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Associate Professor, Associate Dean Undergraduate Programs

Is your retail super fund shrinking your savings?

Analysis | 18 April 2018

Kevin Liu

Associate Professor, Associate Dean Undergraduate Programs

New research sheds light on why not-for-profit funds do better

In its continuing review of the competitiveness and efficiency of the Australian superannuation system, the Productivity Commission has clearly set out what is at stake.

"Small changes in the system can have a real impact on people's standard of living in retirement," it writes, in its terms of reference.

So it's timely that Kevin Liu, a lecturer in the school of risk and actuarial studies at UNSW Business School, and Elizabeth Ooi, a lecturer at UWA Business School, have been examining how superannuation returns are affected by the way different funds use related parties to help them manage their members' retirement savings.

Liu and Ooi's forthcoming paper, The Impact of Related-Party Outsourcing and Trustee Director Affiliation on Investment Performance of Superannuation Funds, forms the basis of their submission to the Productivity Commission's inquiry.

In their study, the authors examined the performance of 101 super funds between 2015 and 2016. They found sharply different results for the two main superannuation sectors – retail funds, such as those run by banks and investment companies; and the not-for-profit sector, including industry funds, corporate funds such as Telstra, and government funds.

Superannuation funds routinely outsource a range of functions such as administration, auditing and funds management.

In fact, it has become an indispensable operational component, leading the authors to note that "the heavy reliance on service providers implies that these external parties have a significant influence on the costs and performance of superannuation funds, and hence the investment experience of fund members".

'Even after controlling for asset allocation differences and risk, our results remain robust'
KEVIN LIU

Lower returns

Liu and Ooi considered the breadth of outsourcing by funds in five categories – administration, asset consulting, custodian services, insurance and auditing. Liu says they were unable to include outsourced investment management because most funds did not report investment management data at a sufficient level of granularity for empirical analysis.

While both retail and not-for-profit funds outsource, the researchers found that each does so in a different way. Not-for-profit funds predominantly use unrelated service providers, whereas retail funds tend to outsource to related parties.

Outsourcing by retail funds to related-party service providers has expanded considerably during the past decade, despite the introduction of enhanced trustee duties and new disclosure requirements as part of recent regulatory reforms.

According to the researchers: "The documented significant increase in related-party service provider usage in retail funds raises serious concerns about growing conflicts of interest in the retail sector and their detrimental impact on retail fund members' investment performance."

Superannuation funds are overseen by a trustee and for multi-member funds this usually takes the form of a trustee board, with between five and 10 members.

The researchers examined the extent to which different funds employed affiliated trustee directors, meaning they were either employed by the parent entity which owned the super fund, or sat on multiple boards of funds owned by the parent entity.

On average, 78% of retail fund trustee directors were affiliated. Further, more than 94% of retail assets and member accounts were managed by trustee boards dominated by affiliated trustee directors.

Next, the authors examined how related-party outsourcing arrangements and trustee director affiliation affected returns and found that those funds with more related-party outsourcing and affiliated trustee directors provided lower returns.

'As this business model is found to be significantly detrimental to retail fund members’ interests, it should be of preeminent relevance to the current Productivity Commission review' –
KEVIN LIU & ELIZABETH OOI

Captive boards

The researchers believe their work shows "more severe" conflicts of interest and a consequent underperformance is likely to occur with higher levels of trustee director affiliation.

And retail funds that are part of a conglomerate group are likely to be subject to more severe conflicts of interests and duties, which leads to more significant underperformance.

"Our findings further suggest that the profit motivation of retail funds leads to a particular business model where 'captive' boards dominated by affiliated trustee-directors tend to engage in a commercial endeavour through related parties to make a profit at the expense of fund members' interests," they write.

Liu says affiliated trustees often find themselves in a difficult position where they have to decide whether company shareholder profits or superannuation fund member benefits should take priority in making decisions.

If a director of a super fund is also a director of the parent company, the Corporations Act requires them to act in the best interests of their shareholders, but the SIS Act requires them to act in the best interests of the fund members. These may not always coincide.

The legislation states that wherever there's a conflict, directors should prioritise the interests of the members of the super fund above all others.

However, Liu says their analysis shows where trustees are affiliated, they are more likely to use a related-party service provider and that leads to underperformance.

