RDP 9605: The Evolving Structure of the Australian Financial System 4. Funds Management

A basic distinction in principle can be made between intermediaries, which offer deposit and loan services on a capital-guaranteed basis, and funds managers, which manage but do not bear investment risk on behalf of their account holders. This distinction is reflected in the differing balance-sheet structures of the two types of institutions. Financial intermediaries require capital in order to shield depositors from investment risks whereas funds managers have a structure in which investment risk is borne by the members; in effect, members' funds are a form of equity. To a large extent the two sets of institutions have developed separately in Australia, and their structure and growth need to be explained in terms of rather different forces. It was also argued earlier that households have tended to view deposits and funds under management as quite distinct products and not closely substitutable; at any rate, the broad historical experience seems consistent with that interpretation. Nonetheless, a number of areas of growing competitive interaction between intermediaries and funds managers can be identified, including the increasing involvement by banks in funds-management activities already discussed in Section 3. The discussion that follows focuses mainly on the life insurance and superannuation sector, which comprises the bulk of the funds-management sector.^[31] We first look at the historical sources of growth of these institutions and then move on to consider the issue of competition between funds managers and intermediaries.

4.1 Life Insurance and Superannuation: Sources of Growth

Historically the life insurance and superannuation sector has represented around 20 to 25 per cent of the total assets of the Australian financial system. It is currently a little above that range, having grown rapidly in recent years. The structure of the industry has been influenced by a number of major policy developments during the past 10–15 years. Three were particularly important.

The first was a shift in the tax treatment of superannuation. Prior to 1983 superannuation was taxed at extremely low effective rates, with contributions fully deductible, earnings untaxed, and only a small tax on final benefits. Subsequent tax changes (the most important of which were made in 1983 and 1988) reduced this concessional treatment substantially by introducing or raising taxes at all three of these levels; the treatment remains concessional relative to other financial savings, but much less so than previously.^[32] Ironically these changes, by reducing inequities and fiscal revenue costs, laid the foundation for subsequent expansion by making private superannuation a more suitable vehicle for mandatory saving. However, the successive layers of tax changes have enormously increased the complexity of superannuation and appear to have contributed to rising administrative costs for superannuation funds.

The second main policy development was the introduction of award superannuation beginning in 1986, when the Industrial Relations Commission endorsed a claim for a general employer-provided superannuation benefit, set initially at 3 per cent of income. This benefit was gradually incorporated into employment awards as they came up for renegotiation over the next several years. Payments were directed either into existing funds or into union-created industry funds which in other respects were the same as those already in existence (that is, managed by private funds-management firms); these funds now represent the fastest-growing part of the superannuation industry, although their asset base remains small. A consequence of this history is that many of the structural features of superannuation coverage for the newly-covered employees (for example, the choice of fund, and the nature of benefits provided) are written into awards which continue to govern those basic conditions under the newer government-mandated scheme.

The third main development was the introduction of the Superannuation Guarantee Charge in 1991. This gave the mandatory system its current basic shape by legislating a timetable for further increases in contributions and setting tax penalties for non-compliance. The target level of employer contributions, to be phased in over a number of years, was set at 9 per cent. Further policies announced in 1995 specified a timetable for supplementary contributions by employees of 3 per cent, with a matching contribution from the federal government, to bring the total contributions rate to 15 per cent by 2002. These broad parameters now have bipartisan political endorsement, although the new government has indicated that the delivery method for the employee and government contributions could still be varied.

The higher contributions rates resulting from these policies can clearly be expected to have a major impact on the industry, and indeed on the financial system as a whole, in future decades.^[33] Already the proportion of employees covered has increased dramatically from around one-third of private-sector employees in the early 1980s to around 90 per cent at present. But this increase has yet to have a significant impact on the sector's overall asset growth, which is largely explained by other factors outlined below.

Trends in the superannuation sector's overall size and its sources of funds are summarised in Figures 15 and 16.^[34] Broadly, the historical growth of the superannuation sector can be divided into three phases. The first phase, which ended in the early 1970s, was one of moderate and fairly steady growth. In the second phase, which comprised most of the 1970s, superannuation assets shrank relative to nominal GDP, largely reflecting poor earnings performance and high inflation. The third phase, from the early 1980s onward, has been one of rapid expansion in which total assets more than doubled as a ratio to GDP, although this may have slowed down in the latest few years. The data presented in Figure 16 divide the sources of superannuation asset growth between net new contributions and a residual representing earnings on existing assets and capital gains. Although net contributions have fluctuated significantly in some periods, it is apparent that most of the variation in overall growth performance is attributable to variation in the earnings and capital gain component, rather than in contributions.^[35] The three growth phases outlined above correspond broadly to periods of moderate, negative, and high real rates of return on financial assets, as summarised in Table 8.

