‘Short-term, benchmark-hugging’: Could Australia’s YFYS rules deter climate investment?

One of the world’s oldest and largest pools of retirement savings comes from the land down under. By some estimates, Australia’s superannuation system has been around
since the 1800s and at last count, total
assets managed by Australia’s super funds stood at $4.1tn.

The scale of Australian superannuation capital accords it a degree of systemic significance for climate solutions allocations. Several of the country’s largest super funds have set targets in that regard. Rest, for example, is aiming
to deploy $2bn in at a portfolio level, by 30 June 2025.

The scale of superannuation capital also invites requisite prudential oversight. One such regulation is an annual performance test intended to hold trustees to account on the returns their products deliver.

However, investors say the test – which has been around for over four years now – is deterring climate solutions allocations.

The test

Back in 2020, the Your Future Your Super reforms
were introduced on the premise that the super fund system was ‘letting too many Australians down’. By that, the government meant, that the system was less efficient than it should be – fees were rising and returns were not. Underperformance, in particular, was a key concern.

To correct the issue, YFYS reforms proposed an annual performance test. The test worked on the basis of a benchmarking exercise undertaken by Australian Prudential Regulatory Authority (APRA). A 0.5% underperformance relative to the product’s net investment return benchmark over eight years would count as underperformance.

The consequences were intentionally dire. Fail the test once and members need to be notified in writing. Fail it twice in a row, no new members until performance improves.

At odds

Although Australian asset owners recognise the value in correcting underperformance, their concern is that the test is at odds with the Canberra’s net zero ambitions.

“We speak to our members every day, including Australia’s largest super funds and international asset managers. It’s clear from these conversations that the current performance test could be having significant unintended consequences”, says Nayanisha Samarakoon, head of policy and advocacy at the Responsible Investment Association of Australasia (RIAA).

“That is, it acts as a disincentive for funds to consider long-term decisions around investing in things like the climate transition – new and emerging sectors – and being able to adapt to a changing future. In this way the test is undermining the achievement of other government policy objectives, like reaching net zero by 2050”, Samarakoon told Net Zero Investor.

With no transition index option for tracking performance – although these are available – the test relies instead on carbon-intensive benchmarks.

“There’s a risk that funds demonstrating responsible and sustainable investment practices face an unstable tracking error against the performance test benchmark, even if they do demonstrate high levels of due diligence and a returns outlook in line with the fiduciary duty of the fund and time horizons of members”, Samarakoon warns.

While emphasising the fact that several super funds with a market-leading responsible investment tilt currently pass the test, she adds:

“It remains the case that the short-term, benchmark-hugging nature of the test in its current form risks deterring funds from pursuing long-term sustainable investments”.

Resurfacing concerns

Even though these concerns resurfaced at the recently concluded RIAA annual conference, they are not new.

Rest, which manages over $93bn in assets on behalf of 2 million members, raised these issues in response to the Treasury’s consultation in April 2024.

“The reliance on benchmarking against existing indices means that even a good long-term investment strategy may result in a failed test outcome where benchmarks are not representative of the investment strategy”, the fund said in its response.

The Australian Sustainable Finance Initiative (ASFI) cited similar concerns in its response to the same consultation. “An important consequence is that the test is significantly constraining the ability of super funds to adopt green or sustainable finance investment strategies at scale”, ASFI noted.

While asset owner discontent over the test’s current form is evident, views on the best path forward differ. Rest, for instance, supports an additional metric for member outcomes or new benchmarks to base the test on.

“There are differing views across industry regarding the appropriate approach (if any) to amending or replacing the performance test. But funds tend to agree that it has achieved its original objective of addressing underperforming funds”, says RIAA’s Samarakoon, “The test now needs to provide flexibility to consider investments which would have long-term benefits. This would better serve everyday Australians”.