Australia’s superannuation system is held in extremely high regard around the world and therefore we are deeply interested in whether the proposed Your Future, Your Super reforms 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.
Aggregate costs will rise
Australia’s institutional DC 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.
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 – 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%pa and ‘nothing happens’ but underperform by 0.5%pa 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 8-year performance test is really low.
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 systems perspective shows that the problem must be managed without raising systemic risk.
In this article we have argued that the proposed reforms will, in the main, move the Australian DC system away from, rather than towards, global best practice that truly puts member needs and outcomes above all other considerations. Specifically, that 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, however 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.