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How pension funds will bring social policy into investment planning

By Sean Kidney. First published in the  Australian Financial Review in 2000. I’m re-publishing it because, having reread it recently, it still seems right.
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Discussion about superannuation (or pensions) seems to mostly be about how best to maximise retirement income. “Have I got enough?” or “Will the pension still be there?” If you’re lucky enough to have assets of note, then it’s discussion about shares vs property or fixed interest.

But, along with the change in how we fund our retirements, the growth of superannuation savings will see changes in how we run our economy in the next 10-20 years.

As superannuation/pension funds become the dominant investment players in our economy, they will be forced to look more closely at the underpinnings of growth economies, and, in particular, at the one in which they and their members live.

Their deliberations will of necessity canvass fiscal policy, productivity growth, and micro-economic reform. And the more forward looking funds will take a close look at the social policies that underpin growth: investment in education and science, provision of stable regulatory infrastructure, and even enhancement of social cohesion. They’ll also look at the social issues that their members talk about: environment, human rights, job opportunities for young people.


Size will bring a focus on macro issues

Repeatedly touted as the next item on the Government's 'to do' list, superannuation's future still looks bright despite the government's repeated bungling of the choice of fund issue and a tax regime that long ago gladly handed the keys of the asylum to the lunatics.

Depending on your view, the happy or sad reality is that super fund investments will comprise over 30% of the capitalization of the Australian stock market within the next couple of years. Total super fund assets already stand at $416 billion, compared to assets deployed on the ASX of $867 billion.

Assuming the debate about the need for higher levels of contribution is lost for the moment, fund assets under management will continue to grow at over 10% per annum.

In the US, pension funds already make up over a third of the capitalisation of the New York Stock Exchange, the world’s largest. The UK boasts a similar figure.

Experience there has shown that when pension fund money reaches such a large portion of the stock exchange, movements of investments in individual stocks or sectors gain the potential to destabilise those share registers. This can occur whether a company's fundamentals are OK or not. The sentiment of the largest market players (like AMP) has always been a key issue, and in Australia super funds are becoming market players like never before.

This newfound position will give these funds an enormous responsibility to the whole economy. It also gives them an enormous opportunity to take a macro view of the economy, to be a player in directing its long term development -- and to be party to intelligent allocation of capital to address issues that threaten economic health, like salinity, low university research budgets or poor primary education.


An inevitable slide to responsibility

The question, of course, is will trustees ever want to, or be able to, exercise that level of responsibility or will they try and avoid the issue?

Some commentators insist that a passive approach of diversifying investments among arms-length fund managers and avoiding playing the individual holdings in one move is the best route for funds. And pigs do fly.

Industry superannuation funds, for example, realised a while ago that one fund manager would be selling BHP at the same time as another was buying. They paid two lots of fees, yet might end up with the same holdings. They quickly developed an overview of combined holdings in companies such as Telstra, Coles Myer and BHP, and began to think about how to exploit them. The Australian Retirement Fund turned their Coles Myer shares into an investment choice option for members that delivered a store discount card.

As investments controlled by super funds grow, disputes will inevitably arise between the funds and individual companies, whether it's about the share options of Paul Batchelor or a company's environmental practices or the long term commitment to the particular industry sector in which the fund is based.

As those stresses occur, funds will inevitably find themselves exercising the power that is growing at their fingertips. The exercise of this power will focus trustees’ minds on the enormous impact they can have, and, in the more enlightened arenas, will lead them to discussing how it could be best be used to benefit their members.

This is already happening overseas. The experience of the world’s third largest pension fund, the US$160 billion California Public Employees Retirement Scheme (CalPERS), suggests that not only will funds manage more of their holdings with 10, 20 or even 30 year horizons, but that they will look at broad issues of corporate health. CalPERS has, for example, been a leader in promoting new corporate governance standards in the US.

When Australian super funds become so big that their investment plays shape the market, the smarter ones can be expected to begin to also embrace issues relating to the economic ecology in which they pursue investment strategies. In doing so they will start spending lots more money on consultants to inform them about the broad direction of the economy, where it should go, and about their powers and role in shaping that direction.

They will start wondering about picking industries with the greatest chance of success -- in the way that biotech or IT are being selected now. Success will mean not just direct returns, but having a spillover effect on broad growth in the “new” economy, supporting their other widespread investments.

