Sizing Up
Why scale and a passion for excellence matter to Australian funds and the retirement security they provide.
By Leo de Bever
Super funds exist for one purpose only: growing member savings into as much retirement income as possible in the long term while controlling the risk of losing capital in the short term. But there is currently a sizable gap between current practices and what Australian funds would be like if they adopted the best features of the better international funds—notably, efficient scale and an independent governance model that fits the fund’s investment goals.
The history of long-term bond and stock market returns gives us a good fix on the returns that are achievable. One could invest everything in safe long-maturity government bonds and earn 2% above the Consumer Price Index. At the other extreme, one could put everything in equity market index funds and earn an extra 4% per year in the long run (i.e., 6% above inflation instead of 2% above inflation). To put the difference in perspective: every 0.25% of annual return increases a member’s annual post-retirement income by 10%.
The problem is that equities are volatile. They can do much better than expected for many years, as they have in Australia over the last five years, but they can also have long periods of low annual returns. Over 20 years or more, equities will almost certainly perform better than bonds. However, since putting all of one’s eggs in the equity basket may not be wise from a diversification perspective, super funds typically keep equity allocations at 60% to 75% for working members and less than 50% for retirees. This strategy lowers the incremental annual return on taking equity risk from 4% down to 2.5% to 3.0%. Net of approximately 0.2% for implementation and oversight, that’s about the maximum value that taking risk in equity markets can deliver for plan members.
There is always the hope that one can improve on this return through active management and the magic of alternative assets. But the fact is that two-thirds or more of Australian and international wholesale retirement funds cannot deliver stock and bond market index returns on their asset allocation after expenses, and the bulk of retail funds in Australia and elsewhere typically do worse. Two main reasons stand out: one, the way the investment process is organized adds more costs than return, and two, the cost of plan governance, marketing, distribution and account administration is high.
Costs are, in part, a function of plan size. Being bigger does not guarantee being better, but in money management, the absence of size means reduced opportunity for efficiencies of scale. Running an investment program for a fund with less than $1 billion in assets can cost in excess of 1%. By the time you get to $40 billion, 0.5% is easily achievable and at $100 billion, costs can fall to 0.2%.
Size brings with it the financial capacity to employ a larger and more qualified internal staff, and to create a better mix of external and internal management. Good internal managers paid at commercially competitive rates can be very cost-efficient. External management has its place, but it is generally very expensive.
Greater internal management depth also creates the opportunity for a better balance between board oversight, and management design and implementation of the investment strategy. The process becomes much easier when the board is independent and the board membership selection criteria are based on the ability to contribute to the outcome of retirement security.
Smaller funds also have difficulty paying the largely fixed cost of portfolio management systems, risk systems and client account management software. Systems may not be very glamorous, but they can make a big difference by giving management and investment professionals a better understanding of where the money is, what the real exposures are and what can be done to further coordinate the efforts of individual managers. Poor cash management alone can easily subtract 0.25% to 0.4% per year from the total return.
A subtler link between scale and results is the capacity it creates to pursue strategies that take advantage of size and management depth. Larger funds are able to respond faster to large opportunities best suited to a fund with a long-term investment horizon— opportunities that require significant amounts of cash and patience.
So, what are the obstacles to creating a better fund industry? To be fair, industry funds have recognized size as an issue, and many accept that the consolidation to date has been insufficient. There is an urgent need for a few $100 billion units—or, barring that, to outsource the investment process to a jointly owned organization that can speak for $100 billion. Size holds the greatest advantage in areas such as infrastructure (because it is easier to control larger transactions) and private equity investing (because it makes you a more attractive partner).
As always, some of the obstacles relate to pride in the history of individual funds and the interests of existing board members. It is not easy to accept that voting to consolidate— and, by implication, relinquish one’s board seat—is a move toward the common good. But it may be what’s best for clients’ pensions.
Leo de Bever recently left Victorian Funds Management Corporation in Australia to become chief executive officer of Alberta Investment Management Corporation. leo.debever@aimco.alberta.ca
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© Copyright 2008 Rogers Publishing Ltd. This article first appeared in the August 2008 edition of BENEFITS CANADA magazine.
