Since leaving the Future Fund, I’ve had many conversations with peers working in and around superannuation.  The Your Future, Your Super (YFYS) reforms, including the performance test, have been a prominent topic of discussion.  The imperative behind YFYS is to enhance system efficiency by eliminating underperforming super funds, thereby improving member outcomes in retirement.  While this is a worthy goal, the prevailing view in the industry is that the execution has been poor.

The test is a blunt instrument that was not designed to distinguish bad luck from incompetence.  It is backward-looking, so investors are keenly aware that they’re only as good as their worst year in the past eight.  The test also risks collateral damage by instantly creating ‘winners’ and ‘losers’ from an arbitrary starting point.  Nor does it account for changes that might be made to constructively address underperformance in the future.  Even for the survivors, proximity to failure will be an important driver of behaviour and risk appetite.

It has been widely noted that the test discourages ‘off benchmark’ positions like factor strategies, credit, responsible investing and private markets.  Moreover, the test penalises the treatment of currency as a separate asset class and, while this has not received much attention, it is critically important for Australian investors.  Assuming effective governance arrangements are in place, these ‘off benchmark’ activities are often accretive to long-term investment outcomes.

The test will therefore place downward pressure on investment horizons, explicitly prioritise managing relative rather than absolute portfolio risk settings, implicitly reinforce already elevated levels of peer awareness and increase the risk of correlated failure rates across the industry.  None of this is in the best interests of members.

Put simply, the mission of superannuation is to underwrite a dignified retirement for Australians by providing a stable and sustainable source of retirement income.  It would imperil this mission if super funds were to focus primarily on managing the test.  Rather, the test should be viewed as a constraint to be optimised around in the context of their long-term goals.

Funds should consider flexible and holistic approach

No single investment model is suitable for all investors.  However, I firmly believe that elevating a whole-of-portfolio lens on an investment program provides the right foundation for long-term success.  In my experience, a total portfolio approach (TPA) clearly aligns an investment business with its mission and cuts through the day-to-day ‘noise’ to generate better risk-adjusted returns.  For super funds in the YFYS era, this would help maintain a clear focus on enhancing retirement outcomes for members.

To offset the perverse incentives created by the test, super funds should consider a flexible and holistic approach to portfolio construction that better aligns with long-term objectives and accommodates different stakeholder groups.

As a proponent of TPA investing, I would argue that strategic asset allocation (SAA) as it is broadly understood and implemented has some major structural problems.  However, this is probably beside the point in the new regime, since the test requires the use – or at least reporting – of an ‘SAA’ that, by regulatory attrition, is not well-aligned with the traditional definition anyway.  The clear incentive is to mark reported SAAs to market as frequently as possible while also capturing near-term plans so that unintended ‘tracking error’ is minimised under the test.  This tracking error is a valuable and potentially scarce commodity to be provisioned and rationed for an investor’s active risk budget.

Some may see this as ‘gaming’ the test, but the grave consequences of failure mean it could rather be viewed as prudent management of existential risk.  However, APRA may look unfavourably on frequent changes to SAAs and seek to impose an even more counterproductive framework.  Moreover, the prospect of frequent SAA changes in response to the test evokes Goodhart’s law and is not practical anyway given the lead time required to amend product documents through member-facing teams.

Test should focus on members’ best interests

Nonetheless, I expect the test to circumscribe the horizon and utility of the SAAs used by investors.  To offset this, super funds should consider a flexible approach to portfolio construction that aligns with long-term investment objectives and accommodates different stakeholder groups, including APRA.  This might be achieved by:

  • focusing on current portfolio positioning and near-term plans to build a shorter horizon, compliance-based SAA framework under the test.
  • clearly defining an active risk budget to deploy against the test.
  • using multiple horizons and lenses on portfolio design to promote a more robust investment model and better elevate long-term investment objectives.

The test should be managed with the best interests of members in mind.  It is here that elements of a TPA can help maintain a focus on mission and enhance member outcomes.

An unconstrained TPA, like that employed by the Future Fund or New Zealand Super, is not practical for most super funds under the test.  However, total portfolio thinking can help an investor:

  • foster cultural cohesion, unity of purpose and collaboration based on a common organisational understanding of mission. This also serves to clarify and simplify the governance frameworks required to enable success.
  • develop a common language of risk and return that is well understood and widely used to discuss, plan and manage portfolios, and communicate with different stakeholder groups.
  • clearly define its strategic risk appetite to align the investment program with long-term objectives.
  • achieve real – not illusory – portfolio diversification by allocating (or at least interpreting) risk across a common set of market factors, rather than allocating capital to asset classes comprised of these factors.
  • efficiently allocate the marginal dollar of active risk by applying a whole-of-portfolio lens to the opportunity set.

Continued success of super in the national interest

Superannuation is now a critical pillar of the Australian economy and financial system.  It plays a key role in underwriting dignified and sustainable retirement outcomes as the nation ages and helping to ensure intergenerational equity at the same time.  The sector is also an increasingly important source of capital for the domestic economy and the generation of national income and wealth through its growing offshore investment activities.  For these reasons, the continued success of the sector is not just in the best interests of members, but in the national interest.

The imperative behind the YFYS reforms, including the test, is to enhance the efficacy of the Australian retirement system by eliminating underperforming super funds.  While this is a worthy goal, poor execution has created perverse incentives.  It would jeopardise the important mission of superannuation if super funds were to prioritise managing the test above pursuing their long-term objectives.  Even in the presence of the test, I believe that certain elements of a TPA can enhance collaboration and investment efficiency, help to strengthen governance arrangements, and ultimately improve member outcomes in retirement.

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