The introduction of the landmark Your Future, Your Super (YFYS) reforms and the subsequent performance test has spurred widespread change in the superannuation sector.
While Mercer supports regulation that aligns with members’ best financial interests and improves the industry at large, the current approach to the performance test has brought with it several unintended consequences that risk impacting overall retirement outcomes for members.
If the government chooses to extend the performance test to include Choice products without addressing such issues, these unintended consequences will be further amplified with Choice members potentially being exposed to the consequences of less choice and lower investment returns.
Unintended consequences
A fair performance test should consider risk-adjusted investment returns and administration costs alongside the ultimate goal of providing true value for members in a way which aligns with their unique wants and needs.
While it’s true that the test has achieved its purpose of removing some underperforming super products, it has brought with it several unintended consequences, particularly in relation to the investment behaviour by fund trustees.
- Issues relating to the time horizon: The performance test is measured as at 30 June each year over rolling eight-year periods. A rolling test by its very nature means that at each 30 June, the eight-year performance of a fund will change by including the latest twelve-month period and omitting the earliest twelve-month period that was previously included. Hence, the performance in the omitted twelve-month period directly impacts on the performance required in the new twelve-month period to pass the test to the same degree. In some cases, this may result in super funds making investment decisions restricted to a twelve-month time horizon to ensure they pass the test.
- Issues relating to the benchmarks and investment selection: Despite the wide range of asset classes used by super funds, the current performance test for MySuper products provides a limited number of benchmarks. This means that many funds are invested in asset classes that do not have a relevant benchmark, such as Emerging Market Equities and International Unlisted Infrastructure, and they are therefore required to consider the level of “tracking error” risk they are taking relative to the prescribed benchmarks. In some cases, the tracking error risk is considered too great a risk to take, resulting in a portfolio that becomes less diversified. As referred to below this issue will become even more important for many Choice products which are by nature less diversified than the MySuper portfolios.
It’s also important to highlight that the nominated benchmarks do not necessarily align with the government’s push to mobilise institutional capital to invest in areas like social infrastructure and, in fact, may deter funds from investing in private or unlisted assets.
The impact on Choice
Now let’s consider the objective of Choice products – that is, to provide members with the ability to choose the investments and products they are invested in, based on their personal circumstances, values or preferences. For example, many members want their super invested in ways that are consistent with environmentally-related principles.
It’s for these reasons that Choice investment menus seek to provide members with access to products that are distinct from those provided through the MySuper default. This leads to a much broader range of investment strategies and styles available; in turn, amplifying the likelihood that some of the benchmarks currently adopted for MySuper products are inappropriate for Choice products.
Given this, an extension of the performance test to Choice products could see trustees choose to remove options that are at higher risk of failure, and thus reduce the variety of investment options available to members.
Moving forward
The YFYS measures must deliver on their original aim of ensuring Australian super funds perform better, deliver dignity in retirement, and avoid adverse outcomes for members.
The current performance test for MySuper products must be improved and the benchmarks must be reviewed well before expansion to include Choice products is considered. With that in mind, the performance test should be refined to include:
- Expanded benchmarks: while the existing MySuper test should continue, current benchmark indices should be supplemented with metrics that reflect the nature of the various asset classes in which super fund portfolios invest and capture the typical exposures that are included within those asset classes.
- Trustee-directed (or Choice) products: ensure that any extension of the test is limited to Choice products which comprise of at least four broad asset classes within the portfolio, which means a diversified portfolio.
- Modify the consequences: Rather than taking a pass/fail approach, the consequences of failing the test, especially for Choice products, should be modified with an approach similar to the existing APRA heat map process, with regulators working with underperforming funds towards improvement through remediation.
The goal is for funds to remain competitive and to strive for improved outcomes for all members. Therefore, in Mercer’s view, trustees must be allowed to innovate their investment approach and offerings to enhance the overall value proposition without the significant restrictions imposed by the performance test.
