6. Prudential Standards

Date

The SWG has recommended that APRA be given a power to make prudential standards. The SWG is of the view that APRA should consider developing prudential standards that cover capital, investment rules, outsourcing, governance and operational risk. This Chapter considers each of these issues in further detail.

Recommendation 15

The SWG recommends that APRA consider developing prudential standards that cover capital, investment rules, outsourcing, governance and operational risk, in consultation with relevant stakeholders.

6.1 Capital adequacy

Proposal

The Government invites comments on the following issues relating to capital:

  • the need to reassess capital requirements for Approved Trustees with a view to aligning those requirements with the size of the fund and the actual operational risks in each fund. This could include a capacity for APRA to vary the minimum capital standard for different types of superannuation funds;
  • the role of capital in funds without Approved Trustees, and means of raising such capital if it is considered appropriate; and
  • whether the option allowing the substitution of capital held in custodians is appropriate to ensure that capital is available to meet the needs of fund members.

It should also be noted that in its draft report on the Review of the Superannuation Industry (Supervision) Act 1993 and Certain Other Superannuation Legislation, the Productivity Commission made the following recommendations which are relevant to this discussion:

      The net tangible asset requirements for approved trustees should be strengthened through legislative amendment. All approved trustees should be required to have a specified minimum amount of net tangible assets (or approved guarantee or combination thereof) regardless of their custodial arrangement. Approved trustees who use custodians should not be required to have more than the specified amount.10

      The operating capital requirements for approved trustees should be revised, through legislative amendment, so that they represent a specified proportion of an approved trustee's operating costs.11

Views from the consultation process

The most common comment made in submissions was that capital requirements should not be imposed on not-for-profit funds. The major reason given was that this would destroy the lower cost structure currently available to members of these funds, leading to lower retirement savings and greater concentration of superannuation assets into a small number of large funds.

It was suggested that other options such as indemnity insurance, arm's length investment rules, compliance and governance systems, including personal liability for directors, may be just as effective (the Securities Institute of Australia, the Law Council of Australia, the Meat Industry Employees Superannuation Fund, a number of smaller funds). The view was put that such options would also avoid the distortions and inefficiencies that result from the unproductive tying up of capital. As an alternative, ASFA suggested that APRA develop a system of allocating points for certain protections, with sufficient points alleviating any need to satisfy a capital requirement.

Further, it was argued that holding capital would not create a buffer against operational risk where there is a high degree of outsourcing (the Law Council of Australia), and no capital adequacy requirement will satisfactorily address a catastrophic investment loss or avert fraud (Sunsuper).

However, the Australian Bankers' Association supported imposing capital requirements on funds without Approved Trustees, suggesting that capital be raised directly by the employer(s).

The Trustee Corporations Association of Australia was among a number of organisations supporting the application of capital adequacy requirements to all commercial entities involved in operating superannuation funds, and for these requirements to take into account the number and size of the funds for which services are being provided and to have regard to risk mitigation through insurance.

The Industry Funds Forum opposed any change to the existing rules in this area for Approved Trustees and noted that the key protection against operational risk is competent management of contractual risk, not capital requirements. The Investment & Financial Services Association Limited also opposed any increase in capital adequacy requirements.

NSP Buck proposed creating portfolio insurance aimed at building capital through a levy or premium rather than creating a capital reserve in isolation.

During the focus group sessions, participants generally expressed a preference for any capital requirements to be related to the risks of the fund.

Some participants also queried the rationale for enabling non-public offer funds to rely on insurance to meet the costs associated with operational failure, while requiring public offer funds (those requiring a trustee approved by APRA) to hold capital as was suggested in the draft recommendations released by the SWG on 4 March 2002.

A number of participants indicated that the removal of provisions allowing a custodian to hold capital on behalf of the trustee (as proposed in the SWG's draft recommendations) would have a serious detrimental effect on members of funds that, while having an Approved Trustee, operate on a not-for-profit basis. Stakeholders indicated that such trustees would experience difficulties in raising capital, and would be unlikely to attract investors. In the absence of other sources, trustees would be forced to seek capital holdings primarily from members. There was some discussion about the validity of these arguments given the existence and use of other reserves in not-for-profit funds with Approved Trustees to meet losses arising from operational risks. Participants queried the ability of the legislation to distinguish between profit-making and not-for-profit trustees, and between those funds making offers to the public versus those whose membership is limited.

