Are funds managing the risks members face to their retirement outcomes or are funds instead managing their own business risks?

The Royal Commission released its interim report on the 28th of September 2018.  In its findings it is evident that “From the executive suite to the front line, staff were measured and rewarded by reference to profit and sales”[1].  Banks specifically have been challenged in that their sole focus of attention has been their ‘share of the customer’s wallet’.  Is this limited to the banks or do we have the same focus at play in Superannuation?

When it comes to selecting a fund, the focus tends to be on the most recent investment performance or the lowest fees, as this is what funds receive awards for.  Unfortunately, these are often also considered in isolation, with the oversight made that the highest investment performance and lowest fees are often not from the same product, even if both were achieved by the same fund.  To make matters worse, this distinction is often misrepresented when it comes to marketing to the general public.  As a result, a lot of emphasis is placed on peer relative rankings and league tables to attract new members and increase funds under management.  But how does this translate into what members actually experience and furthermore their retirement outcomes?  Let’s start by considering what the industry defines as success.

#### Defining Success

Just by looking at the headlines in the press, it is quite easy to see that the focus is on Time Weighted Rates of Return (“TWRR”) in the good times as well as the bad times.  TWRR is a measure often used to compare the performance of Asset Managers who do not have control over their external cash flows.  This is a suitable measure for institutional clients who give these Asset Managers specific mandates.  One could naively argue that super funds also don’t have control over their cashflow (ignoring the fiduciary duty they have), although the Super Guarantee percentage (“SG”) does provide an estimate of what cash flows are coming based on the member base.  However, using TWRR is one of the major flaws when assessing fund performance relative to member outcomes, as members actually experience Money Weighted Rates of Return (“MWRR”).  A simple example illustrates the point. Comparing two investment scenarios; an initial capital lump sum of $400 (scenario 1) versus annual contributions of$100 at the start of each of the next 4 years (scenario 2).  Scenario 1 is reflective of the asset management industry investing lump sums, whereas scenario 2 is more reflective of member contributions.

If the return for each year is assumed to be as per the table above then the capital lump sum would grow to $422.40, whereas the scenario with annual contributions would in fact make a loss and result in a final balance of$354.60 which is less than the total amount contributed.  Both scenarios would result in the same TWRR, however scenario 2 would actually result in a negative MWRR which is more reflective of what members actually experience.  However, this tends to be omitted in the conversations with members and promoting fund performance, not to mention handing out awards and ranking funds in league tables.

Short-termism exacerbates this even further as the focus is on the last year’s performance instead of the last ten years.  The incentive is therefore created to manage peer relative risk as your primary objective to claim the top position in the rankings[2].  But what does this mean for portfolio construction and its inherent risks?

#### Portfolio Construction

In order to have the closest like-for-like comparison, funds tend to offer a “Balanced” option which usually blends the asset allocation between “growth” and “defensive” assets.  Regrettably, these comparisons are not as straight forward as most individuals like to believe, unless you are following the herd and investing in the same assets as all the other funds for the sole purpose of managing your peer relative performance.  For example, asset classes are classified using broad definitions and therefore Nominal Bonds and Synthetic Futures would both be grouped as “Fixed Interest” exposure, which tends to be seen as defensive assets. The Synthetic Futures in reality could behave more like growth assets with the added benefit of diversification depending on how they are structured.  Another example amplifying the subjective nature of this is the fact that some funds are including unlisted infrastructure as defensive assets in their classification, despite the fact that the global financial crisis of 2008 highlighted that the reliance on such assets in stressed market conditions do not support this classification[3].  Unfortunately, this is completely ignored by rating agencies when comparing fund performance and handing out awards.

The short-termism also has the perverse effect that funds who shoot the lights out in any given year are celebrated and rewarded with little attention paid to their longer-term performance.  However, more than often these are the funds that took the highest risk and got rewarded for it, as evidenced by the fund ending at the top of the rankings this year with no fixed interest holding[4].  Unfortunately, these high-risk funds do get it wrong from time to time and end in the significantly lower return territory as illustrated by the bottom right orange quadrant[5].

