Managing the changing landscape of retirement savings

Managing the changing landscape of retirement savings Report on a study of administrative costs in the Hong Kong Mandatory Provident Fund system November 2012

Managing the changing landscape of retirement savings2

Contents Executive Summary 04 Background 08 Study purpose and methodology 12 Findings of the study 14 Cost drivers and strategic responses 24 Summary of indicative cost savings 28

Executive Summary The Mandatory Provident Fund (MPF) system continues to evolve in response to the developing needs of its members and their long-term retirement goals. In the 11 years of the system s existence, Hong Kong has experienced many changes that have had an impact on the retirement savings system. Despite the fact that MPF is relatively young, it is already more advanced in some areas than the more mature models in some other countries (see figure 3). It is an opportune time to review what the MPF system has achieved, revisit fundamental objectives, identify opportunities for potential improvement and agree upon decisive actions to improve outcomes for members. Ernst & Young was engaged by the Mandatory Provident Fund Schemes Authority (MPFA) to perform a cost study of the trustee and scheme administration costs of the MPF system. We conducted this study via analysis of the overall Hong Kong MPF industry structure and stakeholders as well as analysis at the individual trustee administration process level. The findings were compared with information from selected international pension systems. The objectives of the study were: 1. To identify the more costly areas of administration, and the reasons for such costs 2. To review lessons learned from comparable international pension systems and 3. To make recommendations on how to achieve simplicity, economies of scale, and cost reductions. Figure 1: Indicative breakdown of fund expense ratio (FER) Fund Expense Ratio 1.74% Investment Management 0.59% Administration 0.75% Fee and cost analysis The introduction of the fund expense ratio (FER) by the MPFA in 2004 was an important landmark in providing a single indicator disclosed for all MPF funds, aggregating fees and other expenses charged to MPF funds and underlying investments. Our analysis allowed us to break down the FER ratio as follows (figure 1) based on the published weighted average FER of 1.74% (the weighted average of the FERs of MPF constituent funds for financial periods from 1 July 2010 to 30 June 2011). The three major components of the FER are as follows: 1. The investment management fee represents charges for managing MPF funds, based on fees disclosed in scheme documents. 2. The administration cost is the focus of this report and represents the total expenditure incurred by trustees in performing MPF administration functions, including charges from outsourced third party administrator and other service providers. Data collected from trustees and administrators indicates the administration cost is a weighted average of 0.75% of the assets under management (AUM), breakdown shown in figure 2. 0.40% Sponsor Charge, Trustee Profit, Member Rebates, & Others 4 Managing the changing landscape of retirement savings

3. The remaining balance includes (i) trustee profit (our estimate is based on their most recent annual financial statements that the weighted average profit of trustees which relates to MPF, by adjusting for the possible profit from ORSO schemes, is between 0.09% - 0.15%), (ii) member rebates and (iii) sponsor fees related to their product support (sponsor fees include items such as disseminating MPF marketing materials and product development activities), and any other costs excluding scheme administration and fund management. It should be noted that trustees must delegate the investment management function to investment managers, and may delegate the administration function to other parties. There may be a profit element within the fee being charged for such delegated functions. The FER breakdown components are indicative figures which are derived from professional estimations based on publicly available trustee financial statements, cost data from trustees (not all trustees provided full cost data), and trustee s qualitative explanation of costs. Data collected from trustees and administrators indicates that the weighted average administration cost, based on AUM, across the system is 0.75% of AUM, i.e. costs of HKD 2.7 billion, based on the 2011 Hong Kong MPF AUM of HKD 356 billion. We further analyzed these costs using a structural framework based on Ernst & Young s pension administration value chain model, which defines six components in the value chain (refer to figure 6 (p.11) for details). The most costly components within the value chain were member support (representing costs of 0.19% of AUM, HKD 0.7 billion) and contribution handling (0.14% of AUM, HKD 0.5 billion). The full breakdown of the costs across the value chain is shown in Figure 2. Our analysis then sought to identify the key reasons, or drivers, for these costs with a view to making recommendations that would lead to future cost reductions. Administration cost drivers In reviewing industry, process and international data, we identified a number of factors related to system features and maturity, governance structure, and industry practices that explain why Hong Kong s MPF system has the highest fees and administration costs as a percentage of AUM when compared to other selected international pension systems (Australia, Chile, Mexico and the USA). Hong Kong s MPF system has: 1. A higher percentage of manual and paper based administration processing, meaning that each additional transaction adds costs 2. A larger percentage of small employers and self employed persons, increasing the volume of the employer transactions for administrators 3. A more flexible, full service system offering wider member services, increasing process complexity and workload for administrators 4. Smaller scale of assets under management, which limits the benefits of economies of scale 5. Lower industry co operation to resolve industry wide issues collectively and effectively, limiting the ability to spread infrastructure costs across the system 6. Insufficient pricing competition, reducing the pressure for providers to contain and minimise costs in order to maintain profit margins It is expected that over time the number of MPF members will increase, and this combined with the introduction of the ECA program, which offers employees a choice of providers, will increase transaction volumes in the MPF system. If the system continues with no process and infrastructure changes, this means there will be more MPF accounts per member that will require servicing, additional transfers between administrators and as a result more manual and paper-based transactions and costs. In the context of these cost drivers, our analysis suggests that it is likely that costs will escalate in future if no action is taken. Figure 2: MPF administration cost and expenses breakdown by value chain Total Administration Cost: 0.75% of AUM Pension Administration Value Chain Marketing Member and Scheme Administration (including Member Support (0.19%), Contribution Handling (0.14%), Benefits Payments (0.11%), and Reporting (0.02%)) General Administration Cost as a % of AUM: 0.03% HKD 0.1 billion 0.46% HKD 1.7 billion 0.26% HKD 0.9 billion Managing the changing landscape of retirement savings 5

