Mercer's David Knox: The problem with choice

By Elizabeth Fry

Mercer senior partner David Knox has joined the growing push to overhaul the performance test for choice or trustee director products as the problems far outstrip those for My Super options.

Assistant Treasurer and Minister for financial services Stephen Jones has asked the treasury to examine whether performance test discourages certain investment decisions or infrastructure investments.

The test has long been slammed for its check-the-box rules and failure to address the importance of asset allocation, merely measuring the fund's strategy against asset sector benchmarks.

This stops funds from maximising member outcomes through constructing diverse portfolios and managing specific portfolio risks such as fixed interest duration and sustainability.

At the same time, the minister hit the pause button on extending the test to choice products for at least a year.

What's very clear is that some funds prefer to hug the index to minimise the chance of failing," says Knox who supports the 12-month delay for choice products, ahead of changes to curb any unintended consequences.

"Infrastructure assets are good long-term investments for super funds. But when the pandemic hit, airports were less valuable since no one was flying.

"All of a sudden, the value of an infrastructure asset has fallen, and a fund could fail the benchmark even though it is a good long-term investment," he says.

"Similarly, in respect of fixed interest assets, investors were correct to put their money in shorter-term securities when we knew interest rates were rising. Yet, the benchmark has a longer-term horizon so we are going to get inconstancies."

Knox thinks Canberra should fine-tune the My Super performance test, rather than make sweeping changes.

Misses by miles

His main concern is for the choice options test which he argues is far more problematic - especially those aimed at capital preservation and environmental sustainability. These products sit much further away from the benchmark than default options.

"Choice potions are much more specialised," says Knox. They might be purely equities, or they might be infrastructure, so they don't have the diversification of the MySuper portfolio," he adds.

"They're the ones where the members have already made a choice. I might be an individual who is quite happy with Australian shares but I want low volatility shares. Yet, in a particular period, those low volatility shares might not perform well compared to high growth and high volatility, but they are what I wanted.

"It will also be very confusing for members of a super fund which might have 6 or 8 choice products (or investment options as designed by the trustee) ranging from say, conservative to high growth.

Knox notes that each option is tested against different benchmarks based on the asset allocation of each option.

Consequently, one of these choice products might fail the test, whereas all the others will pass.

In that case, he says, what is the message for the fund members? Will that mean the fund can no longer offer that investment option to its members?

Knox is not saying there shouldn't be a performance test since the super system is compulsory.

"If we have to save, it is appropriate that the government puts some framework around the system to ensure it works.

He wants to see more subjectivity. If a fund fails the test, the regulator should scrutinise the cause of that failure and check whether it was beyond their control.

He argues that the discretionary component is essential, as it's not easy to predict the impact of the pandemic, the Ukraine war or interest rates rising to three per cent.

"MySuper test may not be perfect, and the treasury review will look at that, but we have the second round of MySuper published in August. 13 funds failed last year, and most underperforming funds have moved on or have merged. Broadly speaking, that first round has almost achieved its purpose."

"We've got to have a somewhat more flexible approach - with a test that can cater for the full breadth of choice investment options.

"The government still wants to identify poor performance, but the regulator must have the scope to make appropriate adjustments.

New measurements

Neither does Knox buy the prevailing wisdom that the MySuper benchmark should be changed.

"Let's enhance the existing benchmark-based approach. But let's be cleverer about it," he says.

"There must be some flexibility so that in falling markets, funds aren't forced to cling to the index rather than look for opportunities."

Some suggest that the benchmark should be replaced by new metrics for choice products.

Knox says we are nowhere near that point.

"I think we need to do more work on whether we need new metrics and decide on appropriate tweaks to the benchmarks. We are not in that space yet. Jones has announced there will be a review, a consultation paper, and people will make suggestions on the tweaks."

As for retirement, Knox says it is a work in progress.

"We're seeing a gradual evolution. Funds have published their retirement strategies which is a good step.

"Also, the retirement income covenant - which takes effect this month - says superannuation trustees must look beyond accumulation and focus on how they spend money in retirement."

The industry leader hears the criticism that the covenant is too general and that the rate of progress is glacial.

He concedes that there is some truth to that but says it's a start.

Setting a super goal

His overriding concern is that Australia still hasn't set an objective for superannuation that highlights retirement.

And he has been banging that particular drum for many years.

"The minister is talking about setting an objective for superannuation which government should have done years ago. Let's not set an objective for super but for the retirement income system," he argues.

"The old objective was that super should supplement or substitute the age pension. But in practical terms, I don't have a clue what that really means."

Does that mean that government wants to get out of paying a pension or not?

"Retirement should have the twin goals of alleviating poverty amongst the aged and for most people who have had a career to maintain the living standards they have grown accustomed to in their post-work years.

"We still don't know what we're doing yet," he warns.

"For instance, you can be a MySuper member all your life as you don't understand super and have no interest in it. Yet, there is no mechanism to put you in a default retirement product.

The critical issue is advice.

"We need to get a mechanism whereby superfunds and others can provide high-level strategic advice to members at an affordable cost, and that's not happening. That would be much cheaper than offering a fully fledged financial plan - the advice would not even have to suggest products."