Participants also noted that outsourcing reduces the risks directly relevant to the trustee, and that a prudent trustee board would ordinarily require a custodian to hold custody of the assets of the fund. Both of these factors should be taken into account in assessing how much capital trustees should be required to hold.

Consideration of the proposal

In the existing superannuation framework capital requirements are limited to minimum requirements for Approved Trustees. Approved Trustees are required to hold $5 million net tangible assets (NTA), an approved guarantee for that amount, or to comply with custodial conditions. Those funds that operate without an Approved Trustee are not required to hold capital.

As shown in Table 6.1.1, currently around 35 per cent of Approved Trustees are approved on the basis that the trustee holds $5 million NTA. Around 50 per cent are approved on the basis that the trustee uses a custodian, and thus hold only $100,000 NTA, or a guarantee for the amount of $5 million. Around 5 per cent of Approved Trustees are approved on the basis that an irrevocable guarantee for $5 million is in place, and around 10 per cent are approved on the basis that they invest all fund assets solely in approved prudentially regulated institutions.

Table 6.1.1: Approved Trustees by capital arrangement at March 2002

Capital arrangement

Percentage of Approved Trustees

Trustee holds $5 million NTA

35

Custodian (Trustee holds $100,000 NTA or guarantee)

50

Irrevocable $5 million guarantee

5

All assets invested in approved prudentially regulated institution

10

Source: APRA, 2002.

The Background Issues Paper proposed two options in relation to capital:

  • Option 1: Reform the existing requirements applying to Approved Trustees; and
  • Option 2: Bring capital requirements for non-Approved Trustees into line with requirements for Approved Trustees.

Based on these options and the views received in the first round of the consultation process, the SWG, in its draft recommendations released on 4 March 2002, suggested capital should be required for Approved Trustees and that insurance or some other risk mitigation measures should be required for other trustees. The basis for this draft recommendation was twofold:

  • as raised in consultations, non-public offer funds may not need capital to show financial substance or to provide an incentive to manage the fund well; and
  • given that most such funds are run on a not-for-profit basis, it would be difficult for them to access capital.

Further, some modifications were suggested to the current requirements for Approved Trustees. It was also recommended that the requirements be further refined to reflect a risk-based approach to capital over time.

In the focus group discussions in the second round of consultations, a number of concerns were raised with these draft recommendations. In particular, it was suggested that if insurance was appropriate for non-public offer funds, then it should also be appropriate for Approved Trustees.

Questions were also raised about the appropriateness of the distinction between Approved Trustees and non-public offer funds. APRA approves trustees under section 26 of the SIS Act to act as trustee for public offer superannuation funds. The majority of public offer superannuation funds offer, or intend to offer, superannuation interests to the public on a commercial basis. In contrast to trustees of non-public offer funds, many trustees approved under section 26 are investment professionals who are in the business of managing retail funds for a profit. However, there are some exceptions to this. In particular, some traditional industry fund trustees have moved into the public offer market in order to market products to a broader range of employers or directly to the public. It was suggested that the arguments for not applying capital to trustees of non-public offer funds applied equally to these not-for-profit industry funds.

In consequence, it was suggested that the appropriate distinction should be between trustees of profit-making and not-for-profit funds. Such a distinction is not currently made in the SIS Act, and the SWG believes that such a distinction would be extremely difficult to define. One suggestion was that it should be determined by the governance structure of the fund; funds with equal employer and employee representation would be regarded as not-for-profit. However, even in funds with equal representation there are activities, which seek to generate a profit from members.

In light of the focus group discussions, the SWG considers that it is not appropriate to distinguish between types of funds for the purposes of determining whether capital is required by trustees or not. Rather, if there is a justification for capital for trustees of all funds, then a requirement should be applied across the board. However, the SWG believes that a range of factors exist which will influence the appropriate level of capital for trustees of each individual fund.

In assessing the need for and level of capital, it is essential to determine the purpose for which the capital is to be held. The reasons for requiring superannuation trustees to hold capital will not necessarily be the same as the reasons for other prudentially regulated institutions or for responsible entities of managed investment schemes.

The Background Issues Paper identified three reasons for capital requirements for superannuation trustees:

  • to demonstrate financial substance and long-term commitment by the trustee;
  • to have money-at-risk to provide an incentive for the trustee to manage the fund well; and
  • to act as a buffer against operational or governance risk that may arise.