Strategic responses to cost drivers We were asked to develop strategic responses within the current framework of the MPF system, which is a privately operated, market driven, and mandatory occupational pension system. We have not considered reforms that would change these system features. Many of the cost drivers can be managed. We developed five strategic responses which we believe would improve simplicity, scale and drive cost reductions. We suggest the MPFA to consider: 1. Industry-wide initiatives to deliver end-to-end online and electronic payments and data processing, to reduce costs and streamline processing 2. Introduce measures to facilitate account consolidation, to reduce costs associated with member support activities for personal accounts (formerly known as preserved accounts), while transitioning to full member choice to promote competition 3. Facilitate industry consolidation of MPF schemes, investment funds, trustees and administration platforms 4. Clarify MPF system objectives (e.g. low cost vs full service) to guide future reform, which may lead to the consideration of more fundamental changes to the MPF system 5. Improve governance and transparency to facilitate ongoing cost reduction, promote competition and increase public confidence in the system The first three of these strategic responses are intended to directly reduce processing costs, whilst the remaining two relate to longer term structural considerations which we believe will guide more fundamental reform (or confirm the current system direction), and facilitate ongoing cost reduction in administration activities. In the body of the report we outline more detailed initiatives to give effect to these five strategic responses. Estimate of potential cost savings The final section of this report outlines a high level estimate of the potential cost savings that could result from the five strategic responses. We have estimated the total potential savings to be 0.35% of AUM per annum (HKD 1.2 billion per annum), if all initiatives are implemented and benefits are fully realized. This estimate does not take into account the significant effort and capital investment that may be required to implement these initiatives. It is also important to recognise that the full benefits will not be realized without significant behavioural change from all stakeholders in the MPF system. The MPF is a legislated mandatory pension system operated by the private sector, and as such needs to balance the important goals of ensuring protection of member interests while still providing adequate incentives for providers to reinvest in infrastructure and member service innovation. As an essential next step, we propose that the MPFA conduct a detailed feasibility and cost/benefit study of the recommended initiatives. We hope the findings from our study will shed light on issues of interest to sponsors, trustees, employers and other stakeholders. Embracing change will create opportunities for the MPF system to innovate and invest in infrastructure, products and capabilities, while generating additional returns for its members. 6 Managing the changing landscape of retirement savings

Managing the changing landscape of retirement savings 7

Background The MPF system plays a role in Hong Kong s policy framework for old-age protection. Retirement savings schemes are commonly described in terms of the three-pillar classification set out in the World Bank s 1994 report Averting the Old-Age Crisis: Policies to Protect the Old and Promote Growth (Pillar 1 Social safety net; Pillar 2 Mandatory contribution scheme; Pillar 3 Voluntary savings and insurance). In this context, the Hong Kong MPF system, launched in December 2000, is a Pillar 2 scheme, which is defined as: A mandatory occupational pension system which operates on a defined contribution basis, whereby members and their employers make contributions into a scheme, which invests those contributions until the member s retirement. On retirement, the accumulated contributions and investment earnings are made available to the employee. Management of schemes is carried out by the private sector. 8 Managing the changing landscape of retirement savings

MPF stages of development Figure 3 shows five horizons of pension system maturity which Ernst & Young has developed based on its global experience working with pension funds and pension systems. Figure 3: Pension system maturity horizon Hong Kong Mexico Australia Horizon 3 Chile United Kingdom Horizon 4 Singapore United States Horizon 5 Horizon 2 Horizon 1 Common maturity time frame 10 Years 20 Years 30 Years 40 Years Strategic focus Infrastructure setup and penetration of employers and members Enhance product choice and system equity Enable provider choice and focus on fees Focus on ef iency for all stakeholders and introduce customer experience System re nements & incentives to contribute more Secondary focus Equity across members Delivering value through good returns Member and employer disengagement Outcome transparency Integration of retirement and ageing Key challenges Balancing of upfront planning and setup versus immediate needs Short term returns versus long term growth Choice for some members versus system simplicity for the majority of members Economies of scale versus economies of scope Accumulation versus asset consumption focus while retaining system focus The MPF system currently sits on horizon 2 of the pension system maturity curve, as a system still under development and expected to mature over 40 years. This is the appropriate timeframe required to enable members and employers to make sufficient contributions to achieve the desired level of income replacement. Despite the fact that the MPF is a relatively young system compared with benchmark countries, the MPF is already more advanced in some areas than the more mature systems, and there are a number of opportunities to accelerate the MPF in moving up the maturity curve. As it progresses towards horizon 3, the MPF system will enable provider choice for members. The first step is the introduction of the Employee Choice Arrangement (ECA) initiative in November 2012. Managing the changing landscape of retirement savings 9

