Speech by Nick Renton to the Institute of Actuaries of Australia in Melbourne on 1997-07-07
I suppose one regret I have in regard to the repeal of the Victorian Friendly Societies Act 1986 is that a delightful circular argument will disappear.
I refer to section 51, which amongst other things says that a person is qualified to be an actuary to a friendly society if that person has a current certificate of approval under section 50. So one looks at section 50 and one sees that a person who is qualified as required by section 51 may apply for a certificate!
While we are dwelling on the past, I have in my hand "Friendly Society Finance considered in its actuarial Aspect" by Alfred William Watson FIA - a book that was published in 1912. It says that it appeared probable at one time that friendly societies had reached the limit of their expansion but "recent developments indicate that the scope of the voluntary work of the societies is likely to be maintained and even extended in the future".
It is a curious book by today's standards, because we read of expense rates of three farthings and things of that sort. He talks of the cards that are used for valuation purposes with occupations on them such as lunatic, in the workhouse or pauper. I don't think modern actuaries encounter those things.
Friendly societies are institutions which have been transplanted from the other side of the world in the last century. They are all mutual, founded in the days when it was considered a desirable thing to be mutual. I think it no longer seems to be worth while, having regard to what is happening in the life office scene.
Certainly, the societies had their period of development in the days before unemployment benefits, before Medicare, before social security generally and a large part of the activities of the original friendly societies involved funny hats, Masonic-type activities and fraternal sections.
The societies have been killed off, not by changes of legislation, but simply because of developments such as television and the Internet. Modern people just do not think that fraternalism is appropriate for commercial organisations.
In the 1980s some lateral thinkers exploited the tax freedom that friendly societies had had because of their mutual and co-operative origins. I spent part of my life wearing a hat I no longer wear, trying to get the taxation basis of life offices and friendly societies onto an even keel.
At the time, before 1 July 1983 when friendly societies started being taxed, there were in fact 46 percentage points difference. Life offices in those days were subject to the then company tax rate of 46 cents in the dollar and friendly societies paid 0 cents in the dollar and that is a fair margin.
If one looks at what happens to $1000 accumulating at 10 per cent under the life office tax rate one can have $700 worth of bonuses at the end of the 10 years and it gets even more dramatic if one uses a longer period. Compared with the $700 per $1000 for the life offices the equivalent in round figures for the friendly societies would have been $1600 worth of bonuses. That is quite a fair competitive advantage.
One of the things the new Act does - although Wallis may well change that - is that it perpetuates a system of regulation at the State level. It has always struck me as very curious that 97 years after Federation we still pretend that the States matter.
The market quite clearly in Australia is one national market. Customers come from all over the place. Even if we have mirror legislation in the States we are going to have duplication. The chief competitors of friendly societies, the life offices, have had a Federal legislative environment since 1945, and even that took a long time after Federation.
There are bits of business that friendly societies do which have Federal involvement. I refer to superannuation and health and, of course, the main pieces of legislation that affect them - other than the regulatory legislation - namely, taxation and social security, are both in the Federal domain.
We are still going to have the separation of friendly societies and building societies, despite the fact that if a building society is owned by a friendly society then, in an economic sense and a practical sense, it is really just another benefit fund. To have separate legislation for it seems curious, to say the least.
On the other hand, we allow within the friendly societies framework activities that are far more different than building societies, such as retirement villages and dispensaries. One would have thought that it would make more sense to have those under separate regimes and to have financial type products all under the one regime.
I think that something that is often overlooked is that many people who are in friendly societies as members like the culture of them and it has always surprised me the large numbers who go to the annual meetings.
With the society that I am associated with, a characteristic that I never encountered in the life office world is that people attend an annual meeting almost as a social outing. They are not interested in corporate governance. They are not there to exercise a meaningful vote or anything of that sort or even to ask questions except in one area.