The focus groups considered whether each of these requirements applied to the various types of funds that exist in the superannuation industry. It was suggested that trustees of non-public offer funds need not hold capital for the first two reasons, primarily because a corporate sponsor has already demonstrated long-term commitment in setting up a superannuation fund for its employees, and because other incentives already exist to manage the fund well (for example, the obligations imposed on trustees in the covenants and liability for breach of legislative requirements).

The SWG has identified further reasons for holding capital. Firstly, capital is available to assist in the orderly wind-up of a superannuation fund (although arguably, this reason is a subset of the 'buffer against operational risk' reason). Secondly, capital can also serve as a barrier to entry, to prevent marginal players from entering the industry where the trustee does not have sufficient resources to meet the financial promises and long-term commitment necessary to operate in the industry (arguably this is a component of the 'financial substance and long-term commitment' reason).

The SWG notes that in all other industries subject to APRA's prudential regulation, capital exists as a barrier to entry ($50 million for ADIs, $10 million for life insurers, and $5 million for general insurers under the GIRA amendments). However, the proposed prudential licensing regime will provide a mechanism for ensuring that marginal players do not enter the superannuation industry, and therefore capital may not be necessary for this purpose for superannuation trustees.

The key purpose for capital that is relevant to all superannuation funds is that it is necessary to act as a buffer against operational risk. While insurance may be available to cover some operational risks, it will not cover all of them. Furthermore, insurance suffers from the disadvantage that it requires the trustees who may have caused the loss to make the claim on behalf of members. Similarly, not all operational risk will be addressed through management of contractual risk.

Given that all funds are subject to some form of operational risk, it follows that as a matter of principle some form of capital is necessary for all trustees to ensure that operational risks can continue to be addressed on an on-going basis. While all funds will have different levels of operational risk, depending on a range of factors, there are many difficulties associated with distinguishing between capital requirements on the basis of fund type. As a result of this, the SWG believes that a risk-based framework for capital should be developed and applied to all superannuation funds as part of the licensing process, rather than as a longer term objective as originally recommended.

One of the suggested licensing requirements is that all trustees have adequate resources. The SWG considers that APRA should consider when licensing a trustee the level of capital appropriate to demonstrate 'adequate resources', particularly in relation to the operational risks faced by the funds operated by the trustee. This is consistent with the legislative requirements for responsible entities of managed investment schemes under the Corporations Act. Under those provisions, the requirement is expressed at a high level of generality (to have adequate resources), and A
SIC provides further guidance in policy statements of what will be regarded as adequate in particular circumstances.

The SWG considers that the legislation should broadly identify certain factors that APRA must consider in determining whether the trustee has adequate resources. In particular, the following factors would be relevant:

  • the composition of the trustee, including the trustee's skill, knowledge and experience. Independence of the trustee and equal representation will also be factors;
  • the composition and quality of management, which can act as a means of increasing or decreasing capital requirements. Independence of management will be taken into account;
  • governance issues, including compliance with regulatory requirements, delegation structures and outsourcing arrangements. This would include the level of residual legal risks which remain with the trustee after outsourcing (for example, the enforceability of the contract between the fund and the outsourcer and the quality of internal delegation arrangements);
  • the existence and quality of internal risk management systems, including compliance committees and internal audit;
  • administrative issues, including an assessment of the level of back-office activity (record keeping, reporting and other administrative tasks), soundness and efficiency of administrative and computer systems. The use of an administrator transfers some operational risk associated with, for example, systems failure, contributions and benefit payments;
  • custodial arrangements, and the degree to which custodial requirements reduce overall risk. The use of a custodian can reduce the risk of fraud, identification risk and some legal risks (clearing, settlement, and safekeeping of assets);
  • issues relating to investments, including internal investment experience, the role of investment managers, the quality of systems to ensure investments are within the fund's investment strategy and/or investment managers act within their mandate; and
  • the type and level of insurance coverage.

Further guidance on capital requirements could also be articulated by APRA in an appropriate form such as a prudential standard or guidance note, specifying factors that increase or mitigate risk, and allocating a risk weighting to each (see Recommendation 15).

There have been some concerns expressed that the SWG's proposals might result in trustees being required to hold less than the $5 million currently required of Approved Trustees. The SWG is proposing a framework that provides, on the face of the law, the general principles, leaving the detail to be determined in standards or guidance notes. The law would not specify a minimum or maximum amount of capital required; the amount of capital required would be assessed in the licensing process based on the risks related to the fund/s being operated by the trustee. In practice, capital requirements may be more or less than the currently required $5 million, but either way, they would be much more risk-responsive.

