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Regulation of Financial Plans and Allocated Pensions (CIFR - E045)

Project Summary

This project will research the question of regulating for financial plans, allocated pensions and account-based pensions that carry less investment risk on the cusp of retirement and are better tailored to the spending plans of retirees. In 1992 compulsory superannuation was added to Australia's pre-existing voluntary arrangements, resulting in the world's first compulsory and pre-funded scheme in which ordinary workers bear sizeable investment risk. Following two reviews of the financial planning industry in Australia, we now have legislation under the headings of the Future of Financial Advice and MySuper. However, the legislation does not seek to regulate asset allocations, including those for less-affluent workers on the cusp of retirement, in contrast to most OECD countries that have instituted compulsory prefunded superannuation with a defined-contributions emphasis. Nor does FoFA regulate for better disclosure of risks in financial plans. This project will help inform measures needed to fill the gaps.

Research Team

Team Leader:
Professor Geoffrey Kingston
, Department of Economics

Researchers:

Significance of findings

The US, the UK and Canada all have first-cum-second pillars of retirement income that include defined-benefit schemes, both public and private ones. The resulting link between wages and total income in retirement ensures that these schemes perform an income-replacement function for people of middle means. Australia's distinctive problems in regulating financial advice arise from our distinctive policy of a first pillar consisting of a means-tested public pension, along with a second-cum-third pillar consisting mainly of privately-managed defined contributions, which are supposed to perform the income-replacement role. High allocations to growth assets go hand in hand with high fees to advisers and managers. This tempts adviser-managers to overweight growth assets, especially in portfolios for people of middle means who are on the cusp of the point of retirement, a time of life when funds under advice and management tend to peak.

Means testing of the pension creates moral hazard on the demand side. The problem is compounded by compulsion, leading to unengaged investors who place undue reliance on default options in superannuation funds.

The upshot has been superannuation portfolios in Australia that have the riskiest asset allocations of any OECD country. The income-replacement function of the second-cum-third pillar is vulnerable to market crashes.

An OECD report notes that Australia imposes no limits on pension fund investments by asset class, although investments involving 'self-investments/conflicts of interest' are capped at 5 per cent of the portfolio. More generally, OECD countries outside the common-law ones tend to regulate pension fund investments more heavily. For example, Switzerland caps equity investments at 50 per cent and real estate investments at 30 per cent.

Candidate reforms:

  • Part of the solution could be mandatory target-dating (aka glide paths) for MySuper accounts. These accounts are intended for disengaged superannuation contributors. For example there could be a simple two-step mandatory glide path: a 60 per cent weight to workers under 55 years of age, and a 40 per cent weight to growth assets for workers over 55 years. We would not object if these caps were revised up to (say) 70 per cent for the under 55s and 50 per cent for the over-55s. Engaged investors would remain free to choose their preferred allocations.
  • Following the US, performance fees charged by advisers to unsophisticated investors in actively-managed funds could be confined to fulcrum fees whereby benefits and costs to advisers are symmetrical around a passive benchmark. This would ameliorate the problem of chronic index-hugging behaviour on the part of Australian actively-managed funds.
  • Following the UK, financial advisers should be required to identify themselves as offering either restricted or independent advice.
  • Following Canada, reviews of financial plans should not take place on a fixed two-year schedule (as prescribed by one version of FoFA) but on a contingent, 'trigger' basis. One such trigger would be when a client's life circumstances change. For example, if the person responsible for managing household finances passes away before her partner, it could take a considerable time before the surviving partner learns about trail fees that have become superfluous to family needs, absent a triggered review. Put another way, the absence of any review smacks of 'inertia selling' of the kind banned by the Corporations Act.

In traditional holistic financial plans it can be hard to figure out how much is allocated to safe interest-bearing securities. A minimum requirement could be a simple two-part classification: growth assets (stocks and property), and safe assets (AA, i.e. interest-bearing securities rated 'high quality' by one of the major credit rating agencies.) The growth-assets class could be subdivided, but not at the expense of the safe interest-bearing securities class. If the portfolio is geared up with secured loans, as often occurs with wealth accumulation plans outside superannuation, an explicit net figure ─ presumably negative ─ could be mandated for the overall exposure of the recommended portfolio to safe-interest-bearing securities.

Implications of research

Regulators:

At the time of writing (July 2014) the regulation of financial advice in Australia is in limbo. FoFA in its original form has not been implemented. The Corporations Amendment (Streamlining of Future of Financial Advice) Bill is in draft form but has not been enacted. It seems unlikely to survive either a change of government or another market crash, whichever comes first. Now is as a good time as any to stand back and review how financial advice is regulated, in the leading common-law countries as well as Australia. Section 3 above offered several suggestions for incorporating the best features of overseas legislation into future versions of FoFA.

Industry:

My 2104 article with Lance Fisher considers a family that retires on $1 million. Allowable retirement-year spending is found to be $48,000, or $8,000 higher than under the '4 per cent rule' that is popular in the financial-planning community. The expected rise in the share of growth assets during retirement is 28 percentage points, in contrast to popular 'constant mix' strategies whereby the proportionate exposure to growth assets is held constant throughout retirement. This upward-sloping 'glide path' for the share of growth assets can be implemented by financing early retirement mostly by drawing down interest-bearing assets, and financing late retirement mostly by drawing down growth assets, an approach sometimes as a 'bucket strategy'. Our suggested plan turns out to imply an expected estate of $285,027. This contingent outlay represents a discretionary item that has alternative uses, notably, as a cushion against the contingencies of spending more than 30 years in retirement, or unexpectedly low returns to growth assets, or uninsurable health setbacks late in life.

Related resources

Journal articles:

Working papers:

  • Regulating financial advice: evidence from the United States, the United Kingdom and Canada
    Hazel Bateman and Professor Geoffrey Kingston,
    June 2014