They like to be reassured that their money is safe and, of course, what answer would they expect to get from those sitting at the top table other than that "your money is perfectly safe"? That is the answer that is given by any financial institution on the day before it closes its doors for the last time.
So why members believe such answers to naive questions is beyond me, but nevertheless they get a lot of satisfaction out of being told that their money is safe.
Which brings me to what has always been the greatest worry I have in relation to friendly societies - that is the possibility of a run. We have not seen this in this country. We have seen odd scares in relation to building societies, as when we had a State Premier using a loud hailer to pacify the queues. We have had an incident where a NSW radio announcer was scaring people by using carelessly worded comments in a broadcast.
We have not seen this sort of thing yet in relation to friendly societies, but it well may happen one day. It may not happen for any logical reason. Runs don't often have a logical origin - it may be just some rumour that is completely unsubstantiated. The 1996 Act recognises that possibility by setting out a 15 per cent liquidity requirement.
There is, of course, a cost in that, in terms of lower investment earnings. I think that it is probably a worthwhile cost, but it may mean that society returns will be perhaps half a percent per annum less than they otherwise might have been.
Looking to the future, one wonders whether the marketing of financial products is not going to be very different in the fullness of time. One already sees the start of this on the Internet, where a number of financial products are being marketed on screen. That allows sales without the intervention of intermediaries and therefore avoids the commission cost inherent in that.
It also means that disclosure documents will be cheap, at least in the physical sense, although preparation costs will still be the same. To have a disclosure document that does not need to be printed avoids wasting stocks of documents that become obsolete, and so on. That would be a cost saving which the community might well appreciate.
Managements will have to learn different skills, because to make a World Wide Web page interesting requires different techniques from making something in print look interesting. We are getting to a generation where 16-year-olds know more about computers than I do. I can paraphrase their thinking as: "If something is not on the Internet then it does not really exist."
I think that friendly societies as well as all other institutions will have to recognise that. There also appears to be an interesting correlation between Internet usage and education, just as there is between wealth and education. While it may take another generation before we in fact get a reasonably computer literate customer base I think that that is going to happen.
FEATURES OF FRIENDLY SOCIETIES
Three characteristics of friendly societies are worth special mention.
The first one is "mutuality". The first thing that can be said about that is that while this is obviously of great value in one sense it is never appreciated by the members. They certainly don't know the word "mutuality" and even if they did the concept is not something they value. They regard themselves as customers. That phenomenon, of course, does not only apply to life insurance companies and friendly societies - it also applies to the institution on whose premises we are meeting. The RACV is a mutual organisation. Today's members are members of a Club. They are entitled to vote in elections, but do they regard themselves as members? Of course not - they regard themselves as customers buying a road service which they appreciate. But they value it as customers and not as owners.
I think the same thing applies to financial institutions. Somebody who becomes a member of a friendly society does not do so because he thinks the membership is worth anything. Instead, he looks at the bonus rate. Perhaps if he is more sophisticated then he looks at the expense rate or into the quality of the management or whatever, but he does not really look at the voting power in deciding whether or not to become a member.
Of course, being mutual is not necessarily an advantage in this day and age. The absence of capital makes for a less secure institution. The need for higher reserves, effectively retained profits against the rightful owners, is really a disadvantage. Certainly, being mutual at least theoretically is less of an incentive to be mean and lean. The industry lacks shareholders and a stock exchange watching every move.
Then there is "customer loyalty". Well, customers may be loyal in one sense, but this does not stop them dying. They still become old and if they are old to start with then they will die off at a fair rate. They are also not going to be loyal if the society's tax rate is going to be even more nasty to them than it already is.
At the moment it is 33 per cent, on the way up to 39 per cent. Of course, all that may change when a certain committee reports to Parliament, but compared with the 20 per cent rate which was there for a long time - and the nil rate that it was before that - it is a relatively high rate.
