The Australian superannuation system is one of the world’s largest and most sophisticated pension systems. Driven by mandatory employer contributions, employers of Australians with “super” accounts contribute 11.5% of employee pre-tax income to funds that invest and grow those contributions for retirement. Today, these funds manage AUD $3.5 trillion AUM, equivalent to about 150% of the country’s GDP, and continued inflows and asset value growth are projected to drive superannuation AUM to $11.2 trillion by 2043.
Historically, Australia’s superannuation funds have had lower allocations to alternatives than their US-defined benefit pension counterparts, focusing mainly on public equities, fixed income, and infrastructure. As of last year, only 4.9% of total superannuation assets were invested in private equity, venture capital, and private credit. However, many funds have looked to grow their allocations to alternatives over the past several years, often exploring offshore opportunities in the asset class. AustralianSuper and Aware Super’s recent expansion with offices dedicated to alternatives in New York and London, respectively, offer prime examples.
As superannuation funds continue to grow and increasingly invest in alternative assets, regulatory scrutiny has intensified. Specifically, private (unlisted) asset valuation concerns in the superannuation sector came to the forefront early in the Covid-19 pandemic, which sparked fears that funds were too slow to adjust their valuations amid heightened market volatility. This issue was further complicated when government officials allowed emergency early access to AUD $20,000 of superannuation balances before many funds had fully assessed and recognized the extent of potential write-downs, surfacing both valuation and liquidity concerns.
As a result, the Australian Prudential Regulation Authority (APRA) has introduced several initiatives over the past few years to improve transparency in superannuation fund reporting, governance, and performance. Here, we examine how the “Your Future, Your Super” (YFYS) reforms and APRA’s Superannuation Data Transformation project (SDT) project are affecting the management of alternative asset classes within these funds.
APRA has intensified pressure on fees and performance as part of a broader strategy to enhance the efficiency, competitiveness, and sustainability of the superannuation system. The YFYS initiative, which mandates annual performance tests, has been a key driver of these changes. The test compares a fund’s 8-year rolling annualized return against APRA’s strategic asset allocation benchmark. Under the law, funds underperforming the benchmark by more than 50 basis points for two consecutive years are prohibited from accepting new members, while a single year of underperformance prompts a notification to members.
Superannuation fund leaders generally support a performance test to protect consumers; however, many industry experts, from CIOs to consultants, believe the YFYS reforms’ benchmark-based model is flawed and could harm returns. These critics argue that the benchmarks and their supporting indices fail to accurately represent the various asset classes super funds invest in to enhance returns, manage risk, and diversify portfolios. Moreover, they worry that portfolios built around the test’s constraints could have lower expected returns over time.
While many investment strategies seek to outperform a benchmark, APRA’s performance test challenges this approach. For example, funds with significant tracking errors can outperform over the long term. However, the year-to-year variability increases the risk of “failing” the performance test in any given year, regardless of projected long-term gains.
The key question is whether the performance test’s implications will begin to affect some funds’ investment horizons. In a recent research report, one superannuation fund CIO interviewed by the Conexus Institute, a think tank, noted, “Longer-term investing was a real advantage, but YFYS takes that away.” Broadly, funds are taking various approaches to the reform.
Given the consequences of compliance failures, some funds have integrated the YFYS into their investment frameworks, setting up regular processes to monitor performance test tracking errors and facilitate ongoing discussions with boards and committees. Conversely, other funds with strong track records of outperformance credit their existing processes and argue that directly incorporating the YFYS test could be detrimental.
Ultimately, the impact of YFYS on superannuation funds’ investment processes hinges on a fund’s buffer from the benchmark. Funds outperforming the benchmark have been largely unaffected. In contrast, those closer to the benchmark (or already underperforming) have faced increased pressure, with the reform more directly impacting their investment strategy and process. Regardless of their position, all funds have experienced added strain on portfolio management due to the test’s implications.
Of further intrigue is how the reforms will impact superannuation funds’ portfolio construction within alternatives like private equity and venture capital, as they exhibit a pronounced J-curve effect. Additionally, since these strategies often invest capital on a 10-12-year fund timeline, they realize results well beyond the YFYS 8-year performance test. Said differently, private capital investments that could make a fund appear to underperform during one performance test could be the driver of strong outperformance in the long run.
As funds adapt to the YFYS performance test, they could face difficulties growing or building allocations in these strategies, as these characteristics inherently demand long-term investment horizons (especially in venture). While vintage diversification can help funds combat this effect, it will be interesting to see if demand for secondaries and co-investments grows due to their J-curve mitigating qualities. It’s also worth noting whether funds will increasingly favor lower-volatility alternative strategies, like private credit and infrastructure (which is already a staple in superannuation fund portfolios.)
HESTA’s new co-investment arrangement with Stafford Capital Partners and Cbus’ push into co-investments perhaps highlights how some funds are rethinking their private equity strategies. Further, a surge of interest in private credit from some of the country’s largest pensions, including AustralianSuper, Rest Super, UniSuper, and the Australia Retirement Trust, may signal how these funds are reorienting their approach to alternatives.
Despite criticisms, some highlight the YFYS reform’s positive effects, particularly in accelerating significant industry consolidation. The total number of funds decreased from 174 in September 2021 to 137 by the end of March 2023. Mergers ultimately benefit members by enabling superannuation funds to achieve greater economies of scale, reducing costs by spreading fixed expenses across a larger member base. Administration fees across the industry have already noticeably come down since the YFYS was enacted. Between 2022 and 2023, the average operating costs across superannuation funds decreased from 0.27% to 0.24% for all funds.
Further, scale also unlocks access to a broader range of alternative investment opportunities and access to top-performing fund managers, which are often unavailable to smaller institutions. Additionally, larger funds typically have more leverage to negotiate better terms on investment fees.
APRA’s multi-year data transformation project to enhance the breadth, depth, and quality of data from superannuation funds is another regulatory push funds are facing. Intended to facilitate more effective scrutiny and comparison of fund and product performance, the new requirements will broadly require funds to improve their reporting by submitting more detailed data on a more regular cadence.
The project, focused on collecting more granular data on superannuation funds’ asset allocation, liquidity management, investment exposure concentrations, and unlisted valuations, introduces several new requirements, some of which include:
Further, alongside increased reporting requirements, APRA has introduced new standards for data quality, pushing for rigorous data validation protocols and procedures to identify and correct any discrepancies, stressing that reporting should come from “systems, procedures, and internal controls that have been reviewed and tested.” As funds adapt to both the frequency and detail of reporting, they will likely need to introduce operational changes in data collection, management, and reporting to ensure they meet requirements and provide high-quality, consistent data.
Importantly, the YFYS and SDT reforms are just two pieces to a broader regulatory push to increase transparency across superannuation funds’ alternative allocations. The Australian Securities and Investments Commission (ASIC) recently unveiled its 2024-2028 strategy, which includes an examination of private market growth and superannuation fund’s financial reporting. Other initiatives, such as the recently introduced Prudential Standards aimed at investment governance and operational risk, further exemplify the larger regulatory desire to gain greater visibility into superannuation funds’ alternative portfolios.
Technology offers important support for superannuation funds increasing allocations to private equity as they navigate increased reporting standards while trying to increase risk-adjusted returns.
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