Superannuation

In this draft report, the Commission has proposed criteria to assess whether, and the extent to which, the superannuation system is efficient and competitive in delivering the best outcomes for members.

The publication of these criteria is intended to provide transparency and certainty to the superannuation industry about how it will be assessed in the eventual review of the efficiency and competitiveness of the superannuation system.

The Australian Government has stated that the Productivity Commission will be asked to undertake this system-wide review following the full implementation of the MySuper reforms (after 1 July 2017) (figure 1).

The Commission has proposed assessment criteria and corresponding indicators for the superannuation system. The system is bigger than just the superannuation funds (the industry). It encompasses many horizontal and vertical relationships on the supply side, decisions of members on the demand side, and actions of regulators on both the supply and demand sides. The unique features of this complex system are discussed in chapter 2.

There is little precedent (including internationally) for what this study is trying to do, or for the ultimate assessment itself. Most studies of the efficiency of the Australian superannuation system have focused on operational efficiency and matters that readily lend themselves to measurement (such as returns and fees).

The system-wide perspective is unique and makes this a challenging task. The Commission encourages readers to keep this system perspective front and centre in their thinking as they consider the proposed assessment criteria and indicators.

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This draft report does not contain findings or recommendations. However, the Commission welcomes feedback on all aspects of its proposed assessment approach. The Commission is particularly keen to receive feedback on the draft criteria and indicators. The criteria are summarised in table 1; the full set of criteria and indicators are set out in chapter 7.

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The Commission's approach in this study (stage 1) involves three steps (figure 2):

1. Defining system-level objectives — what is the superannuation system trying to achieve?
2. Formulating assessment criteria based on these objectives — that is, the performance standards by which to assess if the system-level objectives have been achieved.
3. Identifying indicators and other evidence to facilitate the assessment.

What are the objectives of the superannuation system?

What is efficient ultimately depends on what you are trying to achieve: the objectives of the superannuation system (chapter 4). The Australian Government recently announced that the objective of superannuation is 'to provide income in retirement to substitute or supplement the Age Pension'.

The Government's objective is framed within the principles of fairness, adequacy and sustainability, and casts superannuation as only one part of the broader retirement income system. Retirement incomes are a function of many factors outside the influence of the superannuation system (such as government policy).

The Commission has therefore developed system-level objectives that are within the scope of influence of the superannuation system, are specific to the principles of competitiveness and efficiency, and link back to the overarching objective set by the Government.

Broadly speaking, the system-level objectives target the best interests of members. Competition in the superannuation system is not an end in itself, but an intermediate objective insofar as it drives more efficient outcomes for members.

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• Proposed system-level objectives

  • The superannuation system maximises net returns on member contributions and balances over the long term.
  • The superannuation system meets member preferences and needs, in relation to information, products and risk management, over the member's lifetime.
  • The superannuation system provides insurance that meets members' needs at least cost.
  • The superannuation system complements a stable financial system and does not impede long-term improvements in efficiency.
  • Competition in the superannuation system that drives efficient outcomes for members.

Developing the assessment criteria and indicators

Formulating assessment criteria involves identifying attributes that a competitive and/or efficient superannuation system would be expected to have (chapter 3). As such, they are closely linked to the system-level objectives.

The Commission has taken current policy settings as given when developing the assessment criteria. This is done either by omission (the Commission is not proposing to assess the system on what is outside its influence, such as the overall adequacy of retirement incomes), or by recognising the influence of external factors when proposing criteria and in interpreting particular outcomes.

The Commission's proposed assessment approach relies heavily on benchmarking. The term 'benchmarking' is used broadly: performance will be benchmarked against others (for example, other funds or countries); against stipulated objectives (for example, an 'efficiency frontier' or a market benchmark); and over time.

In some parts of the assessment, the Commission will complement its benchmarking exercise with a 'negative test' — an examination of the barriers that may be impeding the efficiency and competitiveness of the superannuation system (such as barriers to entry).

The Commission will rely on a large number of indicators to facilitate collective assessment, along with evidence-based interpretation and judgment. This will include input and process indicators, output indicators, behavioural indicators and outcome indicators. Some indicators will be quantitative while others will be qualitative.

Some of the proposed indicators may be ambiguous and cannot be interpreted in isolation. Robust evidence and judgment will be required to interpret the meaning of each indicator. In some cases, this meaning may only surface in the presence of other indicators. This means that the indicators need to be considered and interpreted collectively to inform the assessment.

The interpretive narrative for the indicators is a role for the stage 3 review, although some elements will emerge in this study through the exercise of simply considering indicators.

The Commission has erred on the side of being as comprehensive and specific as possible with the indicators proposed in this draft report. The Commission welcomes feedback on whether the indicators are measurable and any material interpretation issues. Table 2 provides an example of the types of indicators proposed for two similar criteria.

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The Commission is proposing two complementary approaches to assess the nature and extent of competition in the superannuation system:

• a 'structural' assessment of the market, which evaluates whether the conditions within the market are conducive to competition
• an 'outcomes' assessment, which focuses on actual conduct and outcomes, and tests whether these are consistent with what is expected in a competitive market.

The second element in particular is necessary to keep the focus of competition on improving outcomes for members.

Structural assessment of the market

The Commission proposes to assess whether the current market structure is conducive to rivalry between incumbent providers of services. Measures of market concentration are often used to assess the degree of rivalry.

However, such measures can be ambiguous (for example, high concentration can be a consequence of economies of scale realised due to competition). Therefore, an indicator of market concentration needs to be accompanied by robust empirical evidence on how outcomes have changed following changes in market concentration.