On the basis of currently available data, aggregate net contributions to superannuation funds do not yet show the upward trend expected to result from the compulsory plan.^[36] A number of possible reasons can be given for this. First, there is likely to be a strong cyclical influence on net contributions. They fell substantially in the recession of the early 1980s, when withdrawals related to early retirements are likely to have been particularly important. This may again have been a factor in the early 1990s. In addition, many voluntary schemes contain a tranche of employee-contributed funds which do not have to be preserved to retirement but can be withdrawn on leaving a job.^[37] There is also provision to allow early withdrawal of funds in cases of hardship. For all these reasons, recessions can be expected to result in significantly increased withdrawals from superannuation funds as jobs are lost. Secondly, many employers were already satisfying, at least partly, the requirements of the compulsory plan under pre-existing voluntary arrangements. This has allowed some scope for absorption of the compulsory scheme into existing arrangements, and has meant that the aggregate effect of the new compulsory schedule has so far been relatively small; but it can be expected to increase as the mandatory contributions rate increases significantly above levels currently prevailing. Thirdly, an important factor in the second half of the 1980s was the phenomenon of overfunding of existing defined-benefit schemes. High rates of return meant that surpluses were accumulated in many of these schemes, enabling the employers who sponsored them either to withdraw funds, or to finance their superannuation liabilities with reduced contributions. Finally, it is possible that increased tax rates on superannuation savings after 1983 have discouraged voluntary contributions.^[38]

To summarise these trends, it is apparent that most of the variation in the growth of superannuation funds' assets in recent decades is attributable to changes in the funds' earnings rates, combined with the fact that the long-term nature of superannuation accounts tends to mean that earnings are locked in and automatically reinvested. Although a sustained lift in net superannuation contributions is projected for the future under current policies, there is little evidence of that so far in the available data. This observation is relevant to debate as to the potential for compulsory superannuation to divert household funds that would otherwise have gone to financial intermediaries.^[39] On the basis of the trends outlined above, claims that this has already occurred to a significant degree would not be substantiated. Nonetheless, competition for new savings between banks and superannuation funds is likely to be an important issue in the future. Most projections of the impact of compulsory superannuation assume a degree of crowding out of other forms of saving,^[40] implying a reduced flow of household funds into other savings vehicles as compulsory superannuation flows increase. To the extent that this occurs, however, it may affect households' direct asset holdings more than deposits with intermediaries, since the former are more likely to be regarded as closely substitutable with superannuation accounts.

4.2 Competition with Intermediaries

Related to this issue is the more general question as to whether the structure of financial institutions is changing in a way that brings funds managers and intermediaries more directly into competition, through overlap in their functions or increasing similarity of product lines. One aspect of this, already discussed in Section 3, is the involvement of banks in funds-management business through subsidiaries. In principle however, the existing regulatory and prudential guidelines keep these businesses separated. For example, banks are not permitted to offer funds-management products on their own balance sheets or to apply their capital directly to funds-management operations.

Putting that aspect aside, a good general case can be made that the two sets of institutions have operated in fairly distinct markets. On the assets side of the respective balance sheets, the banks' core business of direct lending can be contrasted with the life and superannuation sector's main investments in debt securities, equities and property. However, one area of overlap historically was that life offices were significant mortgage lenders for a period of time up until around the early 1970s. Their involvement in mortgage business reflected a number of conditions prevailing at the time, including the banks' inability to meet fully the underlying demand, and the relatively early stage of development of alternative mortgage lenders. The life offices were also able to link their loans with the provision of whole-of-life policies which benefited from generous tax treatment. Life-office mortgages were generally on fixed-interest terms, which meant that their profitability declined substantially as the general level of interest rates rose in the 1960s and 1970s. Total direct lending by life offices has declined steadily in relation to their balance sheet, dropping from around 40 per cent of assets in the late 1950s to around 7 per cent at present. Similarly, superannuation funds (to date at least) have only a small involvement in direct lending (Table 9).^[41] The growth areas for investment by life and superannuation funds have for a number of years been in equities and foreign assets. More recently, however, some life offices have again become more active in the home-mortgage market, seeking to take advantage of the same kinds of competitive opportunities as the mortgage managers.

