Treasury’s Your Future Your Super (YFYS) ‘design options’ consultation paper deserves credit. It demonstrates that Treasury understands the shortcomings of the current test design, and sets out a range of options for change. Now, it’s the industry’s turn to respond.
This creates a “red pill or blue pill” moment for the super industry to channel a key scene from The Matrix films. The red pill involves facing up to the reality that the current test has major shortcomings, and doing the best possible to design a better test. The blue pill represents a do-nothing option where we remain in the world of the existing test.
We are sensing a view in the industry that some may prefer to take the blue pill and not make any substantial changes. The train of thought leading to this position is not unreasonable. It is based around consideration of cost to industry and ‘better the devil you know’.
However, we advocate for the red pill on the basis that what is best for consumers is what matters. And we see an opportunity to improve member outcomes.
This review makes it clear that the YFYS performance test will be permanent. Some of this is due to the explicit outcomes the test has delivered thus far, along with the associated narrative: funds are being held to account and members have benefited as underperforming funds exit and fees reduced.
Some of it is undoubtedly down to politics. It would be very difficult for a government to be seen to be reducing consumer protections in superannuation by removing the test.
Thus, this review is not about removing performance testing. Rather, it is an opportunity to design a better performance test.
Acknowledging the shortcomings
The concept of a single-metric, backwards-looking performance test implemented retrospectively is deeply flawed. It runs contrary to some of the messages provided to consumers. It conflicts with all the education and learned experiences of the investment management industry.
Whatever happened to the adage that “past performance is no guide to future performance”?
While some might find it cathartic to detail the flaws of the test, it is a necessary starting point for improvement. The main high-level issues with the test are that it is:
- Backwards-looking, i.e. doesn’t account for forward-looking prospects and is blind to changes made to improve those prospects;
- Purely quantitative i.e. doesn’t reveal reasons for underperformance.
- Measures only one component of performance – implementation – with flaws, such as imperfect benchmarks.
- Now being actively managed, even gamed;
- Directing portfolio management activity (albeit to an unknown degree); and,
- A ‘bright lines’ pass-fail nature that relies on the test metric being a perfect measure of underperformance.
Some of these flaws were exacerbated by the retrospective application of the test, with mixed alignment to member outcomes without providing industry time to adapt.
What is needed is a test that incentivises funds to focus on delivering good member outcomes and fails funds who are incapable of doing so. The current test is not fit-for-purpose to deliver either.
Funds are prioritising passing the test, in some cases ahead of member outcomes. With funds now actively managing the test, there is a reasonable likelihood that no MySuper options will fail in the future.
The case for change
The test is here to stay, and the desire to maintain a bright lines result persists. Hence (1), (2) and (6) are effectively locked in. However, there is an opportunity to improve (3), (4) and (5) that is well worth taking. Especially as it may be the last opportunity.
The benefits to consumers of a better-designed test would be both explicit and implicit. There is an upside in better aligning the test with the broader set of investment management activities undertaken by super funds that matter for member outcomes. In particular, testing the impact of overall investment strategy – including asset allocation and risk management, for instance – rather than just strategy implementation.
Think of it as creating a larger overlap in the Venn diagram between what funds can and should do for their members and what the test assesses. A well-designed test should reinforce the range of investment activities that matter for member outcomes.
Another key goal would be to neutralise the tendency for funds to manage or “game” the test as an overriding priority. Designing a quantitative test that is hard to game is near impossible. But it may be possible better align the test and to dilute the incentive to manage it.
This provides an argument in favour of a multi-metric test, which would be much harder to manage. Another solution might be to introduce a qualitative overlay. However, this appears to have been (unfortunately) ruled out.
While we accept that flaws would remain, there is considerable benefit in changing the design, even if a perfect test is well out of reach.
Why the reticence?
The industry felt burnt by the retrospective introduction of what was seen as a flawed test. They saw examples of rough justice for some funds, while others came close to living their own “near-death” experience. Funds have now adjusted to the test, and most feel they are on a sound footing to manage the risk of failing the test going forward – even if that does come at a cost to consumers. Now funds potentially face a new test being applied retrospectively. We can see the case for the blue pill.
However, we argue a redesigned test could be better aligned with member outcomes and create less distortion. A transition mechanism can be developed to minimise the impact of retrospective application. We acknowledge the risks of a new test being poorly designed, but think a constructive and collaborative approach by industry can reduce this risk.
The red pill provides the opportunity to improve consumer outcomes. That is the pathway we should be taking.
David Bell is executive director and Geoff Warren is research fellow at The Conexus Institute, a not-for-profit think-tank philanthropically funded by Conexus Financial, publisher of Investment Magazine.