The Commission plans to assess the contestability of the market by looking at barriers to entry and exit. There are two main barriers to entry that can give rise to incumbency advantages in superannuation: default fund status and vertical/horizontal integration.

• Defaults are an important policy feature of the superannuation system, and will be taken as given. The relevant assessment therefore is whether the process of selecting defaults is contestable and competitive.
• Vertically and horizontally integrated entities often benefit from access to well-developed distribution channels and economies of scope. While being a barrier to entry, this may not necessarily be inefficient. Concerns would arise, however, if this integration led to anticompetitive behaviour.

Traditional assessments of competition tend to end here (the supply side). However, the Commission's assessment will extend to the demand side (the member side, including their intermediaries).

The Commission considers that some level of member engagement is required to signal preferences, and to ensure that the benefits of wholesale-level competition flow through to the member. However, the quality of decision making is the ultimate goal.

Measures of member engagement need to be accompanied by consideration of financial literacy and how (and what form of) member engagement relates to better outcomes. The Commission has proposed a number of criteria and indicators to assess the level of member-driven competitive pressure (chapter 5) and welcomes feedback on these.

Assessment of conduct and outcomes

Product proliferation, high advertising expenditure, competition on irrelevant non-price (non-fee) aspects and high search costs are potentially signs of unhealthy competition. In contrast, in a market where competition is facilitating efficiency, funds would compete on factors that are relevant to members, which are most often fees and returns.

The Commission plans to assess whether there is a high degree of competition on costs, and whether there is a decline in costs and subsequently fees charged to members over time.

There is a need to consider fees in tandem with other features that members value (such as returns and service quality). But in the long run, and as other markets have consistently demonstrated, it is possible to achieve both lower prices (or in the case of superannuation, lower fees) and higher quality.

Economies of scale have been identified as a potential source of efficiency in the superannuation system, and competition is a key way to realise economies of scale. (Scale can also be achieved from exogenous growth in the system due to regulatory fiat.)

The Commission will assess (in stage 3) the magnitude of unrealised scale economies and the extent of pass-through of benefits of economies of scale to members. Further details on the proposed measurement approach can be found in chapter 5.

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The Commission is proposing criteria that span all three aspects of efficiency: operational, allocative and dynamic. They also cover the three phases of superannuation: accumulation, transition and retirement. Standalone criteria are proposed for insurance within superannuation. Further information on the efficiency criteria can be found in chapter 6.

The proposed assessment criteria rely heavily on quantitative benchmarking using historical data — an ex post assessment of efficiency. Assessments of current and expected efficiency are facilitated using qualitative indicators.

The assessment of efficiency will sometimes draw on the same indicators used to assess competition (as can be seen in the example in table 2), as the two often go hand-in-hand.

Maximising net returns (after fees and taxes) is the most important way in which the superannuation system contributes to adequate and sustainable retirement incomes. The Commission will focus on assessing system-wide long-term net returns, and compare them to various benchmarks.

The assessment will also be applied to particular segments (for example, institutional superannuation funds and self-managed superannuation funds), where it can provide insights about system-wide performance.

The Commission plans to take a straightforward approach to risk adjustment by benchmarking net returns at the asset-class level and by comparing net returns among products with similar risk characteristics.

A related criterion is whether the system minimises costs and fees, since higher fees will reduce net returns, all else equal. The Commission also proposes to assess whether there are any institutional or market impediments to investment in upstream capital markets (for example, is fund size an impediment to investing in certain asset classes?) that may be leading to higher costs and/or lower returns.

Assessing whether the superannuation system achieves allocatively efficient outcomes is impossible, given the wide variation in individual members' circumstances and preferences. However, the Commission will assess whether inputs and behaviours in the system are consistent with allocative efficiency.

For example: are funds collecting information on their members and using it to design products that better meet member needs? Are funds using lessons from behavioural finance to help members make better decisions? The assessment will rely significantly on qualitative and case study information.

The Commission's assessment of efficiency will potentially have to consider trade-offs between short-run operational efficiency and long-run dynamic efficiency.

For example, a high degree of competition and lean margins may increase the risk of entity failure that affects stability and confidence in the system. Therefore, the Commission also proposes to assess the extent of systemic risks in the superannuation system.

Transition and retirement phases

The transition and retirement phases have not received as much policy or market attention as the accumulation phase of superannuation. And yet this is when members typically have the largest balances and the efficiency of the system comes to the fore.

While some in the system are now focusing more on these phases, the Commission plans to assess whether the system is meeting the needs of members during these phases, including via product innovation that addresses tax effectiveness, transition and longevity risks.

Insurance

The cost of insurance held through superannuation detracts from retirement balances and ultimately retirement incomes. However, policy dictates that life and total and permanent disability insurance are bundled with superannuation on an opt-out basis in default products.

Given this constraint, the Commission plans to assess whether trustees are offering the most appropriate insurance for their members, and whether the costs of insurance are minimised for the type and level of cover provided.

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Assessing the efficiency and competitiveness of the superannuation system will be data intensive. Some data relating to the assessment criteria and indicators are already publicly available.

Other data have been collected, but have not been made public. And in some areas, the data simply do not exist. Chapter 7 discusses data needs and availability in more detail.

The Commission's guiding principle for the ultimate assessment in stage 3 will be to draw on data that are already collected from the system as much as possible. This includes regulator data as well as data held by the private sector.

New data will be sought only where it is feasible to collect within the short-to-medium term and the benefits of collection are likely to exceed the costs.

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