Australia: Scale, Strategy And Super Fund Boards: Merger Momentum Under Stronger Super

By Braydon Heape

The drive toward consolidation in the superannuation fund sector dates at least from the last big round of compliance changes in the middle of the last decade. This spawned the RSE Licence (a requirement from July 2006), and a host of ancillary regulations and prudential guides.¹ It is fair to say, though, that the enormous increase in superannuation fund mergers that this regulatory upheaval produced was not the result of an express policy, set out in legislation. It was simply the economic consequence of a very large ramping-up of compliance costs.

The latest round of changes, under the umbrella of Stronger Super ² are different in this respect. They are explicitly designed to promote economies of scale. For the first time, the regulatory regime will demand that trustee boards consider scale as part of their strategic focus. That is, economies of scale will now be a matter of success or failure for superannuation funds, not because good practice suggests that this should be so, but because the legislation now requires it.

The changes will be momentous for the structure of the sector and the strategy of trustee boards.

Whether a fund has sufficient scale will no longer be tested by a one-off event, but by a continuous and dynamic competitive process. This will require the constant attention of trustee boards. Their focus must shift from succeeding at an isolated compliance task to anticipating the moves of rivals.

In achieving success boards need to be clear about the obligations to be imposed on them. They also need to understand the costs of getting them wrong. For smaller funds, boards need to be realistic about the limited strategies they can now pursue to claw back ground from their larger competitors, who start the race for scale from a position of structural advantage.

The provisions in detail

The central legal provision in this regime is intended to be s 29VN(1)(b) of the SIS Act. ³ This provision requires that the trustee board determine on an annual basis whether holders of their basic product (a deliberately commoditised "MySuper" product, into which most employees will be required to be placed) are disadvantaged compared to such product holders in other funds. The board's assessment of disadvantage must consider:

• Whether the number of the fund's MySuper beneficiaries is insufficient.⁴
• Whether the number of the fund's beneficiaries as a whole is insufficient.⁵
• Whether the pool of assets in which the assets underlying the MySuper product are mixed is insufficient.⁶

However, other provisions support this obligation, including:

• The requirement for the board to include in the investment strategy for the MySuper product the details of the board's determination.⁷
• The general obligation of trustees to promote the financial interests of MySuper beneficiaries, meaning in particular the net returns of beneficiaries.⁸
• The requirement for each director to exercise a reasonable degree of care and diligence - at a professional standard - to ensure that the trustee complies with these obligations.⁹
• The right of a person who has suffered loss, as a result of breach of any of these obligations, to recover the loss against any person involved in the contravention.¹⁰

It is true that the Stronger Super changes, and in particular those falling under the Super Stream data and e-commerce component of the reforms, will also impose heavy compliance costs. In its recent paper on taxation relief to support the implementation of Stronger Super Treasury notes that the costs associated with the upgrade of systems may be substantial and are likely to influence potential merger decisions. ¹¹ The influence of compliance costs is not new, but it will of course be a powerful input into the board's scale determination.

APRA enforcement

The role of APRA in enforcing the requirements will obviously be critical. In this regard, the following additional elements of the Stronger Super regime are very significant:

• The gathering of fee, cost and net return information from funds in relation to their MySuper products by APRA, and the publication of this information quarterly.¹²
• The intention of APRA to review the sufficiency of scale requirement as part of its prudential supervision.¹³

The last point is particularly important. It is one thing for trustees to be subject to a focused requirement to consider the best financial interests of beneficiaries. It is another for trustees to be held to a standard of performance of the task by a structured process of appraisal, administered by a regulator that has access to detailed industry cost and performance information. ¹⁴ In a recent publication APRA noted:

"Under current legislative proposals, trustees offering a MySuper product will need to conclude annually that the product has sufficient scale to provide optimal benefits for their members.... As a clearer picture emerges of the requirements of MySuper and the heightened requirements of trustees, it is expected that fund mergers and successor fund transfers will remain part of the superannuation landscape for some time to come." ¹⁵

Against this background it is useful to consider more closely what trustee boards need to consider in making an assessment of the scale of the fund's MySuper product.

The determination of scale - what does "insufficient" mean?

What does it mean to determine whether a fund's beneficiaries or assets are insufficient for the purposes of s 29VN? As noted above, the overarching test has components that consider:

• the number of beneficiaries of the fund (both for the MySuper product and for the fund as a whole); and
• the asset pool in which the MySuper assets are invested,

in light of the financial disadvantage of the fund's beneficiaries, compared to beneficiaries of other funds.

