The Conexus Institute has just released new research exploring how much the Your Future, Your Super (YFYS) performance test will constrain investment strategy resulting in an opportunity cost to consumers of $3.1 billion per annum.
Based on this datapoint alone, one cannot conclude the YFYS performance test is having a negative net impact on consumer outcomes. There appears to have been sizable benefits to the test, such as lower administration fees and a sharpened investment focus, which cannot be ignored.
Even if the net assessment was negative, this doesn’t mean the performance test should be abandoned. Indeed, there is near industry consensus that consumers in default super funds deserve the protection of a high-quality performance test.
The key challenge for policy makers is the “high-quality” bit: how to deliver the benefits of a well-designed performance test, while minimising unintended costs. It is an extremely difficult challenge and for various reasons I am unsure this review will get there.
A sustainable investment strategy
In our research, we explore the concept of a sustainable investment strategy for super funds. Here, investment strategy is reflected by the degree of performance test tracking error, which is applied to activities such as risk management and return enhancement. In a YFYS environment we consider that a sustainable strategy is one which has a low likelihood of failing the performance test, and a low likelihood of having to change significantly in response to short-term performance.
It is this second point which drives our result as funds would first respond to poor performance by reducing tracking error to improve their likelihood of not failing. There are costs to reducing tracking error and then restoring it over time including transaction expenses, difficulty of transacting illiquids assets, restricted ability to manage risks to member outcomes, and impaired relationships with the external marketplace.
Our modelling suggests one per cent is a sustainable level of tracking error for funds. Anecdotally we believe that many funds are currently running at two to two-and-a-half per cent tracking error. The model allows for assumptions – such as fixed expected outperformance, information ratio, permitted through-time variation in tracking error, and threshold likelihood of passing the test and having a stable strategy – to be changed. Working through the model would be a great investment committee workshop for super funds.
If our modelling and assumptions are reasonable then, over time, funds will have to reduce their tracking error, or risk having a poor short-term result which creates the need to alter their investment strategy. Of note, our research found that these results are largely independent of performance test ‘buffer’ or ‘banked performance’. This is because each year creates a new performance series.
Estimating the long-run opportunity cost of the YFYS performance test is relatively straight forward. We multiply the expected reduction in tracking error by a conservative information ratio (the ratio that tracking error is expected to be converted into investment return – we use 0.2) and apply this to the pool that the test applies to (defined contribution assets, non-government, non-SMSF). This is how we reach $3.1 billion per annum.
One frustrating aspect of the YFYS performance test is many of the unintended consequences were flagged as concerns by many groups through the original consultation process. Concern around some aspects has become more significant, particularly the incorporation of ESG and sustainability considerations, and managing trustee-directed portfolios. Other issues will arise which the test will struggle to cope with, meaning the test is not evergreen.
My working view is that an empowered and heavily resourced APRA could deliver better outcomes by applying multiple metrics and a qualitative overlay.
However it is important to acknowledge how difficult it is to, first design and implement, then change, policy. Consider the current situation. No government minister would want to reduce consumer protections (unless the case is clear cut that the performance test is detrimental to outcomes). Timelines (the test must be run again next July) and constraints around data collection (an issue that industry often complains about) mean that the scope of changes are likely small. Retrospectivity is an overhang issue – some funds would like changes to apply retrospectively and others wouldn’t, depending on their own situation.
All these issues contribute to a policy grind and, unfortunately, I think we will only see moderate change. No one can be directly blamed. Fingers crossed for something more – consumers deserve better.
Thanks to Nick Callil from WTW for reviewing the model developed for this research.