Structural change and the cost of administration over time

The Australian finance industry has undergone significant structural change in the period since deregulation in the early 1980s. Factors besides deregulation have included the increasing exposure to and integration with international financial markets, the introduction of new technologies, a reduction in the banking branch network and a reduction in front- and back-office labour. Major trends have included an increase in the size of financial entities due to mergers and consolidation, and the emergence of financial conglomerates due to mergers across the previously existing boundaries between insurance and banking (Kent and Debelle, 1999: 15-16) These trends have contributed to a rapid increase in profitability, particularly in banking.

The two main internal structural changes in the superannuation industry are increasing outsourcing and increasing concentration, both taking advantage of economies of

scale. The industry has also been shaped by government policy, which has driven an increasing proportion of income through the pension system.

Many of the activities of funds are outsourced to specialised service providers who also service other institutional investors including mutual funds. Activities often outsourced include funds management, administration, asset consultants, broking, actuarial and legals. Use of consultants for these tasks is standard practice, such that a superannuation fund is often a shell with responsible trustees but very few employees.

Around 71 per cent of funds are invested via an external fund manager being either a life insurance company (32 per cent) or an independent fund manager (39 per cent).

And 60 per cent of all large funds use external consultants for administration (Clare and Connor, 2000: 8, 15).

Market concentration in these superannuation service industries is high compared to the numbers of actual funds. In fund management, the top ten operators hold around 63 per cent of the market. In asset consulting the major five hold around 75 per cent of the market. In administration, two major players - AAS (an AMP subsidiary) and Jacques Martin Industry - dominate the industry fund sector with a combined market share of 83 per cent. In the corporate fund market, there are six majors, including subsidiaries related to the two major players mentioned above (Clare and Connor, 2000: 18-19).

The number of independent funds is also shrinking. APRA figures show that between June 1995 and June 2002, the number of 'non-small' funds decreased from 5,001 to 3,742, a reduction of 25 per cent (APRA, 2003: Table 9).

Government policy has also continued to drive growth in the super industry, and this can be expected to continue. Initiatives to increase growth include measures to block loop-holes allowing early removal of funds (particularly at change of employment), and steadily increasing contribution levels. Contribution levels reached the final planned stage at 1 July 2002 at 9 per cent of income. Net transfers (contributions minus benefits) have continued to rise, as is shown in Figure 4.4.

Figure 4.4 Net annual contributions to Australian superannuation

Source: APRA, 2003: Table 3 and author's calculations.

In competitive markets, cost efficiencies should be passed on to customers in the form of reduced price. The outcome is different in an uncompetitive market. Cost savings driven by concentration, growth and outsourcing contribute to higher margins.

Figure 4.5 shows a data series produced by APRA of super fund internal operating costs. The data excludes a range of important external costs, including external fund management. Nonetheless, it is a constant series that provides an indication of trends in total super costs. The chart shows annual administration, and the ratio of

administration to assets. In absolute terms the costs rise steeply, increasing by 122 per cent. Internal costs as a proportion of assets fell slightly between 1995 and 1998, before rising to its highest level in 2001 and 2002. The first two quarters of 2003 suggest a record figure for that year also.

The data suggests that the efficiencies gained from market concentration, outsourcing and growth have not been passed on to consumers. Costs have risen as a proportion of assets, despite rapid and unsustainable asset growth. Efficiencies gained through increasing economies of scale and outsourcing are not being passed on to members.

Figure 4.5 Aggregate internal operating costs for Australian superannuation

Source: APRA, 2003: Table 3 and Table 1b and author's calculations.

4.6 Summary

When production is organised by profit-driven operators in a market setting, as private pensions are in the Anglo-American countries, efficiency is dependent on competition.

A necessary condition for competition is that consumers understand the products, and the prices associated with those products, and exercise choice on the basis of that understanding. All available evidence points to a lack of necessary understanding.

Consumers are consequently making inappropriate choices, driven in no small part by the ‘advice’ of paid agents of profit-driven suppliers. Pension administration cost when organised in a plural market is far more significant than it need be. Efficiencies resulting from structural change are not being passed onto consumers.

5 Account proliferation

In Australia, compulsion to join pension funds, inflexible rules governing membership based on employment, and an absence of centralised account management combine to cause account proliferation. This partly explains how a country of less than 20

million people can support over 3,500 pension funds (APRA, 2003). In Australia in November 1995, there were 6.6 million superannuation fund members and 15.5 million accounts at an average of 2.3 accounts per person. The number of accounts increased by another 25 per cent to 20.55 million by December 1999 (Clare and

Connor, 2000: 2). In 2000, accounts per person reached 2.6 accounts (Clare 2001: 32).

Unofficial estimates from the Australian Tax Office suggest the number might now be as high as 3 accounts per person.

This results in lower net returns for members with more than one account, due to the prevalence of administration fees with a fixed component. The impact on savers is amplified because the retail sector - with more expensive fees - accounts for a disproportionate share (56 per cent) of accounts (Clare, 2001: 32). The implications of multiple accounts are significant for administration cost and therefore rates of return and final accumulation. Additionally, having smaller account balances results in higher rates of fees due to low balance penalty rates and high balance discount rates.

The analysis of cost by fund type provided above (section 4.4.1) suggests that retail funds are up to 2 – 4 times more expensive than non-profit public offer funds. While the cheapest option is to have all one's super in a single non-profit fund, the average option is three accounts, two of which are retail accounts. Assuming fixed costs represent 50 per cent of fees, on assets of $10,000, the average option will cost 3 – 6 times the cheapest option (author’s calculations). Presumably, some members have 5 or more accounts, with administration costs proportionately higher. Small accounts would be protected by (nominal) balance protection legislation, resulting in real balance erosion.

