Gonksi goes long: does choice of fund lead to short term-ism?

Gonksi goes long: does choice of fund lead to short term-ism?

Posted: Thursday 04 June, 2015

The Australian reported today that David Gonski, Chairman of the Future Fund, suggested that a feature of Australia’s superannuation system known as “Choice of Fund” should be re-examined by the Government.

“Choice of Fund” was a reform of the superannuation system, implemented around eight years ago, pursuant to which most super fund members are now able to direct their employer contributions to any eligible super fund.

There is something to be said for allowing super fund members to have a say about where their contributions go.

Some other countries, however, do it differently.  In the United States, for example, my retirement savings contributed by my prior employers (a large law firm and a financial regulator) were not able to be directed into any fund I wanted.  Instead, they were contributed into a single provider (T. Rowe Price, in the case of the law firm, and the US Government Thrift Savings Plan in the case of the financial regulator), and employees could allocate their contributions among a few options offered by the provider.

Most would agree that Choice of Fund has been good for industry super funds. Choice of Fund has coincided with significant market share growth of industry super funds.  But, eight years after the introduction of Choice of Fund in Australia, Mr Gonski has raised the question: is it good public policy?

Mr Gonski noted that Choice of Fund can make it more difficult for super funds (or more precisely, their investment managers) to focus on long term investment.  In particular, he argued that Choice of Fund “encouraged short-term thinking by managers to prevent money from moving to other funds, rather than the pursuit of long-term investment.”  The reason being that managers “have to be eternally vigilant to keep the money in the superannuation fund, otherwise people will turn out of it.  If we judge (fund managers) on a one-month basis, people could be moving.  If people were educated to look longer, and the doctrine of choice was maybe moved out a bit, it would allow super funds to invest more for the long term.”

Mr Gonski is right that Choice of Fund needs to be considered in a balanced way – when weighing up the perceived benefits there are also some drawbacks, and he is to be congratulated for his courage in raising this for discussion.

Choice of Fund can make members more confident about their control over their savings.  When it was adopted, Choice of Fund was “expected to provide employees with a greater sense of ownership over their retirement savings.”  It is hard to say whether Choice of Fund has resulted in a greater sense of ownership.  But it is worth asking the question of whether the retirement outcomes for members are better, and taxpayer burdens are reduced, with Choice of Fund.

The upsides of choice are pretty straightforward. In theory it should allow a member to move from a poor performing fund to a better one, and allow them to stick with a fund they have been happy with if they change employment (whether this happens in practice is another thing). As to the possible downsides, here are a few of my thoughts on this issue:

  • Short term incentives.  As Mr Gonski notes, Choice of Fund can make fund managers more focussed on the short term, undermining long term investment.
  • Portfolio distortions to manage redemption risk.  Choice of Fund also affects the risk profile of fund portfolios.  When a fund member exercises choice, the member’s old fund needs to produce cash equal to the member’s account balance quickly and transfer that to the member’s new fund. Managing redemption requests requires having sufficient cash available, and/or liquid assets available to sell.  Prudential regulation requires funds to be able to manage this redemption risk not just in ordinary times, but in times of stress.  With the number of members switching remaining relatively low, funds could be constructing portfolios in anticipation of high stress switching rather than actual behaviour.  As a result, super funds will hold higher allocations of cash and liquid assets in an environment of Choice of Fund than they otherwise would.  This has a few consequences including:
    • The rate of return on cash and liquid assets is lower, all else being even, than less liquid assets.   By increasing a fund’s allocation to cash and liquids beyond that which is optimal, Choice of Fund can, all else being even, reduce the risk adjusted return of super funds, resulting in less money for members’ retirement.
    • Long term investment and patient capital involves greater allocations to illiquid assets.  It involves being able to commit to an investment for the long term.   Holding excess cash and liquid assets to manage redemption risk arising from Choice of Fund can undermine the ability of super funds to make long term investment, including in infrastructure and productivity-enhancing capital.
  • Choice and real world member outcomes.  Some scholars have looked empirically at what happens when members exercise choice.  For example, Professor Paul Gerrans examined the choices made by Australians over a three year period including the GFC.  For those members who did exercise choice, they clearly acted in response to short-term market performance, and chased returns.  Specifically, these members moved out of shares and growth assets at the bottom of the market.  This resulted in a “double hit” to their retirement savings — they suffered the declines in asset prices, but did not share in the subsequent market rebound.  It is an unfortunate lesson that members who exercise Choice of Fund among funds or choice within a fund can wind up worse off financially because they tend to act after a market-moving event has occurred.

The Government has announced that it will hold an inquiry into Australia’s financial system.  Mr Gonski has suggested that Choice of Fund be considered in this inquiry.  We should thank him for raising this for consideration – there are good reasons to have a balanced discussion about Choice of Fund.  Does it help members toward a better retirement?  Does it help unlock the potential of superannuation to fund the economy and needed infrastructure?  Are the downsides of Choice worth the sacrifice if only a small minority of members are using it? These are issues worth discussing.  After eight years of Choice of Fund, the impacts should be evaluated, and we should be careful about further policy changes that seek to expand choice or reduce the ability of superannuation to support long term investment without fully thinking through the consequences.