How many superannuation industry leaders truly make every decision through the lens of what they believe is right for their members?

Peer group awareness is a major driver of superannuation industry behaviour and can incur significant opportunity cost, from constraining risk management decisions to dampening innovation. But the existence of a peer group risk focus has other interesting impacts; it creates a guard-railed industry environment, one where breakthrough moments of significant industry change can still occur, but an industry where continual policy nudges are required to maintain evolution.

Peer group risk is born of agency interests. Agents of the system, primarily decision-makers such as trustees, executives and investment managers, fear the scenario of standalone failure – as Keynes hypothesised “…it is better for reputation to fail conventionally than to succeed unconventionally”.

Exacerbating this agency issue is that industry outcomes tend to be measured over short timeframes. Agents address peer risk by measuring their activities relative to the activities of peer funds.

Investment peer group risk well recognised

Investment peer group risk is an acknowledged component of investment management and a strong feature of superannuation. Some funds are open and acknowledge their peer group focus, espousing that industry awards and new members are won through a competitive process and performance relative to peers needs to be actively managed. For other super funds, peer group risk management is undertaken behind closed doors.

When you see a fund adopt an investment strategy that generates significant peer group risk, the admiration is multi-faceted.

QSuper is probably the best example with its SAA strategy which replaced a sizable portion of equities exposure with long duration bonds. Participating in financial repression, the fund has been a good performer and delivered reduced volatility to members but realised high tracking error to peers. I wonder which feature is most admired by industry – the investment decision or the bravery to implement in size.

There are examples of strong investment capability being curtailed by peer group risk. For instance, at least two super funds recently made large profits using put option protection for their defined benefit funds, but didn’t execute the same trades in their peer-sensitive defined contribution strategies.

The Future Fund views that not having to consider peer group risk has been a major advantage – in the fund’s Statement of Investment Policies it states that that it will focus only on their mandate and ignore peer group risk. This has resulted in a very different portfolio and good results.

Does peer group risk management align with the sole purpose test? It is possible to construct a linkage that runs along the lines that sizable peer relative underperformance could lead to outflows and an impaired ability to maintain an investment strategy and cost structure. This sounds like second-order rather than first-order reasoning.

Operational peer group risk just as prevalent

Operational peer group risk, while a less common term, also permeates through the super industry. The focus on costs remains sharp and APRA’s Outcomes Assessment Test will mean that service offerings will be benchmarked. Super funds which run substantially different business models carry the risk of running at a cost-impairment relative to peer funds or not being able to match the range of services provided by peers.

There are many good examples of areas which can generate operational peer group risk, such as administration structures and systems, distribution and marketing structures, advice models, administration fees (fixed versus asset-based and fee caps), and even the number of major offices.

An interesting example is retirement solutions where there has been very little innovation, to the point where the concept of a prescriptive rules-based policy (CIPR) was proposed. While policy uncertainty is a valid concern I suspect peer group risk remains a significant impediment to developing retirement solutions. I remember a conference where a highly regarded super fund CEO first explained the fantastic capability they have for designing and developing a retirement solution, then explained in a very rational manner why there is little upside in being the first to develop a solution and that being a fast follower offered a superior return-for-risk trade-off. Yes, completely rational when viewed through the corporate lens, but perhaps less so through the consumer lens.

Of course, this case reveals the societal cost of a system where every agent is a peer grouper. If it is rational for every agent to be a fast follower, then in theory innovation never occurs. This is where policy nudges are required. So, arguably, constant policy change is partly due to industry peer grouping.

It’s worth reflecting that substantial peer grouping, resulting in an industry group-think innovation environment, challenges the substantial industry-level executive salary bill. How should we reward innovation versus implementation, while being careful to acknowledge that many innovations will not be successful?

Peer grouping not always a negative

There are positive aspects to peer grouping. First it provides a ‘wisdom of crowds’ effect whereby major issues such as product design, asset allocation and operational model are effectively vetted by industry. This is particularly relevant in investment management where large uncertainty exists around the ability to successfully time markets and add value through implementation. Peer group awareness provides an idea filter, sharpening the focus so that only the highest conviction ideas consume any fund’s ‘peer group risk budget’.

