Chair: David Vines, Balliol College
It is hard to imagine a bigger long-term challenge for advanced economies than funding their pension systems going forward. To address this, many countries have introduced ‘defined contribution’ schemes through private pension funds. However, as Nicholas Morris highlights drawing on his research on Australia, such funds could also face complex management problems that lead them to underperform.
Prof. Morris begins by setting the context for his talk. Pension funds in Australia have accumulated assets worth over 100% of national GDP that are expected to grow to 7 trillion Australian dollars by 2035. As a result, complex industries have emerged to manage the funds, charging relatively high fees in comparison to international benchmarks. However, such funds have still underperformed for several key reasons despite no lack of scrutiny and reports. First, while they look diverse on the surface, they tend to only have limited competition in practice leading to oligopolistic behaviour. Second, splitting the regulator into five different agencies overseeing pensions has meant that nobody takes overall responsibility. Third, legal changes have weakened trust law protection, particularly by not forcing unregulated entities to report costs, which has often led to the outsourcing of management.
Prof. Morris backs these comments with his empirical work. In his first study, he compares pension fund performance with the counterfactual of passively investing in a moderate portfolio, allowing for generous management costs worth 1% of assets. His results show that over 20 years since 1997, this would have generated higher returns of between 20% and 40%, suggesting therefore in reality up to a third of pensions were ‘chewed up’. Even if the funds have pursued the simplest strategy of investing in fixed interest assets, they would have generated more than 700 bn Australian dollars more during this period. Whereas the results appear robust, he cautions that it is hard to comment whether the difference was used to fund yachts for the managers or was just a result of mismanagement.
In another study, Prof. Morris uses a detailed database to generate an international comparison. He looks at the period 2004-2012 and uses data envelopment analysis to estimate an efficiency score for each fund to account for differences between funds. In his comparison with a mixture of US, Canadian, and EU funds, no Australian fund outperforms the benchmarks, while around half of international ones do so. The results hint that a combination of high costs and underperformance is to blame for poor performance. In particular, even efficient funds can underperform due to high costs (particularly administrative costs) or due to picking the wrong assets.
One particular reason Prof. Morris highlights is the separation between fund managers and members. Australian regulation has allowed for unresolved principal-agent problems and an overly complicated structure in which 85-90% of fund activities are outsourced over several layers. Crucially, this happens without the need to disclose costs, obscuring actual management costs. Thus, the managers to whom decisions are outsourced take a cut from the performance of the fund and transfer back money net of costs to original fund manager, which means that such schemes do not show up in a high cost structure. In this way, external management and provision of choice has paradoxically ended up increasing costs more than improving performance and returns.
The problems are further accentuated by the limited extent of competition in the sector. At its core, one finds just four banks that run the majority of pension funds, particularly those of retail customers. On the corporate side, managers are wary of managing pension funds alone and have some tax incentives to move to bank-provided schemes. Meanwhile, union leaders also prefer to delegate management to the private sector in order to avoid criticism for potentially mismanaging the funds. Finally, trust law in Australia also allows for professional advice to be overridden by retail members who might be led to choose a package, which does not reflect the optimal allocation of assets.
In closing, Prof. Morris examines what can be done going forward. He acknowledges that a regulatory response is inherently limited by the circumscribed knowledge and power of public authorities, particularly given the fragmented regulatory setting in Australia. Therefore, he proposes three ideas for addressing the issues. First, he argues there is significant scope for the effective use of competition law in this area, which has until now been perceived as largely competitive by the political system. Second, disclosure should be made stronger and clearer to remove the incentives to outsource material aspects to non-regulated entities. Finally, the state can set up a public administered fund that is available for everybody, which itself becomes the benchmark that then pushes the fees of all others down. Other measures could include regulatory reform aimed at a single regulator, use of codes of conduct, and the enhanced importance of reputation, particularly when it comes to trustees.