This will have a curious resemblance to what has in the past been called state intervention in the economy.

Funds might even seek to marry government policy with investment policy, because government can't be ignored as a critical player in the economic climate given the size of its stake in the economy, let alone its prudential, regulatory and investment directive functions. (Of course this is something more traditional owners of capital, like Kerry Packer, have been doing for years.)

But first, is there really a new economy?

The “new economy” doesn’t simplistically mean new companies; it means new ways of working within companies, whether achieving rapid response, tailored production; dramatic cost savings through new IT or through internet-based commerce; or a fresh bout of beneficial, global specialisation allowed by the wider, reduced-“friction” markets that are flowing from the IT revolution.

There is no doubt that the productive fabric of industry is changing. Technology innovation has traditionally been the main driver of real productivity increases. According to US productivity growth expert, Robert Gordon, of Chicago’s NorthWestern University, prior to 1913 labour productivity in the US grew 0.69%; from 1913 to 1972 it doubled to 1.42%, before falling back to 0.69%. Since 1995 it’s been 2.19%. Last year it grew 5.1%, and this is year it’s growing by 5.7%.

Work by Stephen Oliner and Daniel Sichel of the US Federal Reserve Board shows quite clearly that at least two thirds of this productivity growth has been due to advances in information technology. Oliner and Sichel further suggest that ecommerce and IT will contribute further efficiency gains in coming years. Recent OECD research backs them up on both counts.

Even sceptics like France’s Socialist Prime Minister, Lionel Jospin, have joined Federal Reserve Board Chairman Alan Greenspan in believing that we are witnessing a step up in productivity and economic performance that is not merely cyclical or smoke and mirrors.

The Secretary General of the OECD, Donald Johnston has gone further:

“Our generation stands on the very cusp of the greatest technological revolution that mankind has ever faced …. this revolution, when it has run its course, may have greater impact on the planet than anything that has preceded it. No part of human enterprise will have been spared.”

Some would argue that every generation makes this claim about the impact of technology; but this particular wave has already been bigger than anything since the impact of World War 2.


The new economy will favour member-focused funds

A feature of many of the new capital holders, in terms of economics, is their 'virtual' organisation approach to services delivery. A large proportion of super funds, whether corporate, industry or public service, are independent of funds managers and service providers. For some, like the public sector funds, this separation is new (in NSW fund management arms were sold to banks, and administration arms corporatised and de-coupled only in the past few years; at a Commonwealth level it’s still happening).

Unaligned funds are free to play the service provider market in a way that bank and insurance company-tied funds are not. Industry funds lead the way with this sort of bargaining, and their impact has already led to cost structures in the industry being been driven down in recent years.

Funds will have even more chance to extract competitive deals in the next few years, as digital revolution changes flow through.

That means even more opportunities for funds to keep reducing costs. Even if this is balanced to a small extent by pressure for increased marketing expenditure as choice of funds comes in, it also means less reliance on tied relationship to individual service providers. Ie. the freedom to move to get a better deal will bring better prices and service.

The disaggregation of financial services flowing from both deregulation and the digital revolution of the last 20 years has meant a huge growth in new retail players. In the US, banks used to manage two-thirds of capital flows in the 70’s; they now manage roughly a third.

These new, flexible players have won significant market share. As far as customer relationships are concerned, this is only the beginning.

In superannuation, as in all financial services nowadays, you no longer need to own back-room functions to run a fund and develop the loyalty of hundreds and thousands of customers. In fact it’s the reverse -- if you play banks and insurance companies against each other you can get back room services at increasingly low costs. This is what industry super funds have been doing for years, and corporate and public sector funds are now following their lead -- becoming “virtual” institutions, as new economy jargon would put it.

The massive move of financial transactions to the lower cost, easy-switch internet (Morgan Stanley Dean Witter estimates 34% compound growth for US consumer financial services on the internet) will drive this disaggregation further in the next few years. (Morgan Stanley Dean Witter further estimates that in 1999 already 38% of all retail stock trades were executed over the internet and Ernst and Young predicts that 50% of financial services transactions will be conducted online within 5-10 years.)

Of course banks and insurance companies will still prosper -- those that take quick advantage of internet technologies and invest in customer relationships. Others may become wholesale product and service providers to the new customer relationship owners.