The risk-responsive nature of the capital requirements will also enable not-for-profit funds to demonstrate a range of measures that they have taken to mitigate operational risk, which, if regarded as sufficient by APRA, may mean that they do not have to hold capital at all or only minimal amounts.

This option would also enable APRA to readjust capital if the risks to a fund changed. Ultimately APRA would have the option of revoking the licence if the trustee does not respond to requirements to increase capital holdings.

The SWG also considers that there would be benefits in removing the ability of all trustees to hold capital through either a custodian, or through a guarantee provided by an ADI.

The SWG considers that an appropriate transitional period should apply to enable trustees to make alternative arrangements for the holding of capital. APRA should also be given powers to deal with trustees that are unable to meet these requirements after the end of the transitional period.

Recommendation 16

The SWG recommends that, as a part of the licensing process, APRA should determine the amount of resources, including capital, required to be held by each trustee to address the operational risks relevant to that trustee. The legislation should list the factors APRA is required to take into account in determining an appropriate amount of capital, but should not specify a minimum or maximum amount of capital required for each trustee nor how it should be held. APRA should also provide guidance to industry on the weightings it intends to apply to those factors. The SWG recommends that the revised capital requirements be developed in consultation with relevant stakeholders, and be phased in at the same time as the licensing requirements.

6.2 Investment rules

Proposal

The Government invites comments on the development of a set of prudential standards covering the investment activities of a range of types of superannuation funds. The main aims of these standards could be to ensure:

  • that the investment objectives and strategy of the fund are consistent with the expectations of fund members;
  • that fund investments are sufficiently diversified so excessive risks are not borne by fund members;
  • the appropriate management and oversight of delegated activities; and
  • that the appropriateness of investments, and the risk/return profile of the fund are assessed on a regular basis.

Views from the consultation process

While there was some unqualified support for this proposal and some equally unqualified opposition, most submissions emphasised particular concerns.

Submissions supporting the proposal tended to emphasise the need for appropriate risk management strategies to be followed, and that this is already industry best practice.

Those opposing were generally of the view that it would be inappropriate for APRA to prescribe rules for investment of fund assets, as these are best determined by fund trustees, reflecting the wide diversity in membership profiles in various funds. For example, Jacques Martin Industry Funds Administration Pty Ltd stated that these sorts of issues are 'a "judgment call" for a suitably qualified professional, not the stuff of prescriptive rules.' Many of these submissions expressed strong opposition to an overly prescriptive approach and/or indicated that existing powers under the SIS Act were sufficient (the Australian Institute of Superannuation Trustees, the Australian Venture Capital Association, CPA Australia, the Institute of Actuaries of Australia, the Investment & Financial Services Association, KPMG, PricewaterhouseCoopers). A number suggested that it would be difficult to regulate without being overly prescriptive and that increased disclosure may be a better approach.

While submissions reflected a range of perspectives, other common themes were that:

  • consistency between investment strategy and member expectations is the critical link;
  • sufficient diversification is essential, but difficult to define; and
  • the role of fund trustees, who need to follow appropriate risk management strategies, is critical.

Other specific comments in individual submissions included:

  • support for strengthening the obligations on trustees to diversify investments, including by giving APRA the power to request, then require, a fund to follow an agreed asset diversification schedule on a case-by-case basis and to conduct field surveillance and audits to enforce arm's length rules (ASFA);
  • that consideration should be given to restricting smaller superannuation funds to pooled investments in registered managed investment schemes and pooled superannuation trusts, unless they can demonstrate to APRA the ability to manage an alternative inve
    stment strategy (Westscheme);
  • opposition to prescribed investment rules, as they would lead to more conservative investment strategies, diminishing retirement benefits (the Investment & Financial Services Association);
  • opposition to any extension of the in-house assets 'net' or the abolition of such investments (the Small Independent Superannuation Funds Association); other submissions expressed the opposite view;
  • that high-level limits should be placed on large exposures, related party dealings and excessive concentration of risk (the Trustee Corporations Association of Australia);
  • that risk analysis suggests APRA should focus on smaller corporate funds where diversifiable investment risks are most likely to occur (ASFA);
  • that regulation should be limited to fiduciary and integrity issues (the Australian Venture Capital Association); and
  • that risks could be covered through access to capital, reserves, insurance or a statutory fund and a minimum level and increased frequency of investment reporting to trustee board meetings (NSP Buck).