MPF system participants There are 19 approved MPF trustees in Hong Kong, of whom 15 are trustees operating MPF schemes while the other 4 trustees do not operate any MPF schemes. The majority of these 15 trustees delegate some or all administrative functions to various service providers, who receive a service fee in return (figure 4). Members pay trustees a total fee, either as a single amount or as separate fees for investment management and other management services. Trustees also apply different forms of charging mechanisms. Figure 4: Stakeholders in the MFP system Regulates Contributions Member Advice & Support Member Fees, Information & Statutory Compliance & Reporting MPFA Regulate Activities Investment Asset Management Investment Manager Enrolment & Contributions Trustee Schemes Administration Administrator Sell MPF Products & Advise on MPF Funds Sell MPF Schemes & Services Employer Select Scheme, Enrolment & Contributions Marketing & Other Operations Support Marketing & Distribution of MPF Products MPF Product Sponsor Custodian of Trust Assets Custodian MPF Intermediaries 10 Managing the changing landscape of retirement savings

MPF administration process & value chain model Because of the nature and frequency of interaction with the MPF providers that members experience they may not realise the breadth and complexity of administration processes required to support an MPF scheme. We have outlined below a typical MPF administration process (figure 5), following the member activities over the life of their employment and hence their MPF membership. Figure 5: MPF administration process Joining MPF Scheme Managing MPF Account Withdrawing Benefits Employer enrolls employee in a MPF Scheme Employee specifies fund choice Trustee handles the enrollment Trustee handles the contributions made by employer and employee and provides regular statements to employee Employee proactively checks his/her MPF account Trustee handles fund switches according to employee instructions Trustee handles employer s and employee s enquiries Trustee handles payment to employee upon termination (e.g. retirement) Trustee handles transfer of benefits according to employee instruction (e.g. change of employer) Trustee handles benefits offset according to employer request Whilst the activities that occur over the life of a member s MPF account appear relatively straightforward when viewed from the member s perspective, in order to fully support an MPF scheme and fulfill their related obligations trustees and administrators require a range of activities and expenses as outlined in figure 6: Figure 6: MPF administration value chain model Value Chain Marketing & Product Management Member Support Contribution handling Reporting Benefit Payment General Administration & Compliance Develop, Distribute Marketing & Enrolment Materials MPF Enrolment Contribution Collection Reporting Enrolment Information to the MPFA Transfer of Benefits Out of Pocket Expenses (e.g. sub custodian fee, postage & printing fees, etc) Maintain Marketing Materials & Offering Documents Manage Member Register Assist in Recovery of Outstanding Contributions Prepare Scheme Accounts, FInancial/ Statutory Reporting, & Documents for Audit Payment of Benefits upon cessation of membership Fund Administration Value Chain Processes Commission Handling & Payment Handling Member/ Employer Enquiries Allocation of Contributions for Investment Regular Reporting to Members (e.g. member benefits statement and fund fact sheet) Handling Unclaimed Benefits Regulatory Compliance & Investment Monitoring Product Development Handling Complaints Establish & Maintain Voluntary Contributions Others (System Support & Maintenance) Regular Communications with Members Fund Switching Managing the changing landscape of retirement savings 11

Study purpose and methodology The purpose of this study is to analyze the costs of administering MPF schemes, excluding investment fees. We collected financial and nonfinancial data related to fees, costs and administration activities, conducted a benchmarking comparison and considered relevant experience from international pension systems. Our objective was to identify areas of significant opportunity for industry stakeholders to work together to achieve further simplicity, economies of scale and cost reductions. 12 Managing the changing landscape of retirement savings