The use of related-party service providers by retail funds is an inherent part of the business model of that sector. The aim is to maintain control of, and capture margins in, each of the functions in the value chain of their conglomerate groups.

"As this business model is found to be significantly detrimental to retail fund members' interests, it should be of preeminent relevance to the current Productivity Commission review in considering alternative default selection models and a relevant focus of any future governance and prudential reforms in the superannuation industry," the researchers write.

Robust results

Liu sees several possible reasons for the underperformance. Fund trustees may find themselves in a challenging position to negotiate outsourcing fees with related-party service providers and so are more likely to pay higher fees for their services than outsiders. Further, related-party service providers may not be monitored as closely.

And if the remuneration of a related-party director is aligned with the profit of the parent company, which could be their employer, and not with the performance of the super fund, then they are more likely to favour the parent company where there is a conflict of duty.

The researchers found that related-party service providers underperform their peers by 1.29% per annum at the total fund level. This can add up to a significant sum in the 40 years or so a worker may be saving for retirement.

Opponents of Liu and Ooi's research claim it doesn't take into account the 'liquidity premium' that industry super funds receive. That is, industry super funds receive large and predictable amounts of investment flowing into what are called default funds – those funds that workers' super contributions automatically go into if they haven't made a specific choice.

This is said to give industry funds an advantage, because they are able to make long-term investments in assets such as infrastructure, which typically perform well over many decades.

But Liu says this has been controlled for in the research analysis, which uses three types of investment return measures – normal return, value-added, and risk adjusted value-added (RAVA).

"The results are the same regardless of measures used (return, value added, or RAVA). This shows that even after controlling for asset allocation differences and risk, our results remain robust, and not influenced by the 'liquidity premium' issue."

As part of its review, the Productivity Commission will make recommendations to improve outcomes for members and system stability as well as on how to reduce barriers to the efficiency and competitiveness of the $2.5 trillion superannuation system.

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<h1>Is your retail super fund shrinking your savings?</h1>

