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Super performance test will destroy viability of some funds

The Your Future, Your Super (YFYS) annual performance test will apply to MySuper products from 1 July 2021 and ‘trustee directed’ products from 1 July 2022. Some of its key features are:

  • Product performance is tested against a benchmark comprising prescribed indices weighted in line with a fund’s strategic asset allocation (SAA). This means that the test measures the effectiveness of a fund’s implementation of its strategy relative to its YFYS benchmark, not the suitability or performance of the strategy itself.
  • The performance measurement period is generally eight years (seven years for the first test). While a year of ‘good’ performance helps, each year is the start of a new performance period and so consistency of performance will be rewarded.
  • A product passes the test provided the product return (including allowance for administration and advice fees) does not underperform the benchmark by more than 0.5% pa.

A test with teeth and major consequences

The result of failing the performance test is highly visible. Funds must send their members a notice (by paper mail, adding another expense) commencing with the words:

'Your superannuation product has performed poorly. You should consider moving your money into a different fund'

It's an unpalatable action for any fund. Two successive years of failure will see a product barred from accepting new members, which would damage cash flow and destroy the viability of most funds in a reputational sense.

So, this is most definitely a test with ’teeth’. All funds will weigh up the priority that should be given to meeting the performance test relative to other objectives. Some, perhaps most in the longer term, will change how their investment portfolios are designed and managed.

The risk of underperformance

As an indication of what might be in store, using APRA’s December 2020 MySuper Product Heatmap, 11 single strategies, and a similar number of lifecycle strategies, were more than 0.5% p.a. behind the Listed SAA Benchmark over the six years to 31 December 2020. It’s important to note however that the YFYS performance benchmark differs slightly from the Heatmap benchmark.

Looking forward, a year-by-year approach which blends past performance with forward-looking modelling will be required for products that have experienced underperformance in the past eight years.

Longer term, our analysis of a subset of MySuper options suggests a typical forward-looking probability of failing the performance test over a single eight-year period falls in the range of 10-15%. There is obviously some variability between products, with estimated tracking errors relative to the YFYS benchmark ranging from 2-4% per annum and probabilities of failing the performance test over a single eight-year period ranging from 6-16%.

While the likelihood of failing the test over a single eight-year period is a useful starting point, it doesn’t accurately represent the prospect of the fund failing the performance test over a longer time period that incorporates a number of rolling eight-year time periods.

The chart below demonstrates the cumulative probability of failure over longer periods, assuming a 10% likelihood of failure over a single eight-year period.

Cumulative probability of failing the performance test

If we look at 10 consecutive performance measurement periods, covering a total of 17 years of fund performance (i.e. the first test covers years one to eight, while the 10th test covers years 10-17), the cumulative probability of underperformance reaches 35%. If we extend this to 20 measurement periods, then the cumulative probability of underperformance increases to over 50%.

Over the same period, the likelihood of failing the test in two consecutive years is also around 35%. The longer-term risks of falling foul of the test are clearly material.

Implications for super funds

We have already seen funds make portfolio and product changes, in anticipation of the test becoming law. Conceivably, we could see a bifurcation of strategies adopted.

Those with a strong brand name and market presence, or a well-defined and ‘sticky’ membership base, may consider a failure of the test (at least for one year) to be manageable and hence may be comfortable sticking with their existing investment approach and strategy.

Those with a weaker franchise might make passing the test their highest priority, dialling down the underperformance risk to an acceptably low level.

The broader implications of the YFYS package will play out over several years. It seems clear though that prioritising investment objectives, including determining how much emphasis to place on the YFYS performance test, will become a top tier issue for all funds.

 

Nick Callil is the Head of Retirement Solutions and Tim Unger is Senior Investment Consultant at Willis Towers Watson Australia. This article is general information and based on a current understanding of the YFYS legislation.

 

13 Comments
Guy Metcalfe
July 12, 2021

The cumulative probability of failing the performance test graph is somewhat misleading. There is at least one way to guarantee a fund passes the test every year. Implement the policy portfolio with low-cost index funds and keep total fees and costs well below 0.5%.

