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The Government has long been concerned about the potential for underperforming superannuation funds and products to undermine the achievement of the system’s objectives. It was however a surprise to many in the industry when the government included amongst its October 6 Budget announcements a mechanism designed to force underperforming funds out of the industry, under the banner ‘Your Future, Your Super’.

Your future, Your Super

How will it work? The investment performance of all MySuper and trustee-directed superannuation products over 8-year rolling periods will be compared to a specially-composed benchmark with the same overall asset allocation and market returns within each asset class. The trustees of products that underperform that benchmark by more than 0.5 per cent per annum will be required to notify members of that underperformance. If the underperformance continues the following year, they will have to close the product to new members. The test will apply annually to all MySuper products from July 2021 and all trustee-directed products in July 2022.

The test was inspired by a recommendation of the Productivity Commission in 2018 that there be a ‘right to remain’ test in respect of all superannuation products. It is undoubtedly directed at ridding the system of underperformers, an admirable objective. There are a number of technical issues about the tests, including the fact that it does not include consideration of all the costs borne by the member and has no regard for the particular needs of the funds’ members. However, the focus of this article is on the retrospectivity of the proposal which has both fairness and practical dimensions. To see why, it might be first worthwhile to consider something more familiar to most people than the arcane complexities of the superannuation system.

A relatable example

Consider the following example. Over 1,000 people die in motor vehicle accidents in Australia each year and many more are affected by injury or loss. Appropriately, there are a range of measures in force in every jurisdiction in Australia designed to minimise that tragic carnage, including speed limits, seatbelts and competence-based driving tests. Licensed drivers found not to have complied with the rules can ‘earn’ fines and also demerit points. Accumulate too many demerit points over three years and your licence can be suspended. And that three-year period rolls forward continuously. Suppose now that the government announced that the period over which the demerits were calculated was extended to seven years. If that new test was applied immediately and without a transition period, there would be uproar in the community. Large numbers of people would lose their licence instantly, despite never having breached the three-year requirement, perhaps because their transgressions were widely spaced. Suppose that, in addition, the government
extended the definition of dangerous driving to include driving at less than 50 per cent of the speed limit applicable on that stretch of road. The combination of the two changes would mean that conduct that was lawful in the past (driving slowly) and that happened a long time ago could cause a driver to lose his or her licence today. There would be no account taken of the prevailing driving conditions or the speed of other drivers. The community uproar would be great indeed.

Retrospectivity in the law is a very dangerous matter. At best it is unfair. Drivers, in this example, deserve to know the standards by which they will be judged so that they can govern their behaviour accordingly. However, retrospectivity can be used much more cynically. Because the conduct is past, the rear-view mirror can be used to fine-tune and target the rule to ensure its impact is felt by specific individuals or cohorts. The common law is right to be leery of retrospectivity.

Linking back to the superannuation system

The driving example above is not a perfect analogue of what is proposed in the Your Future, Your Super reforms. There are points where it is very similar – it involves a recalibration of standards that are applied to performance retrospectively, it involves conduct accumulating over a rolling period and it is in pursuit of a meritorious social object. There is no ‘right’ to drive and no one has a ‘right’ to manage public offer superannuation funds. Both are socially licensed activities from which some in the community derive a living and many derive utility.

In other respects, the analogy is not so apt. It is almost always the case that a driver can avoid driving too fast or under the influence of alcohol or a drug. On the other hand, investment underperformance is rarely, if ever, deliberate or even negligent. One can put one’s foot on the brake, or call for a taxi, but one cannot simply work harder to get better investment performance.

How, then, is the current proposal ‘retrospective’? A retrospective law is one that has been described in the courts as one that attaches ‘new legal consequences to facts, or events which occurred before its commencement’ (Fisher v Hebburn Ltd (1960) 105 CLR 188, 194 (Fullagar J)). Attempts to deem certain types of conduct unlawful, and to backdate the application of the law is an obvious example. However, retrospectivity can be more subtle than this.