MPF data collection The study team collected MPF scheme administration data on a voluntary basis from the 15 MPF trustees who operate MPF schemes via a series of individual interviews, workshops and questionnaires. The financial and non-financial information collected included data on administration costs, operational information such as volumes of transactions, automation levels and process challenges, as well as other information provided by the trustees. Benchmarking countries selection No two pension systems are alike, due to different stages of maturity, market forces, market environment, taxation systems, regulatory structures and focus, among other factors. Accordingly our comparison was restricted to those reference system areas that demonstrated the most relevance for the cost analysis. The reference systems selected were Australia, Chile, Mexico and the US, as these systems have aspects that are relatively comparable to Hong Kong s MPF system. These are defined contribution, occupational pension systems operated by the private sector, with sufficient AUM and maturity to enable the drawing of useful insights relevant to the MPF system. The table below describes the factors considered in our country selection criteria: Benchmarking Table Country selection criteria (based on OECD Report Collective pension fund comparison criteria) = Fit Criteria Australia Chile Mexico United States Scheme Nature: Defined Contribution There are two main types of plan: Defined Benefit (DB) plans and Defined Contribution (DC) plans. Plans with similar natures are selected for benchmarking analysis. Administration differs significantly as DC plans deal with individual accounts while DB plans provide guarantees and handled at a collective level. MPF schemes are DC plans and we therefore excluded all DB plans. Operational Model: Private Trustee Managed Pension Plans The MPF system is highly service oriented and provides a wide range of investment options to members, offering a level of service and flexibility comparable to a retail system. The MPF system outsources the management of the plans to private/ commercial trustees. We therefore excluded all plans that are not run by private trustees, i.e. set up by the government or the employer. Nature of Membership : Open Plan Membership The nature of the membership will affect how the Trustees operate their plans. MPF schemes are open plans with regular new joiners and we therefore excluded all closed plans in the benchmarking selection. Size of Plan Assets: Large Asset Size In order to help us to understand the benefit of economies of scale in this Study, we selected countries with comparable types of pension plans with significant size of assets. Maturity: Experienced System The maturity of the system is an important aspect in studying administration cost efficiency. The MPF system is a young system having only been established for 11 years. Therefore, mature systems are selected for comparison to help identify areas for future cost efficiency improvement. We did not perform a detailed analysis of the UK pension market, as it has had a variety of different pension systems over the past 30 years. However we did consider some aspects of the recently launched UK NEST system to consider relevant learnings for Hong Kong. This is a defined contribution (DC) system, and although currently the size of this system is relatively small it is expected to eventually become one of the world s largest systems. Importantly, the system is designed as an automated, low cost and low service system and therefore is relevant for this study. Many commentators refer to Singapore as a benchmark for the Hong Kong MPF system. In relation to administration costs Singapore is not a valid comparison, because Singapore s CPF system is administered centrally by the government, and includes social security features such as a guaranteed return, the ability to draw down to fund housing and the pay for medical costs in certain circumstances. Similarly, whilst there are a number of other international markets which prima facie have low management fees, they are also not comparable (for example, most plans in Asian countries are either defined benefit, e.g. Taiwan and South Korea, or run by the government, e.g. Malaysia and Thailand). Managing the changing landscape of retirement savings 13

Findings of the study The findings of our analysis are summarized in three categories: industry level findings, findings on administration processes, and findings representing reference system learnings. 14 Managing the changing landscape of retirement savings

Industry level findings This section summarizes our findings on the MPF system setup and scale, governance structure, fee structure, industry practices, and cost implications. Finding #1: The MPF system scale is small, which limits benefits of economies of scale in operations. The provision of pension administration services involves fixed operational investments in property, IT, and general administration support. These costs are fixed regardless of system asset size. Several studies have concluded that as AUM increases, there are reductions in operational costs as a percentage of assets. 1 Finding #2: Trustees managing significant scheme assets enjoy greater benefits of economies of scale in operations compared to smaller trustees. While there are a total of 15 trustees operating MPF schemes, the five largest manage approximately 80% of employers and 77% of AUM in the MPF system. Figure 8: Distribution of employers and employees across the MPF industry (41,928) 20% (824,087) 26% Figure 7: AUM size of reference systems (HKD) 2 United States $21,326bn Hong Kong $356bn Employers Employees 80% 74% (172,124) (2,296,455) Top 5 Trustees Other Trustees Chile $1,096bn Mexico $962bn Australia $10,426bn The MPF system scale in terms of AUM is small relative to the selected reference countries, limiting the benefits of economies of scale in operations. Figure 9: MPF asset distribution among 15 trustees 100% 50% (HKD 274bn) 77% (HKD 338bn) (HKD 365bn) 100% 95% 0% Top 5 Trustees Top 10 Trustees Smaller administrators experience higher costs as a percentage of AUM as they lack economies of scale. Despite the relatively small overall MPF system scale, the concentration of AUM enables larger trustees to benefit from economies of scale in operations, in comparison with small trustees who are marginally profitable. Some have made strategic decisions to outsource operations to third party administrators to benefit from their scale of operations. 1. Investment Company Institute (2011); Oxera (2006) 2. Reference systems: Australia Superannuation; Chile Administradoras de Fondos de Pensiones (AFPS); Mexico Administradora de Fondos de Ahorro para el Retiro (FORES); US 401(K) plan. Managing the changing landscape of retirement savings 15