When considering what members actually experience (with the $100 annual contribution example above in mind), the better portfolio for the member will be the portfolio that consistently achieves higher risk-adjusted returns but with lower volatility (top left quadrant above). This portfolio would not necessarily end at the top of the league tables in any given year, but consistently outperform its benchmark. It is important to achieve consistently good returns over time as this is how members actually grow their savings. Saving for retirement is a long-term plan and should not be mistaken for a roller coaster ride as most Industry Balanced funds[6] experience due to the desire to end at the top of the rankings in any given year and therefore follow the herd through fear of missing out, with volatile returns as a result as depicted below. The Better Balanced portfolio would therefore result in a more stable accumulation for members’ savings and smooth the actual member experience. The Better Balanced fund represented here is an actual fund in the industry that removed itself from the league tables, and at a time when it was in fact at the top of the rankings. This fund made the decision as it recognised that it is not actually serving members’ best interest by managing its own business risks (through self-promotion in the league tables) instead of focussing on what members actually experience. The consistently good returns achieved actually resulted in members being better off over the long term as illustrated in the graph[7] below through the compounding effect of investment returns over time. This graph shows the accumulation over time for a starting balance of$50,000, purely using compounding investment returns.  The departure from the peer relative objective occurred in 2011 and it can be seen that since then the fund’s performance actually resulted in a smoother member experience compared to the median industry balanced fund performance, as well as consistently delivering higher accumulated savings for members over the long term.  This is unfortunately not measured and celebrated by the Industry even though this is more in line with what members actually experience.  Instead, the focus in the Industry is on wealth accumulation through the spurious measure of using TWRR.  The next piece of the puzzle is to consider whether the focus on wealth accumulation actually manages the members’ risks relative to their retirement outcomes?

#### Luck of the Draw

The defensive assets in a Balanced fund are seen as the assets which tend to reduce the volatility of the unit price.  Hence, the purpose for including these assets in the portfolio are to reduce the drawdowns on the capital values.  Including such assets are often seen as an opportunity cost, especially when a country has experienced uninterrupted growth for 28 years like Australia has.  It is worth calling out that while Australia has experienced uninterrupted growth, super funds do not only invest in Australian equities.

However, the emphasis remains on being exposed to growth assets, which for the majority of funds tend to be through large exposures to equity investments (domestic and international).  The rationale being that equities surely can’t lose over the long run.  Also, with rates currently being relatively low one CEO was quoted saying “Why would you be in fixed interest when it’s not yielding [much]”.  This is starting to look very similar to the ‘single bets’ and high-risk exposure from the earlier graph which sometimes result in significantly lower returns (orange quadrant).  Furthermore, this is usually based on the assumption that all members have long investment horizons forgetting that there is a disconnect between accumulation during their working lives and consumption during their retirement.  Members experience sequencing risk when they retire as they need to switch from accumulation to some form of retirement product to benefit from the favourable tax treatment.  This results in significant timing risk.  Usually, the flexibility in the timing is limited as most members need to draw on the funds in their retirement and therefore can not weather a storm in case of market downturns.  This results in members being exposed to the luck of the draw as to when they retire if they were in a Balanced option all the way to retirement, as the Balanced options are designed for the average member, which nobody is in reality.  While high growth allocations will on average give better outcomes over the long term, that does not mean much to an individual that retires in the middle of the GFC for example.

“Balanced options are designed for the average member, which nobody is in reality.”

As mentioned before, the defensive assets in a Balanced option are usually included to manage the volatility of the unit price and hence the capital value at retirement.  However, the purpose of the system is not wealth accumulation.

#### The Objective

The (proposed legislated) primary objective for the superannuation system is ‘to provide income in retirement to substitute or supplement the Age Pension’[8].  The objective is therefore not to provide an uncertain lump sum accumulated up to retirement, but instead to target a more certain retirement income.

When framing the challenge as a retirement income objective, the risks a member face are much more complex than only the volatility of the unit price.  Instead members are exposed to a number of other risks such as inflation, real rates, longevity, adequacy and outcome certainty to name a few.

These risks often result in a trade-off.  For example, adequacy risk can be potentially reduced through investing in more growth exposure assets at the expense of higher volatility and therefore higher outcome uncertainty.  It is therefore just as important to raise investment risk when a member can afford to as to manage investment risk when a member can’t afford to take full investment risk.  The objective to provide a retirement income changes what classifies as “defensive” assets.  This shifts the focus from using cash as the defensive asset to preserve capital, to instead using assets which can produce a real income stream during retirement.  So, back to the Industry Fund’s CEO making the statement as to why would you be in fixed interest.  The answer to this would be to manage real rate risks for members as most members rely on term deposits and other real rate exposures during retirement to provide them with income.

#### Shifting the Focus to Member Outcomes

The focus on peer relative performance and league tables have forced funds to manage their own business risks instead of what really impact member outcomes.  When considering members’ risks relative to their retirement income objective, the focus needs to shift away from TWRR and more towards managing the risks that really impact members.  As an industry, we surely can’t continue to celebrate and reward measures that detract from the primary objective of the system, which is to manage members’ risks relative to their retirement outcomes.  The Royal Commission is expected to release its final report in February 2019.

###### [8] https://www.legislation.gov.au/Details/C2016B00182

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