Pensions: To Merge, or Not to Merge

(January 16, 2014) — Investors could be forgiven for thinking that 2014 was going to be an easier year for pension funds. Riding off the back of at least 18 months of good equity returns, pension funds’ balance sheets haven’t looked this healthy since before the 2008 financial crisis.

But for many, the boost to assets’ value hasn’t been enough of a boon to detract from the myriad issues hitting the funds and the employers who sponsor them. Increasing complexity, rising levels of regulation, and an alarming number of investment and taxation rules to comply with means that for many, having a pension fund is still too big a burden to bear.

One solution is to team up with someone else, to merge with another pension fund. While the Australians have been leading the way on consolidation since the mid-1990s, fund mergers in Europe have only been evident for the past five to 10 years. Here, we investigate the triggers behind pension fund mergers, the benefits involved, and the risks that need to be overcome for a successful partnership.

Australia

The Land Down Under has arguably seen the biggest transformation in terms of pension fund mergers. Statistics from the Australian Prudential Regulation Authority show a huge contraction in industry, corporate, public sector, and retail superannuation funds since the 1990s.

In 1995, there were 5,001 large regulated superannuation funds. By 2011, that number had shrunk to 389, and last year it dropped further to 325.

The biggest fall came from the corporate sector: in 1995 there were 4,211 superannuation funds, but by June 2013 that figure had fallen to 108. Industry funds also saw large levels of consolidation, falling from 152 in 1995 to 52 in 2013.

While each sector had some individual drivers behind the merger mania, there were common triggers for consolidation across the board.

The general reasons supporting superannuation mergers include the benefits of economies of scale, access to greater investment opportunities—especially for unlisted securities—and the ability to negotiate lower investment fees, according to Dharmendra Dayabi, head of portfolio analysis and implementation at UniSuper.

He also cites the greater levels of complexity in running super funds, brought about by an increase in regulation, which has resulted in the need for more resources.

“In recent times there have been major reforms in the Australian super industry,” he tells aiCIO. “Two major reforms were the Stronger Super reform, which aims to create a stronger, more efficient super system, and the MySuper reform, which forced funds to offer a new product with very prescriptive reporting obligations.”

In areas such as staffing, IT, and advisors, the need for resources has seriously increased—something smaller funds havenot been able to tolerate easily. It has led many of them to seek a merger with a larger, more sophisticated super.

Janice Sengupta, CIO at Aon Hewitt in Australia, says it would be rare to find an Australian superannuation fund today that has not thought about a merger or successor fund transfer.

“The complexity of running a fund has increased dramatically in terms for governance, requisite board experience, and reporting to the regulators. Competitive pressures play a role as well,” she says.

“Scale helps in negotiating fees with fund managers and sourcing research. In addition, larger funds are insourcing some functions. For example, there is a growing trend for funds to have a CIO.”

It may be surprising  that the phenomenon has not been the sole preserve of the smallest supers: mergers are happening across the board.

While there are plenty of examples of smaller funds completing a merger, such as the AUST(Q) Super, with $181 millionin members’ assets merging with the giant $65 billion AustralianSuper in 2013, mergers also happen at the other end of the scale—AGEST, an industry fund with more than $4.3 billion in assets under management, merged with AustralianSuper on 31 December 2012.

After almost two decades of fund mergers, the Australians have become good at spotting the associated risks.

Sengupta highlights the following: Can the trustee affirm that the merger is in the members’ best interest? Do the transactions costs and risk merger risk outweigh potential benefits? What are the tax implications? How can the transition risks be mitigated? And are we prepared for market and political conditions to change?

When asked about transition risks, she expands: “Time out of the market, downtime in processing of ordinary member switches, pension payments, technological challenges in changing administration and IT systems, and equitable valuations all need to be assessed.

“And on the known unknowns, mergers planned for one or two years would have faced a shock when markets were paralysed with fear in September 2008, as fixed income markets were not trading because nobody knew how to price bonds when Lehman collapsed.”

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“In recent times there have been major reforms in the Australian super industry,” he tells aiCIO. “Two major reforms were the Stronger Super reform, which aims to create a stronger, more efficient super system, and the MySuper reform, which forced funds to offer a new product with very prescriptive reporting obligations.”

In areas such as staffing, IT, and advisors, the need for resources has seriously increased—something smaller funds havenot been able to tolerate easily. It has led many of them to seek a merger with a larger, more sophisticated super.

Janice Sengupta, CIO at Aon Hewitt in Australia, says it would be rare to find an Australian superannuation fund today that has not thought about a merger or successor fund transfer.

“The complexity of running a fund has increased dramatically in terms for governance, requisite board experience, and reporting to the regulators. Competitive pressures play a role as well,” she says.

“Scale helps in negotiating fees with fund managers and sourcing research. In addition, larger funds are insourcing some functions. For example, there is a growing trend for funds to have a CIO.”

It may be surprising  that the phenomenon has not been the sole preserve of the smallest supers: mergers are happening across the board.

