As the Australian superannuation funds evolve and get bigger they face a question of whether to copy the organisational structures of their bigger, more sophisticated Canadian counterparts, or find their own way that more adequately befits some of their unique features and better serves members. Amanda White looks at the Australian superannuation market evolution and what it can learn from Canada.
The Canadian pension fund market, with its concentration of large, sophisticated, governance-first, internal investment-driven funds, has been a pinup for other markets as their own pension systems mature.
In Australia, a raft of regulatory and market forces has resulted in fast-paced consolidation of superannuation funds and a vastly changing market. It is only natural that as the funds mature they look to their Canadian counterparts for clues on what happens next.
The number of superannuation funds in Australia has fallen from 185 in 2014 to 97 in 2022 and, like the Canadian market, assets are now concentrated in only a handful of very large funds. Five funds in Australia have assets of more than $100 billion, compared to only two funds five years ago, and they make up 34 per cent of the A$3.4 trillion market. More than half of the superannuation system’s assets overall reside in just 16 funds, each with assets of more than $50 billion.
As the Australian marketplace goes through these changes at a rapid pace, it gives pause to ask whether big is necessarily better, whether members are better off, and whether these funds have the essential organisational structures and technologies necessary for success.
New research by Geoff Warren and Scott Lawrence, Do Superannuation Fund Members Benefit from Large Fund Size? importantly puts the fund members at the centre of the conversation. The paper looks at the advantages, disadvantages and challenges of Australian superannuation funds operating at large size. Their conclusion: it is not fund size per se that matters, but how size is used.
The authors are keen for the Australian conversation to shift away from the “size is good” mantra towards a keener focus on ensuring members benefit from increasing concentration. The paper suggests particular attention needs to be paid to whether the boards and management at the large and growing funds are establishing the capabilities to succeed at size.
“Implementing effectively at scale is the key,” Geoff Warren, research director at The Conexus Institute, says in an interview with Top1000funds.com.
Big is better, Canadian-style
It is commonly accepted that there is a size pay-off when it comes to institutional investment.
The consolidation of 89 local government funds in the UK into eight pools is a recent example of success, with the pools driving hundreds of millions of pounds in cost savings, access to better investment opportunities, and better returns. One fund alone, the London Pension Partnership has saved £113 in costs million since inception in 2016.
Toronto-based CEM Benchmarking has long researched the benefits of scale among pension fund clients, with analysis of its database of large asset owner cost and performance data revealing larger funds add value over smaller ones. CEM says the advantages of scale most prominently manifest in the ability to implement private asset strategies internally, resulting in lower fees.
Instead of going through fund of funds or even co-investments, having large internal teams means funds can go direct, which not only decreases costs but increases the chance of higher returns. CEM says that the median costs of internal management for private equity is 25 bps, while externally it is 165 bps.
Internalisation also gives teams more flexibility. Typically, the governance structure of funds with large internal teams have more delegated authority to make decisions allowing for more flexibility with allocations and faster decision making in response to markets.
The Canadian funds do all of these things. They are not just big, they are also sophisticated. They have supreme governance models with clear delegated authority. They have large, highly-paid internal teams with the best technology in place for trading, portfolio analytics, risk management and portfolio completion. And importantly, they invest a significant portion of their assets in direct private markets. Investments are managed with a total portfolio approach, and a key factor in their success is how the funds allocate nimbly right across the capital structure.
Ontario Teachers’ Pension Plan, for example, has generated a total-fund net return of 9.6 per cent a year since the plan’s founding in 1990. It has always been actively managed, with more than 80 per cent of assets in-house. And the governance structure, and the delegated authority, means it has an ability to be agile. (See OTPP: Positioning the fund for the next decade)
CPP Investments, known for its total portfolio approach is conducting a study on its best organisational and investment design as it approaches $1 trillion of assets.
Chief investment strategist at CPP Investments Geoff Rubin who is leading the project says funds of enormous scale will require a new cross-disciplinary approach, and innovative incentive and rewards schemes to foster the organisational culture needed as it looks to move beyond a total portfolio approach to a “one-fund” approach. (See $1 trillion funds need new incentives and investment styles)
With the large internal teams, access to direct deals and complicated organisational structures with big budgets, payrolls and technology spends, also comes larger executive compensation packages that require well thought out incentive plans and can cause complicated communication issues with stakeholders. (See OTPP makes paying well pay off)
Funds need to grapple with all these issues as they mature their organisational design.
Australia’s unique challenges
The Australian funds, it seems, are trying to replicate the Canadian model, according to the Conexus Institute’s Warren.
