There are four main components of the Your Future, Your Super reforms; stapling of accounts, a new comparison tool, an investment performance test and the obligation for trustees to act in members’ best financial interests. All of these measures will have a significant impact on the industry; however, the performance test has without doubt attracted the most attention.
There has been extensive discussion within the industry on the test’s design flaws, namely, its limited benchmark indices and therefore lack of benchmarks for some asset classes, particularly among alternatives. In addition, the test’s exclusion of investment risk from the calculation is concerning.
In the recently published draft regulations, historic administration fees have also been included. This is certainly a positive, as it gets the test closer to a total member outcome view. However, if such a retrospective view is adopted, it must reflect the average fees actually paid by members. In addition, funds that have significantly reduced their fees in the past seven years or provide discounts in different forms will be penalised, even if they have superior investment returns versus peers. Surely, this requires further consideration.
If the Government is looking to test the total member outcome, there is another major component missing – the total level of investment risk taken. And, how this is allocated across different asset classes. This is driven by the trustees’ investment beliefs and tolerance for market volatility on behalf of their members, which in turn drives a fund’s Strategic Asset Allocation (SAA). This is by far the most significant contributor to investment returns. Insurance is another important missing element.
By excluding these factors, the test just measures a fund’s ability to implement its investment strategy. And the extent to which this is achieved is limited, too, given the limited number of benchmarks and the exclusion of risk in the proposed test.
Even with the two new unlisted benchmarks, there are still meaningful elements of a fund’s strategy that aren’t being captured due to the approach and the very limited number of benchmarks. This will be highly restrictive for funds that are looking to minimise the chance of failing the test. Just some of the strategies that will be discouraged going forward and could lead to poorer member outcomes include:
- Dynamic Asset Allocation (DAA) positions that aim to reduce total portfolio risk. For example, trustees will be dis-incentivised from de-risking their portfolios in order to preserve capital for their members if the market starts to overheat as this will result in benchmark deviations.
- Low volatility, responsible investment and tail risk hedging strategies. These will result in deviations from the available benchmarks but add value to members by managing market volatility and ESG risks. Given the increased risk of failing the test, these strategies are likely to be removed or reduced in portfolios in the future.
- Any alternative asset class that is unable to beat the 50:50 equity / bond “other” benchmark (for example commodities). If a strategy is unlikely to beat its assigned benchmark, it will be excluded going forward. This may result in reduced total portfolio diversification and therefore increase the market volatility that is experienced by members.
Given these limitations, funds that thoughtfully de-risk to protect members from anticipated negative outcomes or deviate from the restricted number of benchmarks for other sensible and rational reasons could fail the test. And on the other hand, funds that increase risk and get lucky may pass. The solution?
- Introduce more benchmarks
- Add a secondary test that accounts for risk-adjusted fund performance
- Use current actual average administration fees (not historic “rack rates”)
- Review the implications of failing the test
Under the current YFYS proposal, funds that fail the test must inform members of this result. It’s right that members should be made aware if their fund is underperforming (assuming it is truly underperforming). But, the ramifications for disengaged members that stay with the fund are severe and must be considered. Many members won’t take action and as a result their balances will suffer from underperformance. They’ll also bear the brunt of a fund with depleted assets, caused by those that do walk out the door.
Therefore, an action plan for improvement should be implemented following a failed result. And, if the fund can’t meet the terms of the action plan within two years, there needs be somewhere for the disengaged members to be transferred as they are the ones that are most likely to suffer. This approach could also treat the “good” funds that have inadvertently failed the test more fairly as the cause of failure would be carefully assessed and the action plan would be tailored to the reasons behind that fund’s underperformance.
YFYS will change the super industry beyond recognition. They are well-intentioned proposals that seek to improve our retirement system and hold underperforming funds to account. By taking on board industry feedback and strengthening reforms, intentions can become reality in a way that improves member outcomes other than encouraging poorer outcomes.