In addition to particular suggestions, the ASFA submission provided a more comprehensive comparison of regulatory approaches in the OECD which drew on research undertaken by the World Bank (with evidence from the OECD). ASFA indicated that, in general terms, investments tend to be regulated in one of two ways - either through the prudent person rule more prevalent in Anglo-American countries (including Australia), or through particular quantitative limits which are more prevalent in continental European countries. It also noted that as the prudent person approach is less prescriptive, investment returns tended to be higher in those jurisdictions that relied on that approach.

During focus group sessions most participants reiterated views expressed in written submissions that they did not feel that APRA should set prescriptive limits in this area. Discussions revolved around the need to find an independent and appropriate mechanism to certify that the investments chosen by the trustee in respect of a particular fund reflect the 'label' applied to the fund by the trustee. Participants (and particularly representatives of the auditing and actuarial profession) emphasised concerns about any proposal to require those professions to certify that the fund's investment strategy is in compliance with the fund's objectives (or further, that investments comply with the fund's investment strategy and are in compliance with 'superannuation purposes').

Some individuals preferred that APRA aggressively test its investment powers and send signals to the industry, prior to the introduction of new standards in this area.

Discussions highlighted the benefits of engaging professionals in the development of the fund's investment strategy to ensure that the strategy aligns with superannuation purposes. Such professionals would then be in a position to certify that the strategy has been developed in accordance with certain material factors, and that it was disclosed to members. It was felt that certification could be achieved through the annual compliance audit, incorporating audit of the risk management plan, which would highlight strategies used to address key risk areas particularly in relation to investments.

Participants also debated the appropriateness of the current in-house asset rules for funds with employee members. (Further discussion of in-house assets is contained in Chapter 9: Member approval for giving benefits to related parties.)

Consideration of the proposal

The SIS Act trustee covenants (contained in section 52) require superannuation funds to have investment objectives and strategies that align with member needs. In particular, the SIS Act requires that investment strategies take into account portfolio composition, diversification and liquidity. The Issues Paper indicated that this requirement has been difficult to translate into practice, given the subjectivity involved in determining what is a sufficiently diversified and liquid portfolio, and what are appropriate goals or strategies for funds.

Under the SIS Act, the trustees are solely responsible and directly accountable for the prudent management of members' benefits. It is the trustees' duty to make, implement and document decisions about investing fund assets (including formulating and implementing an investment strategy or strategies, codified in the SIS Act as a covenant) and to monitor the performance of those assets.

In the past, APRA has released a circular in relation to investment. However, this circular needs updating and currently lacks legal backing. It could form the basis of a prudential standard in relation to investment (subject to necessary revisions).

Recommendation 17

The SWG recommends that APRA update Superannuation Circular No. II. D.1 - Managing Investments and Investment Choice (April 1999).

The SWG recognises that excessively tight prescription of investment classes allowed in superannuation portfolios, or other requirements designed to alleviate the problem of potential investment losses, could dramatically reduce the returns produced by funds over a long time frame, to the detriment of fund members. Such rules may also be at odds with the prudent person approach reflected in the SIS Act covenants.

The Background Issues Paper identified three options to reform the SIS investment rules:

  • Option 1: Revise the existing operating standards in this area;
  • Option 2: APRA could make a prudential standard relating to investments; or
  • Option 3: Amend the SIS Act to require that funds have a compliance plan to ensure proper consideration of the existing provisions.

The SWG considers that there would be considerable benefits in requiring the trustees to identify in a risk management plan the measures they are adopting to ensure that the fund's investment strategy matches the fund's objectives. Firstly, it would require the trustees to document how they will ensure that the investment strategy matches the fund's objectives. This will provide an important accountability measure. Secondly, the members would be able to access the trustee's reasoning by obtaining a copy of the risk management plan from the trustee. Thirdly, such a document would provide a useful risk management tool.

