The Your Future, Your Super performance test is not a measure of performance at all. It is a guarantee of mediocre outcomes, Wouter Klijn, Editor of [i3] Insights writes.
From 1 July 2021, superannuation funds will be subjected to an annual ‘performance test’ under the new Your Future, Your Super legislation.
If they fail to match the performance of a set of simple benchmarks that are supposed to reflect the fund’s strategic asset allocation, then they will need to notify their members.
To call this a ‘performance test’ is an interesting choice of words because the test is not a performance test at all.
It is an implementation test.
Let me explain.
Consider a fund that decides to put all of its members’ money into cash, a decision that from a performance perspective is a disaster as they are now guaranteed not to achieve their investment objectives over any time frame.
Yet, this fund will pass the performance test, as long as the fund has stated in its product disclosure statement that its strategic asset allocation will invest members’ funds 100 per cent in cash.
Why? Because investing all funds into cash will mean the performance of the portfolio will deviate very little from the benchmark.
Now, let’s take another example where a fund invests nearly 100 per cent of the money in equities and provides portfolio protection on top of that.
Over the previous 10 years, this fund would have shot the lights out at a manageable level of risk due to the portfolio protection, but the element of protection also means it would have deviated greatly from the listed equity benchmark at certain points of the cycle and, therefore, most likely would have failed the test.
In other words, instead of measuring how a fund performs, the test simply measures how well a fund tracks its chosen asset allocation.
This has vast implications for investment strategy.
First of all, the test doesn’t take into account risk management. Most superannuation funds spend a great deal of time on achieving the optimal construction of their portfolios, taking into account the investment climate, the demographic of their member base and the access to available strategies.
Some funds might have a high allocation to equities, but have implemented that allocation in a relatively conservative way. For example, they might seek out stocks with lower levels of volatility. But since this will introduce greater tracking error, they are likely to fail the test in certain years.
Here, the Your Future, Your Super test penalises a decision that arguably is in the members’ best interest.
Many funds also look to manage risks by allocating to alternative investments. Not all alternative investments are super-high-octane hedge funds that aim for double-digit returns. In fact, many funds use defensive alternative strategies to create better diversification and hence lower risk.
But the test measures the entire alternative investment spectrum against a benchmark that contains 50 per cent equities. Under these conditions, allocating to defensive assets is likely to translate into greater tracking error. Again, the test penalises thoughtful risk management.
Finally, the test requires funds to stay within about 0.5 per cent of the benchmark portfolio or they will fail. This requirement causes a whole raft of issues.
Awareness of peer risk, already at a magnitude that it cripples investment innovation, will increase further.
It will also reduce funds’ appetite for active management as a 0.5 per cent deviation from a benchmark is not an active strategy, it is enhanced passive.
But perhaps most troubling is the question, as Nick Callil, Senior Consultant with Willis Towers Watson, astutely points out: will funds wind back tracking error to reduce the risk of failure, even if this is expected to reduce long-term returns for members?
The answer is yes, because we have already seen evidence of this from a number of funds shifting their asset allocation in the lead-up to the reforms becoming legislation.
If this test has any effect on super fund performance, then it will be the diminishment of long-term returns for members.
Is this what members want? Definitely not.
Then why implement such poorly designed measures?
The government has indicated it wants to see a drastic reduction in the number of superannuation funds and perhaps it is willing to take the chance of creating a system that produces mediocre outcomes for members in order to achieve its target.
If that is the case, then perhaps the legislation should be clear on this front and be renamed ‘Your Future, Our Super’.
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.