While there are plenty of examples of smaller funds completing a merger, such as the AUST(Q) Super, with $181 millionin members’ assets merging with the giant $65 billion AustralianSuper in 2013, mergers also happen at the other end of the scale—AGEST, an industry fund with more than $4.3 billion in assets under management, merged with AustralianSuper on 31 December 2012.

After almost two decades of fund mergers, the Australians have become good at spotting the associated risks.

Sengupta highlights the following: Can the trustee affirm that the merger is in the members’ best interest? Do the transactions costs and risk merger risk outweigh potential benefits? What are the tax implications? How can the transition risks be mitigated? And are we prepared for market and political conditions to change?

When asked about transition risks, she expands: “Time out of the market, downtime in processing of ordinary member switches, pension payments, technological challenges in changing administration and IT systems, and equitable valuations all need to be assessed.

“And on the known unknowns, mergers planned for one or two years would have faced a shock when markets were paralysed with fear in September 2008, as fixed income markets were not trading because nobody knew how to price bonds when Lehman collapsed.”

In addition, evidence is starting to appear that the smaller, more nimble superannuation funds are able to outperform their larger counterparts, thanks to their ability to invest in less liquid assets and sell poorly performing assets more quickly.

Another major risk is that some of the perceived benefits of merging never materialise. UniSuper’s Dayabhi explains: “Research suggests that post-merger, the fixed–dollar administration fee per member and percentage based member administration fees have not seen any reductions for the majority of the merged entities.”

His view is supported by a 2011 article into super mergers by superannuation journal FS Super, which declares that in all of the industry super fund mergers it has witnessed, “there’s effectively been no reduction in member fees and in one very recent high profile merger, the member fees actually went up”.

Finally, there is the risk that the merger plans never reach completion. Several high profile merger attempts have fallen apart in Australia, with lessons the rest of the world could learn from.

“Cultural difference can cause breakdowns in superannuation mergers. Melbourne-based funds Vision Super and VicSuper pulled out of talks in 2013 in part because of the differing investment beliefs (Vision Super believes in active investing whereas VicSuper has buy & hold approach),” says Aon Hewitt’s Sengupta.

“Vision Super had earlier looked at merging with CareSuper; Caresuper ended up merging with the larger AustralianSuper. And Vision Super’s discussions with Equisuper broke down due to discord and different operating models.”

A 2013 paper from Deloitte predicted that superannuation mergers were likely to slow down over the coming years, but it remains to be seen how the merger market plays out in 2014.

The Netherlands

As with the Australians, the Dutch pension funds started to consider consolidation in the mid-1990s. Fifteen years ago there were more than 1,000 pension funds in the Netherlands, the vast majority of which were corporate. Today there are fewer than 400. And the Dutch central bank appears to want to shrink this number further.

In 2010, Joanne Kellerman, then the head of pension fund supervision at the Dutch National Bank (DNB), publicly stated that the Dutch industry should aim for no more than 100 pension funds—and  most Dutch pension experts believe  it still holds this view.

“As we speak, the DNB is issuing a letter to 60 pension funds in the Netherlands to advise them to ‘think about their own future’. This is another act from the legislator to encourage pension funds to merge,” says Hamadi Zaghdoudi, an actuary at Towers Watson in the Netherlands.

“Formally, it will say ‘we’re not encouraging the merger, we’re only making them aware of the risks and we want them to think about all aspects’. My humble opinion is that’s b******s. It has its own agenda: it’s easier to look after say 100 or 200 pension funds than to look after 400 pension funds. A lot of pension funds have been made upset and angry that the DNB has done this.”

To suggest the only reason for consolidation is the pressure from the Dutch regulator would be unfair however. There are other reasons Dutch pension funds consider mergers.

As with the Australian example, economies of scale and increasing complexity of investment strategy are key triggers, but governance is top of the agenda for many.

“I think the governance is most likely to benefit,” says Evalinde Eelens, senior investment strategist at A&O Services, the industry pension fund for painters.

“Economies of scale will enable higher expertise and better governance at a lower cost per participant. This is one of the reasons why the supervisor wants the consolidation: to professionalise the industry at limited costs.”

Employers too are keen on mergers, particularly if they’ve been forced to contribute lump sums to their pension over the past 10 years in order to keep them afloat.

“When the pension funds go into trouble financially, they went to the employer for a lump sum to help them out,” explains Zaghdoudi. “The employer says ‘Ok, I’m willing to do so, but what I want is for a collective defined contribution plan to be agreed so you’ll never ask me for money again’ or they’ll say ‘We’ll help you out, but I’m going to ask that you’ll go into a bigger pension fund if there is one that becomes available so I don’t have any fuss in the future’.”

The new regulations hitting Dutch pension funds from January 2015—where they must choose whether to offer a nominal or real (inflation-linked) pension fund to members in future—is also causing headaches, and leading employers to seek merger partners to take the decision off their hands, according to Zaghdoudi.

Tune in tomorrow for more on what the Dutch consider to be the risks of merging pension funds, and how the Brits are tackling the issue.