As the dust starts to settle on the first round of early access to super, perhaps it is a good time to reflect on the governance and regulation of unlisted assets in super funds. It is a complex area, with consumer protection provided by super fund governance overseen by the prudential regulator.
The quality of these two layers and how well they integrate determines how well consumers are protected.
When a super fund offers daily transactions and invests in unlisted assets it creates a range of challenges. One of these, meeting cashflow obligations, is the first order issue. There are three second order issues just as important: the quality of the remaining portfolio, equitable unit pricing, and the performance impact of generating liquidity (which is borne by all investors). The first order issue is binary (you either can or cannot, meet cashflow demands as and when they fall due). The second order issues are more nuanced, but there exist no industry standards.
Before we consider how trustee governance on these issues, it’s important to understand the regulatory framework.
APRA is the prudential regulator of RSE’s (registrable superannuation entities). Conceptually, the prudential regulation model is one whereby firms are required to control risks and hold adequate capital, as defined by a range of requirements and limits, reporting and supervisory activities. APRA’s application of prudential regulation to super funds is principles-based, whereby prudential standards are set in a way to achieve low intervention and failure but allow for innovation and discretion for funds to develop an approach appropriate to the scale and complexity of their activities.
Let’s return to the case of super funds and unlisted assets. SPS 220 (Risk Management) sets out the requirement for an effective risk management framework to ensure sound management across all operations. SPS 530 (Investment Governance) sets out the requirement for an investment governance framework that considers a large range of investment activities including monitoring and risk management.
SPS 530 specifically focuses on liquidity risk, requiring funds to determine procedures to measure and manage liquidity on an ongoing basis, to develop a liquidity management plan, and to undertake periodic liquidity stress testing. Procedures and plans need to cover all investment options offered by funds.
SPS 530 focuses on the first-order issues associated with investing in illiquid assets (i.e. the ability to meet liquidity requirements). However, it is largely silent on the second-order issues. True, they should be captured by a fund’s operational and investment governance framework, but are they? I suspect they aren’t explicitly addressed because: They are complex issues; the ramifications may be painful (e.g. close or significantly re-engineer processes and some investment options), and APRA hasn’t called these issues out and the governance frameworks of many funds probably develop responsively rather than proactively.
There is potentially a fourth issue, peer group risk: if addressing these issues restricts a fund relative to the activities of peers, there may be a hesitancy to formally address the issue.
How would we know if these risks are addressed in risk management and investment governance frameworks? A simple three-question survey of funds would probably be sufficient:
- Does your fund have a formal portfolio quality test (post-liquidity) which feeds back into the trustee decision around suspending redemptions?
- Does your fund have a formal limit on estimated unit pricing inequity due to the stale pricing impact of assets with lagged pricing?
- Does your fund account for the performance impact of generating liquidity, and how is this managed by the trustee (e.g. variable spreads, suspending redemptions etc.)?
If these issues are being addressed by all funds, then this is a great example of a prudentially regulated industry operating with high governance standards. If not, then there is need for improvement.
One solution would be for APRA to expand the issues addressed in the appropriate prudential standards to incorporate these second-order issues. Funds, assisted by consultants, would then address these issues. However, some of the issues, such as the degree of unit pricing inequity, can provide funds with a competitive advantage. Strongly adopted industry standards could assist. The alternative is a more prescriptive approach from APRA, setting some standards where appropriate.
The media is getting into these issues, digging deeper and targeting specific funds. These are topic areas that can only reduce consumer confidence in superannuation. Enhancing the regulatory focus on these nuanced areas associated with funds investing in illiquid assets can only improve the baseline outcome for consumers. It also creates a “nothing to see here” environment for media, while having no adverse impact on those funds with good governance already in place.
David Bell is the executive director of the Conexus Institute