Maximising freedom of choice has always been a core principal of Coalition superannuation policy. It was invoked again on Monday when Kelly O'Dwyer, the Minister for Revenue and Financial Services, announced a set of reforms that are intended to "give consumers more power".
The Liberal Party is being true to its name in giving households the freedom to choose how they save for retirement, and in general that is a good philosophy. But it must be alloyed with pragmatism about the capacity of ordinary households to make good choices. Freedom of choice is a blessing for households if they have the information, tools and energy to make rational decisions. Otherwise, it is a curse.
No other country gives its citizens more freedom to choose their superannuation arrangements. But very little has been done to improve the capacity of ordinary Australian households to comprehend and navigate a complex superannuation system.
The result is predictable – millions of households have frozen in the face of complex choices, and do nothing. There are many examples of this inaction. About two thirds of employees don't make any kind of election about where their super will be managed. By default, their employer has to choose where to put their super. At this stage the employee should insist that payments go into an existing account that they had with a previous employer, but far too often they do nothing and accounts proliferate.
Once the money goes into a fund the great majority of super fund members never change the allocation of their super across asset classes to match their own situation. For instance, we might expect younger members to take more risk, and members in retirement to take less, but for the most part they don't.
Even members of self-managed super funds become inert. In total, SMSFs have about 30 per cent of their money in cash. That is not just an expression of risk aversion, it is a mass failure to execute an investment strategy as money pours into SMSFs and it is never properly invested.
We might expect that policy changes that give households more freedom of choice in superannuation would be matched with programs that give households the knowledge and advice they need to make good decisions.
Unfortunately, those programs have been sadly lacking. A comparison of education programs for the physical health of individuals to education programs for their financial health shows how much is missing. The government has ongoing education programs about smoking, drinking, eating, mental health and activity levels that are intended to educate individuals and nudge them in the direction of better choices.
Where are the analogous education programs in relation to financial health? Yes, physical health is much more important, but where is the concerted effort to raise financial literacy and improve aggregate financial decision making? It is a pity that the Financial Systems Inquiry did not give this issue a higher status.
More choice for households is a generally good principal, but not always. Unfortunately, the reforms announced by Kelly O'Dwyer contain an unwitting exception. The reforms will give members of all superannuation funds an automatic right to opt out of life and disability insurance. That is a bad idea that exhibits a misunderstanding of fundamental economics.
There is an information problem in insurance, called adverse selection, that arises from the insured party knowing more about that their likelihood of making a claim than the insurer does. In this case super fund members know much more about their health, and hence the likelihood of making a death or disability claim, than the insurer knows.
The problem then is that whatever price the insurance is offered at will seem cheap to those individuals who are more likely to make a claim and expensive to those individuals who are less likely to make a claim, and the insurer can't tell the two apart. The insurer's price offer leads to a "selection" of insured individuals that is "adverse" to the insurer, and hence the name for the problem.
Adverse selection exists in every insurance market. If it can't be controlled then there will be no insurance provided (think of how many risks cannot be insured against). The more closely it can be controlled then the more efficient and effective the insurance market is.
An important, and widely used, solution to this problem is "grouping" in which an offer of insurance is made to an entire group of individuals on a take-it-or-leave-it basis. Either the entire group accepts the insurance or not, but there is no cherry picking by individuals on the basis of whether they have high probability of making a claim.
Kelly O'Dwyer's proposal to effectively ban "grouping" by insisting that individuals have the right to opt out of mandatory insurance provision in super funds, is based on bad advice. That proposal needs to be taken back to the drawing board, with some well-trained economists present.
25 July 2017