Margaret Cole, deputy chair of APRA, has made clear the prudential regulator is satisfied that the Your Future Your Super performance test is having its intended impact.
“Since the inaugural MySuper product performance test, the number of products failing the performance test benchmarks has fallen from 13 in 2021 to just one this year,” Cole told the AFR Super & Wealth Summit in Melbourne on Tuesday.
“With the performance test extended to trustee directed products this year, and the heatmaps extended to choice products in 2021, there is even greater light being shone in the super sector.”
The deputy chair also reiterated APRA’s encouragement of funds to shift their mindset to consider member needs at all life stages, urging them to be “brave and bold” on the retirement challenge.
Cole’s comments follow those of APRA chair John Lonsdale, who last month told a separate AFR roundtable, that there was the potential for performance testing to be extended from accumulation products to retirement-phase options.
“When we think about what we’ve managed to do in the accumulation phase – we’ve got the [Your Future, Your Super] performance test, we’ve got the heatmaps – we don’t think it’s that big a step now to do it in the retirement phase,” Lonsdale reportedly said.
While legislation would be required to extend the YFYS test, the related APRA heatmaps could be an initial step on the pathway to performance testing in the retirement phase. Take note: performance testing of retirement solutions is now a live issue.
YFYS remains a vexed issue
The YFYS test was originally proposed by the Productivity Commission, with advocates pointing to the need for an objective “bright-lines” test to protect members from underperforming funds. APRA asserts that the test has improved member outcomes through industry consolidation and reductions in fees.
Critics mostly support a test to protect disengaged members, but focus on how test design impacts on portfolio management practices in ways that could ultimately lead to worse member outcomes over time. The Conexus Institute has undertaken extensive research on YFYS. Among the many issues, we highlight the following:
- Failure to consider the full performance outcome, most importantly the impact of asset allocation decisions;
- Backwards-looking nature that ignores changes made by funds to improve performance;
- Risk agnostic, meaning the impact of risk management activities are ignored;
- Benchmarking is very challenging beyond mainstream publicly listed assets.
Funds now appear to be ‘managing’ to the YFYS test such that it appears unlikely that many funds will fail in the future. We see considerable risk of a significant implicit cost to members as fund trustees focus on passing the YFYS test as their first priority.
Best practice retirement solutions
Beyond the issues highlighted above, two additional and difficult challenges emerge that relate to the assessment of retirement solutions:
First, retirement differs significantly from accumulation. Delivering retirement income is a complex problem that should not be reduced to the single dimension of return generation.
While returns have a direct link to member outcomes in accumulation, this is not the case in retirement where the primary concern is the level, stability and sustainability of income over a long period of time.
An income (rather than return) lens is required to assess the extent to which a solution is likely to deliver good member outcomes. Additionally, the long timeframes involved necessitate ex ante rather than ex post assessment.
To further complicate matters, the definition of retirement income is open to interpretation. For instance it may (or perhaps should) include income from other sources such as the Age Pension.
The YFYS test struggles as a measure of member retirement outcomes due to focusing on backwards-looking investment performance rather than the future stream of income arising from the assets.
Second, retirement solutions are much more than a single product. These solutions may integrate multiple products such as an account-based pension and lifetime income streams (annuities), an asset allocation and a drawdown plan. There is likely to be greater tailoring of solutions to member needs, compared with accumulation where defaults reign.
We thus expect large differences in both the retirement solutions offered by funds and the solutions offered to members within the same fund. In this context, the existing YFYS test framework again appears a poor match for assessing retirement solutions.
Focusing on investment performance only evaluates one component of the full retirement solution – the account-based pension. In the same way the test is agnostic to investment risk, it is agnostic to longevity risk so cannot be applied to lifetime income streams.
And the greater degree of member tailoring will make it difficult for APRA to identify a ‘test case’ retirement solution as a benchmark for assessment.
Overall, there would be a significant mismatch between the policy problem of protecting members from poor-performing retirement income solutions and the policy tool – a backwards-looking, benchmark-focused, risk-agnostic return-based test.
Is there a way forward?
Simply put, the existing YFYS test is not fit-for-purpose if the retirement solutions offered by funds develop as we anticipate. However, there is a narrow pathway for pushing forward with performance testing as the foundation for retirement solution assessment. It looks like this:
The super industry lands on a basic and reasonably standardised approach where the majority of funds focus on account-based pensions replicating their accumulation offerings. Meanwhile, lifetime income streams are offered as a member choice option, rather than integrated into retirement solutions.
The connection between performance and potential retirement income would then be more direct (though still far from perfect), providing a more sound case for extending performance testing to account-based pensions.
This would not be the best scenario. We would rather see richer solutions combined with more effective methods to assess these solutions through an income lens. Further, this scenario would risk penalising
the more innovative super funds who are striving to best meet their obligations under the Retirement Income Covenant.
If performance testing of retirement products is introduced by policymakers and/or regulators, at a minimum we hope that the testing methodology would be evolved and that this will not be taken as “job done” on retirement. Members deserve much better.
David Bell is executive director of The Conexus Institute
Geoff Warren is research director of The Conexus Institute, and an Associate Professor at the Australian National University