Finding #3: Inability of employees to select their MPF provider for current contributions lessens price competition and therefore potentially reduces pressure on providers to reduce their costs. Members do not currently choose the MPF scheme into which their current contributions are paid. The employer selects the MPF trustee for its employees, based on a number of criteria but not solely based on the cost to members or on what employees value. The inability of individual members to select their preferred MPF scheme potentially results in lower ongoing fee (and hence cost) pressure on MPF providers. The introduction of ECA in November 2012 is a significant change to the MPF system and is intended to give members more control over their MPF investments. However, this only allows transfers of existing account balances rather than allowing current contributions to be redirected to the preferred scheme. As ECA and future reforms introduce additional member choice, it is also important that members are able to make well informed choices when selecting their preferred scheme. The introduction by the MPFA of the fund expense ratio (FER) in 2004 was an important landmark in providing a single indicator disclosed by all schemes, aggregating fees and other expenses charged to members. The FER allows members to make an overall comparison among schemes, however the current lack of consistency in fee-charging structures prevents a clear comparison of the breakdown of MPF fees among schemes. This makes it impossible for members to understand how much they are being charged for the different services they receive, and to therefore decide whether this represents good value for money. We believe this reduces public confidence in the system overall, and will make it more difficult for members in future to make well informed choices on relative value for money for services between different schemes. Finding #5: Trustees currently try to individually resolve administrative operational issues that are common across the industry. Better industry co operation would allow such infrastructure costs to be spread across the industry and hence benefit members. The administration issues and challenges identified in our study are common to all trustees and no individual trustee has identified a complete solution. Currently Hong Kong has very few systemwide infrastructure or process initiatives that would reduce costs for trustees and ultimately all members. This is in contrast to international pension systems where such infrastructure is more common (please refer to finding #14 and #15 for the details). As the MPF system is a mandatory occupational pension, industry wide solutions, led by the industry, would provide the benefits of centralization while retaining a market led philosophy. Leadership and engagement from the larger trustees in particular to develop and support such industry wide initiatives would help build momentum, provided this can be achieved in a manner that is not anti-competitive. Finding #6: The MPF is a flexible system that offers a wide range of member services, resulting in higher administration costs. The MPF system operates on a model oriented to member service. Members enjoy a wide range of investment options, and can maintain multiple MPF accounts across the system as they change employers. Furthermore, members are serviced comprehensively directly by trustees (not by their employer, who in some other occupational systems has a broader role). This flexibility in member investment choices and broad customer service incurs extra administration costs. Finding #4: Trustees have no power over MPF product sponsors - limiting pressure to reduce costs. The MPF product sponsors are the owners of the MPF products and major stakeholders in the MPF system. They play an important role in the set up of an MPF scheme, designing the product and setting fees. In the current MPF market, the majority of the trustees are part of the same corporate group as the sponsors, and sponsors are usually the parent company. In other cases, the trustees are third parties independently engaged by the sponsors to fulfill the MPF obligations. The trustees generally have limited power or influence over the sponsor in relation to fee setting, limiting their ability to exert pressure on the sponsor to reduce fees. In addition, unlike the trustees which are the regulatee of the MPFA, sponsor activities in relation to the MPF are not subject to regulation. The MPFA s ability to exercise oversight on fee setting is also limited even though the MPFA has taken the fee factor into account in approving products. 16 Managing the changing landscape of retirement savings

Finding #7: The high percentage of self employed individuals and small employers increases transaction costs and presents challenges to the industry s ability to move away from manual and paper based processing. Small employers (1-10 employees) and self-employed persons (SEPs) represent over 90% of the total employer population. Electronic and straight-through processing is more difficult and less economically attractive for administrators to implement for this group. While a monthly contribution payment from a large employer includes hundreds of members, each contribution for a small employer or SEP has far fewer members but requires similar levels of processing. Figure 10: MPF employer composition (including SEPs) (54,560) 11.4% (6,219) (27,821) 5.8% 1.3% 0.1% (483) (124,969) 26.1% (264,397) 55.3% Self employed persons 4 10 employees 51 500 employees 1 3 employees 11 50 employees 0ver 500 employees As part of the system design and Hong Kong s social policy small to medium-sized employers and SEPs are included within the MPF occupational pension system. This inevitably increases transaction volumes and costs compared to reference systems such as the US 401(k) plan, Chile s APFS, and Mexico s FORES which have not mandated the inclusion of SEPs or all SMEs. Managing the changing landscape of retirement savings 17

