The Rise of Choice: Investor Empowerment in Australia’s Defined Contribution Market
In the past two decades, Australia has witnessed a revolution in the size, structure and complexity of its retirement savings sector. This rapid change has resulted in assets of more than AUD$1.4 trillion, making it the fourth largest funds’ market in the world.¹ Simultaneously, investors have gained access to levels of choice and control that were never foreseen in the early stages of the retirement sector—not in the traditional, not-for-profit industry fund segment that serves most Australian workers for retirement savings.
In the early years, a one-size-fits-all, "balanced" investment approach was the industry mainstay. Today, increased choice allows investors to exercise preference for retirement fund, asset allocation, investment philosophy and even individual security selection. Choice, among other factors, has contributed to investor empowerment, which brings opportunities and challenges. Investor empowerment is a natural step as the Australian pension sector responds to market turbulence and shifts toward higher levels of member engagement. However, choice also has delivered consequences for large funds and for investor returns. The outcomes have not always been optimal for the policy goals of the savings system or the individual participants. Furthermore, the proportion of investors within mainstream funds that exercise choice has remained a minority. Less than a quarter of total fund assets are invested in accordance to investor choice decisions.
The effects of increased competition
One of the many factors driving this change is the increased strength of fund competition. Since 2005, investors have been empowered to select their own fund and even to opt out of the fund system altogether and set up their own savings vehicles. These self-managed super funds (SMSFs) have provided an alternative to mainstream fund offerings. As competition has increased to retain investors, funds are seeking additional scale to drive down costs and increase product investment, and smaller funds are being absorbed into larger more viable entities. The increased competition has driven a renewed focus on investor needs and a greater level of product innovation within the sector. This trend looks likely to only increase as fund rationalisation and market competition for investors continues to intensify. In this environment the proportion of engaged investors exercising choice, while small, represents the contestable market for investor switching and opting out. To remain engaged with investors, funds will continue to focus on member needs through delivering choice.
In the early eighties, the majority of retirement savings were carried in defined benefit funds. This changed with a public policy shift in the early nineties to move open-ended investment risk and retirement liabilities to the investor. This policy change was accompanied by the broadening of coverage to the point where the vast majority of Australian workers have been covered by mandatory contributions into retirement accounts since 1991. Funds were structured as single diversified or balanced options and investors were largely restricted to the default fund for their employer or industry. As a result, the level of investor engagement was extremely low. Early choice offerings were limited to the selection of risk weightings via broad bundled packages or asset allocation selection through asset specific offerings. The motivation for funds was the recognition that they were unable to assess individual investors’ risk appetites or investors’ non-retirement asset circumstances. Introducing some choice for investors was seen as a more principled approach given that the retirement savings risk rests with the investor. Further defining this period were mandatory contributions to a single fund option.
The first signs of fundamental change came in the mid-nineties with the option for a small portion of the market to opt out of formal funds and create their own SMSFs. The size of the market selecting this alternative was initially small—around four percent of overall assets—yet they represented a key concession to investor right of choice and a source of potential investor leakage from traditional funds.
The second wave of change was driven by the investor’s ability to nominate the fund of their choice. In 2005 legislation allowed most Australians fund choice—the ability to move retirement savings accounts between funds or into the SMSF system. This concession introduced competition for investor balances with funds needing to grow to deliver scale benefits and further improve their ability to retain investors. Choices in areas such as sustainable investments or environmental, social and governance dimensions were developed. The introduction of "ethical" choices permitted funds to build brand visibility and sympathetic investment values. Generally these options have remained niche, yet they represent the increased willingness of the sector to respond to broader social trends to lift investor engagement and retention.
The majority of investors remained in the default alternative (either failing to exercise choice or consciously choosing the default). Nonetheless, increasing investment flows began to move toward the SMSF sector, especially from engaged participants in the system. Investors leaving funds were disproportionally older, had larger balances and were motivated to gain control of their retirement savings. The SMSF segment has grown by 89 percent in the five years to 2011 versus 45 percent growth for the retirement savings sector as a whole. With more than AUD$480 billion in current assets (well over 30 percent of the system), SMSFs have moved well beyond their starting market share to become a major influence. As a proportion, 86 percent of participants exiting the formal fund system for SMSFs were motivated by a desire to gain increased control of their investment outcomes. Poor returns and the erosion of trust in financial institutions drove investors to seek greater control over their financial destinies.
Managing choice to build market share
Innovative funds such as AustralianSuper, the largest broad industry fund in the retirement segment at over AUD$50 billion, saw an opportunity to offer investors control and yet remain within the safe harbour of the broader fund environment. The launch of AustralianSuper’s Member Direct platform, allowing a level of direct portfolio oversight at the investor level, has attracted considerable interest and allowed their investors an alternative to a full SMSF and at a much lower cost. Through this they have become one of the first larger industry funds to offer the full range on the investor choice spectrum in order to retain investors and build scale.
Examples such as AustralianSuper, which are driving benefits of scale and competition to retain investors and stem the flow to SMSFs, are now motivating funds to empower investors and increase product choice. The fundamental "right to choice" for a mandatory defined contribution market still holds some authority. Nonetheless, academic studies showing poor investment outcomes has in some instances deterred funds from promoting these options against their professionally managed default options. In addition, the regulatory framework made it clear that fund trustees retained a fiduciary obligation to their investors even where they had relinquished control over investment selection. These factors constrained promotion of choice alternatives within large traditional funds, and with the proportion of investors in funds exercising choice remaining at around 20 percent,² it appeared that demand was limited.
Today’s evolving fund challenges
The industry—with its long tail of small funds serving niche industries and investor segments—is being remodelled to emphasise scale and long term viability, offering investors liquidity, cost savings, breadth of investments and the stability to ride out financial storms. Industry thinking, as well as expressed government policy, is requiring funds to demonstrate this scale and so focus on investor acquisition and retention. The industry is starting to resemble traditional consumer markets by focusing on the customer.
Increased choice allows investors to exercise preference for retirement fund, asset allocation, investment philosophy and even individual security selection.
Choice, among other factors, has contributed to investor empowerment, which brings opportunities and challenges.
With the significant proportion of investors being unengaged, the battle for investors has been driven by the needs of the 20 percent of engaged members who have exercised choice already and who are a flight risk, both to SMSFs and to retail funds that offer broader, more tailored choices than traditional industry funds. In order to compete, the majority of industry funds are now offering asset choice, blended investment mixes and, as in the case of AustralianSuper, a number of "fast follower" funds (i.e., mass customisation of portfolio choice across a broad retail investor base). This allows investors to select from a menu of industry and retail fund offerings, asset classes, pre-mixed options and their own investment selections.
The new reality comes with challenges. Superannuation funds more than ever have the responsibility to facilitate choice through providing education and impartial financial planning advice on tailoring the investment mix and through the delivery of controls and transparency on the risks and exposure of investments. The market is now focussing on new values above the traditional role of industry trustees to protect and grow investors’ retirement savings. With competition has come the need to focus on seeking new investors to bolster scale, to develop strong research and metrics around investor needs and retention drivers, and to invest in brand and marketing strategies. Part of this new reality will continue to be a proliferation of product innovation and investor choice that will see the not-for-profit sector start to converge toward the retail funds that have always competed for investor balances.
- IBISWorld’s “Superannuation Funds Market Research Report,” December 2012, www.ibisworld.com.au
- Australian Government’s “A Statistical Summary of Self-Managed Superannuation Funds,” 10 December 2009, www.supersystemreview.gov.au