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DISCUSSION PAPERS IN ECONOMICS, FINANCE
AND INTERNATIONAL COMPETITIVENESS
The Economics of Choice of Superannuation Fund
Michael Drew & Jon D. Stanford
Discussion Paper No. 102, February 2002
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Series edited by Dr Andrew Worthington Dr Andrew Worthington Editor, Discussion Papers in Economic, Finance and International Competitiveness School of Economics and Finance Queensland University of Technology GPO Box 2434, BRISBANE QLD 4001, Australia School of Economics and Finance Telephone: 61 7 3864 2658 Facsimilie: 61 7 3864 1500 Email: firstname.lastname@example.org
THE ECONOMICS OF CHOICE OF SUPERANNUATION
Thus, employees have no choice as to which fund their contributions are to be paid.
However, self-employed persons are able to set up their own superannuation funds, the “DIY funds”, and self-manage these funds.
This compulsory direction of employee contributions stands in contrast with the highly market oriented approach to other decisions, such as asset selection or portfolio composition, which have to be made by superannuation funds.
The Commonwealth Government has announced a policy of choice of fund in 1996 and introduced a detailed proposal in the 1997 Budget. Specific proposals for choice of fund were introduced into Parliament in December 1997. Originally introduced as Schedule 5 to the Taxation Laws Amendment Bill (No &) 1997, the choice legislation was re-introduced on November 12, 1998 in revised form as the Superannuation Legislation Amendment (Choice of Superannuation Funds) Bill 1998. This Bill passed in the House of Representatives on February 16, 1999, but debate on the Bill in the Senate was adjourned on February 1999 and the Bill remains in limbo.
The Wallis Committee endorsed choice of fund with some caveats in their 1997 Report.
We examine whether employees should have a choice of superannuation fund and whether this choice should be unrestricted. The basis of our examination is how can a contributor to a superannuation fund maximize their retirement balance. In doing so, we review the decisions that have to be made about investment of superannuation fund balances and examine whether * Michael E Drew, School of Economics and Finance, Queensland University of Technology, Brisbane, Qld, 4000, Australia, Email: email@example.com (Correspondent Author) and Jon D. Stanford, School of Economics, University of Queensland, Brisbane, QLD, 4072, Australia, Email: firstname.lastname@example.org.
these decisions by trustees and managers of superannuation funds are efficient, rational and likely to maximize the retirement benefits of contributors.
The Current Superannuation Arrangements Current government policy has a policy of compulsory superannuation, which requires that contributions to a superannuation fund be made for each employed person. Contributions are of
1. Under industrial agreements and awards; and
2. Under the Superannuation Guarantee Charge (SGC).
Prior to 1992 many awards had specified that wage and salary increases were to be paid as superannuation and not direct to employees. The National Wage case of 1987 had prescribed that three per cent of salary and wages was to be paid to a fund as specified under the agreement or award. Payments under these arrangements continue to be made for a large number of employees after the introduction of the Superannuation Guarantee Charge.
From July 1, 1992 employers have been required to pay a specified percentage of an employee’s wage or salary into a superannuation fund. The Superannuation Guarantee Charge was originally set at three per cent with the intention that it would increase to 9 per cent by 2003.
The current level, from July 2000, is eight per cent. Coverage of the employed workforce is high1. The two types of contributions mean that most contributors have at least two superannuation funds. Some, particularly part-time and casual workers, would have more. In 2000, there were over 22 million individual superannuation accounts while the workforce was less than 10 million.
Rationale of Compulsory Superannuation Compulsory superannuation is hoped to increase national savings, to reduce dependence on government age pensions and to provide retirement benefits for contributors. The focus of this article will be on the accumulation of funds to finance retirement.
Individual contributors to a superannuation fund wish to maximize the accumulated balance of their superannuation account at retirement. However, we do not examine the options for obtaining post-retirement income2.
It was estimated in 1992 that that 79 per cent of the work force is covered by award superannuation. The estimates made by the ACTU are cited in the Second Report of the Senate Select Committee on Superannuation (SSCS) (p.14). Some employees, particularly casual or part time employees may not earn the minimum threshold as provided for in the SGC. The minimum threshold for award superannuation is lower than that for the SGC.
APRA (2000) gives ABS data showing that 91 per cent of employees are covered by superannuation with 81 per cent of all workers and 36 per cent of employers, including self employed, covered by superannuation.
Government policy is to encourage retired person to take retirement benefits in an income stream instead of the currently preferred lump sum benefit largely to discourage “double-dipping,” i.e., spending the lump sum and then taking out the age pension.
Goal of a Contributor to a Superannuation Fund
The goal of a contributor to an accumulation fund is to maximize the accumulated benefits at the date of retirement as this will purchase the highest value annuity or pension. There may be other strategies such as restricting the accumulation to the limit of the assets test for the age pension;
however we shall ignore any such strategic behaviour.
