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The road to super hell is paved with good intentions

Australia’s superannuation system is held in extremely high regard around the world. We are deeply interested in whether the proposed Your Future, Your Super reforms (which include the performance measurement of super funds) will further strengthen it for the benefit the super fund member, or weaken it.

The reform’s intentions are unquestionably good, however we believe that, in three important areas, they will be counterproductive and will make member outcomes worse. In our view, member outcomes will suffer because aggregate costs will rise, long-term achieved returns will be lower and systemic risk is likely to increase.

1. Aggregate costs will rise

Australia’s institutional system comprises a retail sector and an industry funds sector, with an SMSF opt out for individuals. Given the adoption of an identical investment strategy, retail funds have typically had higher costs than industry funds. The higher costs reflect that it is more expensive to recruit individual retail members than to recruit a new business with underlying employee members, and paying a profit margin to a shareholder is an additional expense.

By stapling one super fund to the member, all other super funds will now have to compete as if they were retail funds, in order to persuade individuals to unstaple themselves and restaple to a new super fund. This reform shifts the industry funds from a business-to-business operating model, to a business-to-consumer model with the associated significant increase in cost of acquiring new business.

2. Long-term achieved returns will be lower

If the costs of the super fund business go up then the net investment returns to members will go down. A higher cost of acquiring new business is certain and carries no obvious return benefits (perhaps slightly increased scale benefits), and so is likely to reduce the net return to members.

However, this is not the only way in which we believe long-term achieved returns will be lower.

The performance test is likely to be counterproductive in that it will divert skill and attention away from maximising absolute returns towards the management of career risk – the returns relative to the Your Future, Your Super composite benchmark.

In the current super fund system, the risks and rewards of trying to maximise absolute returns are somewhat symmetrical and fairly muted. The peer group comparisons mean that getting it wrong, or right, in the pursuit of absolute returns will put a super fund at the bottom, or top, of the table. In the post-reform super fund system, the risks and rewards become distinctly asymmetric and the consequences become highly significant.

Underperform the benchmark by 0.49% p.a. and ‘nothing happens’ but underperform by 0.5% p.a. and you are likely to have to exit the business. This may sound over dramatic. However, while a super fund has 12 months to rectify its performance, in reality, failing the first test will imply something like a 90% probability of failing the second test a year later.

At this point the super fund then cannot accept new members, and whilst this is not necessarily terminal, we believe a failed test would be an existential event.

Faced with those consequences, how would you manage the portfolio? To maximise the long-term absolute returns or to not fail the performance test?

In some market conditions, or for some periods of time, the two objectives may happily align but that will not be case at all times or in all conditions. The reforms invite super fund investment teams to more fully emphasise the management of their career risk.

Jeremy Grantham has written extensively on career risk, calling it the biggest driver of investment behaviour. By upping the ante on career risk, the reforms will change investment behaviour. It is our contention that this will act to reduce the long-term absolute returns achieved.

While on the subject of investment returns, the bluntness of the test is hugely significant. Of the seven largest pension countries that we track in the Global Pension Asset Study, Australia is already the worst in terms of pursuing the proxy goal of peer performance (as opposed to member outcomes).

This proposal accentuates an area where experts agree Australia already has an issue. The aim should be to get the best measure of prospective expected outcome; however the validity of proxying that with an eight-year performance test is really low.

3. Systemic risk is likely to increase

One of the implicit aims of the reforms is to compress the range of investment outcomes by cutting off the underperforming tail. If that was the only effect on the range of investment returns then we would have no problem.

However, the career-risk point makes it reasonable to assert that this is unlikely to be the only effect. We believe is it likely that herding behaviour will increase and further narrow the range of achieved investment returns. This, in turn, increases the correlation of member outcomes, meaning that when the DC system fails to deliver the expected, or hoped-for, returns, it fails to deliver them for all members at the same time.

This then has implications for the age pension and taxpayers. While we in no way condone the protection of persistently underperforming funds, a system's perspective shows that the problem must be managed without raising systemic risk.

In summary

The proposed reforms will, in the main, move the Australian system away from, rather than towards, global best practice that truly puts member needs and outcomes above all other considerations.

Specifically, the proposed reforms are highly likely to be counterproductive by raising costs and systemic risk, and by reducing long-term returns. Furthermore, we believe the reforms are likely to negatively impact business models, behaviours and investment practice.

