The Productivity Commission’s draft report on how to improve efficiency in the super industry was something of a breath of fresh air after the usual Punch and Judy show between industry funds and retail funds.

It’s a draft report, rather than a ruling, and the big issue for super funds is the report’s proposal to update the much-debated default system with a ‘Top 10 Funds’ proposal.

It’s certainly got some logic but most people agree it will need a bit of tuning.

First of all, it doesn’t replace what the industry calls the choice market: it specifically proposes that a first-time employee merely be given more options than the default system now offers. Ten choices rather than one, basically.

The intention is to use a panel to choose the best-in-show performers among the super funds of both industry and retail origins, reviewed every four years.

That would represent quite an upheaval. If it did become a reality, what would the consequences be?

The most widely tipped is consolidation in the industry. The Australian Financial Review recently listed the 10 best and 10 worst performers among pooled super funds and it was clear several funds that have turned in less than 1.8 per cent growth a year over 10 years probably don’t deserve to exist, never mind make it to the Premier League or Top 10.

Given that those funds are unlikely to get noticed by anyone in a free-choice market, they are going to have to merge or close down.

The Productivity Commission is probably all in favour of consolidation. Choice is one thing (there are about 67 funds qualifying for a MySuper badge) but the PC noted at its hearings last year that there are 80 super funds alone “in outflow territory”, where there is more money going out than coming in. Small funds are going to have to bulk up or get eaten.

Financial advisers have noticed a sharp uptick in enquiries from clients wondering if they should move their accounts across to industry funds.

“It’s been far more marked than the number of inquiries I was getting in the wake of the royal commission,” said James Gerrard, who runs an independent advisory business.

He said the clients appeared to be basing their concerns on the commission’s observations that industry funds have consistently outperformed retail funds by a measurable percentage.

“That’s not new, and it relies on two factors,” Gerrard said. “One, the industry funds have a much less mobile membership than the retail funds – workers who join in their 20s and usually stay on board until they retire. The retail funds always have to be ready for withdrawals if their performance shows signs of weakening, and that means they can’t invest so much in high-quality but illiquid assets such as infrastructure assets.”

“Two, the industry funds are huge beneficiaries of the massive cashflow they get from industry awards, which interestingly, is something the Productivity Commission is suggesting needs an overhaul,” he added.

Gerrard said there appeared to be no mechanism for advisers to pick up any fee other than fee-for-service from moving clients across to industry funds, even though the latter would be happy to accommodate them.

“I think some of this reaction might be a bit knee-jerk,” he said. “I understand one of the industry funds got a call from an angry member who said, ’I want to move out of your fund and into one of those industry funds.’ ”

In the first 48 hours after the Productivity Commission report came out, the umbrella body for industry super funds, Industry Super Australia, reported a tripling in the number of inbound inquiries.

Much to consider

But there are certainly complications with the proposal.

I’ve asked around and here is just a sample of the questions being raised:

How about the age-old point that past performance is no guarantee of future performance?

What about market cycles? Funds with a value bias and funds with a resources or cyclicals bias are going to behave differently at different times in the cycle.

Shouldn’t you be buying assets (funds being nothing but big piles of assets) when they are undervalued, not when they are most popular?

Won’t big funds on the list just get bigger and, thus, less nimble?

What if a fund is running 11th or 12th in the league table? Won’t it be tempted to massage its performance numbers close to decision time to reach the all-important Top 10? And won’t the same apply to those trying to avoid relegation?

What about the panel that chooses the Top 10? Who is going to be on it, and are they going to be both independent and well informed?

Even if they are, won’t they be risk averse? The critics will be lining up with baseball bats if the panel recommends a dud fund.

Independent trustees

The other potentially controversial element of the Top 10 Funds proposal is that industry funds would get onto the list only if they have a certain number of independent directors.

That aligns with proposals that have long come from the Liberal side of federal politics, to increase the number of independent directors in industry funds.

The industry funds’ defence, for years, has been the correct one – that they outperform retail funds on average – but that is very unlikely to reflect the wisdom of the union members who make up almost half the funds’ trustees.

They outperform mostly because they have a far stickier membership than do the retail funds, which always have to be ready for an outflow stampede if they’ve had a bad quarter.

The duration of most industry fund memberships is so long that the funds can diversify far more into illiquid assets such as infrastructure and utilities.

The industry fund model was designed a long time before the 21st-century corporate governance model started pressing for independent directors – in particular, chairs – on large corporate bodies.

The unions essentially had first-mover advantage with the “equal representation” model, to the extent that many people forget there are as many employer representatives on industry funds as there are union nominees.

There are dozens of stories of union reps picking up industry fund trusteeships out of longevity rather than industry knowledge. It’s easy to understand how that happened – the unions helped design the system – but there has to be merit in suggesting that people who serve on industry fund boards should have long experience in investment markets.

If the industry funds are ahead already, how about getting further ahead, thanks to a bit of expert advice?

Let’s at least assume that the Productivity Commission has fired the first well-merited shot in an attempt to make the superannuation industry in Australia more efficient.

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