For a given contributions schedule and given taxation structure, this goal requires that the superannuation fund earn the highest rate of return consistent with a given risk exposure. The problem for the fund is to place the fund contributions into assets, which will produce the highest rate of return. Future rates of return are uncertain; past experience is a guide but not a complete one. Previous experience suggests that over the long term the highest returns will be obtained from exposure to equities so that the equity premium can be obtained. The proposition that investors with a relatively long investment horizon should hold equities is supported by Levy and Cohen (1998). Mehra and Prescott (1985) give historical evidence on the equity premium and calculate it as in excess of six percentage points a year. Siegel (1999) reviews the historical evidence and claims that the forward – looking equity premium may be considerably lower than the historical average. Kingston, Piggott and Bateman (1992) through numerical simulations demonstrate that an age-phased investment strategy embracing substantial allocations to a risky asset in the early decades of working life can generate a substantially greater final accumulation.
18.0 0 16.0 0 14.0 0 12.0 0 10.0 0
A rational strategy for contributors is to select a superannuation fund whose portfolio contains a high proportion of equities. We do not discuss the optimum proportion of equities in this paper but note that it is an important question. Conventional wisdom maintains that this proportion should diminish with the age of contributor. As will be seen later, Australian superannuation funds in the aggregate hold over 60 per cent of heir funds in equities. Thaler and Williamson (1994) suggest a strategy of holding 100 per cent equities at all times while Bierman (1998) advances qualifications to this proposition but support a high level of equity holdings.
At juncture, it is sufficient to note that the return on equities will be the single most significant determinant of returns to a superannuation fund.
Types of Superannuation Funds Superannuation contributions on behalf on an individual employee are paid into a superannuation fund which has been established or designated under an award or is a complying superannuation funds under the SIS legislation. The SIS legislation provides for prudential supervision of superannuation funds.
Superannuation funds are defined in the following way by the regulatory authority:
1. Corporate funds which are sponsored by a single non-government employer or group of employers;
2. Public sector funds which are sponsored by government employers or by government business enterprises;
3. Industry funds which are established under an award or agreement;
4. Retail funds which are pooled super products marketed by intermediaries to the general public; they include master trusts and personal superannuation products offered by life insurance companies and other financial institutions;
5. RSA are superannuation products offered by banks and other deposit taking financial institutions;
Excluded funds which are commonly referred to as “DIY funds” and which have fewer than five members3.
The relative size of each class of funds is shown below in Table 1:
Table 1: Proportion of Superannuation Balances held by each type of fund
For our purposes it is also important to know whether funds are accumulation, or defined contribution, funds because this type of fund is the one for which the SGC was effectively designed4.
The DIY funds have a special place in the superannuation arrangements being designed for self employed contributors and may not include other employees. Amendments to the Superannuation Industry (Supervision) Act 1993 in 1999 changed the position regarding excluded funds considerably. Small funds with fewer than five
members from March 31, 2000 have to be either:
1. Self-managed superannuation funds (SMSFs); or,
2. Small APRA funds (SAFs).
Self-managed superannuation funds (SMSFs) have the following characteristics:
1. Fewer than five members;
2. All members are trustees (or directors of the trustee if a corporate trustee) and no other persons are trustees;
3. No member is an employee of another member unless the members concerned are relatives; and
4. Single member funds may have one additional trustee/director provided the member is not an employee of the other trustee/director; and,
5. Trustees must not receive remuneration for their services as a trustee.
After March 31, 2000 any superannuation fund with fewer than five members, which does not satisfy the requirements to be a SMSF, is required to have an approved trustee that has met the capital, solvency and other requirements under Part 2 of SIS. SMSFs are supervised by the Australian Taxation Office and SAFs by Australian Prudential Regulation Authority. An important decision in relation to SMSFs is that unrelated employees cannot join their employer’s self managed fund for the reason that such “arms length members” cannot in the normal course of events adequately protect their interests in such a fund. However, SAFs are no longer exempted from certain SIS requirements simply because they have fewer than five members so that, unlike SMSFs, SAFs will be required to establish a complaints handling procedure. Both SMSFs and SAFs will operate under member directed investment so that members can direct the trustee where to invest. This is expressly denied to all other funds.
At June 30, 2000, according to APRA (2000) there were nearly 22 million individual superannuation accounts.
Ninety per cent of member accounts in the private sector were in accumulation funds. There are some funds predominately in the public sector which are defined benefits plans; however, the trends in the public sector has been to close such funds to new entrants.
Accumulation funds are mutual investment vehicles, which pool individual contributions and distribute net earnings of the fund to individual accounts each year. The value of the individual contributor’s account at any time is the sum of accumulated contributions plus net earnings. The retirement benefit provided by an accumulation fund is the value of the contributor’s account at the date of retirement. The value of the retirement benefit, for given contributions, depends on the net returns earned by the fund so that the aim of the fund is to obtain the highest returns for a given risk exposure. Earning a low rate of return is the investment risk of the contributor.
Management of Superannuation Funds Each fund is managed by a trustee who, in addition to being the legal owner of superannuation funds assets, is responsible for the administration of the fund and who makes the asset allocation or portfolio choice decision regarding investment of contributions.