A key plank of the highly touted Your Future Your Super legislation is the ‘performance test’ that will apply to industry super funds and other My Super products. The sector had been somewhat immune from targeted regulation for several years, outside of aggressive questioning from Parliamentary committees and sailed through the Royal Commission ultimately unscathed.
The proposals which will be considered by legislators in the coming months place long awaited pressure on the massive sector but with a particular focus on underperforming funds and the ‘stapling’ of accounts to individuals. It has been met with significant concern and commentary, generally for good reason. There is little doubt in the importance of the sector, however, the sheer market power warrants regular reviews and updates according to the Government.
Being key beneficiaries of the Super Guarantee legislation by virtue of a great deal of the Australian population being ‘defaulted’ into an industry fund, places the sector in a unique, and powerful position. The performance test, when combined with the other key policies, seems to be aimed at increasing transparency and evening the playing field.
But does it go too far?
According to the proposal, the products that underperform their annual benchmark by 0.5% over an eight-year period will be classified as ‘underperforming’. These funds will need to inform their members that they have ‘failed’ to deliver and if they underperform for a second consecutive financial year may be banned from accepting further contributions.
The change is truly significant, with the devil of course in the detail. A number of major industry funds have flagged concerns around three key parts of the legislation. The first is the performance comparison being made against a ‘listed’ equity or bond market benchmark. The second around the lack of consideration to risk and volatility and finally, the lack of any mention of sustainability or ESG-type investing.
The first concern is clearly the most important and potentially offers the greatest opportunity to the financial advice industry. The use of listed equity and bond market benchmarks is expected to see more funds forced to move further to passive, index tracking investment strategies or risk underperforming if the benchmark does well. This may have the unintended consequence of reducing the ability for funds to allocate member funds towards the direct property and other unlisted assets that have been the key contributor to returns over several decades.
Further, the legislation doesn’t differentiate beyond the traditional asset class definitions, nor account for the benefits of active asset allocation and volatility that occurs within each review period. It simply compares to a benchmark as if it had remained the same and relies on published, static asset allocation data.
Where there are losers, there are also winners
The financial advice or independent financial advisory (IFAs) may stand to be the biggest beneficiaries of this change, at least in the short term. Typically managing discrete, but similar portfolios for each client, the ability to apply a performance test to non-default or My Super products is likely to be extremely difficult. On the face of it, the financial advice industry seems positioned for a renaissance for a number of key reasons.
The first is the ability to offer access to true active management, particularly against the smaller industry funds. With sharemarkets around the world at or near all-time highs and the talk of bubbles continue to gain traction, intuition would suggest now is not the time to be moving towards a passive, market capitalisation-based approach like the test suggests.
Similarly, with alternative assets and their diversifying features seemingly not fully appreciated by the proposed changes, IFAs ability to access and include material exposures to investments ranging from private credit, to private equity and direct property, offer a unique marketing opportunity for those willing to adjust.
In recent weeks the US and Australian Government Bond rates have unexpectedly moved above 1.30% despite the incredible monetary stimulus being applied in both nations. If the growing chorus of predictions for an unexpected spike in inflation are in fact true, this does not bode well for long-duration bond strategies. The majority of traditional fixed income benchmarks are long duration, with the benchmark around 7 years at the current time, suggesting a 1% increase in rates would see a 7% capital loss on an existing portfolio of bonds. IFAs have the ability and flexibility to diversify their client portfolios away from the index, to lower duration strategies which funds seeking benchmark relative returns may not.
Returning to active management, 2020 was evidence that the deployment of capital at the appropriate time can deliver exceptional results for clients. But what incentive will industry funds have if they are compared against the benchmark? Selling before the peak may mean they miss out on returns. Buying before the bottom will do the same. IFAs on the other hand are likely to have the constant engagement with clients that is required to take well-timed ‘bets’ that add significant value.
Last and probably most important of all, is the lack of an ESG or sustainability filter, which one major industry fund raised in a recent submission. With listed benchmarks agnostic to Environmental, Social and Governance concerns, and even ESG benchmarks themselves looking eerily similar, IFAs may be one of the only ways for investors to build a portfolio that truly aligns with their values.
This all consolidates the biggest advantage the IFAs and the financial industry currently have, which is the ability to provide tailored and personalised advice. With less industry funds and more members within each fund, it will complicate an already difficult challenge, being to provide advice that spans both the accumulation and drawdown phase.