Legal development

Australias Superannuation Industry is feeling the pressure for consolidation

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    In 2022 Australia was named the most successful pensions market globally.1 However, reflecting on the Australian superannuation system, Wayne Byres, Chair of the Australian Prudential Regulation Authority (APRA), recently made the following observation:

    "... given a blank sheet of paper, you would not give the [Australian] superannuation industry the shape it has today."2 

    The "shape" Mr Byres was referring to is best described as a Prince Rupert drop – the form created when molten glass is submerged into cold water. It has a large tadpole-shaped bulb, which is hard and durable, with a long, thin but weak tail. This is a fitting symbol for the current composition of Australia's superannuation industry.3 

    As of October 2022, there were 141 APRA-regulated superannuation funds.4 The 16 largest of these funds represent the bulb of the Prince Rupert drop. Each holds more than $50 billion in funds under management (FUM) and collectively, over 70% of Australia's superannuation assets.5 In contrast, the smaller funds represent the long, thin tail. 104 APRA-regulated funds each hold less than $10 billion in FUM (78 of which have less than $2 billion) and collectively hold only 6.6% of Australia's superannuation assets.6 Those within the bulb have longevity, whilst the tail of smaller funds are unlikely to survive.

    This paper poses the following question – if the current Prince Rupert drop shape is ill-formed, what shape would be more fitting and what needs to be done to re-mould the industry? Consecutive reform packages have increasingly shone the spotlight on underperformance and sustainability to encourage consolidation in the superannuation industry. However, as made clear from the description above, the previously long held "laissez faire" approach to consolidation has left a significant number of smaller funds marooned at the industry's tail. If we don't want to be left with 100+ "orphan" funds in the future, there needs to be an open dialogue between the industry, APRA and the government about whether organic consolidation will be effective enough or whether more stringent intervention will be needed to get the job done.

    The heat of the spotlight

    Consolidation of the superannuation industry is not a recent idea. In 2004 the registrable superannuation entity (RSE) licensing regime was introduced. At this time, there were 1200 trustees operating approximately 9000 funds.7 By the end of the transition period (30 June 2006), 307 RSE licenses had been granted, meaning over 75% of trustees exited the market.8 Of interest however, was that the median point for the remaining funds was $2 billion in FUM. It was expected that the funds in the lower-than-median cohort would eventually be subsumed within the remaining funds in the short term. This was not to be the case.

    In 2014, the Financial System Inquiry9 concluded that the Australian superannuation system was:

    "not operationally efficient due to a lack of strong price-based competition and, as a result, the benefits of its scale [were] not being fully realised".10

    Fast forward 5 years to January 2019, where the Productivity Commission undertook an inquiry into the efficiency and competitiveness of the superannuation sector, and its observations were much the same. Only this time, one of the Commission's recommendations was the introduction of a "right to remain" test for all MySuper and Choice products.11 From the Commission's perspective, as the "vessel" for the compulsory retirement savings of Australians, superannuation funds need to earn their stay.12 This "right to remain" notion has since culminated into 3 key, super-specific reforms that have shone the spotlight on the performance, competitiveness and sustainability of Australia's superannuation funds.

    First, APRA's heatmaps. In December 2019 APRA released its first superannuation heatmap for MySuper products. From 2021, a heatmap for Choice products was also released. APRA's heatmaps use a graduating colour scheme to provide insights into MySuper products across three key principles: investment performance, fees and costs and sustainability of member outcomes.13 For some funds, its dark red classification is a confronting reminder of its shortcomings, while for others, its clear white classification confirms its superior performance. An important aspect of APRA's heatmaps is that they're for public consumption – meaning each one serves as APRA's report card for funds that can be openly judged by competitors and members. Since the release of APRA's first heatmap in December 2019, 28 MySuper products have been closed – resulting in 1.5 million member accounts and $51.6 billion of member funds being transferred to other MySuper products.14 

    Second, the legislative introduction of the Annual Performance Test. This test was introduced under the 2021 'Your Future, Your Super' reforms to give "greater transparency to beneficiaries and protect ... beneficiaries from underperforming products."15 It currently applies to MySuper products. Briefly, a trustee must inform members if they hold a product that has failed the Annual Performance Test and if a product fails in consecutive years, the trustee will be prohibited from admitting new members to that product. 16 In the second reading speech of the Bill 17 that introduced the test, Treasurer Frydenberg said that it was "expected to deliver $10.7 billion in benefits for members over the decade as members leave underperforming products, some underperforming products improve their performance and others merge with higher-performing funds."18 Of the 14 MySuper products that failed the Annual Performance Test across 2021 and 2022, the majority have since merged with another fund or exited the market.

