Australian super fund performance tests could limit ILS investing

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Government instigated performance tests for Australian superannuation funds, so pension and retirement investment houses, could potentially have an effect of making investing into asset classes like insurance-linked securities (ILS) at scale more challenging, research suggests.

Super funds in Australia manage the retirement pension benefits of much of the population and are among some of the biggest institutional investors in the world.

They’ve also been early adopters of catastrophe bonds, insurance-linked securities (ILS) and other reinsurance investment assets over the years, with some relatively large allocations to the ILS asset class hailing from the superannuation fund community.

But a set of rules instigated by the Australian government in 2021 have the potential to change that, or at least to dampen the appetite for riskier categories of alternative investments, among which ILS may sit (depending on your definition).

The YFYS performance test (Your Future, Your Super) has put super funds into “limp” mode, research from the Conexus Institute in Australia says.

It’s because the performance tests, which mean super funds need to near their benchmarks, in performance terms, are forcing portfolio managers and strategists to change their allocations and adopt defensive approaches to trying to maintain performance at a level the tests deem sufficient.

One ramification is that superfunds are now being seen to become more short-term in their investment strategies, while trying to hit their targets.

The research, which was conducted through interviews with superannuation executives and investment officers, also suggests it may be stimulating some additional risk taking, as super funds look to hit or near target returns.

The need for a performance test is clear, but the way it is implemented is apparently leading to strategic investment allocation decisions that may ultimately not be in the best interest of the retirees whose assets are managed by supers.

The superfunds are now thought so focused on achieving the benchmark that they are unlikely to fail, but they could harm their performance and return potential by this test becoming their main focus.

The performance test also applies a risk level to different asset classes and this is where it’s said insurance-linked securities (ILS) may be penalised somewhat, which may make it harder to invest at scale in the asset class, the research suggests.

While super funds could still allocate to ILS, it is unlikely under the test regime that a new entrant would look to build significant holdings in a riskier alternative like this.

Which, when you consider the complexity of ILS and the sometimes quite long period pensions and investors take to understand it, might make the asset class harder to justify, if all a super fund is focused on is the test result itself.

We’ve yet to hear of any changes in allocations as a result of the performance test, but we have hears some Australian investors have dialled down ILS allocations in recent years, partly in response to catastrophe losses and also to potential exposure to losses in their own country, which is said to be a growing concern at this time (unsurprisingly given the flood and storm activity).

Super funds are calling for change, to the tests and the way they are measured. While wanting to meet stringent requirements to protect their members, they also want to be able to invest sensibly for their future and feel the YFYS performance test may be holding them back in that mission.