Disrupting Super Supply Chains

Vertical integration and outsourcing in the superannuation system

There is a developing trend for trustees of superannuation funds to internalise the investment management, insurance and administration functions which have traditionally been outsourced.

While an obvious motive may be to achieve cost savings by way of scale efficiencies, the process is nuanced, the opportunities more diverse and there are risks which warrant the diligent attention of superannuation fund trustees if they are to ensure that the best interests of members remain paramount.

Superannuation funds are operating in an environment which is the subject of considerable technological, economic, regulatory and competitive change.

1. Prudential regulation specifically requires trustees to regularly review supply arrangements for material business activities.
2. Advances in information technology are enabling more automated transaction processing, and the resulting reliance on trusted data to inform decision making.
3. There is a possibility of greater competition in the form of a market based model for default contribution arrangements with the ongoing Productivity Commission Inquiry.
4. The economic dynamics of the industry continue to shift, with the continued growth in the asset base making scale efficiencies increasingly important in enabling market leading performance.

Vertical Integration and Outsourcing

There ought not be much controversy about trustees internalising material business activities, yet it is often seen as unconventional. The starting position of trust law is that trustees are required to perform duties personally and are precluded from delegating powers in the absence of express authority.

Although this authority often exists, and the appointment of agents is permitted, the commercial reality of supply chains in the superannuation industry is one where most trustees depend on service providers for a broad range of services including investment management, administration, custody and insurance.

Operating and investment expenditure of superannuation funds over the past decade has continued to steadily increase. It should come as no surprise that the efficiency of supply chains is the subject of scrutiny by the Productivity Commission. Trustees should be careful not to be blindsided by prospective changes to the competitive environment. Taking a smart approach to reviewing supply markets can give trustees a competitive edge.

Market agility in an age of disruption

Once outsourcing arrangements are in place, there is an inertia for the status quo in the scope of the services outsourced to suppliers. While a market scan or tender might be undertaken to assess the competitiveness of the arrangements, the scope of the services is often simply rolled over without consideration of changes in the technological and economic environment.

While we have traditionally grouped together administration, custody, insurance and investment management as distinct functions, we may see fractures and blurred lines as new technology advances and the role of superannuation funds as asset owners in the economy increases. Whether it’s investments, insurance or administration; genuine consideration should be given to understanding the underlying market dynamics to guide supply strategy.

Environmental changes are transforming the market for the supply of investment management, administration and insurance products and services.

Investment management

Internalisation of the investment management function involves portfolios of assets being managed on a discretionary basis by the employees of the superannuation trustee. It isn’t merely the selection of investment managers and balancing strategic allocation.

When reviewing the market, attention is needed to understand which asset classes have a strong business case for insourcing and those which don’t. While the case for insourcing real property and infrastructure might be strong, the costs and risks associated with bringing cash management of bonds and fixed interest in house may not stack up.

Administration

Superannuation administration involves a broad range of services clustered around member registry systems. These services may be delivered more effectively or efficiently when unbundled.

Insurers may be better positioned than administrators to manage claims, member services and advice might be disrupted by technology, and new entrants might provide innovative ways of providing behavioural insights or risk assessments to trustees that existing administrators don’t.

Insurance

The collectivisation of risks through insurance has played a significant aspect of managing annuities and defined benefits for many years. Superannuation trustees have relied heavily on third party insurers to manage the risks of early retirement due to disability or death, and are required to outsource to a regulated life insurer.

As we see further attention given to managing longevity, funding and sequencing risks, some trustees may be well place to vertically integrate into life insurance through a subsidiary.

Outsource in-house

Outsourcing in-house is a hybrid model of utilising a wholly owned subsidiary (or subsidiaries) of the trustee. This approach might offer a model which delivers the benefits but better manages the risks associated with internalising a previously outsourced function.

Such an arrangement with a related party will technically be outsourced under the prudential regulation, and will need to be governed by an appropriate contract. This may provide structure to governance arrangements which will promote better monitoring and assessment of performance against standards and potentially offer greater indemnity and protection if there is a significant failure under the contract.

In the case of insurance, there are express restrictions on trustees self-insuring. However, as we have recently seen with the establishment of QInsure by QSuper, the creation of a subsidiary life insurer is possible if the business case is strong and prudential regulations can be satisfied.

Ongoing review of internalised functions is equally important to ensure that the internalised function remains the best strategy. The use of a subsidiary can make the process of objectively assessing performance of internalised functions against alternatives much easier and more reliable.

Opportunities and benefits

The upside of internalising business functions is largely dependent on projections of the size of the fund, circumstances of the trustee involved and the functions being considered. However, there are some common positive themes which might arise from a decision to internalise:

1. Efficiency of scale by converting value based management fees to a fixed cost of a lesser magnitude and the resulting reduction in member fees
2. Better integration of profit for member models within supply chains to minimise leakage of member value
3. More accurate assessment of early retirement risks and resulting insurance premium pricing, aligning with member best interests
4. Portfolio flexibility and a holistic investment portfolio perspective, allowing greater asset control, long horizon investing and ESG risk management
5. Access to more information and investment opportunities because of controlling a broader mandate

In an environment where we are likely to see reforms to promote competition on the demand side of the system, now is the time for superannuation trustees to start aligning the supply arrangements which will promote competitive operating models. However fashionable internalising may be, it’s important that trustees are aware of the challenges and risks.

Taking risks wisely

Superannuation fund trustees need to be particularly attentive and adept at taking risks prudently. The prospect of vertical integration of supply chains needs to be approached with this same level of prudence, as there are potentially challenges and roadblocks:

1. Building operational expertise and capability requires the investment in experience, challenging existing remuneration structures.
2. Operational failure either during the change or following the internalisation is a very real risk where the trustee is inexperienced in the function.
3. Conflicts of interest can be created when integration is achieved by outsourcing to a subsidiary, requiring astute governance management.
4. Financial costs of change can represent a significant barrier to change, particularly where the asset base is small or moderate.
5. If investment management is internalised, care needs to be taken to ensure insider trading compliance obligations are appropriately managed

The challenges and risks are not to be underestimated, however a gradual and incremental approach can assist in managing the operational risks associated with internalising business functions.

Strategic advantage might be achieved by trustees through analysing the supply market through the lens of economic and technological trends before addressing the question of how and whether outsourcing or insourcing presents a more appropriate business case.

Strategic review of supply

To position for the future competitive environment, superannuation funds should be actively pursuing a regular strategic review of supply for material business functions. This review of supply can chart a course of continual adjustments which have an eye on the future rather than supply arrangements reflecting the past.

Astute superannuation fund trustees should commit to undertaking a thorough review of the supply of material business activities at least every 3 years. It can’t be an afterthought and should start at least 18 months prior to existing agreements ending. This allows for the business case to be framed and adjustments in the supply model for disruptions and shifts in the technological, economic or regulatory environment.

There may also be merit in including internalisation as an option when undertaking tenders or similar market or competitive decision making processes.

There are a much broader range of considerations which trustees will need to address than those considered here. However, committing to adopt an active approach to reviewing supply chains is a great place to start.

The March 2017 Issue of ASFA Superfunds Magazine quotes some of the statements made in this article.