The way in which reserves are created and applied in superannuation funds has become a topical subject because of the manner in which some reserves have been dealt with by trustees.

A form of reserve that is mandated by legislation is an operational risk reserve which has to be at least 0.25 per cent of the fund assets. Such a reserve can only be applied to deal with operational risk, which is the risk of loss from inadequate or failed internal processes, people and systems or from external events. That form of reserve is not the subject of this article but was considered by the Federal Court in the IOOF case.

There are various means by which other reserves can be created, including, for example, reserves that result from favourable claims experience on insurance policies on the lives of members. Another means of creating reserves that is often used in accumulation funds is to not credit to members’ accounts the whole of the earnings from investments and to retain some of the earnings in a fund reserve account. That is the form of reserve creation that is discussed in this article.

There are a number of statutory obligations trustees have that are relevant in diverting investment earnings to reserves.

Also, there are principles of trust law that would be applied by a court if the regulator, a member or group of members take issue with such a diversion.

Legislative and trust law considerations 

First, there’s the legislation in the form of the Superannuation Industry (Supervision) Act (the SIS Act) that recognises trustees will have reserves additional to an operational risk reserve.

The Act imposes a covenant that, if there is a reserve in a fund, the trustee has to formulate and give effect to a strategy for its prudential management, consistent with the fund’s investment strategy and its capacity to meet its liabilities (which includes benefit payments) as they become due. There are civil and criminal consequences of failing to do this.

An important element of this requirement is that the trustee must have a strategy to prudently manage the reserve and the adoption of the strategy and its form needs to be recorded. If the strategy is challenged by the regulator or members, the trustee will need to show that the strategy was a prudent one for the trustee of a superannuation trust fund to adopt in dealing with a reserve, bearing in mind that a trustee has a separate operational risk reserve to deal with losses.

An additional legislative requirement that is relevant is a covenant imposed by the SIS Act that a trustee must always act in the best financial interests of its members. Anything that is done, including transferring investment earnings to reserves, can only be done if it is in the best financial interests of the affected members to do so. A contravention of that leaves trustees open to civil and criminal penalties and to transactions being ordered to be reversed or members having to be compensated because of the trustee breaching a SIS Act covenant.

The obligation to act in members’ best financial interests applies both in making decisions to transfer money to a reserve and the way in which money is disbursed from the reserve. This obligation applies in relation to existing members of the fund, not future or prospective members. Therefore, if a court decides that the way in which a reserve was created, added to or disbursed was not in the best financial interests of the existing members, the covenant will have been breached. For example, if money in a reserve is applied to increase the membership of the fund, the trustee, if challenged, will have to show by financial evidence, that that was in the best financial interests of the existing members.

Whilst it is often argued that members’ money spent on increasing a fund’s membership is in the financial interests of the existing members, the reality is that there has often not been any financial benefit that has flowed to the existing members from increasing the number of members.

Another statutory provision that can be relevant to the way in which investment earnings are credited to a reserve is that the SIS Act imposes a covenant on trustees to act fairly in dealing with classes of members and to act fairly in dealing with members within the same class of members.  The State and Territory Trustee Acts are also relevant to trustees of superannuation trust funds. They impose a similar duty to act impartially towards members and between different classes of members.

In addition to the legislation there’s also the long established principles of trust law developed by the courts apply in determining the obligations of trustees of superannuation funds and are often applied in deciding whether trustees have acted properly and in accordance with the law.

One such principle, which has been recognised and applied in a long list of court cases, is that trustees must act fairly, impartially and equitably towards beneficiaries of the trust. This trust law principle is consistent, to some extent, with the statutory provisions.

Investment earnings diversion

The basic tenant of trust law and the legislative requirement that trustees must act fairly to members and groups of members raises an important issue in diverting investment earnings to a reserve from the members’ accounts to which the earnings would otherwise be credited.

The issue is that the investment earnings in an allocated fund are derived from earnings on each member’s own money.

Diversion of investment earnings to a reserve therefore takes away from each member a part of the earnings on that member’s own money which, equitably, belongs to that member. Thus, when the member leaves the fund, unless the diverted earnings on the member’s money is credited to the member’s account, that member will have lost forever money that was earnt by that member’s money and other members will ultimately get the benefit of the diverted investment earnings attributable to that member’s money.

It can be well argued that this issue of diversion of investment earnings is so patently unfair to the departing member that it breaches the trust law and legislative obligations to act fairly towards members and, therefore, exposes trustees to a claim by affected members for compensation.

A superannuation fund is different from a bank or a corporation, which are not governed by trust law, and which can, therefore, put money earnt on investors’ funds into reserves, A superannuation fund is a trust fund, as has been decided in many court cases, and should be administered as such, including by not unfairly putting earnings on members’ own moneys into reserves from which the affected members may never derive any benefit and may never, therefore, get the money back which is justifiably and equitably theirs.

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