    Third, the online comparison tool. The 'Your Future, Your Super' reforms also introduced an online comparison tool to allow the public to compare the fees and investment performance of MySuper products across different funds. Funds are also labelled as either "Performing" or "Underperforming" based on the results of the Annual Performance Test. In his second reading speech of the Bill19 that introduced the online comparison tool, Treasurer Frydenberg said that the tool was "expected to boost retirement savings by $3.3 billion over the decade through empowering more members to engage with their superannuation."20 In its first 6 months of being active, the comparison tool had over 1 million visits and appears to have encouraged Australians to reconsider the "set and forget" mindset to their superannuation21 – noting the right for most Australians to exercise portability.

    Though there has been criticism in relation to the design and benchmarks of these 3 key reforms, well-performing funds are content with the spotlight they cast. For underperforming funds, the spotlight has been harsh and unforgiving. Many have not withstood the heat and have decide to either exit the market or merge. In a 2022 study on the future of superannuation conducted by J.P. Morgan, respondents rated "compliance with new regulations" as the biggest challenge facing funds over the next 3 years – closely followed by "retaining and attracting new members" and "net investment performance".22 There has been an unrelenting pace of regulatory and legislative change of the past few years – and for some of the smaller funds, meeting these demands with fewer resources, lower capability and overarching commercial pressure is unsustainable. There has also been the introduction of the concept of "stapling" of accounts to individual members, as a means of breaking the nexus between destination funds and workplace agreements or modern awards.

    Finding "the one"

    In recent years, there has been a steady stream of funds partnering up, with more trustees heeding the compelling commercial logic that the improved capabilities that come with a fund's increased scale is an important determinant of member outcomes.23 The standard business model of a typical superannuation fund is to rely on more money coming in than departing. Generally, a higher level of FUM allows funds to service members at a lower cost and to invest in more illiquid assets to provide greater opportunities for capital accumulation. Hence, APRA's view that that funds with less than $30 billion in assets are increasingly uncompetitive.24 

    APRA has reminded trustees that a merger should not just better members' financial interests but be in their best financial interests.25 Speaking to this in March 2022, Margaret Cole described APRA's increasing aversion to what she described as "bus-stop" mergers:

    "The merger of two small funds to create a mid-range fund might be an improvement, but it’s not a final destination for members; ultimately, the new entity is likely to need to find another partner down the road."26 

    APRA might aptly be described as a watchful parent, imploring funds to stop engaging in dalliances and focus on courting the more eligible and profitable suitors. While an underperforming fund merging with another small fund might see better outcomes for members in the short-term, there's likely no longevity in the relationship. Ultimately, the newly combined fund will need to look further into the bulb of the Prince Rupert drop for a new merger opportunity. Moreover, while the uptick in merger activity in the past few years has helped the industry develop a more streamlined and smooth transaction process, successor fund transfers remain expensive and disruptive. The period between the announcement of a successor fund transfer and the actual transition date is prolonged and members often feel a sense of being in limbo. This is particularly true for members approaching retirement or retired, who are more cautious of the movement of their nest eggs and periods of limited service. Indubitably, members would prefer that smaller funds take the most direct route to the final destination with their retirement savings, rather than pausing at "bus stops" along the way.

    APRA very rarely intervenes to force a fund merger by imposing RSE license conditions and continues to rely upon its historical model of "encouragement" to promote a successor fund transfer. However, in the quest for merger partners in 2023, it might be prudent for funds to consider the regulator’s expressed opinion on such matters. Courtship in superannuation mergers should be about stability, prosperity and longevity.

     To this end, Margaret Cole also cautioned the larger funds about being dubbed "serial acquirers".27 She said:

    "Over the past few years, we’ve noticed some larger funds becoming what you might call “serial acquirers”, taking over one smaller fund after another, and often moving on to a new deal before bedding down the previous one."28 

    True fund mergers remain complex transactions that require not just an analysis of the "equivalent rights" of members and the SIS Act29 covenants, but also detailed planning to bring together staff, external service providers, IT systems, insurance arrangements and investment portfolios. While the smaller and underperforming funds are feeling the heat to merge, the larger funds must ensure the benefit of consolidation to members is not squandered by poor execution and integration.30 APRA is currently seeking feedback to a discussion paper 31 to inform amendments to the prudential standards32 and prudential practice guides33 to assist funds in the planning, pre-positioning and execution of fund mergers.34 

    Are we asking the right question?

