At the end of February, the Your Future, Your Super (YFYS) legislation was introduced to Parliament and was subsequently referred to the Senate Economics Legislation Committee for inquiry and report by 22 April 2021.
This legislation, if passed, will see the launch of four measures that were outlined in last year’s Budget: The stapling of members’ accounts, a YourSuper comparison tool, an investment performance test and a compulsion for trustees to act in the best financial interests of their members. All four developments are expected to have a significant impact on the industry.
Mercer is highly supportive of the intentions behind these new measures, like many others in the industry; however, we believe that further development and consultation is needed to minimise unintended consequences and ensure improved member outcomes.
A key concern relates to the new investment performance test and the impact it will have on addressing the Environmental, Social and Governance (ESG) issues and climate change. Particularly given the consequences of failing the test.
There is a strong record of commitment to responsible investment amongst institutional Australian superannuation funds (excludes self-managed super) which accounts for ~$2.2 trillion. Many funds consider ESG factors and climate change as part of their fiduciary duty. In fact, the Australian Prudential Regulation Authority (APRA) issued a letter in February highlighting the significance of climate change and to encourage the assessment of investors’ exposure to the potential physical impacts.
Capital allocation to strategies that align with such regulatory guidance, which has been backed by our analysis, is in our view, in the best financial interests of members. It is no accident that many superannuation funds are transitioning portfolios to align with a net zero carbon emission economy and it is a commitment Mercer has made across our Australian Funds and Mercer-managed investment options.
Investing in forward-looking investment strategies within a diversified portfolio is strategically important to protecting member savings; but introducing a new investment performance test for a fixed performance period, ignores the long time horizon of these global systemic risks that have widespread impacts. Investors need the flexibility to deviate from benchmarks at times to address these risks – such as climate change and inequality as well as disruption including technology, energy and more recently, pandemics – to pursue sustainable returns.
Strategies that have a lower alignment to the performance test benchmarks could become high risk for trustees as they could lead to failure of the test, over certain periods, despite longer-term outperformance. Mercer has reviewed the performance of its top sustainable strategies and while the sample outperformed the relevant benchmarks over the past seven and eight years, we have a number of examples where highly rated strategies have lagged their respective performance test benchmark over those periods.
Noting that 37 per cent of professionally managed assets in Australia are managed under responsible investment categories, (according to the RIAA, Responsible Investment Association Australasia), and approximately two-thirds of this is in superannuation, the impact could be significant.
New research by the Conexus Institute has explored the level of acceptable deviation from the performance test benchmark (tracking error) that will enable funds to keep the probability of passing the test above 90 per cent, without having to make regular strategy changes. This level will vary depending on expected alpha, but the research found a 50bps outperformance target would limit acceptable tracking error to approximately one per cent.
This will significantly constrain portfolio management activities. For example, the Conexus Institute calculated that a portfolio with 10 per cent exposure to high yield credit, 10 per cent to unlisted property and 10 per cent to unlisted infrastructure had a historic tracking error of 3.6 per cent per year. With that in mind, in order to meet a one per cent tracking error budget, a fund would be constrained to less than a 10 per cent aggregate exposure to those asset classes. This assumes that all other exposures are passive and match the YFYS benchmark indices.
This could mean that trustees are driven towards strategies that track the YFYS benchmarks in order to reduce the risk of failing the test. This voids the important role of strategic, forward-looking risk management and alpha generation. It does not address the role that trustees play in ensuring that capital has utility, i.e. that investment has the collective power to drive real world impacts, making possible the kind of world members will want to retire into.
We look to Government to consider such implications when reviewing this new legislation as well as the regulations that will set out the details of this performance test including the consequences of failing the test. We believe all potential unintended consequences needs careful consideration prior to implementation. From a sustainable investment perspective, funds must be encouraged to continue the important work they are doing to manage ESG and climate change risks. Not only can sustainability deliver enhanced returns over time, it is what most members expect.