Part 2 of 2 of a Treasury Staff Insights: Rangitaki article by Andreas Heuser
The Treasury recently took an in-depth look at the market dynamics for KiwiSaver funds. In Part 2 of this two part article we discuss possible explanations for the results of our analysis.
The first part of our article discussed the findings of our empirical and qualitative analysis of the KiwiSaver fund manager market. Those findings raise interesting questions:
- Why do KiwiSaver providers not appear to compete vigorously on fees and returns?
- If KiwiSaver providers do not compete on fees or performance, what do they compete on?
- Why are KiwiSaver members disengaged?
- Do policy settings contribute to these issues?
Competition on fees and returns
Our results showed that fee levels are not a significant factor in the success of a fund in attracting new members’ funds and transfer of funds from existing members. While there are other relevant features of KiwiSaver funds that attract customers, this could suggest that there is low demand elasticity for fees. This would mean that a provider which reduced its fees materially would not be compensated for the loss of fee revenue by an increase in new customers. This would especially be the case for larger providers as the total lost revenue from reduced fees across a larger number of members would be greater. Providers (especially the larger ones) therefore face few incentives to compete aggressively on fees. It is entirely rational for the existing providers to maintain the status quo, in the absence of a consumer base that is willing to switch because of price changes.
A new entrant to the market might act differently to incumbents in trying to attract new business. However, a new entrant would also only have incentive to price its fees at a level just sufficient to entice new custom. This is especially the case as new entrants would not have the advantage of the economies of scale enjoyed by incumbents. There have been new entrants into the KiwiSaver market since the scheme began, however, our analysis indicates their success was contingent on an existing financial services brand. Customer growth appears to be driven by an ability to cross-sell KiwiSaver membership from other financial products.
Competition on fund performance also appears weak. This could be due to the relatively low levels of variance between fund returns, especially among the larger conservative and balanced funds. Members therefore do not face significant incentive to change fund (within asset class). Past performance of a fund is not an indicator of future returns, so the encouragement of switching funds based on previous performance is not a desirable policy outcome.
The fact consumers do not appear responsive to fees and returns is possibly rooted in consumers' lack of knowledge and engagement about investment basics. Financial matters in general and concepts like annual rates of return, compound interest and annual management fees are often difficult to understand. Providers do spend some time and effort educating members and complying with their regulatory obligations (and the nine default providers must specifically engage in member education). However, any incentive to improve consumer knowledge levels is not aligned with the economic incentive to retain customers and revenue levels. Moreover, funds management fees are unlike other consumer products. Electricity bills, phone bills or supermarket shopping receipts are expressed in dollar terms and consumers more or less know the price prior to purchase. Funds management fees, however, are expressed in percentage terms and are only indicative in advance with the deduction in real dollars occurring at the end of a period. The simple average annual fee for KiwiSaver is around $87, and will be much higher for regular savers (ie, excluding children or those on contributions holidays). Current fees in dollar terms are probably similar to basic car insurance or a few months' of phone bills.
Another possible explanation for the lack of consumer responsiveness is the composition of KiwiSaver balances. Initially, these included a large proportion of funds contributed by the Government (kick-start and annual member tax credit amounts). Figure 3 shows these proportions over time. Evidence from the literature on behavioural economics suggests that individuals ‘mentally account' for money differently, depending on its source or purpose. Individuals probably, on average, view the Government subsidies and to a lesser extent the employer contributions differently to deductions from their own salary – it is 'free' money as opposed to 'earned' money. Therefore the extent to which fees and performance affect the net account balance matters more or less for different people. As KiwiSaver matures and the balance of savings sourced from individuals' own contributions grows in proportion to the subsidies, members' attitudes to the fees deducted from that balance might change.
Finally, KiwiSaver members evidently care more about factors unrelated to disclosed fees and returns when choosing a fund (and around 2/3rds of members have actively chosen a fund). These other factors could include lower actual fees, reputation, branding, trust and convenience factors:
- Some anecdotal evidence suggests that some providers are enticing KiwiSaver switching with the pricing of other products such as mortgage rates, credit card fees and deposit rates.
- Some investors associate high fees with higher quality or more trustworthy managers so could be tolerating higher fees.
- The convenience factor of linking everyday banking services (internet or app-based banking) to KiwiSaver also attracts consumers. Banks have grown the fastest of all providers, which is probably due to the marketing advantage of a bank branch network and sales discussions between bankers, mortgage advisers and customers.
How can policy support competition?
Our review examined some of the KiwiSaver policy interventions and the effect on market dynamics. The IRD-led KiwiSaver Evaluation also examined policy interventions. Many features of KiwiSaver policy support competitive behaviour. The appointment of nine default providers in 2014 (up from five) resulted in lower fees and more providers benefiting from the default status. IRD's role as a central administrator simplifies the transmission of contributions and processing of transfer and switching transactions. The KiwiSaver (Disclosure) Regulations 2013 ensure that total expense ratios, returns, funds under management and other data are provided on a quarterly basis to the FMA for publication which enables more accurate comparisons between funds (eg, the online FundFinder calculator). The Government's Commission for Financial Capability (Retirement Commissioner) also works to raise knowledge of savings and investment matters and works with industry members as well. The FMA has a strategic focus on KiwiSaver and market conduct such as providers' sales practices.
Our analysis demonstrates the differences that exist between theoretical perfect competition and real-world markets. Perfect competition, or even textbook workable competition require informed market participants. In the case of KiwiSaver, consumers appear to have lower levels of engagement – which is in part due to specific features of funds management such as the complexity of fees and performance disclosure. This reduces the incentives on providers to compete aggressively on their fee levels and instead focus on other features attractive to consumers (branding, bundling of other products and convenience). A significant lift in the level of consumer knowledge of the effect of fees and returns on the balance available at retirement would improve the discipline of the market on KiwiSaver providers. Government policy is directed at removing any regulatory barriers to competition (and entry) and also improving financial capability levels, however it can only go so far. Ultimately, competition in KiwiSaver will depend on consumers being motivated themselves to understand and check the fees paid. Sensitivity to fee levels may change as fund balances grow in the future.
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Treasury Staff Insights: Rangitaki
See Treasury Staff Insights: Rangitaki for other articles in this series.