Many of the problems with the existing Your Future Your Super performance test arise from the tyranny imposed by the benchmark indices. Broadening the test to focus on total portfolio returns will address this issue and achieve the government’s intent, plus more.
Treasurer Jim Chalmers has announced that the government will take “another look” at the test to ensure that there are “no unnecessary obstacles or impediments” for investing in areas of national interest, such as housing. The Treasurer made it clear that the test will remain in place, and that the obligation to maximise member financial best interests remains pre-eminent.
We have previously argued for a broad review of the test rather than just tinkering with it; now we argue there is also a strong case for reconsidering the structure of the test, and for ending the tyranny of benchmarks.
The possibility of failing the test is an existential threat for super funds, and occurs through underperforming the benchmark indices. As a consequence, super funds limit and manage tracking error versus the indices. The indices hence dictate the shape of super fund asset class portfolios to a significant degree.
Three notable problems arise:
- Capital allocation is constrained as funds become reluctant to stray too far from the indices (unless there is some sort of “free kick”, like credit in fixed income portfolios). Wariness of drifting too far from a benchmark constrains investment in areas such as affordable housing, climate transition and sustainable investing in general. It is this problem that appears to be motivating the government.
- Herding is encouraged as the industry anchors to the same benchmarks. This restrains innovation and discourages management of downside risk. Systemic impacts could arise through a large super fund industry investing in a similar way, which is compounded by growing passive investment anchored to similar indices.
- Indices used for unlisted assets are quite poor benchmarks for a range of reasons, including being un-investable and often an unsuitable match for fund portfolios. In effect they help undermine the quality and reliability of the test.
A further issue is that super funds now have the test under wraps through judicious (surreptitious?) management of tracking error. Reducing test failures speak as much to the ability of funds to game the test as to the test’s success. Any such gaming only ingrains the tyranny of the benchmarks.
Dilute the influence of indices
Imagine for now that the performance test is the only concern of super funds, and is based around some measure of total portfolio performance. Performance and tracking error versus the indices become irrelevant, and super funds would be unconstrained in pursuing any investment that improves total portfolio performance. The test would no longer be inhibiting sustainable, national-building and innovative investments – as long as they are in best financial interests of members. The tyranny of the benchmarks fades away.
If some sort of risk measure is added, a clearer path might be opened up for super funds to manage downside risk. This could be useful in (say) retirement portfolios in drawdown. Or funds with members willing to give up some return to limit downside.
Focusing on total portfolio performance helps address the problems raised above, including achieving what the government is setting out to do.
Total portfolio focus no panacea
Don’t get us wrong – switching focus to total portfolio performance is no panacea. It would not solve all the test’s problems and would give rise to other issues. But overall it would be much better.
A big question is how to benchmark total portfolio returns and identify underperformance. We do not intend to get into the details here, but a few possibilities were put forward in Treasury’s Annual Superannuation Performance Test – design options discussion paper on March 2024. Measurement of risk is also fraught.
Another is that other incentives for benchmark-driven and herding behaviour will persist. Peer focus is a major force and encourages funds not to drift too far from the competition. Incentives for asset class investment managers – both external and internal – may still be tied to performance versus the index.
Nevertheless, focusing on total portfolio performance would remove underperformance versus the indices as an existential threat, hence reducing the strength of the constraints on super funds.
Our own submission of April 2024 to Treasury’s consultation on the YFYS test proposed a multi-metric test including the existing test plus two other metrics based around total portfolio performance. We argued that this would significantly dilute the influence of the existing test, and that three tests are harder to game than one.
Our earlier appeal to broaden the review referred to not only the structure of the test, but also the breadth of application, consequences and its role in an evolving industry. Of these, it is the structure of the test that speaks most directly to the government’s motivation for another review. It would be a lost opportunity if the review was restricted to tinkering with the indices when there is a better way to address the issues at hand.
David Bell is executive director of The Conexus Institute and Geoff Warren is research fellow at the Conexus Institute. The Conexus Institute is a not-for-profit think-tank philanthropically funded by Conexus Financial, publisher of Professional Planner.