<figure><img src="https://assets-us-01.kc-usercontent.com:443/4df0558d-5779-0012-00f2-b3fa06d6c950/32aa6680-0c48-41e4-a102-fc7fd8defe06/iStock-815643236.jpg?w=1320" alt="shrinking savings" /><figcaption>shrinking savings</figcaption></figure>
 In its continuing review of the competitiveness and efficiency of the Australian superannuation system, the Productivity Commission has clearly set out what is at stake.
"Small changes in the system can have a real impact on people's standard of living in retirement," it writes, in its terms of reference.
So it's timely that Kevin Liu, a lecturer in the school of risk and actuarial studies at UNSW Business School, and Elizabeth Ooi, a lecturer at UWA Business School, have been examining how superannuation returns are affected by the way different funds use related parties to help them manage their members' retirement savings.
Liu and Ooi's forthcoming paper, <a href="https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3123499">The Impact of Related-Party Outsourcing and Trustee Director Affiliation on Investment Performance of Superannuation Funds</a>, forms the basis of their submission to the Productivity Commission's inquiry. 
In their study, the authors examined the performance of 101 super funds between 2015 and 2016. They found sharply different results for the two main superannuation sectors – retail funds, such as those run by banks and investment companies; and the not-for-profit sector, including industry funds, corporate funds such as Telstra, and government funds.
Superannuation funds routinely outsource a range of functions such as administration, auditing and funds management.
In fact, it has become an indispensable operational component, leading the authors to note that "the heavy reliance on service providers implies that these external parties have a significant influence on the costs and performance of superannuation funds, and hence the investment experience of fund members".
<blockquote>
'Even after controlling for asset allocation differences and risk, our results remain robust'
KEVIN LIU</blockquote>
<h4>Lower returns</h4>
Liu and Ooi considered the breadth of outsourcing by funds in five categories – administration, asset consulting, custodian services, insurance and auditing. Liu says they were unable to include outsourced investment management because most funds did not report investment management data at a sufficient level of granularity for empirical analysis.
While both retail and not-for-profit funds outsource, the researchers found that each does so in a different way. Not-for-profit funds predominantly use unrelated service providers, whereas retail funds tend to outsource to related parties.
Outsourcing by retail funds to related-party service providers has expanded considerably during the past decade, despite the introduction of enhanced trustee duties and new disclosure requirements as part of recent regulatory reforms.
According to the researchers: "The documented significant increase in related-party service provider usage in retail funds raises serious concerns about growing conflicts of interest in the retail sector and their detrimental impact on retail fund members' investment performance."
Superannuation funds are overseen by a trustee and for multi-member funds this usually takes the form of a trustee board, with between five and 10 members.
The researchers examined the extent to which different funds employed affiliated trustee directors, meaning they were either employed by the parent entity which owned the super fund, or sat on multiple boards of funds owned by the parent entity.
On average, 78% of retail fund trustee directors were affiliated. Further, more than 94% of retail assets and member accounts were managed by trustee boards dominated by affiliated trustee directors.
Next, the authors examined how related-party outsourcing arrangements and trustee director affiliation affected returns and found that those funds with more related-party outsourcing and affiliated trustee directors provided lower returns.
<blockquote>'As this business model is found to be significantly detrimental to retail fund members’ interests, it should be of preeminent relevance to the current Productivity Commission review' – KEVIN LIU & ELIZABETH OOI</blockquote>
<h4>Captive boards</h4>
The researchers believe their work shows "more severe" conflicts of interest and a consequent underperformance is likely to occur with higher levels of trustee director affiliation.
And retail funds that are part of a conglomerate group are likely to be subject to more severe conflicts of interests and duties, which leads to more significant underperformance.
"Our findings further suggest that the profit motivation of retail funds leads to a particular business model where 'captive' boards dominated by affiliated trustee-directors tend to engage in a commercial endeavour through related parties to make a profit at the expense of fund members' interests," they write.
Liu says affiliated trustees often find themselves in a difficult position where they have to decide whether company shareholder profits or superannuation fund member benefits should take priority in making decisions.
If a director of a super fund is also a director of the parent company, the Corporations Act requires them to act in the best interests of their shareholders, but the SIS Act requires them to act in the best interests of the fund members. These may not always coincide.
The legislation states that wherever there's a conflict, directors should prioritise the interests of the members of the super fund above all others.
However, Liu says their analysis shows where trustees are affiliated, they are more likely to use a related-party service provider and that leads to underperformance.
The use of related-party service providers by retail funds is an inherent part of the business model of that sector. The aim is to maintain control of, and capture margins in, each of the functions in the value chain of their conglomerate groups.
"As this business model is found to be significantly detrimental to retail fund members' interests, it should be of preeminent relevance to the current Productivity Commission review in considering alternative default selection models and a relevant focus of any future governance and prudential reforms in the superannuation industry," the researchers write.
<h4>Robust results</h4>
Liu sees several possible reasons for the underperformance. Fund trustees may find themselves in a challenging position to negotiate outsourcing fees with related-party service providers and so are more likely to pay higher fees for their services than outsiders. Further, related-party service providers may not be monitored as closely.
And if the remuneration of a related-party director is aligned with the profit of the parent company, which could be their employer, and not with the performance of the super fund, then they are more likely to favour the parent company where there is a conflict of duty.
The researchers found that related-party service providers underperform their peers by 1.29% per annum at the total fund level. This can add up to a significant sum in the 40 years or so a worker may be saving for retirement.
Opponents of Liu and Ooi's research claim it doesn't take into account the 'liquidity premium' that industry super funds receive. That is, industry super funds receive large and predictable amounts of investment flowing into what are called default funds – those funds that workers' super contributions automatically go into if they haven't made a specific choice.
This is said to give industry funds an advantage, because they are able to make long-term investments in assets such as infrastructure, which typically perform well over many decades.
But Liu says this has been controlled for in the research analysis, which uses three types of investment return measures – normal return, value-added, and risk adjusted value-added (RAVA).
"The results are the same regardless of measures used (return, value added, or RAVA). This shows that even after controlling for asset allocation differences and risk, our results remain robust, and not influenced by the 'liquidity premium' issue."
As part of its review, the Productivity Commission will make recommendations to improve outcomes for members and system stability as well as on how to reduce barriers to the efficiency and competitiveness of the $2.5 trillion superannuation system.

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