Another negative symptom of the plural market structure and account proliferation is the growth of lost accounts. After only 10 years of compulsory pensions in Australia, the Australian Tax Office now holds more than $7 billion in 4.5 million lost super accounts (Wade, 9/9/2002). This compares with the $220 million held by the Australian Securities and Investment Commission (ASIC) for all bank accounts, life insurance and lost shares since the 1950s. Many consumers are clearly disinterested in compulsory pensions. An industry in account search services has emerged to help unite individuals with their lost super accounts.

The same dynamics have created similar situations in the UK and US. The quantity of lost pension savings is unknown in the US, but is presumed to be significant, based on UK estimates in 1998 of between £10 and £77 billion (Turner and Bruce, 2002: 2).

6 Negligence and fraud

A plural private pension system sees the direction of vast flows on income through a relatively new and unregulated administrative sector consisting of (mostly) private entities. As we have seen, the level of scrutiny from consumers is so low that more than one per cent of assets in the Australian system are considered lost. The potential for fraud within the industry is significant. The system is also dependent on integrity within the wider financial community, both in relation to the cost and quality of consulting services, and more generally in ensuring assets are correctly valued and well managed.

In Australia, regulation of the pension industry is exercised via an approved trustee structure. Under this structure, trustees for public offer funds must be registered with the regulator APRA (Australia Prudential Regulatory Authority). In extreme

circumstances, APRA has limited powers to replace or remove trustees.

As discussed above, the integrity of the pension system generally is compromised by the selling practices of sales agents and financial planners. However, in respect of administration, the system of regulation in Australia has worked reasonably effectively – at least to the extent that APRA’s powers have been exercised only occasionally. A medium sized superannuation company, Commercial Nominees, had new trustees appointed after losing 80 per cent of member assets in non-performing asset acquisitions (Seeder, 2/7/2001). The trustees of several smaller superannuation funds have also been replaced (APRA, 2001a; 2001b). Some relatively minor frauds have been discovered relating to avoidance of superannuation and false business registry services (APRA, 2001c).

A greater concern is the lack of accountability in respect of the purchase of services by pension fund administrators on behalf of members, and fund managers on behalf of pension funds. Given the absence of direct pressure on parties to these contracts, and the consequent capacity for deals involving kick-backs, there appears to be very little scrutiny of these relations by regulators. There is certainly cause for concern over a failure to maintain arms-length dealings between funds and related service providers.

Indeed, Wynn argues that ‘soft commission’ transactions between funds and brokers represent an institutionalised form of kick-backs, protected by non-transparent cost reporting (Wynn, 2002).

The assertion that this risk is material would seem paranoid if not for the daily reports of wrong-doing on the part of one aspect or another of the financial community. The recent (2002/2003) round of convictions of senior executives in Australia and the US is profoundly disturbing in the context of the commitment of governments to private pension systems. The evidence across a number of major cases exposes a spectrum from small, isolated, opportunistic crimes to groups of executives across multiple entities conspiring over many years to embezzle billions of dollars from millions of people.

At the small end of the scale is the case of famous Australian stock-broker, Rene Rivkin, recently convicted for insider trading after receiving a hot tip concerning an airline take-over. On a medium but intolerable scale are major corporations such as insurer HIH and life insurance office AMP losing billions through negligence and mismanagement, and providing preferential information to an inner circle of shareholders to allow timely sale of shares. On the most disturbing level is the systematic abuse by financial services conglomerates (notably Anderson, Citibank and Merrill Lynch) of research and auditing services in order to secure other business from clients, including IPOs, underwriting, broking and consulting. These practices facilitated the accounting fraud that enabled corporations including WorldCom, Enron and HIH to continue to trade and raise capital while insolvent. It is clear also that the investment banks released specific and general public misinformation to fuel the equity price bubble of the late-1990s. In February 2003, merchant banks had agreed to a $US 1.48 billion settlement (Collins, 20/2/2003).

The political pressure in the US has led to much talk of reform, and ten of the largest US investment banks have agreed to pay $US 1.46 billion in fines in respect of

unethical and illegal practices during the ‘boom-time’ (Maiden, 12/5/2003). However, regulators are reluctant to break up the financial conglomerates. As reported in The Sydney Morning Herald:

New York State Attorney-General Eliot Spitzer's idea of breaking up the stock research and investment banking businesses at Wall

Street firms ''is a very drastic remedy", Securities and Exchange Commission chairman Harvey Pitt said.

Mr Pitt said the federal agency would consider this step ''only as a last resort". (SMH, 13/5/2002)

The background to this white-collar crime wave is apparent general acceptance in the management and shareholding community of white-collar ‘near crime’ in the form of spiralling executive remuneration made up of exorbitant salaries and stock option plans. It seems, in short, that every opportunity is taken to serve oneself.

The pension industry consists of a massive quantity of capital moving through pension systems on behalf of unaware, anonymous and often unwilling consumers, watched over by disinterested regulators. In this context, the absolute cynicism with which the financial community has bent and broken rules for their own advantage is cause for the utmost concern. There can be little doubt, at minimum, that contracts between financial service providers on behalf of pension consumers would involve generous pricing, and relatively low pressure to perform.

7 Alternative systems

7.1 Bolivia and Sweden - funded systems without consumer markets