Outsourcing and Superannuation: Strong partnerships can lead to increased benefits

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Professors Deborah Ralston (The Australian Centre for Financial Studies) and Sarath Delpatchitra assess possible implications of  Prudential Standard SPS 231 Outsourcing by analysing the results of a survey of the Superannuation industry study conducted in partnership with the Australian Institute of Superannuation Trustees. Professor Ralston uses these results to assess the nature of relationships between superannuation funds and external service providers to determine the likely impact of the new regulation.

Outsourcing is widespread in Australian superannuation funds across a range of functions, specifically actuarial services, administration, asset consulting, auditing, custody, legal services, sales and marketing and investment services. In a recent APRA study of 115 of the larger Australian superannuation funds, each outsourced at least one function, and nearly two-thirds outsourced six or more.

Outsourcing in financial institutions imposes a significant set of accountability and risk issues for management. As the Federal Reserve Bank ofNew York(1999) and the Bank of International Settlements (2005) point out, while outsourcing means that direct managerial responsibility for the activity is transferred to a third party provider, accountability for the function is retained by the financial institution.

The literature suggests that one of the key means of mitigating risk and achieving successful outsourcing relationships is establishing strong partnerships with external service providers. Relationship type, that is whether the two parties are engaged in a genuine partnership as opposed to a transactional relationship, has been found to be a key predictor of outsourcing success in a number of studies. It is been found to be positively influenced by factors such as participation, communication, information sharing, and top management support, and negatively affected by age of relationship and mutual dependence (Lee and Kim, 1999).

The Australian Prudential Regulation Authority (APRA) has responded to the potential risks that may result from outsourcing with Prudential Standard SPS 231 Outsourcing. SPS 231 is designed to improve the management of outsourcing risk in superannuation funds and harmonise such regulation with that of banks. This Prudential Standard, which is one of 12 to be enacted on superannuation funds, covers the need for a formal outsourcing policy and risk management strategy, minimum requirements for outsourcing agreements, and due diligence and on-going monitoring requirements. The standard elevates the management of outsourcing within super funds by requiring a formal Board policy, and a legally binding agreement in place for all outsourcing of material business activities. Funds will need to demonstrate that due diligence has been carried out before contracting suppliers and that there are sufficient monitoring processes in place to manage the outsourced services.

To some extent SPS 231 simply codifies APRA guidance to funds and what is considered to be good practice treatment of outsourcing in the industry. The extent to which this new prudential standard impacts on different funds will therefore be a reflection of their current practice and the nature of relationships with investment outsourcing service providers.

In a recent a survey of 26 not-for-profit super funds conducted in collaboration with the Australian Institute of Superannuation Trustees (AIST), the nature of the relationship between funds and their asset consultants, investment managers and custodians was examined. The survey provides some insight into how superannuation funds work with investment service providers and the extent to which superannuation funds are maximising the benefits of outsourcing.

Overall the survey suggests that there is a high level of trust between funds and all three types of service providers, with this being highest for asset consultants. There is a particularly high level of confidence in the service providers expertise and ability to perform their jobs effectively, with integrity and openness.

Respondents displayed quite divergent views when asked about the overall success of outsourcing relationships with service providers, as shown in Table 1.

Table 1: Overall success of the outsourcing relationship

Relationship

Very poor

Poor

Satisfactory

High

Very High

Asset consultants

0

2

10

9

5

Investment managers

0

0

13

10

1

Custodians

0

2

8

12

1

Relationship

Very poor

Poor

Satisfactory

High

Very High

Asset consultants

0

2

10

9

5

Investment managers

0

0

13

10

1

Custodians

0

2

8

12

1

The majority of funds rated the success of their relationship with asset consultants as high or very high, but two funds felt it to be poor. These two funds were both smaller in size, of less than $1bn, and had a partnership type relationship. One fund had a relationship of less than five years and the other had been with their asset consultant for between five and ten years. This result suggests that there may be issues of switching costs to be born by funds in changing asset consultants.

There is a greater commonality of views with respect to investment managers, where only one fund rated the success of the relationship as very high, but almost half though it to be high and the majority rated the relationship as satisfactory. The fact that no funds indicated less than a satisfactory rating for overall success may well indicate that where there are problems, mandates with investment managers can be terminated with relative ease.

Views on the success of relationship with custodians were diverse. Overall success with custodians was seen to be very high for one fund, high for 12 respondents, eight found it to be satisfactory, and two funds rated the overall success of the relationship as poor or very poor. The funds that considered this to be a poor relationship had both been with their custodians for more than 10 years, one in a transactional and one in a partnership style relationship. The length of relationship and lack of success suggest either inertia on the part of the fund or high switching costs. Conversely, the one fund that recorded a very high success rating had been in a largely partnership relationship with their custodian, also for more than 10 years.

Despite views expressed by some respondents, there is no evidence of any significant relationship between success and these variables for either investment managers or custodians. (This conclusion can be drawn from the fact that the regression had a very weak explanatory power with an R2 of less than 10 per cent). The results for the asset consultant regression are shown in Table 2, and interpreted as follows.

Table 2: Regressions results for asset consultants: success v. partnership, monitoring costs, length of relationship and size

Explanatory Variables

Coefficients

p-value

Intercept

1.10

0.33

Length of relationship

0.23

0.22

Monitoring costs

0.01

0.90

Relationship type

0.53

0.03**

Size

-0.11

0.57

R2 = 0.30, Number of Observations =24, ** sig. at 5%

While the regression had a reasonable explanatory power with an R2of 30 per cent, the only variable that was significant was that of relationship type. Partnership is a significant factor in the overall success of the relationship between funds and asset consultants.

Consequently, it would appear that success is more likely when funds have a partnership rather than a transactional relationship with asset consultants. This supports previous research that relationship type is a critical factor for outsourcing success, although this is not the case for investment managers or custodians. A possible explanation for this outcome may lie in the nature of asset consulting which requires shared decision-making and commitment to shared objectives, rather than a transactional approach.

In conclusion, we can surmise that the nature of relationships between superannuation funds and their external service providers are generally strong, monitoring costs are insignificant and there is no indication of a negative relationship between success and the length of relationship. This suggests that superannuation funds (or their asset consultants) are already following robust due diligence and monitoring processes and terminating contracts as required, minimising risk and increasing the benefit derived from the outsourcing arrangement.

Based on this study it would appear that the introduction of the SPS 231 will, in general, have little impact on the operations and processes of many not-for-profit funds. However, for those funds which do not already have written detailed contracts with investment outsourcing service providers, with specified service levels and committed resources for monitoring purposes, the new prudential standard may lead to a review of these functions and potentially a reduction in the number of investment managers. For larger funds this may lead to more in-house investment management, and for smaller funds provide yet another incentive for consolidation.


The research on which this brief article is based upon is reported in more detail in Will Prudential Standard SPS 231 Outsourcing reduce investment outsourcing risks in superannuation funds?

Sarath Delpatchitra is an Associate Professor of Finance at Flinders University.

Deborah Ralston is a Professor of Finance at Monash University and Executive Director of the Australian Centre for Financial Studies.