Fascinatingly, the existence of peer grouping can create a momentum for change. Consider recent developments at HESTA and First State Super to establish Climate Change Transition Plans. This potentially shifts the industry benchmark, generating a peer risk-based momentum for other funds to follow. The system impact of early leaders could prove to be multiples of their own impact.

It’s hard to see peer grouping disappearing anytime soon – the agency interests are too strong. But not all aspects of peer grouping are terrible. Search for the wisdom within the crowd, admire those brave enough to make the big calls, and accept that peer grouping is one of the reasons why micro-reform will be ongoing.

4 comments on “Peer group risk: The industry’s worst kept secret”

    Hi David,

    I think a large number of funds have a peer focus and are too embarrassed to admit it. They oughtn’t be so shy, at least when it comes to serving their “average” disengaged member in accumulation.

    Successful implementation of a strategy that eschews peer group risk requires disciplined and sustained buy-in across an entire organisation including its board, management team, advisers and member communications. Unless messaging is very well-crafted, the pursuit of a differentiated investment strategy can lead to poor client outcomes if members feel compelled to abandon the strategy mid-term in response to a misguided assessment of its quality.

    When returns from a differentiated strategy deviate favourably relative to peers you need to avoid the temptation to claim the outcome was due to skill. Inevitably the comparison turns against you, and that is when you need a clear and consistent narrative to instil confidence among members that they continue to make good progress toward their goals. Without that, it is natural for clients and members to assess outcomes through a peer comparison lens. In those circumstances a strong awareness of peer risk is client friendly.

    This point was brought home to me in the aftermath of the GFC when I was asked to explain to some high net worth clients the reasons for their poor investment returns. While appreciative of my explanations they still questioned whether they should be unhappy with us and our strategy. Their adviser quickly pointed out that their fund’s returns were on the border of first quartile relative to peers. I didn’t find that a particularly satisfactory response. Yet the clients were relieved because it appeared to validate their decision to choose us versus our competitors. And, as a result, it provided them with the confidence to stick with their strategy.

    Successful implementation of a differentiated strategy can create significant value for members provided it receives full group support. Given the additional resourcing burden, it makes sense to prioritise adoption of such an approach in areas where a large cohort of members is quite poorly served by the traditional peer-focussed strategy designed for wealth accumulation. I believe that the delivery of a reliable income stream in retirement is the most compelling member outcome that fits this description.

    David Orford

    Real Lifetime Pensions aren’t innovative – they’ve been around for over 2000 years.
    Funds should not be at the bleeding but leading edge of change.
    The winning funds will be Early Adopters of change.
    Henry Ford said “If I asked people what they wanted, they would have said “A faster horse””
    Executives of super funds are not paid to be average. If they were, then like an index fund (which is the herd instinct) they should be paid average salaries.
    The herd is not your friend but your competitor – you don’t need to be far ahead – yet ahead.
    SIS requires trustees to act in the Best Interests of all members.

    David Orford

    Account Based Pensions are not in the Best Interests of retirees. They have a better outcome than lump sum taken out of superannuation. Best Interest is a lifetime income stream that is payable for life and broadly maintains its value in real terms or RLP. However retirees will need both products to satisfy their needs for:-
    1 income payable for life that broadly maintains its value in real terms – RLP
    2 access to cash (if needed) – ABP and
    3 legacy benefit – in excess of leaving other assets to children – ABP
    From the retiree’s viewpoint, isn’t the first need the most important if they are going to enjoy their retirement?

    David Hartley

    Thanks David. You have raised some important issues here. I am concerned that too much peer focus will lead to a systemic risk that eventually could be very damaging to a large range of stakeholders. However when regulators use peer-relative results in their analysis to “name and shame” the “underperformers” the words of Keynes ring true and innovators will always need to calibrate the extent to which they are prepared to be different.

    I agree that the “wisdom of crowds” can be valuable. However my recollection about the research underpinning the “wisdom of crowds” requires each participant to act independently; hardly a feature of those concerned with peer risk.

    By the way, as I have discussed with you previously, I suspect that the home country bias that is observed in pension systems of across a number of different countries is an example of the “wisdom of crowds”.

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