Global implementation specialist Parametric, part of Morgan Stanley Investment Management, the asset management division of Morgan Stanley, says a moderate level of tracking error (divergence from a benchmark) is a by-product of ESG investment approaches, such as screening and integration.

David Post, Senior Investment Strategist, Responsible Investing at Parametric says: “It’s our view that super fund portfolio tracking error, a key driver of YFYS performance test outcomes, will face downward pressure as funds jockey to meet their new performance requirements.”

Post says Parametric’s analysis indicates funds can achieve desired ESG outcomes and manage active risk, but they may have to employ more sophisticated optimisation tools to find the right balance under the YFYS regime.

Under the YFYS performance test, each year the Australian Prudential Regulation Authority (APRA) will construct an individual benchmark for every product based on the product’s asset allocation. Each product will then be compared against its benchmark.

Products that underperform their net investment return benchmark by 0.5 percentage points per year over an eight-year period will be classified as underperforming.

Trustees whose products fail the test will be required to notify members in writing. Products that fail the test two years in a row will not be permitted to accept new members until their net investment performance improves.

APRA released the first MySuper performance tests results in August, with 13 products representing A$56 billion of assets failing. Next year, APRA will start including trustee directed products in the testing regime.

“The new rules have implications not only for MySuper products that incorporate ESG but also trustee directed products designated as ‘ESG Options’,” adds Josh Mckenzie, Analyst at Parametric.

“Given that around 40 per cent of total Australian assets under management are estimated to be managed according to ESG principles, the impact could be very significant.”

Parametric analysed approaches to two popular ESG practices, exclusionary screening and integration, to determine whether meaningfully different portfolio ESG characteristics can be achieved at low levels of additional tracking error.

Screening is used to exclude companies with undesired activities from a portfolio. Integration refers to a quantitative portfolio construction process that uses company-level ESG characteristics, such as emissions intensity, to be considered alongside other risk characteristics such as sector, country, or fundamental style factors.

The research found that by using optimisation techniques funds can trade off active risk for responsible investment outcomes and achieve modest levels of predicted tracking error and still achieve meaningful ESG impact.

Mckenzie says: “Your Future, Your Super is not the end of the road for responsible investing but super funds will benefit from the use of optimisation-based portfolio construction tools with a focus on navigating the performance test. What super funds will need are better and effective active risk controls.”

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Raewyn Williams

The Retirement Income Panel’s work over the past year should give superannuation funds all the motivation they need to decide what ‘success’ in funding pensions really means, according to a research note by the global implementation specialist manager Parametric.

Raewyn Williams, Head of Research (Australia) and Analyst Josh McKenzie, in a ResearchBite titled “Income-Targeting in a Retirement Portfolio: too much, too little or just right?”, explore how superannuation funds deliver an adequate pension to retired members is a new frontier.

“They are not shackled by legacy products, they’re not the focus of peer surveys or the APRA heatmap. It is a rich ‘greenfield’-type opportunity to get back to the specific needs and sensitivities of fund members and embrace problems not yet solved by the industry – truly, a licence to innovate.”

The authors argue that delivering an adequate pension to retired fund members requires funds to determine what an ’adequate’ yield on the Australian equities component of a retirement portfolio is and be willing to move beyond mechanical, accumulation-style approaches to yield benchmarking.

“One benchmark to determine adequacy could be a portfolio’s yield equaling or exceeding the yield of the S&P/ASX 200 Index over a certain timeframe.

“Franking credits also should be added to the equation because they provide significant value to retirees. Our research shows that franking credits on the S&P/ASX 200 are worth 1.5% annually to retirees and an active, franked dividend targeting strategy can add as much as 2% annually to retired fund members, albeit with a different risk profile.

“A pension-focused Australian equity strategy without franking visibility and ‘smarts’ misses an important portfolio lever to meet its income targets. Can a super fund really answer credibly whether the equity yield outcomes are ‘successful’ without including franking?”

Williams and McKenzie say this market-cap benchmark approach to yield will appeal to many funds. “It’s relatively simple to implement, reflects familiar performance and benchmark concepts and showcases how a super fund’s thoughtful portfolio design can beat a ‘dumb beta’ equity portfolio yield outcome.”

They add that a more ambitious challenge funds could take up is to measure yield ’success’ through the prism of the member – not the fund. “For example, think about a fund with reasonable data or, for some, a good feel about member preferences. Members who would otherwise invest their retirement savings outside super in, say, term deposits, ‘blue-chip’ Australian companies or a rental property really want to know this: whether their decision, instead, to let their super fund invest to generate retirement income has been a good one. So that could translate to benchmarking the yield on their super retirement portfolio against yields on term deposits, blue-chip stocks or rental properties.

To demonstrate the amount of innovation that is possible, Williams and McKenzie also discuss an array of benchmarks funds could use to gauge yield ‘success’ based on age pension entitlements, salary replacement targets and ASFA’s dollar-based living standards for retirees.