But there are a couple of peculiarities in the Australian market that will prevent them from being successful in exactly the same way.
The defined contribution structure and the Your Future Your Super (YFYS) legislation, and its resulting performance test, both impact liquidity and constrain the ability of Australian super funds to invest in private assets the same way the Canadians have.
Australian funds, like the Canadians, were early investors in infrastructure but have much lower allocations to private equity and in total average around 30 per cent in private markets, compared to above 50 per cent for the Canadians.
As defined contribution funds, the Australian funds also have much higher member-servicing requirements.
“With DB funds you have one client; in DC you have hundreds of thousands, and you have to interface with them,” Warren says. “The Australian funds are the most expensive funds in the world and there is a reason for that.”
The Australian funds are the most expensive funds in the world and there is a reason for that.
Warren and Lawrence’s paper outlines how large size can bring efficiencies in administration and the delivery of member services to achieve economies of scale that may reduce costs as percentage of AUM, and deliver economies of scope that can lead to better services.
But it also points out that while larger funds can be beneficial for customisation – most relevant in retirement – size does not necessarily help deliver a personalised experience.
“We view enhanced capacity to deliver customised retirement income strategies as a significant advantage of large size, as funds move to meet their obligations under the Retirement Income Covenant,” the Warren and Lawrence paper says.
“Properly catering for the diverse needs of retired members will require a large shift in product structures at superannuation funds. Significant changes will be needed in the investment capabilities of funds, and the ability to dovetail them with drawdown strategies and longevity risk pooling where it is utilised. Funds of large scale will be most able to assemble the governance structures and resources to fulfil this transition.”
Building effective teams, going offshore
The paper says that to be effective, Australian funds need to develop an investment program that leverages the advantages of size. A key element of that is the capability to operate effectively in private markets.
Many large leading funds around the world have set up multiple offices. CPP Investments alone has nine locations. Canadian funds, and large Dutch funds, have offices in NYC, London, San Francisco, Singapore, Hong Kong, Mumbai, Luxembourg, Sao Paulo and Sydney.
Australian funds are starting to set up overseas offices and invest in their own structures, with AustralianSuper, the country’s largest fund, located in Melbourne, Shanghai, London and New York.
But still, the Australian funds are disadvantaged by their Australian head office locations that come packaged with a difficult time zone and a weaker dollar. The Australian funds are also competing against well-established brands in the guise of their asset-owner peers, and investment managers.
“There is an implementation challenge of taking an Australian fund overseas and maintaining the culture and competing for talent in a market for people who are good at what they do who may not buy into the purpose,” Warren says.
“There are challenges of salary, cost and coordination.”
Size also speaks to the complication of adding complexity to investments and organisational structure which may not translate to better outcomes.
“It is surprising that when you get bigger you might not get economies of scale as much as you think,” Warren says.
“As you get larger you add in more stuff like operating across all jurisdictions, back-office, regulatory regimes, as well as new teams. It’s a new layer of operations and complexity but doesn’t necessarily mean better results.”
Australian funds have the competitive advantage of a mandated system where fund flows are regular, guaranteed and large. But a danger as the portfolio gets bigger is a need to “fill it up”, but that comes with its own complexity, not the least of which is the ability of additional investments to add value.
Many of the larger funds globally, like CalPERS, gave up on hedge funds years ago because the value added at the total portfolio from those allocations was minimal.
“The degree of difficulty is high, and my gut feel is some Australian super funds will do well and one will stuff it up eventually, but the big thing will be how the management handles it,” Warren says, adding governance will be key.
“All stuff-ups have a governance issue behind them somewhere,” he says.
The paper’s authors acknowledge that the degree of difficulty in what the Australian super funds are trying to do is high: they are growing very quickly and transforming themselves from a cottage industry into professional, global investment organisations.
Warren says there’s a high chance funds will make mistakes.
“My sense is governance and culture is critical. Not only do you have to have the governance structure around it to make sure it works and people have the right responsibilities and accountability, but [also] that the culture is encouraging an approach where everyone is in it together to generate the best returns for members and they don’t break into silos.”
Warren says that as the Australian funds get larger there is a big opportunity to do something well.
Deploying large asset amounts, retaining flexibility and resilience requires bespoke operating models. With their unique challenges, Australian funds have the opportunity to create their own way, borrowing from their more-established markets, but tailoring for their own challenges.
The key, says Warren, is to implement effectively.
“Members might be better served if industry participants such as policy makers, regulators and the funds themselves start to ask whether operating models are being configured to succeed at scale, rather than pushing for size for its own sake.”
Disclaimer: Amanda White is a member of The Conexus Institute’s advisory board.