In the case of the underperformance test, decisions taken by trustees in accordance with the rules applying to them over the past eight years now become subject to a test that aligns imperfectly with those earlier rules. It is entirely possible that a product could achieve the objectives set by its trustee over the years, including those articulated in both the fund’s Product Disclosure Statement and Dashboard, and yet fail the proposed test. The trustee may therefore not have breached its duties and yet still be deemed to have ‘underperformed’ when its performance is viewed through this new lens. Moreover, that underperformance will have legal consequences.

[I]t is entirely possible that a product could achieve the objectives set by its trustee over the years, including those articulated in both the fund’s Product Disclosure Statement and Dashboard, and yet fail the proposed test. The trustee may therefore not have breached its duties and yet still be deemed to have ‘underperformed’…

It is true that the proposed underperformance test does not render the decisions leading to the underperformance unlawful and it does not necessarily expose the trustee to legal liability. The trustee is simply required to disclose its underperformance to members, and, if subject to a second strike, to close its doors to new members until performance had improved – the proverbial ‘naughty corner’. However, no prudent trustee would have failed to consider the implications of the new test as part of their decision process had the test been in place when the decisions were being taken. The risk of a run of existing members, and the reduction in cashflow if new members cannot be admitted, would have to be considered in the investment strategy formulated by the trustee. To have failed to do so would potentially constitute a breach of the covenant in the Superannuation Industry Supervision Act 1993 (‘SIS Act’) that requires the trustee to have regard for the circumstances of the fund. Investment in unlisted assets such as infrastructure, property and private equity, as well as active management of share portfolios, all now involve ‘basis risk’ for the trustee; a risk arising because the benchmark does not reflect the underlying holdings in the portfolio. A failure by a trustee to consider properly the implications of underperformance arising from the proposed test would also have disappointed the strategic planning and member outcomes expectations of the Australian Prudential Regulatory Authority (‘APRA’), now formalised in Prudential Standard SPS 515: Strategic Planning and Member Outcomes. So the proposed test does change the playing field, casting as unsatisfactory decisions that were made in accordance with the law at the time they were made.

Is this fair? As noted above, no one can assert a right to be a superannuation fund trustee. APRA administers a licensing regime for superannuation fund trustees and an authorisation regime for MySuper products. It is appropriate that only entities capable of meeting APRA and the community’s expectations be authorised to offer superannuation products. The problem is that although it is appropriate that historical performance inform that assessment, past performance ought not determine that assessment. There are too many reasons why past performance is, by itself, not a good guide to future performance. Indeed, ASIC requires trustees to intone this mantra frequently in its disclosures to members.

Fairness also should consider the interests of members. The members of a fund who receive a notice from their trustee notifying them that their fund has underperformed are quite likely to be very nervous. Some will attempt to leave the fund pretty much instantly. Others will turn to financial advisers, a situation unlikely to kindle much confidence given the experience of pension switching in the UK and other markets. Some won’t even open the envelope. These latter, disengaged members, whose interests the reform is intended to safeguard, will ultimately bear the costs if the departure of their more nimble- footed or financially literate neighbours precipitate a run on the fund.

Where to from here?

The curious thing is that, as noted above, APRA already has an authorisation regime in place for MySuper products. A simpler solution to the problem would be to require APRA to use its authorisation powers more actively to take action in respect of products that it concludes (and this part is crucial) are likely to underperform in the future. There is already provision in the SIS Act for APRA to cancel a trustee’s authority if it has reason to believe that the trustee may not comply with the trustee’s ‘enhanced’ obligations in relation to MySuper products. This would require only minor amendment to encompass circumstances where APRA formed the view that the sub-par performance was likely to persist. APRA could then use its directions power to craft a rescue package that has regard for the circumstances of the fund away from the glare of the marketplace. It is not clear why the government did not go down this route.

The numbers on which the test will ultimately be based are not in yet, but initial reports indicate that upwards of 3 million members are likely to be affected. That’s a lot of potential dislocation to look forward to in July 2021 when the test goes live.

Scott Donald 
PhD CFA, External Consultant, Herbert Smith Freehills and Director, Centre for Law, Markets and Regulation at UNSW.