The per-beneficiary scale test is presumably imposed because even the wealthiest superannuation fund beneficiaries will have account balances that are small in comparison to the fixed administrative costs of a public offer superannuation fund. Therefore the number of beneficiaries will be key to achieving appropriate per-beneficiary administration costs. ¹⁶ The number of these beneficiaries may then be insufficient because MySuper administrative costs can only be apportioned over these individuals' accounts. ¹⁷ Such costs may include:

• The costs of administering the special fee rules for the MySuper product.
• The costs of administering the MySuper product rules and requirements (including, presumably, the costs involved in making assessments for the annual determination of scale itself).

The number of beneficiaries of the fund as a whole will be insufficent where the typical administrative costs of the fund (relating to IT infrastructure, accounting, audit, and general compliance) result in per-beneficiary costs that are disadvantageous compared to beneficiaries of other funds that hold a MySuper product. Again, the key to assessing this part of the per-beneficiary test is whether fixed or "flagfall" costs or fees have been apportioned over a larger number of beneficaries, so that these costs have become relatively less significant.

In relation to the "assets" test, the asset pool in which MySuper assets are invested will be insufficient where it is inadequate to promote economies of scale in relation to the costs of investment and the investment opportunities available. Recent research makes it reasonably clear that there are significant economies of scale to be reaped in relation to investment costs and opportunities. In an APRA Working Paper published in March 2012, ¹⁸ Dr James Cummings finds that larger not-for-profit funds benefit from lower investment expense ratios. This is thought to be due to their ability to use their bargaining power to reduce the asset-based fees they pay to investment managers. Dr Cummings also finds that larger not-for-profit funds earn higher risk-adjusted gross returns than smaller not for-profit funds. This is consistent with their ability to make higher allocations to illiquid investments.

While the justification for the components of the scale determination emerge fairly clearly from the different cost and fee structures faced by trustees, what remains somewhat unclear is what the comparator "other funds" will mean in the board's determination of scale. Does this refer to the standard attained by the average of other funds, the median of such funds, or perhaps the bottom quintile?

The conservative approach would be for the board to start by ranking the cost and long-term net investment return performance of its MySuper product compared to all its competitors. This gives an objective index of the financial disadvantage of the fund's MySuper beneficiaries. Assuming the fund is not ranked in first place on both counts, the board is then required to determine whether the financial interests of beneficiaries have been affected (comparatively speaking) due to the insufficiency of its beneficiaries or assets.

On the basis of the APRA Working Paper research referred to above, it can be inferred with some confidence that fund costs and gross returns are affected by scale. However, for funds in the cohort of the largest superannuation funds the relative inferiority of performance attributable to insufficiency of scale will be much less significant. For these funds it will be easier to conclude that the disadvantage is not attributable to scale. Even if a determination is made that insufficiency of scale is a cause of relatively poorer performance, a board could justifiably conclude that the interests of beneficiaries would be promoted merely by competing harder to gain scale from other competitors.

However for superannuation funds amongst the cohorts of smaller funds the situation will be quite different. The APRA Working Paper research finds that the average notfor-profit fund in the smallest quintile has risk-adjusted net returns that are lower by 28 basis points per quarter (or 112 basis points per annum) compared to the average not-for-profit fund in the largest size quintile. ¹⁹ It will be very hard for the smallest funds to avoid the conclusion that their inferior performance is attributable to scale, and the making of such a determination is likely to have quite different consequences.

Strategies for acquiring scale

The obvious implication will be that such funds should merge with another fund to gain scale. There are of course a number of considerations to bear in mind in taking this course, including successor fund transfer requirements and the associated risks of transition. ²⁰ Some possible alternative options suggest themselves, however, at least for smaller not for-profit funds.

A strategy that is quite unique in the Australian superannuation industry ²¹ is to collaborate with other funds in joint ventures, with the objective of attaining economies of scale without paying third-party profits. This has relevance for both components of the scale test. Scalerelated cost reductions from operational and investment expenses account for close to sixty per cent of the increase in risk-adjusted net returns experienced by the largest not-for-profit funds, referred to above. ²² Therefore the perbeneficiary scale test might be addressed by collaborating in service ventures to reduce operational and investment costs.

Moreover, similar joint investment ventures might permit funds to achieve sufficiency of scale in relation to the pool of assets that they have available to invest. This may improve performance on the "asset" test, by giving funds the opportunity to improve gross investment returns.

It is possible that a collaborative strategy might allow smaller superannuation funds to compete in the area of scale economies in a way that allows them to succeed. However, planning for these ventures would need to be advanced fairly quickly in order to for them to be operational in the time frame required. It is already a requirement of the MySuper authorisation application that the trustee attach the policies and procedures by which it will make its scale determination. ²³ Also, collaborative strategies are not a costless panacea - they take time, management resources (including the cost of negotiation and joint administration), and the establishment of trust to work. Trustees of smaller superannuation funds clearly need to begin very quickly to assess whether these kinds of collaborative strategies can assist them.