Summary of industry level findings The following table summarizes the industry level findings, cost implications, and identified cost drivers for the MPF system: # Industry level findings Cost implications Identified cost driver 1 The scale of the MPF system in terms of accumulated AUM is small compared to international country benchmarks 2 Large trustees enjoy benefits of economies of scale in operations compared to smaller trustees 3 Inability of employees to select their MPF provider for current contributions lessens price competition 4 Trustees have no power over MPF product sponsors and therefore have limited influence over MPF products or fees charged. The sponsor, who has influence over fee charges, does not have an official role under the MPF Ordinance, and is not regulated by the MPFA 5 Trustees face similar administration issues, but there is minimal industry cooperation on improvement initiatives 6 The MPF system is highly flexible, allowing multiple member accounts, offering a wide range of investment options with few restrictions, and providing full member service across multiple channels 7 Mandatory participation in the MPF system for small employers and SEPs presents challenges in implementing process automation Limited economies of scale in administration operations Small trustees administration is more costly Reduces trustees incentive to compete on fees and reduce their costs Trustees have limited influence over fees levied by sponsors Costs are incurred as issues are addressed separately Increased administration costs from high service and account proliferation Trustees continue paper and manual processing with small employers and SEPs, which is costly to the system Small scale of the MPF system and administration Insufficient pricing competition to minimize costs Lower industry cooperation to resolve industry-wide issues A highly flexible, full service MPF system High percentage of small employers and SEPs Administration process findings Our analysis allowed us to breakdown the FER ratio as follows (figure 11) based on the published weighted average FER of 1.74% (the weighted average of the FERs of MPF constituent funds for financial periods ending on 1 July 2010 to 30 June 2011). Figure 11: Indicative breakdown of fund expense ratio (FER) Fund Expense Ratio 1.74% Investment Management 0.59% Administration 0.75% 0.40% Sponsor Charge, Trustee Profit, Member Rebates, & Others The three major components of the FER are as follows: 1. The investment management fee represents charges for managing MPF funds, based on fees disclosed in scheme documents. 2. The administration cost is the focus of this report and represents the total expenditure incurred by trustees in performing MPF administration functions, including charges from outsourced third party administrator and other service providers. Data collected from trustees and administrators indicates the administration cost is a weighted average of 0.75% of the asset under management (AUM), breakdown shown in figure 2. 3. The remaining balance includes (i) trustee profit (our estimate is based on their most recent annual financial statements that the weighted average profit of trustees which relates to MPF, by adjusting for the possible profit from ORSO schemes, is between 0.09% - 0.15%), (ii) member rebates and (iii) sponsor fees related to their product support (sponsor fees include such as disseminating MPF marketing materials and product development activities), and any other costs excluding scheme administration and fund management. It should be noted that trustees must delegate the investment management function to investment managers, and may delegate the administration function to other parties. There may be a profit element within the fee being charged for such delegated functions. The FER breakdown components are indicative figures which are derived from professional estimations based on publicly available trustee financial statements, cost data from trustees (not all trustees provided full cost data), and trustee s qualitative explanation of costs. 18 Managing the changing landscape of retirement savings

Data collected from trustees and administrators indicate that the weighted average administration cost, based on AUM, across the system is 0.75% of AUM, i.e. costs of HKD 2.7 billion, based on the 2011 Hong Kong MPF AUM of HKD 356 billion. We further analyzed these costs using a structural framework based on Ernst & Young s pension administration value chain model, which defines six components in the value chain (refer to figure 6 for the details). The most costly components within the value chain were member support (representing costs of 0.19% of AUM, HKD 0.7 billion) and contribution handling (0.14% of AUM, HKD 0.5 billion). The full breakdown of the costs across the value chain is shown in Figure 12. Figure 12: MPF administration cost and expenses breakdown by value chain Total Administration Cost: 0.75% of AUM Pension Administration Value Chain Marketing Member and Scheme Administration (including Member Support (0.19%), Contribution Handling (0.14%), Benefits Payments (0.11%), and Reporting (0.02%)) General Administration Cost as a % of AUM: 0.03% HKD 0.1 billion 0.46% HKD 1.7 billion 0.26% HKD 0.9 billion Our findings at the administration process level are: Finding #8: A high volume of paper or cheque based transactions increases costs. Our analysis indicates that over 30 million transactions are processed in the MPF system each year. Over 65% of these are paper based and/or executed via cheque, and therefore require some level of manual intervention which incurs extra administration costs. As noted in Finding #7, the nature of the Hong Kong market means it is challenging to expand the extent to which online processing is used. Finding #9: Inefficient administration processes add complexity and system costs. Nearly 60% of total administration costs (0.44% out of 0.75% of AUM, HKD 1.6 billion) were identified in member support, contribution processing, and benefit payments. Many of these processes were designed to protect members and embed infrastructure during the introduction of the MPF system. These processes could potentially be eliminated or streamlined now the MPF system is more mature. Members could still be effectively protected in a mature system via streamlining processes such as member enrolment (e.g. employer could auto-enrol the new employee, and the member enrolment process could be eliminated), employer certificates (certificate could be checked online and the process of issuing employer certificates could be eliminated), contribution reconciliation and recovery activities (could be streamlined by allowing limited tolerance for differences and escalation processes), benefits transfer (could be streamlined by introducing electronic settlement of payments between trustees), and offsetting benefit payments (could refine by reviewing public policy). Administration costs could be reduced if legislative or regulatory amendments allowed or encouraged administrators to eliminate or streamline these processes. Finding #10: Member account proliferation adds to costs. Some elements of administration costs, particularly for member support, are proportional to the number of accounts in the system. Although an account may be preserved, the member may still be active, requiring fund statements and other communications. Over four million personal accounts are in the system or, on average, there are three accounts per member. Costs could be reduced by facilitating or mandating account consolidation. Finding #11: A minimum level of general administration and compliance costs is incurred by trustees/ administrators and schemes/funds. Nearly 35% of total administration costs (0.26% out of 0.75% of AUM, HKD 0.9 billion) are general administration and compliance costs for trustees and fund operations. This cost can be further broken down into four sub-cost components: out of pocket expense (0.14% out of 0.75%), fund administration (0.09% out of 0.75%), regulation compliance and investment monitoring (0.03% out of 0.75%), and system and support maintenance costs (0.01% out of 0.75%). The Out of Pocket expenses include costs incurred by the trustee to fulfill regulatory and oversight obligations that are not included in the management fee but indirectly charged to the member, such as the expense of legal, audit, and other professional fees, insurance indemnity premiums, sub custodian fee and the MPF compensation fund levy. Given its pension market size, Hong Kong has a relatively high number of trustees and investment options available to members. These general costs could be reduced by consolidating and simplifying the number of administration platforms and scheme/fund pools. Managing the changing landscape of retirement savings 19

