For all the talk about the severity of the Your Future, Your Super (YFYS) performance test, it could have been set much tougher. In some areas the industry has been given a free ride. This adds to the catalogue of issues attached to the controversial policy measure.
The proposed performance benchmark understates performance in some areas, meaning that relative performance is overstated. Two such areas are adjustments for withholding tax and benchmarking credit exposure with traditional fixed income indices.
The withholding tax understatement issue is broadly known and I am certain best practice super funds already account for this when undertaking internal performance assessment. Explained briefly, index providers need to consider many different investor jurisdictions, each with different cross-jurisdictional tax treaties in place. Rather than create many jurisdictional indices for each market index an index provider typically calculates a single benchmark based on the most conservative (worst case) withholding tax outcome. For Australian super funds global equity index performance has on average been understated by around 35bp p/a (the level of understatement is higher for higher yielding sectors such as global infrastructure). To their credit most index providers now calculate indices specific for Australian super fund investors, though they do charge an additional fee. Unfortunately, these more appropriate indices were neither used by the Productivity Commission (PC) in its analysis or were specified in the YFYS reforms.
Credit is benchmarked against traditional (composite) fixed income indices. Most investors would expect credit to outperform equivalent duration government bonds over the long-term as investors are rewarded for taking on credit risk. This has proved to be the case: over the long-term high yield has outperformed the global composite bond index by around 3 per cent p/a.
Let’s construct a simple aggregated example: a growth-style balanced fund with 30 per cent in global listed equities and 10 per cent in higher yielding credit. This results in a benchmark understatement (i.e. a free ride) of around 40bp p/a.
What does this all mean? The benchmarking process could be made more appropriate, making a 50bp p/a underperformance test more difficult to pass. Or the benchmarking process could be left unchanged and the underperformance test could be increased to 10bp p/a. However, this would be unfair on funds with no credit exposure. It would be interesting to understand if the PC (at the time) and policymakers (now) have a true concern about the 50bp threshold level and its impact on consumers or whether the level is reverse engineered based on a failure rate.
A credible performance test?
Hopefully other industry participants called out the understatement issue in their YFYS submissions. If industry knowingly held back disclosing favourable shortcomings then trust between policymakers and industry is hardly going to improve.
Ultimately this is just another shortcoming in the performance test.
And there are many shortcomings. As a measurement of performance, my greatest concerns include the failure to account for asset allocation decisions, the ignorance of diversification benefits and the significant variability in benchmark risk across investment sectors due to the benchmarking process. It is a crude measure of implementation performance. Our collaborative work with a range of leading asset consultants (available here) suggests that in some cases the performance test will have similar effectiveness to a coin toss. Ultimately it is a backwards looking test where many funds may already have taken measures to address any performance concerns.
The performance test will influence the way many funds will manage their members’ assets. Unfortunately some elements of members’ best interests do not align well with the performance test.
I think many consumers will not be better off (some will be but in many cases the test is not particularly effective), while many will be worse off (due to confusion and disengagement).
I fear that the test may be a deterrent to industry consolidation and could result in ‘zombie’ funds.
All eyes will be on APRA
I am sure everyone will be watching APRA in their role as test administrator. Of particular interest is the fact that under APRA’s Superannuation Data Transformation project the prudential regulator will be collecting more nuanced data which would permit a fairer performance test and get around some of the benchmarking issues.
It would be strange to put industry through the process of providing this data but not use it.
Hard to see a good outcome
In identifying the free ride issues I am not advocating for a tougher test – there is little point advocating for a harder test unless it is a fair test. I would love to see a more effective test which better aligns with investing for member outcomes.
It is hard to see an easy resolution on the YFYS performance test. I am certain the government will not step away from the idea, given they are largely following a recommendation of the PC. A second, largely orthogonal test (as considered in our submission) could be a simple way to remove many (but not all) of the concerning issues.
My hope is that the consultation process is effective. This would entail lots of high quality, unbiased submissions and policymakers being open-minded to the challenges of delivering best outcomes for Australians.
