The Productivity Commission (2016-2019) identified default fund allocation had a “lottery” effect, which could result in significant differences in outcomes between like individuals. The metric used to assess outcomes was a measure of implementation performance which formed the genesis of the Your Future, Your Super (YFYS) performance test. Unfortunately this does not provide a full picture of a fund’s overall operation.
Significant lottery effects remain in superannuation, whereby at least four other factors which could impact consumer outcomes by a similar magnitude are largely overlooked. These other factors aren’t scrutinised and regulated to anywhere near the same degree as implementation performance, creating a distorted environment for super fund trustees.
Here we look at the five factors that are big determinants of consumer superannuation outcomes, including implementation performance. From here we can better understand the current environment and challenges ahead.
1 Level of investment risk
The outright level of investment risk is probably the most significant driver of investment outcomes. In Australia, it is generally measured as the growth/defensive exposure of a portfolio (which we know isn’t perfect). The higher the growth exposure, the greater the expected outcome (which we will describe as a primary outcome). Higher growth exposure also increases investment volatility, broadening the range of possible outcomes (which presently appears a secondary consideration).
APRA collects this data but there is no formal measure of trustee accountability relating to the chosen level of investment risk. Of concern to many is that the Your Super Comparison Tool does not consider investment risk at all, not only ignoring a lottery effect but potentially fostering a consumer behaviour to chase funds with higher investment risk.
2 Fund design: balanced or lifecycle
Related to the level of investment risk is an individual’s exposure to investment risk through their lifetime. Consider the case of someone who is constantly employed full-time through their working life: real superannuation investment earnings in their final year of work are expected to be around one hundred times the earnings in their second year (i.e. based off a full year of contributions).
This illustrates the significant variation in investment exposure (measured in dollars) through one’s lifetime. This is the motivation for lifecycle strategies (which vary investment risk through time, decreasing investment exposure as people age) versus balanced strategies (which run a constant level of risk). Lifecycle strategies are a form of risk management but, as noted previously, risk is a secondary consideration and lightly assessed.
APRA collects this data, but difficulty arises through the absence of any assessment based on the forward-looking range of outcomes.
3 Strategic asset allocation: populating the investment risk target
There is a broad spectrum of investment opportunities and performance variation within the asset pools considered ‘growth’ and ‘defensive’ can be significant. Consider the difference in performance between Australian and global shares over rolling periods in the growth category, or between cash and domestic bonds in the defensive category.
Asset class decisions are important. The YFYS performance test is inconsistent in how it assesses strategic asset allocation decisions. The test is agnostic to some asset allocation decisions (the impact of allocation decisions between the eleven benchmark indices are ignored) but captures any decision related to a non-benchmark index (for example inflation-linked bonds, credit, emerging market equities, and alternatives).
While APRA produces a measurement of strategic asset allocation performance in its Heatmap, there is no direct consequence to funds with poor performance.
4 Implementation performance
Implementation is important – returns can be diluted by high costs and poor implementation, whether internal or external. Implementation impacts outcomes across all asset classes.
The YFYS performance test is often described as a test of implementation performance. In this context it would be more appropriately described as a “crude plus” implementation test. “Crude” because it focuses only on the level of outcome (with no adjustment for risk) and uses a limited number of indices, and “plus” because it also accounts for the performance of tactical positioning and operational expenses.
Due to the consequences of failure, the YFYS performance test, despite its flaws, underpins implementation performance assessment by industry. It is managed actively by many funds to the extent where it is arguably gamed by certain funds.
5 Retirement solutions
Under the principles-based Retirement Income Covenant (RIC) fund trustees are required to develop a retirement income strategy which incorporates a considered trade-off between income, risk management and flexibility. Inherent in this requirement is the concept of ex-ante assessment: determining a strategy appropriate for an unknown future which encompasses a broad range of possible outcomes.
It is likely that there will be diversity amongst funds in the retirement income strategies they offer based on the characteristics of their member cohorts. This will generate a broad range of outcomes.
Presently there is no measurement, by industry or regulators, which matches up well to this requirement to be forward-looking and account for multiple objectives.
Three reasons why we need to step up how we measure outcomes
The first is that, when you consider the range of important issues which impact investment outcomes (the first four factors above), the extreme focus (with strong consequences) on a single measure (implementation performance) is highly disproportionate and this distorts decision-making. This reflects better on APRA (who consider a range of metrics in their Heatmap) than it does on the Productivity Commission and policymakers (who created the YFYS performance test). The longer this disproportionate framing remains, the greater the distortionary impact.
Second, is the risk that the super system forever remains trapped in a construct of weak misdirected assessment. The system may remain focused on expectations rather than the range of possible outcomes. This would manifest itself in an ex-post measurement world focusing on past performance and failing to direct and support trustees who need to make forward-looking (ex-ante) decisions. Creating frameworks which focus on the forward-looking range of outcomes that consumers may experience would inform and guide better trustee decision-making. Ex-post has an important place but it should not stand alone.
Finally, there is a need to develop outcomes-based measurements which focus on consumption in retirement. To do this well requires working out how to integrate all five factors (plus more!) into a consumption-based measure. That doesn’t mean throwing away return-based measures – they have a role to play. Here, considering the range of outcomes in an ex-ante framing is just as (if not more) important when assessing consumption-based retirement outcomes.
There is no DC retirement income system in the world which has evolved to this level of measurement and framing. This is a crucial component of rising to meet the retirement income challenge: creating well-designed accountability frameworks which support quality decision-making. The Australian system has plenty of talent. Will it rise to the challenge?
For an update one year on from Your Future Your Super, register for this webinar.