The SWG also considers that trustees should be required to ensure that the investment strategy of the fund is in compliance with 'superannuation purposes' specified in the sole purpose test contained in section 62 of the SIS Act. The sole purpose test provides that to qualify as a regulated superannuation fund, a fund must be maintained for the sole purpose of providing benefits to members on their retirement or on their reaching the age for payment of preserved benefits, or to a member's dependants or estate on the death of the member before retirement. Payment of other benefits is also approved as 'ancillary purposes' under the sole purpose test, and these include benefits on termination of employment, disablement benefits on termination of service due to ill-health, benefits to a member's dependants or to the member's estate when the member dies after retirement.

Recommendation 18

The SWG recommends that trustees be required to:

  • ensure that the fund's objectives are clearly articulated; and
  • identify in their risk management plan the measures that the trustee is adopting to ensure that the fund's investment strategies match the fund's objectives, and are in compliance with the sole purpose test contained in section 62 of the SIS Act.

The SWG also recommends that trustees be required to certify whether a fund's investment strategy is in compliance with the fund's objectives. This would be subject to the fund's annual compliance audit.

6.3 Outsourcing

Proposal

T
he Government invites comments on whether a prudential standard on outsourcing should be extended to superannuation funds, and whether the forthcoming ADI standard provides an appropriate model.

Views from the consultation process

While the submissions indicated broad support for the development of standards relating to outsourcing arrangements, there was concern with a number of aspects that could affect the implementation of outsourcing contracts. Several submissions queried whether APRA was adequately resourced to undertake such supervision. Submissions also expressed concerns in relation to:

  • the provision of unspecified powers to APRA (the Industry Funds Forum);
  • the requirement to give APRA prior notification before being able to make an appointment or enter into contractual obligations, particularly where timing may be critical (ASFA, the Corporate Superannuation Association); and
  • applying outsourcing standards for ADIs to superannuation funds, noting the differences between the two types of entities (the Australian Bankers' Association).

The focus group sessions discussed a number of technical matters. Participants suggested that APRA should be required to notify a trustee that APRA is taking action against an outsourced party. Participants also recognised that where a small number of organisations provide services to superannuation trustees, APRA would need to consider communicating with all of the relevant trustees about any issues it may have with a particular service provider. It was noted that the trustee remains liable for the acts of its delegate. A participant also indicated that many outsourcing contracts were drafted prior to the commencement of the GST, and that any change to the contract would trigger liability for GST.

Consideration of the proposal

APRA has identified a number of concerns in relation to outsourcing activities, including:

  • failure to put in place formal legal agreements for outsourcing arrangements;
  • failure to execute an arrangement where a contract does exist;
  • lack of coverage within agreements with respect to key risks or issues that should be considered as part of an outsourcing arrangement;
  • failure to adequately specify recourse to service providers in the event of failure to fulfil obligations; and
  • inadequate on-going risk monitoring control processes.

The Issues Paper proposed the development of standards for superannuation entities when entering into contracts with third parties for the provision of services, with implementation either through amendments to the SIS Act, a new operating standard or a new prudential standard.

Currently, the SIS Act only regulates custodians and investment managers to a limited extent. The operating standards power that exists in the SIS Act does not extend to making standards binding on third parties. This limits the extent to which operating standards may regulate the outsourcing of superannuation entities' functions to others. The same problem may arise in relation to a power to make prudential standards unless the relevant provisions made it clear that they could bind third parties. However, there may be a limit to the Commonwealth's constitutional power to bind third parties.

APRA does not have any formal powers in respect of service providers. Typically in other prudentially regulated regimes, APRA has required the regulated entity to include in the outsourcing contract any requirements for APRA to have access to the service provider. For example, under the new general insurance prudential standard on risk management, insurers are required to ensure that records held by a service provider are readily available at all times to the insurer and, where APRA considers it necessary, to APRA.12 The insurer would have to ensure this is included in its contract with the service provider.

The SWG considers that universal licensing of all superannuation trustees would assist in the management of risks associated with outsourced entities. A condition could be placed on the trustee to require that they have adequate systems in place to supervise functions which have been outsourced to third parties. In addition, as with the approach taken in the insurance regime, APRA could require the trustee, as a condition of its licence, to insert a term into a contract with a service provider, that provides APRA with a right of access to the third party (this would also ensure existence of formal legal arrangements).

Both conditions would sit well within the current superannuation framework, by ensuring that the trustee retains responsibility for its own activities and those that it outsources. It would also place the responsibility on the trustee to negotiate its own contract, and would not require APRA to participate in these commercial dealings, which would require significant resources on APRA's part. A licence condition would provide sufficient flexibility to enable APRA to remove a trustee's licence if the trustee does not have appropriate arrangements in place to deal with service providers.