In terms of liabilities, the basic differences in financial structures of intermediaries and funds managers have already been noted. Superannuation fund liabilities are the long-term savings of their members, whereas bank liabilities are a combination of transaction balances, short-term savings and marketable-debt instruments. The banking system in Australia has not traditionally been an important vehicle for longer-term saving,^[42] so the competition with the long-term savings institutions for household-sector funds has not been particularly strong. This short-term/long-term distinction reinforces the conceptual distinction between capital-guaranteed deposits with intermediaries, and funds-under-management which are subject to investment risk. On the basis of these two sets of distinctions, intermediaries and funds managers have historically been competing for household funds in quite different areas of the market.

In a number of respects, this neat division is becoming less clear cut. Specialist funds-management institutions, such as unit trusts, are able to offer a range of short-term investment services, some of which closely resemble deposits, and these institutions have grown substantially in recent years. Increasingly banks are offering the same services, but not on the balance sheet of the bank itself. Also important is that the superannuation sector has become a major holder of essentially mobile or short-term savings of retirees. This trend has been boosted by increasing rates of early retirement, the wide availability of lump-sum retirement benefits and the advent of rollover funds, which retain the status of tax-favoured superannuation vehicles but offer some of the characteristics of shorter-term savings.^[43] This has provided a category of relatively high-wealth individuals with a highly attractive alternative to financial intermediaries for holding what are fairly liquid balances. Another important consequence of these developments is that the funds-management sector has itself become an important provider of funds to financial intermediaries. For example around $40 billion, or 15 per cent of superannuation assets are currently held as bank securities or deposits with financial institutions, a significant proportion of these institutions' liability base. Growth of these ‘wholesale’ sources of funds to the banks represents a potential source of upward pressure on their average cost of funds.

The banks clearly believe there are advantages to be gained from combining their intermediation role with funds-management activities, and have pushed for allowance of more direct involvement in retirement-saving products, as well as having introduced a range of over-the-counter investment products in recent years. These developments, and the changing nature of the funds-management sector itself, point to increasing areas of overlap between the products offered by banks and funds managers. Although the legal distinction between capital-guaranteed and other products is preserved, the system seems to be moving towards a spectrum of more closely substitutable products in place of the clear traditional dividing line between deposits and funds-management services.

Footnotes

Cash management trusts and other unit trusts are also usually classified as funds managers, although in some respects (particularly in the case of cash management trusts) their activities resemble those of deposit-takers. Some aspects of these institutions are discussed in Sections 2 and 3. [31]

Fuller discussions of these tax issues are provided by Edey and Simon (1996) and Fitzgerald (1996). [32]

Projections by Knox (1995) suggest that the superannuation sector could roughly double as a ratio to GDP, from its current level of 40 per cent, over the next 25 years, eventually reaching something like four times GDP when the system reaches its peak asset holdings. [33]

For statistical purposes this discussion treats life insurance and superannuation funds as a single aggregate because their activities are similar and much of the historical data does not distinguish between the two. [34]

Capital gains are likely, however, to be understated in the 1960s and 1970s, and overstated in the early 1980s, as a consequence of the widespread use of historical-cost valuations prior to the 1980s. [35]

These data should be interpreted cautiously, however, as they have in the past been subject to substantial revision. [36]

Recent regulatory changes restrict this right of withdrawal, subject to grandfathering of existing withdrawable amounts. [37]

There is also a serious longer-term policy concern: the potential for funds to leak from the compulsory scheme due to incentives favouring early retirement and dissipation of accumulated savings. See Edey and Simon (1996) and FitzGerald (1996). [38]

This issue was discussed by the Martin Committee report (1991). [39]

Official projections are discussed in Saving for Our Future (1995). These assume that one-third of the projected increase in superannuation contributions is offset by reductions in other forms of saving. Similar non-official estimates are also available. See Covick and Higgs (1995) and Corcoran and Richardson (1995). [40]

The 7 per cent balance-sheet share shown in Table 9 is likely to be overstated, as it includes loans to public authorities by public-sector superannuation funds. [41]

This view is documented by Edey, Foster and Macfarlane (1991). [42]

Following rule changes in 1992, rollover-fund operations can now be carried out within ordinary superannuation funds. [43]