Submissions to the Productivity Commission’s (Commission) issues paper for the third stage of its enquiry ‘Assessing Competitiveness and Efficiency’ closed in August 2017 and the Commission is now starting the process of measuring the industry against the stated efficiency metrics, produced in its first-round report.

The Commission’s brief was extended by the Minister on 30 June.  It must now assess the value of life insurance as a benefit within superannuation.  This has certainly galvanised the sleepy insurance industry to respond and the release of the long-awaited Insurance in Superannuation Code of Practice has been expedited.  We will comment on this document in next week’s Insight.

Meanwhile, one of the key elements in the assessment of the success of the superannuation industry is the delivery of high performance on investments to members.  Over a person’s career and retirement years, the single most important factor is the earnings delivered on their benefit.  Indeed, in the Commission’s own words:

“Maximising long-term net returns (after all fees and taxes) on a given account balance, including by taking account of the risks associated with investment, is the most important way in which the superannuation system contributes to adequate and sustainable retirement incomes.”

The latest Morningstar results (published in September Superfunds) show that, collectively, balanced funds (more latterly MySuper products) have earned 7.6% a year over the last 25 years, from the time the SG system commenced.  This is a return of 5% above CPI which exceeds the targets most funds seek for long-term returns.

Clearly, the trustees have been successful as a group over an extended period, and the real returns have provided a strong capital market as well as enhancing the retirement benefits of middle Australia.

We know that past returns are a function of asset allocation and how markets perform, and of strong governance.  We also know that markets are volatile and the past cannot be extrapolated into the future – in fact, ASIC requires funds to state prominently in all fund collateral and marketing activities that past performance is not an indicator of future performance.

So how do we measure the likelihood of getting good performance in future?

The Commission’s Issues Paper requested respondents address several technical questions related to the measurement and benchmarking of historical returns, including what reference portfolio should be used, what asset class indexes to choose and the appropriate application of fees and taxes.  No doubt, the industry technocrats will all have their different opinions on how best to address these issues (as do we).  But, an issue of a higher order has been left unaddressed.  To what extent do our industry’s historical returns act as a predictor of whether we are efficient today or will be in the future?

Consequently, we believe a forward-looking approach is sensible as part of the PC’s assessment process.  There are strong arguments for taking this approach, including that:

• Many investment experts have been forecasting lower expected future returns because of the current era of low interest rates and the likelihood that these returns will continue for some time.
• The introduction of MySuper saw the creation of many new investment options and strategies, particularly lifecycle options. For these, benchmarking on previous performance is inappropriate in this context.
• The population is ageing and as demographics shift we are likely to see changes in asset allocations and investment strategies.

Thus, it is important to ensure that Trustees have set their investment strategies in a way to continue to earn real returns above inflation into the future.

Past performance does provide us with useful information.  Those funds which have performed relatively badly will have failed in some areas, whether asset allocation, governance or high costs.  The first step in any analysis is to test whether the reasons for failure have been overcome.

Looking ahead, Rice Warner uses a stochastic investment model to project asset returns into the future, based on the medium to long term expectations from our annual investment survey of asset consultants and other investment professionals in Australia.  This forward-looking process measures the expected balance at retirement, longevity of retirement income and expected volatility of outcomes based on a given asset allocation.

The model is not perfect.  Unless we put in value for ‘alpha’, it will always show passive investments as equal to active ones for the same asset allocation.  However, it is a good tool for assessing the likelihood of achieving fund targets over the next decade or so.  Most funds will use similar tools from their asset consultants.  We would hope that their expected outcomes give a probability of at least 67% of achieving the investment targets.  Any less than this and members would consider the risk of under-achieving the target is too high.

To read a copy of our submissions to the Productivity Commission please click here.