Conclusion

The bottom line is that consideration of scale by trustee boards is now part of a continuing requirement, not the consequence of a one-off round of compliance costs. A standing requirement to benchmark against peers means that the need for scale is part of a dynamic competitive process. More so than ever before, real competition for scale has been introduced to the superannuation sector. The effects of this process on the structure of the sector and the strategy of trustee boards is likely to intensify in years to come.

Footnotes

¹ Under the Superannuation Safety Amendment Act 2004 amendments to the Superannuation Industry Supervision Act 1993 (SIS Act).
² See Stronger Super - Government response to the Super System Review issued on 16 December 2010 by the Hon Bill Shorten MP and Stronger Super Information Pack - Government decision on the key design aspects of the Stronger Super reforms issued on 21 September 2011 by the Hon Bill Shorten MP, both accessed at http://strongersuper. treasury.gov.au/content/Content.aspx?doc=publications.htm.
³ See Superannuation Legislation Amendment (Trustee Obligations and Prudential Standards) Bill 2012 (Trustee Obligations Bill).
⁴ Proposed s 29VN(1)(b)(i) of the SIS Act. The meaning of "insufficient" is discussed further below.
⁵ Proposed s 29VN(1)(b)(ii) of the SIS Act.
⁶ Providing the assets of the fund that are attributed to the MySuper product are to be pooled with other assets of the fund, or assets of another entity or other entities: proposed s 29VN(1)(b)(iii). If not, the assets supporting the MySuper product must be considered in isolation.
⁷ Proposed s 29VN(1)(c) of the SIS Act.
⁸ Proposed s 29VN(1)(a) of the SIS Act. It is possible to argue that this provision is the centrepiece of the new policy. But trust law has always required that trustees act in the best financial interests of beneficiaries. What is new is that this standard is given a disciplined focus that it previously lacked by the scale determination requirement.
⁹ Proposed s 29VO of the SIS Act.
¹⁰ Proposed s 29VP(3) and (4) of the SIS Act. Directors may therefore be personally liable where they fail to exercise sufficient care to ensure the trustee complies, or where they are otherwise involved in a trustee's breach of the requirements.
¹¹ Proposals Paper Taxation Relief to support the implementation of Stronger Super May 2012.
¹² Proposed s 13(4A) of the Financial Sector (Collection of Data) Act 2001 and s 348A of the SIS Act (see Exposure Draft Superannuation Legislation Amendment (Further MySuper and Transparency Measures) Bill 2012) (Further MySuper Bill).
¹³ Note APRA's September 2011 Discussion Paper Prudential standards for superannuation, at p 14. The Explanatory Memorandum to the Trustee Obligations Bill notes that APRA will also provide prudential guidance (at paragraph 1.27).
¹⁴ The ability of members to take proceedings does not alone satisfactorily resolve the principal-agent problems inherent in superannuation fund governance, as Justice Drummond noted in ASIC v Parker [2003] FCA 262 (at paragraphs [4]- [5]). Class actions may change this enforcement problem in a way that restores the importance of trust law's "beneficiary principle".
¹⁵ APRA Insight, Issue One, 2012, p 22 (emphasis added).
¹⁶ Some administrators charge for their services on the basis of a fixed "flagfall" fee plus a variable per-member component. In these cases it is easy to see that the larger fixed component declines in significance as the number of members increases, so that the per-member fee approaches the smaller variable component.
¹⁷ See paragraphs 1.23 and 1.24 of the Explanatory Memorandum to the Trustee Obligations Bill, and proposed s 99E of the SIS Act, which forms part of the Further MySuper Bill.
¹⁸ APRA Working Paper "Effect of fund size on the performance of Australian superannuation funds" March 2012 by Dr James Richard Cummings.
¹⁹ Above, note 18, at p 22.
²⁰ See APRA's letter to trustees of 28 February 2011, addressing relevant operational and governance risks of mergers and transfers. The relevant considerations for implementing a merger will be considered more fully in a future article.
²¹ APRA Working Paper "Australian superannuation outsourcing – fees, related parties and concentrated markets" 12 July 2010 by Kevin Liu and Bruce R Arnold. See also: " Is Pension Fund Collaboration Possible and Sustainable? Insights from Australian Experience" 31 March 2009 by Christine Brown and Kevin Davis (the authors have kindly granted permission to cite this draft version), accessed at http://kevindavis.com.au/secondpages/ workinprogress/Brown-Davis%20-%20Pension%20 Fund%20Collaboration-version%202-1.pdf.
²² Above, note 18, at p 28.
²³ APRA Application Form Authority to offer a MySuper product issued 3 May 2012.

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