Summary of administration process findings The table below summarizes the administration process level findings, their cost implications and the identified cost drivers for the MPF system: # Administration process findings Cost implications Identified cost driver 8 65% of the 30 million administration transactions processed in the system are paper based or executed via cheques The current high level of manual processing in the system involves high administration costs High levels of manual and paper based processing 9 Inefficient processes add complexity to administration Current legacy/inefficient processes in the system limit economies of scales and increase the need for manual processing High levels of manual and paperbased processing 10 System does not restrict the number of accounts per member. Member account proliferation burdens member account maintenance and support processes 11 Trustees/administrators and scheme/funds incur a minimum level of general administration and compliance costs Current high number of member accounts in system increases maintenance costs Current large number of trustees/ administration platforms and schemes/funds in the system limit economies of scale A highly flexible, full service MPF system Small scale of the MPF system and administration Reference system learnings Our international benchmarking comparison of total fee and administration cost as a percentage of AUM (figure 13) indicates Hong Kong is the highest of the reference systems, which can be explained by maturity, scale, design and structural differences. The lowest cost systems have significant scale advantages, provide limited or no flexibility for members or exclude self-employed individuals and SMEs. In order to allow comparison in absolute terms at a member level, and reflect the impact of fixed fees and multiple accounts on fees for members, figure 14 compares administration costs per account and member. Hong Kong still has higher absolute costs, expressed as either cost per account or cost per member than the benchmarking countries with the exception of Australia. Figure 13: Comparison of total fees and administration costs as a % of AUM (in order of administration cost highest to lowest) Figure 14: Comparison of administration costs per account and member Administration costs in HKD Cost per account Cost per member Hong Kong 400 1,000 Australia 1,500 3,800 Mexico 80 80 Chile 300 325 United States 350 The cost per account is not available for the US. The cost comparison does not take into account the differences in cost of living of the reference systems. Exchange rate: HKD 1 = AUD 0.1247; MXN 1.6689; CLP 62.2731; USD 0.1282 2.0% 1.74% 1.5% 1.21% 1.32% 1.0% 0.83% 0.60% 0.5% 0.0% 0.75% 0.42% 0.39% 0.27% 0.10% Hong Kong Australia Mexico Chile United States Administration costs Other fee components The fee and cost comparison is against mature systems which have more established administration operations. 20 Managing the changing landscape of retirement savings

We have analysed the reference systems to identify those features which enable them to achieve lower fees and costs: Finding #12: Large system scale enables low cost administration (Australia, US). The chart suggests an inverse correlation between scale and administration costs; Australia (administration cost of 0.42% as indicated in figure 13) has 30 times the AUM of Hong Kong and the US (administration cost of 0.10%) has 60 times the AUM. Lower costs and fees are expected to result from economies of scale in administration operations, and a large scale system allows fixed costs to be spread across a greater asset base, lowering the cost as a percentage of AUM. Finding #13: Having a limited number of service providers in the system, so that all are large, enables low cost administration (Mexico, Chile, and US). In Mexico, Chile, and the US, pension administration is operated by a limited number of large pension service providers. The scale per provider maximizes the economies of scale, which can be fully or partially passed on to members through lower fees. By contrast, the Hong Kong system, which operates on free market principles, has 12 administration platforms and 15 trustees providing MPF services. We observe that only a few of the providers in Hong Kong come close to achieving the scale benefits enjoyed by many of their overseas peers. Finding #14: Centralization of administration platform enables low cost administration (Australia, Mexico, and UK s NEST). Although privately operated, the reference systems have centralized either some or all of the administration functions, include member enrolment, contribution processing, benefits transfer and payments. In addition to benefiting from economies of scale in operations, such centralized platforms also facilitate and enforce standardization of pension data and processing. This allows straight-through processing, increases industry transparency, and promotes competition in fees and services. Finding #16: Account consolidation policies and rules enable lower cost administration (Australia, Mexico, Chile, and UK s NEST). The reference systems adopt various approaches to minimize account proliferation, including automated account consolidation (e.g. Australia), or only allowing members to have one account in the system (e.g. Mexico, Chile and UK s NEST). Implementing such measures reduces account maintenance costs, and provides members with a consolidated view of their pension portfolios to facilitate management of their savings. Finding #17: Best practice governance with legislated trustee responsibility to act in the best interest of members; regulators monitor the pension value chain, balancing commercial and member interests (Australia, US). Following the OECD best practice guidelines for pension funds, many mature pension systems explicitly legislate that the trustee acts as a member advocate. Trustees have a legal responsibility to protect member interests across product, distribution, investment management, and administration value chain. This responsibility means that any commercial arrangement within a group or with external providers has to withstand a best interest and market test. This provides built-in incentives to drive initiatives for cost and fee reductions, and service improvements. The governance role of the trustee creates a built-in tension and protection mechanism within the privately-managed administration system, while the pension regulator supervises the proper implementation, evolution and compliance of the trustees and scheme administrators. Finding #15: Online solutions and electronic payments enable low cost administration (Australia, Chile, and UK s NEST). Using online solutions for member enrolment and contribution, and implementing electronic payments enable administration processing in these reference systems at a lower cost than manual processing (lower process error rates). In addition, an online platform reduces costs by enabling straight-through processing, and standardization of data and processes. Managing the changing landscape of retirement savings 21