It is hard to imagine a bigger long-term challenge for advanced economies than funding their pension systems going forward. To address this, many countries have introduced ‘defined contribution’ schemes through private pension funds. However, as Nicholas Morris highlights drawing on his research on Australia, such funds could also face complex management problems that lead them to underperform.
Prof. Morris begins by setting the context for his talk. Pension funds in Australia have accumulated assets worth over 100% of national GDP that are expected to grow to 7 trillion Australian dollars by 2035. As a result, complex industries have emerged to manage the funds, charging relatively high fees in comparison to international benchmarks. However, such funds have still underperformed for several key reasons despite no lack of scrutiny and reports. First, while they look diverse on the surface, they tend to only have limited competition in practice leading to oligopolistic behaviour. Second, splitting the regulator into five different agencies overseeing pensions has meant that nobody takes overall responsibility. Third, legal changes have weakened trust law protection, particularly by not forcing unregulated entities to report costs, which has often led to the outsourcing of management.
Prof. Morris backs these comments with his empirical work. In his first study, he compares pension fund performance with the counterfactual of passively investing in a moderate portfolio, allowing for generous management costs worth 1% of assets. His results show that over 20 years since 1997, this would have generated higher returns of between 20% and 40%, suggesting therefore in reality up to a third of pensions were ‘chewed up’. Even if the funds have pursued the simplest strategy of investing in fixed interest assets, they would have generated more than 700 bn Australian dollars more during this period. Whereas the results appear robust, he cautions that it is hard to comment whether the difference was used to fund yachts for the managers or was just a result of mismanagement.
In another study, Prof. Morris uses a detailed database to generate an international comparison. He looks at the period 2004-2012 and uses data envelopment analysis to estimate an efficiency score for each fund to account for differences between funds. In his comparison with a mixture of US, Canadian, and EU funds, no Australian fund outperforms the benchmarks, while around half of international ones do so. The results hint that a combination of high costs and underperformance is to blame for poor performance. In particular, even efficient funds can underperform due to high costs (particularly administrative costs) or due to picking the wrong assets.
One particular reason Prof. Morris highlights is the separation between fund managers and members. Australian regulation has allowed for unresolved principal-agent problems and an overly complicated structure in which 85-90% of fund activities are outsourced over several layers. Crucially, this happens without the need to disclose costs, obscuring actual management costs. Thus, the managers to whom decisions are outsourced take a cut from the performance of the fund and transfer back money net of costs to original fund manager, which means that such schemes do not show up in a high cost structure. In this way, external management and provision of choice has paradoxically ended up increasing costs more than improving performance and returns.
The problems are further accentuated by the limited extent of competition in the sector. At its core, one finds just four banks that run the majority of pension funds, particularly those of retail customers. On the corporate side, managers are wary of managing pension funds alone and have some tax incentives to move to bank-provided schemes. Meanwhile, union leaders also prefer to delegate management to the private sector in order to avoid criticism for potentially mismanaging the funds. Finally, trust law in Australia also allows for professional advice to be overridden by retail members who might be led to choose a package, which does not reflect the optimal allocation of assets.
In closing, Prof. Morris examines what can be done going forward. He acknowledges that a regulatory response is inherently limited by the circumscribed knowledge and power of public authorities, particularly given the fragmented regulatory setting in Australia. Therefore, he proposes three ideas for addressing the issues. First, he argues there is significant scope for the effective use of competition law in this area, which has until now been perceived as largely competitive by the political system. Second, disclosure should be made stronger and clearer to remove the incentives to outsource material aspects to non-regulated entities. Finally, the state can set up a public administered fund that is available for everybody, which itself becomes the benchmark that then pushes the fees of all others down. Other measures could include regulatory reform aimed at a single regulator, use of codes of conduct, and the enhanced importance of reputation, particularly when it comes to trustees.
Ivaylo Iaydjiev (St Antony’s College, Oxford)
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