4-in-a-thousand pension funds do pass muster

Only four in 1000 South African pension funds have enough members to feature on the right side of the financial sector regulators’ latest ‘economies of scale’ charts. An updated study commissioned by National Treasury (NT) and the Financial Sector Conduct Authority (FSCA) suggests that the optimal retirement fund should have 300000 or more members, a feat achieved by only 4 in 1000 funds. “The updated Economies of Scale Report reveals some remarkable insights about the shifting dynamics of the industry, and [proposes] valuable interventions to improve fund member outcomes,” said NT and the FSCA, in a joint media statement on the report findings.

The economies of scale debate

The updated report expands on a 2011 study called ‘Economies of Scale and Pension Fund Plans: Evidence from South Africa’. That report, which assessed retirement fund data from 1996 to 2006, revealed that there were between 25% and 30% of “unused scale economies in the retirement fund industry”. At the time of its publication the optimal retirement fund would have served 220000 members. According to NT and the FSCA, the 2021 report will prove useful in guiding discussions on social security and retirement reforms. Its findings are based on an expanded dataset that contained information on administrative expenses, assets, benefit structures, benefits paid, fund classes, fund types, fund status, member contributions and membership numbers up to end-2018. 

Regulators have been on a multi-decade crusade to reduce the number of local pension funds. In our newsletter titled ‘Four retirement fund supervision truths’ we reported that South Africa had around 1500 active pension funds, with a staggering 1899 on the regulator’s cancellation ‘to do’ list. One of the objectives in reducing the number of funds is to bring down the per member fund administration cost by, you guessed it, achieving economy of scale gains across the remaining funds. This is important given the widely-publicised impact of administration expenses on long-term capital accumulation. 10X Investments, for example, writes that a 1% reduction in fees can increase the sum accumulated at retirement by around 20%, assuming level contributions made over 40-years. Imagine if you could apply a 0.25% saving across South Africa’s vast retirement funding universe! 

Retirement funds house the bulk of SA’s private wealth

Per the Economies of Scale Report’s executive summary: “South Africa’s pension fund and life insurance [assets] constitute the largest category of individuals’ private wealth, comprising 36% of total private assets, which is higher than in many advanced economies; given the importance of retirement funds in households’ wealth, it is necessary to ensure that the system is well-functioning and low cost”. In an FSCA Media Roundtable event, held end-August 2021, the regulator said there were 1952 funds at the end of 2019, with R2.658 trillion in assets under management! And the Association for Savings and Investment South Africa (ASISA) reported that the life insurance industry held over R3 trillion at the end of 2020. 

NT and the FSCA highlighted some of the key findings contained in the latest Economies of Scale Report. First, there has been a general decrease in the number of retirement funds, which ties in nicely with the pension fund regulator’s focus on achieving consolidation in the industry. Second, there has been an increase in the average fund size. This was hardly surprising given that funds under management have climbed steadily over the period of the study. Of greater concern is the third finding, namely that there has been an increase in the average administrative expense per member. Surely, this writer mused, this cost should be rock bottom given the significant advances in technology, and hence productivity, over the period. And finally, “the report finds that most funds operate inefficiently, with differing efficiencies across fund subtype, class and benefit structure”. 

Finding an optimal solution

Identifying the problem is often easier than devising and implementing a solution to it; but it helps to know what the experts believe an optimal retirement fund looks like. “While there may not be agreement on the characteristics of an optimal retirement funds system, it is generally accepted that cost efficiency is important,” notes the report, in its conclusion. “[This is because] administrative costs affect the net rate of return on retirement fund contributions and directly impact the ability of retirees to attain adequate income”. Given that most funds had fewer than 300000 members, the report concluded that there was plenty of  potential to benefit from scale. 

The question is whether consolidation is enough to guarantee cost efficiencies? Our gut feel that a bigger fund will not necessarily be more cost effective was supported by the report finding that many preservation funds and retirement annuities were operating at an efficient scale despite having relatively fewer members than large pension funds. Yes, there are easy wins to be had, with 25% potential economies of scale for admin fees. But the regulators could have much bigger wins if they tackle the destructive behaviour of life insurers. “There are almost 100% potential economies of scale for penalties,” noted the report. 

Fund size is not everything

“These recommendations focus entirely on economies of scale and efficiency, but there might be other important considerations too,” concluded the report. “For example, smaller funds may offer greater levels of service and complexity that their members value”. 

Writer’s thoughts:
The economies of scale argument in the latest NT and FSCA report is common sense, as is the observation that the number of fund members does not guarantee reduced admin costs. My attention was, however, drawn to the “100% potential economies of scale for penalties” line, having recently taken a massive penalty ‘hit’ for making an RA paid up. Do you believe scale is the best ‘fix’ for our pension funds industry, or should we be placing costs and penalties under the microscope first? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts [email protected].

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