Publishing indirect costs for the previous financial year may be at an end. A new era in which super funds are expected to predict the future, at least as far as indirect fund management costs are concerned, is being ushered in by the corporate regulator.
Funds which still have an indirect cost ratio (ICR) may find themselves having to include additional amounts – amounts which, for some reason, managed funds are permitted to exclude – and wondering why they have been put at that competitive disadvantage.
In December 2014, ASIC published a new class order (CO 14/1252) and proposed changes to its regulatory guide on the disclosure of fees and costs (RG 97). Both impact the way super funds calculate and disclose their ICRs and investment costs from 1 January 2016. At the time of writing, the proposed changes to the regulatory guide have not yet been finalised. ASIC is still considering the submissions which were made by industry on the proposed changes earlier this year.
Costs incurred via interposed vehicles
Most attention has focussed on the move to make it clear that costs incurred within interposed vehicles must be included within a super fund’s ICR. This is not necessarily controversial, as many super funds have long been including costs incurred within pooled vehicles and private equity funds in their ICRs. Indeed, what might be more controversial is that some funds may not have been doing so all along. That said, the definition of ‘interposed vehicle’ is a particularly technical one and can turn on the wording in a fund’s product disclosure statements (PDS). Submissions have highlighted several potentialities. Careful wording in a fund’s PDS may be enough to fall outside the new rules, meaning that the costs of those investments could be omitted from the ICR. On the other hand, some structures which were probably not intended to be interposed vehicles might inadvertently be caught by the new rules, meaning that amounts which ought not to be included in the ICR might technically be required to be included.
However, there are other aspects which are far less widely appreciated and which potentially stand to have more significant impacts for super funds.
Diverting costs away from the ICR and into investment fees
When the Stronger Super reforms were enacted, there were initial concerns that the definitions of ‘ICR’ and ‘investment fee’ overlapped. ASIC was quick to allay industry’s concerns and clarified that there was no obligation to ‘double-disclose’ investment costs. Essentially, super funds were left to decide whether to include investment costs in their ICR or, alternatively, in their investment fee.
However, on one reading, the new class order would take away that choice, so any investment cost incurred by a super fund must be disclosed as an ‘investment fee’ and not be disclosed as part of the ICR. For example, fees paid to an investment manager acting under an investment management agreement would have to be included in the fund’s investment fee, instead of in its ICR as has traditionally been the case. To an extent this issue may have had its genesis in the original Stronger Super reforms, but the new class order compounds the issue.
This is potentially a paradigm shift.
What’s in a name: why shifting costs away from the ICR matters
This may involve a change in practice for many; especially funds which are accustomed to treating particular amounts as part of their ICRs, and not as an investment fee charged to members. Some may cease having an ICR altogether – for example, if they do not make any investments through interposed vehicles.
This involves a fundamental change in how these costs are disclosed to members. The rule has always been that funds must disclose an ICR calculated for the most recent financial year end. Super funds emphasise that actual costs (and therefore their ICR) in future years may be different. In contrast, investment fees must be disclosed prospectively.
With investment costs migrating from the ICR category into the investment fee category, super funds would be required to make forward looking estimates concerning the level of investment costs in future.
Super funds would therefore have to grapple with the conundrum of estimating future investment fees. There are many reasons why this would be difficult. ASIC has foreshadowed that it would not be sufficient to use the previous financial year’s figures.
For example, it is typical for a super fund to have appointed a range of investment managers across the different asset classes, each of which charges different rates of fees. Estimating future fees would involve making assumptions not just about asset allocations at different times during the following year, but also assumptions about the size of each manager’s portfolio throughout the year – not to mention future terminations and appointments of new managers and their fees.
Estimations will be even more difficult where performance fees are involved. Super funds would have to make assumptions about performance, not just at the asset class level, but at the level of each portfolio, given that different managers would no doubt have different capture rates, hurdle returns, high-water marks and possibly positive or negative amounts carried-forward from previous years.
Different rules make super funds appear more expensive than managed funds
Originally, the same rules applied to super funds and managed funds when calculating and disclosing ICRs. Issuers which offered both a super and non-super version of a particular investment strategy would conceivably have the same ICR for both products, for example.
This ceased being the case when the Stronger Super reforms were implemented. Super funds had to start including transactional and operational costs, such as stamp duty and brokerage, in their ICRs. Managed funds remain exempt from this requirement. It is unclear whether this was a deliberate policy decision by the Government or an unintended anomaly in the legislation. What is clear, however, is that there has been a regulatory uplift applied to every super fund’s ICR.
Building on this, ASIC has foreshadowed further inclusions within ICRs for super funds: amounts which many super funds will not be accustomed to including in their ICRs, and which managed funds will be exempt from.
There is an important question here for the Government to address: why are super funds required to include additional components in their ICRs when managed funds do not have to do so? If these additional components are so important, why aren’t investors in managed funds entitled to see these amounts included in their ICRs?
ICRs will increase with new inclusions
Super funds will potentially have to start including buy-sell spreads on all OTC derivatives in their ICRs. Managed funds would apparently be exempt from doing so when OTC derivatives are being used for hedging purposes. Again, it is unclear why different rules apply to each.
Apart from the question of ‘why’ buy-sell spreads on OTC derivatives should be included, there is also the question of ‘how’. In the OTC space, trades are often bespoke and there may be no readily visible buy-sell spread for a particular trade. The counterparty to a particular trade could conceivably be the only known party willing to enter into that kind of trade. There is also an unanswered question of how the buy-sell spread should be apportioned if the relevant OTC trade straddles more than one financial year.
All this focus on OTC derivative buy-sell spreads then gives rise to a question of whether buy-sell spreads on exchange-traded derivatives are also to be included in the ICRs of super funds, which would have even further and wider spread impacts.
Many super funds participate in securities lending programs operated by their custodians and share a fraction of the revenue generated with their custodians. ASIC has indicated that revenue sharing arrangements may also have to be factored into a super fund’s ICR. Under ASIC’s proposals, the same would apply to managed funds. It is always appreciated when ASIC foreshadows potential regulatory changes and engages in meaningful dialogue with industry, as they have on this occasion. Hopefully, super funds will be excused from having to dust off their crystal balls and we see sensible parity between super funds and managed funds maintained – or even better, restored.