    As a practical point, APRA's vision for further industry consolidation relies on the assumption that the larger funds continue to be ready and willing to merge with the underperforming and smaller funds to reshape the industry. What if this assumption is wrong?

    APRA may have a vision for Australia's superannuation industry in 2035 – but what if that vision can't be realised organically?

    Risk of rejection

    78 of the 141 APRA-regulated superannuation funds have less than $2 billion in FUM. APRA and the broader industry are largely settled that these funds are unlikely to be sustainable long-term and will need to merge for the best financial interests of their members. However, the larger funds are still digesting the numerous mergers of recent years and their FUM continues to grow. What happens if they lose their appetite?

    We can take an example of a $1 billion FUM superannuation fund approaching one of the larger $100+ billion FUM funds to merge. The larger fund conducts a cost-benefit analysis. It knows that successor fund transfers require dedicated teams and are expensive and disruptive. Furthermore, it is on risk for any due diligence failures. The larger fund might also be experiencing merger fatigue, having been a popular destination fund over the past few years. Thus, the fund might determine that undertaking a $1 billion merger would net only marginal benefits for the fund and its members and that the money and resources required to execute the merger would be better spent elsewhere – such as a large advertising campaign to yield longer term and reputational benefits.

    So where does the small $1 billion FUM fund turn to? Maybe it turns to a medium $35 billion FUM fund instead. However, this medium sized fund is looking to either merge with another medium sized fund to gain bigger scale or merge with one of the larger funds at some point over the next year. Undertaking a merger with a small fund does not fit with this plan.

    So, if the organic consolidation of the industry is limited only for funds already big enough to either join forces with another medium size fund or entice larger funds to merge, where does this leave the smaller funds? The likely answer – marooned at the tail of the industry.

    During the Royal Commission,35 Commissioner Hayne stopped short of recommending any regulatory reform in the successor fund transfer space. However, scenarios akin to the one described above are likely to culminate. Perhaps it's timely to consider the reform that might be required to ensure the smaller funds navigate their way into the Prince Rupert's bulb.

    Change of tact?

    In 2013 new financial reforms required custodial providers to hold net tangible assets of the greater of $10 million or 10% of average revenue.36 These entities were given a 1 year transition period to comply. Could a similar idea be implemented in the superannuation space? That is, a new licence condition imposed under section 29E of the SIS Act or amendment of the prudential standards sets a mandated threshold of say, $10 billion in assets, that funds must exceed? Depending on what threshold is set, one could imagine this would cause a stampede among the smaller funds to merge.

    Nevertheless, even with a mandated threshold – if the medium and larger funds increasingly opt for more strategic consolidation (such as the Sunsuper and QSuper merger) or re-directing a potential-merger budget elsewhere (such as advertising or operational uplift), even where smaller funds must merge – the lure for the larger funds to assist still may not be there.

    Is a potential resolution to this ‘no available suitable suitor' problem to consider a no-risk transfer mechanism to allow the larger funds to merge with these smaller funds with less risk? That is, APRA directs a trustee that has not met the mandated threshold to transfer all of the fund's members and assets to a larger fund. This would not be without its complexities. In these circumstances, the larger fund would need to take only a passive role in the transaction so it’s more likely to be in their members' best financial interests to accept the transfer. So, what would this look like?

    Perhaps it involves the smaller fund cleansing all of the data and incurring the costs of planning and executing the transaction. But what about the risk that would typically be absorbed by the transferee fund? Perhaps there's a need for something similar to the current section 147 "cessation of rights against transferor fund" of the SIS Act. But what about the rights of service providers? The larger fund might still consider the transaction as not being in the best financial interests of its members. Clearly, there are a lot of questions and nuance to be considered here. However they are questions that we need to start asking.

    Are these suggested resolutions to reshape the industry elusory? Perhaps. But policy makers and APRA need to start considering further strategies that may need to be discharged if the utopian ambition that the superannuation industry can consolidate organically becomes increasingly impractical.

    Happily ever after?

    Thirty years after his government introduced compulsory superannuation in Australia, Paul Keating predicted that the Australian superannuation system will mature into 10 "mega funds":

    "If we ended up with 10 funds with half a trillion each, this is better than having a fleet of 10 to 15 destroyers and two aircraft carriers in terms of real economic power.

