This week’s effort is about super choice – as will be next week’s.
It’s amazed me how much effort has been put into choice of fund and yet, particularly in the light of how little people know, how little effort has been put into trying to make those choices reasonably informed.
We have long known and for commonsensical reasons that good information is critical to economic efficiency. Friedrich Hayek argued this within the ‘Austrian’ tradition of economics in prosecuting his case in the ‘socialist calculation debates’ of the 1930s. Asymmetric information found its way into the neoclassical mainstream from the early 1960s on in the work of people like Kenneth Arrow, George Stigler, George Akerlof and Joseph Stiglitz.
Oddly however, this is often where the argument ends. The Austrian tradition has little to say (that I know of) about addressing the various ways in which markets fail in the way they handle information (prefering to focus on how much worse it is under central planning). At least within the orthodox ‘neoclassical’ tradition, market failures in the provision of information are conceded. This leads to a fairly formulaic assertion of the role of regulation to compel disclosure – for instance to consumers and to investors. But this is often where the discussion ends with little real interest in the efficacy of such regulation, and whether it can be improved – and if so how.
At the same time, the idea of ‘performance regulation’ is a buzzword in some areas of regulation like occupational health and safety and the environment. ‘Performance regulation’ is regulation that is tailored as closely as possible to achieving whatever objectives we set for it. Put another way, it targets outputs (like lower levels of industrial accidents) rather than inputs (like more machine guards). Beyond OHS and environment, economic reform has not gone very far down the path of ‘performance based regulation’.
I don’t know of any literature which asks the question ‘what would performance regulation look like in the area of information? I’ve had a go at this here in the context of a more general argument for broadening our understanding of what might constitute economic reform. (Comments appreciated)
Amidst more general comment about good choices requiring good information and some elaboration of the shortcomings of the industry that sells what we euphemistically call ‘investment advice’ this column tries to set out a strategy for ‘performance based’ disclosure regulation in the area of investment advice.
The advertising blitz is upon us. Employees are at long last getting the right to choose how their own hard earned superannuation is invested. But let me hazard a guess. You’ve got no idea what you’ll do with super-choice. Here’s another guess. Even if you start studying now you still won’t know what to do come 1st July.
In life as in economics, choices are only as good as the information they’re based on. And there’s always been a terrible problem in getting people good information about where to invest. It’s an intrinsically difficult problem. Markets often fail doing it and governments can be even worse.
Right now, ‘investment advice’ exists in a netherworld. Having grown organically from the sale of life-insurance, the industry is still regarded by investment funds as a ‘sales channel’ and its commercial structure is identical to the sale of fridges in a department store with each stage of the distribution chain adding its margin and using it to fund sales incentives.
At one level there’s nothing wrong with that. It’s a free country and it works for fridges. Why not for investments? The problem is that there are big rewards for sales people who can get their customers to think of them as fiduciary advisors that is, professionals who act in their clients best interests, usually in return for a fee, as a good doctor or accountant would.
The ambiguities of this situation, together with the usual gallery of rogues on the fringes of any industry make regulation inevitable. That’s no bad thing where it provides basic safeguards like some protection against fraud, fee disclosure and streamlined dispute resolution.
Beyond this, the regulation we’re pursuing will do more harm than good. Why? Firstly, beyond very simple regimes like the panel on a packet of biscuits telling you its fat and sugar content elaborate disclosure confuses and paralyses more than it empowers.
And even more importantly, trying to regulate to improve the advice of a sales oriented industry is not just wishful thinking. It legitimates the subliminal association of salespeople with fiduciary advisors. Regulation not only allows them to parade their ‘government licenced’ status but actually requires practitioners to play the role of advisor by mandating the provision of continuing risk analyses and written investment plans.
These plans generally comprise slabs of standardised text drafted before the event by investment sales executives, vetted by lawyers and disgorged from software packages upon entering of client data. The software gives the impression of independence and expertise, but is promoted as ‘sales technology’ within the industry.
So here’s how I think regulation should work. Beyond basic fee disclosure and effective dispute resolution, we should require any advisor recommending a product charging fees above some minimal level to provide some simple measure of the likelihood that this will pay off with higher net returns.
In the US where we have the best evidence, around 90 percent of investment managers underperform the market. And in Australia the ‘industry funds’ to which award super has usually been paid have generally outperformed commercial funds. Not having to remunerate investment advisors, they charge lower fees which as we’ll see add up over time.
We also need a system where advisors keep independently auditable ‘sample portfolios’ operated in ‘real time’ to avoid “advisors” selecting their best picks (and forgetting their duds) after the event. Then we could measure their performance. The investments in these portfolios would be confidential to protect advisors’ investment management secrets. But their performance in terms of absolute returns, after-tax returns and volatility would be published.
The Government or even an enterprising Opposition – might kick this off with public encouragement rather than compulsion. If leading figures called for action and initiated co-operative work on reporting standards to ensure comparability of performance measures, some industry leaders might start self reporting to highlight their own good performance. But over time I expect it would make sense to regulate to bring everyone into the fold and scale back other regulatory excesses.
And you’ve heard of the miracle of compound interest. You’ve got to decide whether you want it working for you or your ‘advisor’. If you were earning $50,000 a year, your fund was earning a 5% real rate of return and my regulation helped you avoid the 0.25% per annum trailing commission plus GST that most funds pay to advisors, your pay-out after 35 years of compulsory super would be more than $28,000 or 5% higher. If my system helped you pick a fund with an annual return just 0.5% higher again hardly a stellar result it would increase your ultimate retirement nest egg by $85,000 or over 14% on the base scenario. You’d be richer and our economy would function more efficiently and fairly.
Choice of fund is a great idea. Now let’s make it an informed choice. Oh, and there’s something else we could do with super that could make everyone even better off again including the Government. I’ll tell you next week. Until then . . .