It was suggested during the consultation process that APRA could 'pre-vet' all service providers, rather than consider the relationship between the trustee and third parties on an individual basis. While the SWG understands that the various service provider markets are relatively concentrated, requiring APRA to pre-vet such organisations outside of the context of their relationship with specific funds would establish, in effect, a new regime of supervision, requiring additional supervisory resources. It would also require legislative amendments, given that APRA does not currently have the supervisory powers required to undertake this role. Applying conditions on the trustee's licence would appear to be a more effective use of APRA's time and resources, and would avoid restrictions related to the Commonwealth's constitutional supervisory reach by ensuring that the responsibilities continue to rest with the trustee.

Given the concentration within these sectors, it is likely that such contract terms would become the norm over time.

Requiring a trustee to prepare a risk management plan would also ensure that the trustee identifies and assesses all relevant risks, including in relation to outsourcing of services to third parties.

Recommendation 19

The SWG recommends that, as a condition of the APRA licence, trustees be required to include a term in any contracts with third party service providers that provides APRA with a right of access to the service provider in the event that APRA has concerns about the impact of the activities of the service provider on the APRA-regulated entity. The SWG also considers that APRA should be required to notify other trustees using the same service provider of any concerns APRA may have in relation to the service provider.

6.4 Governance and operational risks

Proposal

The Government welcomes comments on a reassessment of existing governance requirements on superannuation trustees and funds.

Views from the consultation process

The majority of submissions supported some formal policy or development of best practice guidelines to mitigate governance and operational risk. While not supportive of the implementation of a prudential standard that would cover governance and operational risk, most submissions were supportive of the refinement of existing requirements already in place. However, this support was qualified by the view that any new standards imposed should not be overly onerous or costly to implement or monitor.

In addition, many submissions linked the development of a more formal policy on governance and operational risk to the use of compliance plans, through which funds would be required to demonstrate how they plan to mitigate such risks as part of an audited compliance plan.

The
few submissions that did not support the proposal either thought that the current arrangements were adequate and that increased monitoring by APRA would solve the problems, or that changes would unnecessarily increase an already high level of complexity. The Corporate Superannuation Association noted the importance of ensuring that trustees are well-trained and suggested that no change in regulatory approach was required.

In light of the discussions concerning risk management/compliance plans, the focus group meetings did not consider this proposal in detail.

Consideration of the proposal

Good governance promotes transparency, accountability, independence and responsibility. Ultimately these factors should promote the safety of members' funds and result in better disclosure of information to fund members. Effective risk identification and management forms a key component of sound governance. A fund's governance may be compromised without a framework for management of risks faced by it.

Operational risk is arguably the largest risk faced by superannuation funds given that investment and market risk are usually borne by fund members in accumulation funds and employers in defined benefit schemes. Operational risk is the risk resulting from a breakdown of processes, people, systems, internal controls or corporate governance, or from external events.

Components of operational risk are covered in various provisions of the SIS legislation. However, there is no all-encompassing standard that requires a superannuation fund to fully identify, assess, and manage all of the operational risks that the fund faces. While the SIS legislation does contain some requirements with respect to risk management, these tend to be widely dispersed throughout the legislation, often with little logical connection. Similarly, the requirements relating to governance are spread throughout the SIS framework.

The Issues Paper proposed either:

  • the introduction of a prudential standard to cover governance and risk management, and removal of the corresponding sections from the SIS regulations; or
  • combining existing provisions contained within the SIS regulations, and placing the governance and risk management-related items into one operating standard within the regulations, rather than having multiple provisions covering various topics as is currently the case.

The SWG considers that a licence condition should require all trustees to have appropriate risk management systems. This would ensure that a particular standard is applied to all trustees. In addition, the SWG considers trustees should also be required to address in their risk management plan how they intend to comply with various provisions relating to governance and operational risk

Recommendation 20

The SWG recommends that, as a component of the licensing framework, trustees be required to demonstrate in their risk management plan how they propose to deal with governance and risk management requirements.

10 Productivity Commission 2001, Draft Recommendation 4.1.

11 Productivity Commission 2001, Draft Recommendation 4.2.

12 Australian Prudential Regulation Authority 2002, Guidance Note GGN 220.5 Operational Risks, Sydney, July.