Philip Carman
July 11, 2021

In my 40 years in the Money Business, dealing with a range of people from highly paid/sophisticated managers of billions to Mums and Dads, I've found very few who deeply understand risk and reward and fewer still who genuinely dovorce themselves from fear and greed as well as the group-think that pervades markets. Fewer still truly know themselves and their insecurities...
Adding a layer of regulation around managed fund performance based on fear of being caught out on a limb that has not (yet) been recognised as sensible (like being short the capital markets in 2006/07) only serves to ensure that few will ever make calls against the crowd...which ultimately must be done to protect capital - sometimes for two consecutive years.
I well remember BT being "wrong" in late 1985/early 1986 when they were aghast at excessive valuations, only to be proven correct in late 1987, but only after they, too, had been dragged (a little) away from their preferred position (of an even lower exposure) by advisers, other managers and the commercial necessity of not being too "out of kilter" with the mob.
The likes of Kerr Neilsen, who had been an important cog at BT in the 1980s, were deeper thinkers and better than the rest (someone has to!) and went on to lead some genuinely independent thinkers (although still at the mercy of the dumb mob, to whom they had to market theior wares) in setting up some leading investment houses. Thinking differently from the mob gets punished by blunt instruments that measure performance in the short term, but ultimately can deliver better and safer outcomes - sometimes.
Here's the thing: if government (and commentators) believe they know best they should set up their own funds and test themselves. For example: the Future Fund should be available to all Australians who wish to use it and then it should be allowed to compete in the open market. Those two ideas are, of course, intrinsically linked and provide perhaps the only possible solution to the problems of ignorance, envy and fear that pervade human's attempts to both understand and beat markets - of which they comprise the core.

Steve
July 11, 2021

No Philip - Here’s the thing - start performing for clients instead of feeding the funds overinflated fees and salaries. True Client focus would be good rather than just rhetoric. Then the investment industry may just climb itself off the bottom rung of trust they are now on and clients may start believing that they are truely working for the clients and not just for themselves.

Jerome Lander
July 11, 2021

Great article. If super funds weren't already overly "benchmark" focussed instead of being client focussed, they will be now. Any good fund needs to have the opportunity for genuine and meaningful active management, and that is being removed for these institutions as they are effectively forced to comply with government edict. Wealthy investors will continue to invest through SMSFs and allocate their capital elsewhere, where it can be managed in alignment with their interests.

Steve
July 11, 2021

It’s about time those super funds that rip off members with high fees to pay for there overinflated salaries were brought to account.

Steve
July 11, 2021

This is really about reducing the number of super funds for the regulator to monitor, and like Hayne2 is about about culling out the number of advisers to supervise. It has absolutely nothing to do with increasing competition & everything to do with increasing fees to the regulator, while reducing their work load. Not unlike State Govts preferring large residential developments over backyard subdivisions. 

Neil Cox
July 09, 2021

Chris has nailed it. This is nothing to do improving superannuation performance. It's all smoke and mirrors to hide the real alternate agenda.

Greig Meyer
July 09, 2021

It is unbelievable that such a dumb idea has ever made it this far. It is the superannuation equivalent of 80% of drivers believing they are above average. By definition 50% of all funds must fall below benchmark, whatever the benchmark is. The impact of this policy on funds management in Australia is going to be far reaching. It is going to impact on companies and cost of capital, and mean that rational thinking about investing is going to be pointless for the majority of money invested in the Australian share market. For companies the only thing they will need to do to survive will be to make sure that they are big and then all the super funds will have to buy their shares regardless of the quality of management or the merits of the business.

Martin
July 11, 2021

If the benchmark is an independent target - say ASX 200, then it is wrong to say that by definition 50% will fall below that. That statement is correct only if the benchmark is the average of all the funds, which it is not. The portfolio benchmark will be a blending of individual external benchmarks for various asset classes weighted by the asset allocation. The sadder part is that funds will tend to adopt portfolio allocations to mimic the test comparator allocations which will mean that innovation will be stifled. It is however a well overdue improvement to highlight fund managers who take fees yet deliver outcomes worse than the index they seek to beat. As James Bond put it, “three times is enemy action”.

Chris
July 08, 2021

It seems this new legislation has a major "unintended outcome", or perhaps it was fully intended by the ideologues within the LNP ??

JohnPascoe
July 08, 2021

Does this apply to personally self managed super funds with the maximum of 4 members [soon to be 6] ?

Graham Hand
July 08, 2021

Hi John, no, the test does not apply to SMSFs. You're on your own with that one.

George
July 10, 2021

Nothing to do with SMSFs. SMSFs and SMSF trustees are not regulated by APRA.

 

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