the fees, there are good reasons for international managers to be marketing themselves to Australian superannuation funds.