Fully franked dividends have already been mentioned as providing something that is very appealing to many people. Of course, many people in the age brackets that use friendly society products have income that is below the threshold or in the 20 per cent bracket, so that it does not really make economic sense for them to be paying 33 per cent through an institution when they could be paying 20 per cent or nil on direct investments.
Nor does customer loyalty have much sway if they need cash. These days many retired people probably do need cash for spending. Again we are dealing with a customer base that is very often in the post retirement years and therefore they normally would want to take cash out of the system.
In the case of a friendly society product which does not pay interest as such but has bonuses added they would need to make partial withdrawals for no reason connected with the efficiency or the solvency or the earning rate of the society but simply because of their normal spending patterns.
If Australia moves to a GST regime, a possibility which seems to be mentioned in the media every day then, of course, this problem will get even worse.
The elderly, as the generation of change, are going to be penalised. They have been subject to a high rate of income tax when they were earning income and they will be subjected to a high rate of consumption tax when they come to draw on their past earnings. So in fact they will have paid twice, whereas the generation before and the generation after will not have that particular problem.
In terms of what members do to friendly society products, if they are going to have to pay 15 per cent or 17.5 per cent more for all their goods and services, they will quite clearly have to take more money out of the system than otherwise would have been the case.
Apart from that, the GST will be inflationary and that will not help fixed the fixed interest type investments so popular among friendly society products.
I now turn to "small size". There are some interesting perceptions there. I suppose the solvency perception is that "big is beautiful". One would rather do business with a multi-billion dollar institution than with a $2 paid-up capital company.
It may not actually be sensible to do that, because one can have an insolvent large institution and one can have a very small highly solvent institution - but the perception is definitely "big is beautiful".
When it comes to the service perception I think the customers look at it the other way around. They like to be in a small organisation rather than a large one, so that may cancel out the point I just made. On the other hand, they still expect to have a local branch office and I do not think that they like the concept of their society being run from a city in a distant State.
The Bank of Melbourne provides an interesting case study. I just wonder whether there is not some element of parochialism that is unconnected with anything we have been talking about. I think the Bank of Melbourne really captured a lot of former State Bank of Victoria customers when that bank became part of the Commonwealth Bank.
It was not so much that it had anything to do with the positive side of the Bank of Melbourne - it was just that they did not want to be part of the Commonwealth Bank - they didn't like its service, its computer system or whatever.
It is very strange actually, because one would have thought that the customers of the old State Bank were people who liked to be in a government institution and the Commonwealth Bank, at that stage, was very substantially a government institution - although things have changed since with the selling off of its shares.
Finally, I turn to retirement villages. If we have some worries about the dangers of running friendly societies we ought, as a community, have even greater worries about what is going to happen to retirement villages further down the track.
It certainly sounds attractive for a friendly society to enter the field because its customer base is consistent with people who might find a retirement village useful. There is a real need at the customer level and it is certainly an activity which is complementary to the business they do.
On the other hand, we do find that the profits of a retirement village are really made only when it turns over residents. There is not that much profit from ongoing residency.
We find a phenomenon that actuaries know about in relation to annuitants - people who buy annuities live a long time. People who move into retirement villages and pay a large sum for the privilege of doing so also tend to live a long time. That destroys some of the assumptions that people sometimes make about the profitability of retirement villages.
Then there are the physical aspects. The ageing population of the residents means that they are going to need more looking after. They need help to get meals and medicines and things like that.
Simultaneously, the buildings are also ageing, which means that they are going to require much more maintenance as they deteriorate physically and economically. Therefore the expenses of running these things may escalate too. To some extent managements may be able to pass that on in charges, but there is a practical limit as to how much income these people have.
It worries me that one could easily have retirement villages as a tail wagging the friendly society dog. In the case of institutions that lack any shareholders' funds to back their reserves and with the likelihood of greater legislative intervention in this area as governments wake up to some of the problems that I have foreshadowed we may be heading for a dangerous situation if that form of diversification is considered an appropriate one for friendly societies.