Summary of reference system learnings The table below summarizes reference system learnings and cost implications: # Reference system learnings Cost implications 12 Large accumulated contribution scale in the reference systems drives fees down through benefits from economies of scale in operations 13 Having a limited number of large service providers in the reference systems drives fees down through benefits from economies of scale in operations 14 Centralization of administration platforms enables low cost administration through benefits from economies of scale in operations, standardization of data and processes that improve industry transparency, and thereby facilitate industry competition 15 Online solutions and electronic payments enable lower administration cost compared with manual processing, and reduce process errors. Online platforms also enable straight through processing, and standardization of data and processes, which again improves industry transparency and fee/ service competition A large scale system allows fixed costs to be spread across a wider asset base, resulting in lower costs as a percentage of AUM Benefits from economies of scale can be passed on to members in the form of lower fees Benefit gains from economies of scale can be passed on to members in the form of lower fees Industry standardization and transparency which result from the centralization of administration further promote price competition to drive down fees Online processing is less costly in comparison with manual processing Industry standardization and transparency which result from the online solutions and electronic payments further promote price competition to drive down fees 16 Account consolidation policies and rules in the reference systems limit the number of member accounts. This helps reduce account maintenance cost, and provides members with a consolidated view of their pension portfolio to facilitate investment planning 17 Trustees have authority or are required to act in the best interest of members and balance this with commercial aspects; and the regulator has more power over the pension administration value chain. These features give trustees incentives and authority to press for cost and fee reductions and other service improvements Lower account maintenance cost per member as compared to Hong Kong, as members do not have so many accounts on average Trustees can drive initiatives for cost and fee reductions, as well as service improvements, while considering commercial implications 22 Managing the changing landscape of retirement savings

Managing the changing landscape of retirement savings 23

Cost drivers and strategic responses 24 Managing the changing landscape of retirement savings

After evaluating the industry, process and international reference system findings we have summarized these into six key cost drivers within the MPF system; the first four are most directly related to administration costs, while the remaining two are related to structural and governance considerations. Based on these cost drivers, we have developed five strategic responses to help provide overall direction for the industry in improving the efficiency of administration processes, encouraging industry scale and reducing operating costs. Cost drivers Compared to the international systems, Hong Kong s MPF system has: 1. A higher percentage of manual and paper-based administration processing, meaning that each additional transaction across the system adds significant additional costs The high volume of transactions involving manual and paperbased administration, the existence of potential unnecessary processes, multiple accounts per member, and the relatively large number of trustees/administrators and schemes/funds, all contribute to high levels of manual and paper-based administration processing, which increase operational costs 2. A larger percentage of small employers and selfemployed persons, increasing the volume of the employer transactions for administrators The high proportion of SEPs and small employers in the system increases the volume of transactions and makes it challenging for the administrators to encourage a move away from manual/paper-based processing 3. A more flexible, full service system offering wider member services, increasing process complexity and workload for administrators The MPF system is highly flexible, allowing multiple member accounts, offering a wide range of investment options with few restrictions, and providing full member service across multiple channels. Such a high level of flexibility and member services inherently increases administration costs 4. Smaller scale of assets under management, limiting the benefits of economies of scale The total pension AUM size in Hong Kong is small compared to the reference systems. However, the MPF industry has 15 trustees, with approximate 80% of AUM (HKD 285 billion) held under five trustees. The rest of the AUM is managed by the remaining 10 trustees, with limited asset scale per trustee. The small scale of the MPF system and the small scale operations of the majority of trustees, mean that while some trustees enjoy economies of scale, the majority do not and will struggle to achieve sufficient scale 5. Lower industry co-operation to resolve industry-wide issues collectively and effectively, limiting the ability to spread infrastructure costs across the system All trustees/ administrators across the industry are dealing with similar cost and administration challenges. However, rather than promoting industry consistency and solutions, they are responding to these challenges individually. The lack of industry consistency on improvement initiatives duplicates implementation efforts and limits benefits from economies of scale, and education of employers and members of their role in the system, to reduce costs 6. Insufficient pricing competition, reducing the pressure to contain and minimize costs in order to maintain profit margins Inconsistency in description, and difficulty in comparing, administration fee charges by different service providers, a lack of trustee s and regulator s authority over the sponsors who set the fees, a lack of clarity of whether trustee s obligation to act in the best interest of members covers the fees aspect, and a lack of incentives for employers to select the lowest cost service provider are factors contributing to a relatively low level of price competition in the MPF system Managing the changing landscape of retirement savings 25