The authors conclude: “Our key message is that as super funds develop and implement their retirement portfolios, they can do better than simply migrate mechanical accumulation portfolio–style yield benchmarks that, in truth, may miss the mark for members.

Super funds could think innovatively and define yield success in a way that more closely reflects what retired fund members would relate to and care about. The estimated 1.8 million members moving into and through retirement in the next five years hope the opportunity to measure ‘success’ well in income-targeting retirement portfolios is one that super funds don’t miss.”

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Raewyn Williams

The possibility for government to increase superannuation taxes in response to the ballooning budget deficit caused by COVID-19 could severely hurt member balances at retirement, according to a research note by the global implementation specialist manager Parametric.

Raewyn Williams, Head of Research (Australia) and Analyst Josh McKenzie, in a short paper titled “Will retirees pay the price for superannuation tax rises?” argue that investment tax inside super may be a political “soft target” because it won’t be felt directly in most voters’ hip pockets, but it will come with an unfavorable “tit for tat” – the longer-term impact on retirement outcomes.

The authors suggest that the two most likely tax options are increasing the headline tax rate of 15% or reducing the capital gains tax concession from one-third. A third option, limiting the claiming of franking credits for Australian share dividends, is discounted as being too political risky.

Using the Productivity Commission’s asset allocation, returns, fees and other modelling assumptions in its 2018 report, they suggest a fund member can expect to retire after 46 years with an account balance of $682,146 at a 15% tax rate.

“The smallest tax increase (15% to 17.5%) causes the member to forgo (in today’s dollars) $40,509 in retirement savings. But if the tax rate is increased to 25%, then the member loses $150,448 in retirement savings, ending up with 22% less than expected outcomes under the current tax regime.

“The ‘tit for tat’ retirement impact of a super investment tax rise is clear, even if not immediately felt by the super fund member.”

Williams and McKenzie say shifting the tax dial to reduce the one-third CGT discount concession would have a much more “subdued” impact on a member’s retirement balance. This is primarily because, unlike increasing the 15% headline tax, a CGT change would only impact some assets inside super and would not erode members’ initial (taxed) contributions into super.

“A very small reduction (3%) in the CGT discount concession to 30% would shave a negligible $1,545 of the member’s retirement balance of $682,146. Even using our most aggressive assumption (the CGT discount more than halving to 15%), the expected loss to retirement savings is a modest $8,446.

“Other more muted changes to the super CGT rules are also possible, such as extending the current one-year holding period rule (for CGT discount eligibility) to three years, capping carry-forward capital losses or limiting the types of assets eligible for CGT discounting.

“Faced with a raft of possible tax changes, the industry should favour changes to the CGT rules over a blanket increase in the super fund tax rate.”

Williams and McKenzie conclude that the possibility of tax increases should send a clear message to the industry – for funds to better manage the tax impacts of their investment decisions.

“Our research on the Productivity Commission’s report showed that a genuine after-tax focus could be more valuable to retirees than reigning in fees. So, what if a super fund responded to a higher-tax environment by adopting a genuine after-tax investment management focus to defend retirement outcomes? After all, good retirement outcomes are the raison d’etre of super; a way to avoid the enormous fiscal drain from public funding of age pensions in future.

“It reminds us that super funds have more in their armoury than they might think as the debate about potential super tax increases plays out. Lobbying against tax changes that will be most harmful to members’ precious retirement savings should be part of the industry’s response. But, behind the scenes, funds should also consider the value of genuine after-tax portfolio management in a higher-tax environment to limit the price paid by future generations of retiring members.”

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Raewyn Williams

All sectors of the superannuation industry agree that successful equity investing entails some short-term pain to enjoy long-term gain.

Superannuation funds and investment managers who embrace an active management philosophy can feel this acutely when their style does not pay off in a certain stage of the market cycle or there is a regime shift to a ‘new normal’. Those with more faith in the market itself – passive investors -feel the pain of underperforming active peers in market downturns or when active theses are having their day.

Yet, all would advocate to ‘hold the line’, for superannuation investing is a long-horizon game designed to benefit members who have a whole working life to save for retirement within superannuation and, for most, decades more in retirement to enjoy the fruits of superannuation.

This long-horizon perspective should make it easy for superannuation funds to continue to evolve their equity portfolios as new, better structures become available.

And yet, there is a roadblock: in Australia, funds invest in a taxable environment and a step forward in the portfolio evolutionary chain can require a fund to write a cheque to the Tax Office. This tax bill too often cuts short or delays what should be a natural, healthy process of superannuation equity portfolio evolution.

Our concern is that, on its face, baulking at a single, upfront tax cost sits rather uncomfortably with an espoused commitment to long-horizon investing, write Raewyn Williams and Josh McKenzie, Parametric Australia, in their latest in-depth whitepaper.

They note : “The important task of evolving equity portfolios may be stymied by upfront tax costs, and suggests a framework super funds can use to solve this problem.”

Read the full paper.

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