The reforms are well-intentioned, but the unintended consequences are too significant to leave them as they are. We urge they be revisited and amended to reduce the chances of damaging one of Australia’s prize assets.

Today’s officials need to be fully conscious that the consequences of their decisions will play out over the longer term, so will require real vision and understanding now to avoid imperilling the next generation’s savings.

 

Tim Hodgson is Co-Head of the Thinking Ahead Group, an independent research team at Willis Towers Watson and executive to the Thinking Ahead Institute. This article is general information and does not consider the circumstances of any investor. 

 

8 Comments
Peter
January 05, 2021

It is not a 2 year test. It is a 9 year test. 8 year returns determine the first failure, so they have 8 years to get that right. Failing that, they have 1 more year to get it sorted, or be banned from taking new members until it is sorted.
Poor performing funds and advisors understandably fear this.
In the longer term, as the bulk of the poor performers are weeded out, we'll need some sort of rule that retains enough superfunds to maintain competition (maybe 20?).

Dane
December 20, 2020

Tim what is your proposed solution to the issue of underperforming funds? Also isn't it better for funds to be measured against a low-cost benchmark according to fund's own long-term SAA, to better guage if they are adding value? Also why should the focus be on absolute returns? CPI+ benchmarks in my view seem to represent a convenient way to avoid being measured against market beta, which tends to set a cracking pace. Absolute returns usually means managers trying to be tactical with their AA, which usually detracts value. Plus goal of most accumulators should be to capture as much of the market risk premium as possible.

I am not saying the current system is perfect but it has way too much bloat (fees much higher than global peers), a lack of transparency and a long-tail of stragglers so some consolidation is needed. Bring on Vanguard, I say..

Ruth from Brisbane
January 05, 2021

Dane I'm waiting for Vanguard as well. But what happens if it fails the tests (which I think are too short term)? I wish governments would stop tinkering so I don't have to continually revisit my plans.

Steve
December 20, 2020

Yes, millions of people need more funds set up every time they change jobs. Simply ridiculous. Stapling is an excellent idea. Perhaps the 1000 intrafund advisers need to earn their (Opt-In free) salary & bonuses & get busy.

Ramani
December 20, 2020

Adding my inexpert views:
The basic flaw in the consuming fixation flows from the understandable need to improve super performance, and the political rush to be doing something - anything - about it. Like world peace, greater equality and impoving acees to water and sanitation, failure is inbuilt into this experimental quest.
DB funds are the closest (though imperfect) choice where outcomes are the target. We have moved away for obvious reasons.
DC on the other hand must make do with robust rules, policed regularly and properly enforced. Like health outcomes, the rest must be left to the stakeholders (risk preferences and left-field events eaten into by rent-seeking). Anything else is the retirement equivalent of alchemy or inventing hindsight. Good luck!
Shining a torch into rolling five year performance (in this fifty+ years super commitment) is appropriate. Even here, as unrealised capital gains and losses which may evaporate when assets are realised are part of investment performance, with tax complicating it further, we are aiming for a fast moving goal.
For the powers that be and APRA which has perceptibly moved from sensible principles-based into prescriptive regulation, the moral hazard is breathtakingly ignored. The cost is unfundable, but will be funded - as in the GFC - by future taxpayers who already subsidise billions in tax. Not because they prefer, but to preempt social implosion.
A cynic would ask: if competition is so good, why don't we afford regulators some: let funds choose from APRA, MAS, OSFI, HKMA..?

Phil
December 17, 2020

The two year then effective no new members test, and the drying up and associated spiral effect on returns of reduced cash in flows, in an ageing population, is very very tough. How they came to the 2 year conclusion a measurement for a long term strategy is difficult to fathom - there must be more evidence available as to how they got there on that in full consideration of all the impacts.

Ramani
December 20, 2020

Sadly, APRA is no stranger to the ravages of tantine, when the remaining members must share the burden of blocked liquidity, strained fire sales and contaminating potential merger candidates. Sensibly, APRA imposes stricter prudential margins on top of central actuarial estimates in run-off insurers comapred with in-business insurance. By contrast, in uncapitalised super (ORFR is a trivial 'astrological' provision, in any case not risk-based like banks and insurers).
The omerta of silence around the implications is astounding. Like the naked emperor's courtiers or more topically, Trump's followers of alternative facts.
Respected industry elders must urge serious debate.

Alexander
December 17, 2020

Surely this reform as planned cannot survive. How many more experts need to point out it flaws?

 

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