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Fund consolidation isn't the answer

One common answer to alleviating high costs is to encourage fund 'consolidation.' The PC talks about merging or aggregating retail and industry funds where smaller super funds combine with large funds.

Today there are 40 industry funds managing about $600 billion in super. There are also 123 retail funds with about $600 billion in assets. In passing, we note over $700 billion in SMSFs (595,000 funds).

The argument is that members will enjoy 'economies of scale' in the merged funds - their fixed administration costs will be spread across more members, pushing down individual member costs. But the PC has completely overlooked 'dis-economies of scale' of investment which will push down investment returns and outcomes as funds become too large.

Today our superannuation funds ($2.7 trillion) are larger than the economy's GDP (which is approaching $1.8 trillion) and our stock market (which has $1.9 trillion in market capitalisation).

Superannuation assets are growing at a faster rate than both the economy and the equity market. Therefore, the ongoing ability to invest capital in Australian growth assets (equities, property, etc.) will become increasingly difficult.

We are seeing the commencement of the dis-economies problem as large industry funds allocate to private equity, engage in privatisations and move more aggressively into offshore markets (dominated by perversely low yields in fixed income and bond markets).

They will also be competing with other massive pension funds from other countries which are also looking for scarce yields - wherever they are available. We observe that recently Australia's Future Fund ($140 billion) has downgraded its investment return target and now expects about 6.5% per annum. (Since inception in May 2006, the average annual return of the Future Fund has been 7.7%.)

Our view is this. As large super funds continue to compound at current rates and grow to excessive sizes, there will be one sure result - returns will decline.

The dis-economies of scale are immense, more so when funds grow at well above domestic GDP. Rather than driving mergers of super funds, the PC should be considering caps that limit the size of funds when dis-economies clearly set in.

Rather than amalgamating smaller funds, they should be encouraged to perform better. Indeed, they will eventually have a competitive advantage when dis-economies affect their peers.

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