Sure, the new economy may still be a few dominated by a small set of global brands, but the names will change. Success will be theirs because they have embraced the idea of offering best of breed services and products and have genuinely and credibly mitigated the consumer’s need to shop around. It will be dependent on their ability to stay close to their customers who are educated, intelligent and have access (via the web) to a lot of comparative information.

In an internet-enabled, “choice” environment, account switching could become as commonplace as mobile phone churn. Over time the winners will be those that meet the much tougher customer relationship imperatives of the internet era:

  • Exemplary quality of customer service, built around an acute understanding of customer needs, and a relentless drive for continual improvement. Organisations that are more open about how they choose the services that they offer their members, and are credible in their arguments about the best deal, will have an edge;
  • Alignment of values with those customers of customers.

But, wait, there’s more!

Workforce changes will magnify these trends.

We are moving into a new economy that relies, and has a huge thirst for, smart, educated workers and where lifelong education/continuing education becomes paramount to success. The economy now needs thinking workers. This will apply as much to agriculture and mining as to IT and hospitality.

If Australia successfully catches the wave of this new economy, it will be dominated by these better educated, creative, thinking workers who will want more than advertising-depth espousal of values, a la soft drink commercials.

You can expect a lot more people to think about all sorts of things, including the social role of their investments.

Appealing to social concerns (eg. “Good returns with environmental activism”) or interests (will we see the “Collingwood Football Club Super Fund”?) will become a powerful differentiator.

According to KPMG research quoted in a recent article in the Australian Financial Review, 80% of people aged between 25 and 39 would consider investing their superannuation in socially responsible investments (SRIs). And such investment options don’t seem to have to attract a penalty -- the Dow Jones Sustainability index, for example, has regularly outperformed the main index.

Already in the US one in every eight dollars professionally invested is in what are called SRIs. In Australia this market is in its early stages with, typically, an industry fund, HESTA, leading the way with its environmentally progressive 'Eco Pool' investment option.

In another area the $3 billion C+BUS fund is entering joint ventures with private sector equity partners to provide jobs as well as investment returns to their construction industry members.

Australian funds are learning that members like investment with influence, and that this influence can be exerted.

But adopting social policy screens on investments will not just be a loyalty tactic with existing members.

Line up a dozen industry super funds and it's almost impossible to differentiate on basic products and services. The same can be said for corporate funds. By carving out a position that has economic and social returns, the more competitive funds will also create a significant differentiation that will stand them in good stead to win new members in a choice environment.

Over the next 20 years a majority of super funds will be controlled by organisations that have become deeply conscious of customer demand, and who work hard to stay aligned to the values of the customer group they target. Paternalism will have to give way to genuine member responsiveness. Retail funds, perhaps the most removed from members of all, will morph into customer-aligned funds or disappear.

Let’s say you’re a fund that is close to your members, has slabs of money, and your members work in one market. Even if you take a conservative line of simply focussing on stable retirement savings, you will eventually realise that, with a flick of your little finger you can send a whole regional economy, or a particular sector, down the chute. You will find yourself debating more and more the macro economic environment, and how to deliver not only returns, but the overall security of the social and economic climate in which members live in.

You will notice that revolutions in economic activity can lead to large scale dislocation (eg. steel town unemployment) and, unless handled well, dislocation can mean major social unrest (ie. crime in the suburbs, riots, One Nation). That’s not a great climate for economic development. Smarter super funds will look for ways of ensuring that the transition from less productive industries to more productive industries is minimally socially disruptive.


Imagine.

Nimble mutuals, member focussed, controlling the ASX, pushed by members and the pressures of investment strategy to get active on broad social and economic policy. That’s 2010.

This is moving closer to worker direction of the economy, and not the more limited shareholder control envisaged by John Howard and co. Sure, it may arrive via more of a Thatcherite share economy than Leninist command economy road, but you can expect it’s impact on social policy to be major.

The outcome will see super funds involved in:

  • Coordinating investment in social (health, education) as well as physical infrastructure.
  • Pursuing a range of investment measures for addressing environmental issues, and
  • Keeping a close, activist, watch on keeping the economy vibrant.

All this, essentially within the ideological parameters of the “free market”. Roll on the future.
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