More risks than rewards seen in super fund reforms

Australia's government is counting on superannuation system reforms to get employees to play a greater role in maximizing their retirement savings, but industry participants fear more harm than good.

Analysts warn the Your Future, Your Super reforms — outlined last October in Australia's 2021 budget proposal and set to take effect July 1 — are likely to constrain asset allocators and hurt the disengaged workers the reforms are ostensibly focused on helping.

A final round of consultations, under the auspices of the Treasury Department, gives industry players until May 25 to urge changes on regulators.

Critics predict that, under current plans, a litany of government good intentions — working toward goals such as weeding out perennially underperforming super funds and preventing job-hoppers from accumulating dormant retirement accounts — could come to naught, due to faulty design and execution.

Their biggest focus for now is on the government's plan to introduce an annual performance test for the MySuper balanced default options super funds were required to launch eight years ago to ensure that even Australian workers unwilling to learn the first thing about the country's highly regarded A$3 trillion ($2.31 trillion) defined contribution system could count on decent retirement outcomes.

To pass the test, as currently constituted, MySuper products can't underperform a reference portfolio of passive exposures tailored to each product's strategic asset allocation by more than an annualized 49 basis points over a rolling eight-year period.

If a MySuper product's performance drops below that, its super fund sponsor will be required to send participants a letter to that effect and refer them to a new "comparison tool" ranking competitors by investment returns and fees, should they opt to select a better-performing fund.

As the government noted, the steady growth of retirement savings from employers' monthly 9.5%-of-salary contributions to employee accounts can serve to obscure subpar investment returns, with severe long-term consequences. For example, the government said employees in the worst performing My Super product would be "up to A$98,000 worse off at retirement."

Meanwhile, funds that don't pass the performance test two years in a row would not be allowed to take on new participants.

Analysts note that the test doesn't touch on areas crucial to retirement savings outcomes, such as asset allocation.

It's "a very narrow test" of whether a fund is doing a good job of implementing its strategy — more focused on operational matters than whether the strategy is effective in terms of long-term outcomes for participants, said David Carruthers, a senior consultant with Frontier Advisors LLC and head of the Melbourne-based firm's members solutions group.

It's "a very harsh measure — 49 basis points, I survive, 50 basis points, I don't, black or white, pass or fail," said David Knox, Melbourne-based senior partner at Mercer Australia and lead author of the annual Mercer CFA Institute Global Pension index.

And it's far from foolproof, according to The Conexus Institute, a Sydney-based research outfit focused on achieving better retirement outcomes for Australians. David Bell, the institute's executive director, said Conexus research suggested the proposed performance test would identify "good" funds as "poor" 35% of the time, while correctly identifying poor funds roughly half the time.

Meanwhile, the asset-class benchmarks the government has signaled it will recognize for those MySuper-specific reference portfolios remain broad, leaving well-diversified super fund investment teams facing enormous tracking error risk.

"It's not your precise strategic asset allocation, it's a top-level strategic asset allocation," Frontier's Mr. Carruthers said. For example, for bonds "there's Australian bonds and there's global bonds but no credit, no high yield, no bank loans" — a much less diversified benchmark, he said.

Likewise, the test doesn't take account of how much risk a portfolio is taking on. "If you were underperforming the test by 50 basis points but ... you had a risk level 2% less than the benchmark, your risk-return outcome — your Sharpe ratio — is much better" but the strategy still gets a failing grade, Mr. Carruthers said.

And with a six- or seven-year evaluation period tail, a fund that takes appropriate or innovative steps to turn around performance could remain underwater for years, analysts said.

Analysts said inevitably a sizable segment of the industry will have an incentive to trim risk exposures to better position themselves to clear the new performance hurdle.

Your Future, Your Super "is forcing funds to reconsider how they construct and manage portfolios, and that will have a bearing on their risk taking," said Troy Rieck, chief investment officer of A$13 billion, Brisbane-based LGIAsuper.

The government's goals are laudable but "there's strong potential for collateral damage, that funds will take actions based on this test that they wouldn't do in the interests of long term member outcomes," Mr. Carruthers agreed.

And that fund-level environment will have broader implications for Australia's retirement preparedness, analysts say.

"Inevitably across the industry there'll be lower returns," resulting in smaller retirement benefits, Mr. Knox predicted. For example, when equity multiples push to historic highs, investment teams that previously would have responded by trimming stock market exposures could decide the risks of doing so are too great, leaving portfolios facing the full brunt of a potential sell-off rather than trying to mitigate potential downside, he said.

"Who can afford to be underweight listed equities, in case you're wrong in the short term," agreed Mr. Rieck. "The implications of what might be sound, long-term investment decision-making are too great," he said.

"If this legislation gets through then the industry in five years' time looks a lot different," with more "index hugging (and) less willingness to try alternative assets that might not be well represented in the indexes," Mr. Knox said.

But it won't be the same for all funds and will vary over time for specific funds, depending on how far head of the benchmark they're likely to be at any point in time, Mr. Rieck said.

For funds comfortably clearing the performance test, the lure of securing the top one, two or three positions in the promised comparison ranking tool — which would make them the easy choice for participants looking to shift out of poorly performing funds — could prompt them to take on more risk, Mr. Carruthers said.

If super funds have different starting points, all are reviewing their investment approaches now.

"Most of our funds have gone through or are currently going through a big analysis on how (the reforms) will impact the investment strategies that they run for their members," Mr. Carruthers said. "All need to know what the impact is and what level of risk it runs for them, or level of risk it introduces for them," he said. For now, however, it's the funds that are closer to that negative 50 basis points danger zone that are "actively doing stuff or have already put stuff in place to make sure they reduce the risk" of being flagged for underperformance, he added.

Much depends on the final list of benchmark indexes used for the annual performance test — a likely focus of submissions to the Treasury over the final week or two of consultations.

On that score, market participants welcomed an April 28 update from Treasurer Josh Frydenberg adding Australian unlisted infrastructure and unlisted property as specific asset classes covered by the test. The government's initial announcement had only mentioned a global listed infrastructure benchmark, which would have left Australian super funds with material allocations to domestic infrastructure and real estate facing big tracking error risks.

The Conexus Institute's Mr. Bell said the ability to use those unlisted domestic infrastructure and real estate benchmarks should slash the bulk of the A$3.3 billion in annual opportunity costs his research team had initially calculated from super fund investment teams having to cut exposures to reduce tracking error. Even so, he said, the continued focus on a performance test that doesn't take account of risk or asset allocation will leave super funds facing considerable challenges.