    If we do this right, we’ll have half a dozen massively capitalised, competent bodies picking up international opportunities all over the place, funding this back into Australia through the superannuation system."37 

    Surpassing Keating's prediction, Australia's current largest super funds, AustralianSuper and Australian Retirement Fund, have indicated goals to have FUMs of half a trillion as soon as 2026 and researchers have projected that each fund can be expected to grow to $1 trillion by 2040.38 

    Everyone has a different prediction of the shape Australia's superannuation industry will take in the next 10 years – a few mega funds and 10 larger funds – or a handful of mega funds only – or a single national fund.39 

    What doesn't appear in any of these predictions is a long tail of smaller funds.

    Closer consideration of how the amalgamation of these smaller funds with their larger counterparts needs to be meaningfully planned to successfully re-mould the industry into a more desirable shape. If we let the current system meander forward, it will be the members who will lose out.

    When the industry was previously given the freedom to call the shots we were left with the fragmented and unworkable Prince Rupert drop.

    While the reform of recent years has shone the spotlight on sustainability and has spurred some consolidation, a new era of thinking and a new approach will likely be required to finish the job.

    Authors: Holly Marchant, Lawyer

    1. Thinking Ahead Institute, Global Pension Assets Study, February 2022, page 7 cited in J.P. Morgan, The Future of Superannuation: A Shared Perspective, page 2.
    2. Speech of Wayne Byres to the Financial Services Institute of Australasia on 19 October 2022.
    3. In this paper, references to "Australia's superannuation industry" and "superannuation funds" does not include reference to self-managed superannuation funds.
    4. Byres (n 2).
    5. Ibid.
    6. Ibid.
    7. Rachel Alembakis, "Australian plan sponsors outsourcing their funds," Pensions and Investments, 7 August 2006.
    8. Ibid.
    9. Commonly referred to as the ‘Murray Inquiry’.
    10. Australian Government, Financial System Inquiry – Final Report, November 2014, page 89.
    11. Productivity Commission, Superannuation: Assessing Efficiency and Competitiveness – Inquiry Report No 91, December 2018, page 575.
    12. Ibid, page 489.
    13. Australian Prudential Regulation Authority, Technical Paper – 2021 Heatmaps – Sustainability of member outcomes, March 2022, page 4.
    14. Ibid page 6.
    15. Revised Explanatory Memorandum to Treasury Laws Amendment (Your Future, Your Super) Bill 2021 (Cth), page 15.
    16. Superannuation Industry (Supervision) Act 1993 (Cth), Part 6A.
    17. Treasury Laws Amendment (Your Future, Your Super) Bill 2021 (Cth).
    18. Second Reading Speech of the Treasury Laws Amendment (Your Future, Your Super) Bill 2021 (Cth), 17 February 2021, (Hon Joshua Anthony Frydenberg, MP), 1020.
    19. Treasury Laws Amendment (Your Future, Your Super) Bill 2021 (Cth).
    20. Frydenberg (n 18).
    21. Media release of Hon Jane Hume, One million visits to the YourSuper comparison tool, 6 January 2022.
    22. J.P. Morgan, The Future of Superannuation: A Shared Perspective, page 9.
    23. Speech of Helen Rowell to the Australian Institute of Superannuation Trustees Conference of Major Superannuation Funds on 19 May 2021.
    24. Ibid.
    25. Ibid.
    26. Speech of Margaret Cole to the Financial Services Council webinar on 20 October 2021.
    27. Ibid.
    28. Ibid.
    29. Superannuation Industry (Supervision) Act 1993 (Cth).
    30. Cole (n 26).
    31. Australian Prudential Regulation Authority, Discussion Paper – Superannuation transfer planning: Proposed enhancements, November 2022, page 4.
    32. Prudential Standard 525: Strategic Planning and Member Outcomes.
    33. Prudential Practice Guide 227: Successor Fund Transfers and Wind-ups
    34. Australian Prudential Regulation Authority (n 31).
    35. The Royal Commission into Misconduct in the Banking, Superannuation and Financial Industry Services.
    36. Australian Securities and Investments Commission Class Orders 13/170 and 13/171 dated 29 April 2021.
    37. Tony Boyd and Jennifer Hewett, "How 10 mega super funds will dominate financial system", The Australian Financial Review, 6 September 2022.
    38. KPMG, Super Insights 2022 – From accumulation to retirement: why it's time to shift the conversation, May 2022, page 25.
    39. Lachlan Maddock, "A moment of truth' arrives for super mergers", Investor Strategy, 18 January 2023.

    The information provided is not intended to be a comprehensive review of all developments in the law and practice, or to cover all aspects of those referred to.
    Readers should take legal advice before applying it to specific issues or transactions.


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