Why are our largest investors not measuring investment performance on an after-tax basis, while this is indeed the norm for a typical individual investor? After all, tax is a large investment expense and should be given due consideration.
Historically, Australian superannuation funds have used pre-tax benchmarks to both communicate performance comparatives to their members and to assess the performance of their fund managers. Further, these pre-tax benchmarks have been used to remunerate fund managers.
But this presents a problem: if we are measuring and remunerating our fund managers on a pre-tax basis, this clearly creates a misalignment between the fund managers and the super funds' main objective - to maximise after-tax returns for their members. How can we encourage our superannuation fund investment managers to assist with achieving the same objective as the superannuation fund?
The problem is regarded as too hard to crack: how to provide fund managers with superannuation fund-level tax information so the fund can incentivise and enable each individual investment manager to maximise the after-tax returns in a multi-manager structure?
At its simplest, a benchmark establishes a goal for the investment manager: if we want to incentivise them to maximise their after-tax performance, we should implement an after-tax benchmark that does this, and further we should remunerate them on that basis, clearly spelling out to fund managers that superannuation funds do think it is the after-tax return that counts.
The resurgence in interest in after-tax returns has been fuelled by Jeremy Cooper's superannuation review recommendations for trustees to have regard for taxation issues at all stages of the investment process - strategy, implementation and monitoring. Fund manager remuneration structures should be adapted to create more incentive to do so. So if Cooper wanted fund managers to put their money where their mouth is, why aren't all funds doing it?
One size doesn't fit all
For many reasons a single consistent after-tax benchmark may not be feasible. There are several factors around tax that are characteristic to the particular investor or superannuation fund that may directly impact on the after-tax outcome. Those same factors need to be taken into account in the benchmark in order to fairly evaluate a fund manager's after-tax performance against the benchmark.
True after-tax performance measurement where capital gains tax considerations are taken into account depends on the starting tax position, cost base and cash flows. Two portfolios that have exactly the same holdings will still have different after-tax returns if they started at different times, have different cost bases and different cash flows.
It is then impossible to have a single after-tax benchmark that could be applicable to all portfolios, even if they are managed the same. This is a very important consideration in the after-tax world - unlike in the pre-tax benchmarking universe, one size definitely does not fit all.
Ultimately benchmarks need to be customised if they are going to be used, but one has to keep going back to the question: why is the benchmark needed in the first place? Some of the reasons include enabling better measurement of returns for clients, allowing a more accurate measurement of performance and improved transparency, and also to allow for a more like-for-like comparison of manager performance.
Overcoming the hurdles of implementation
The main implementation barriers for superannuation funds are traditionally complexity and cost.
The cost of solutions can vary greatly, depending on the approach decided upon, but complex does not have to translate to expensive.
Costs can include changes to the investment manager agreements, changing of investment strategies and the cost of implementing a new benchmark process to standardise the after-tax performance measurement. Funds may also want to move in steps towards the final picture. It is early days in Australia for the introduction of these benchmarks, so adopters may tread cautiously and even cost-effectively for the moment to get part of the way toward the end goal before overcommitting to a solution that may not reap the rewards from the spend.
Aside from cost and complexity, there are other challenges standing in the way for funds, such as the fear of selecting the wrong benchmark or not wanting to unfairly penalise fund managers for adverse tax impacts on their performance, which is outside their control.
The road ahead
After-tax benchmarking starts us on our journey to achieving optimal post-tax returns, but there is still a great deal that can be done. GBSTQuant is already looking at the next phase of tax-aware investing and each of these areas have their own forms of complexity, but that's what keeps this interesting. After-tax benchmarks are a good start to the journey and these benchmarks need to be customised to deliver the outcomes the superannuation funds are looking for.
As the industry moves towards after-tax measurement and performance becoming the norm, the next challenge will be for fund managers to make tax considerations an integral component of their investment process.
