Super performance test a ‘blunt single-issue measure’

Superannuation funds that fail the Government’s proposed investment performance test will be unable to turn their eight-year performance around in one year and will be “very messy for all concerned”, according to Rice Warner.

In an analysis, the research house said underperforming funds would have to set up different structures to accommodate new members and this would be “very messy”. It said this suggested that the Government appeared to hope that these funds would exit the industry.

It noted that there were many ways funds would deviate from the new benchmark or encounter issues such as:

• Most market indices are cap-weighted whereas funds should seek industries which will grow in future rather than those that grew in the past. Similarly if a fund wishes to avoid areas of the market which it considers to be over-valued, then it needs to be able to stay the course if they miss out temporarily from these shares becoming even more over-valued;
• Funds can use derivatives to change their exposure – and this will alter their returns;
• Funds can seek franking credits to maximise after-tax returns. They will participate in off-market buy-backs as these provide strong after-tax returns;
• Funds investing in infrastructure will be measured against a benchmark which could be quite different from their holdings;
• Lifestage products have multiple asset allocations. Each will be measured separately – and theoretically a fund could find itself underperforming in one area. Sorry, you can’t join our default for people under age 30 this year, but why not join the 30 to 45 group instead!
• Some funds will revert to bland indexed investments thus avoiding the chance of underperformance – but forgoing the opportunities for higher performance from unlisted investments;
• While we know that past performance is no guide to the future, funds cannot change the first six years on the forthcoming eight-year test. Even if a fund totally revamps its strategic asset allocation, moves some classes to passive and brings some funds in-house to cut costs, it will still have this past performance within its measured returns; and
• Some funds have had poor returns (after fees) and they will have no option but to wind up. They will not be able to recover in two years when 75% of their return will still be poor.  This applies even though new members will not receive the past performance.  They could start again but are more likely to merge with a high-performing fund (even a very small one) and SFT into that option to preserve the good performance.

The analysis also said that while strategic asset allocation was one of the largest contributors to investment performance, it was not being measured. It was possible, Rice Warner said, for a fund investing in volatile assets to provide a sound return and deliver on member targets but fail the benchmark test in some period.

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“Conversely, a fund could invest entirely in cash and not be at risk of measured underperformance. Yet, it would deliver a poor retirement outcome. This is an extreme example of some unintended consequences, and the reality is that few members would choose this option, but it shows how the new process could distort behaviour,” it said.

Some funds could also fail on investment performance yet do well in other areas such as retirement or life insurance. This meant that the test was a “blunt single-issue measure and there does not appear to be any leeway for tolerance”.

“The over-arching effect of the proposed measures would likely be to pressure funds to forgo opportunities for long-term outperformance to mitigate the risks of underperformance against a nominated benchmark,” it said.

Rice Warner said it was likely many funds would become passive on Australian shares and, in time, prices would be set by the trading activities of foreign investments, the retail investors and self-managed super funds.

“The new system will lead to changed behaviour. We hope funds stay the course and continue to seek alpha in unlisted asset classes. However, they will have to watch the benchmarks carefully and might use derivatives to protect against any major deviation from the fund’s own assets,” it said.