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Promoting confidence in the industry

Friday 11 November 2011

Ross Jones, Deputy Chairman - ASFA 2011 National Conference, Brisbane

The global financial crisis had a significant and immediate impact on pension funds in many countries. Defined benefits schemes which in some countries had not recovered from the collapse of the dot com boom in the early part of the decade fell further into negative positions. Defined contributions funds, especially in those countries that invested heavily in equities, suffered a series of negative returns.

Three years ago when this happened, the response of governments, funds and regulators worldwide was that this is a temporary circumstance and the prevailing message was ‘Remember, pensions are a long term proposition’. However, at the end of 2011 volatility in markets continues and in many countries, pension balances have not returned to pre-crisis levels. In some defined benefits regimes such as the Netherlands, government unions and employers have attempted to renegotiate the pension promise. In many defined contributions markets, especially those that had been established this century (for example some countries in Eastern Europe, Latin America and Africa) member disillusionment with the pension promises made are generating a backlash that is leading to new policy approaches. Even in countries such as Australia, with long established defined contributions funds, member commitment and confidence has been impacted by poor returns.

In many countries throughout the world there is a recognition that the retirement income models of the past decade have lost some degree of public support. In extreme cases, for example Argentina, the private pensions industry has effectively been nationalised.

In a number of countries in Eastern Europe, popular support for defined contributions models has declined and governments have decreased their commitments to such systems. International bodies such as the OECD Working Party on Private Pensions and the International Organisation of Pension Supervisors have been undertaking research designed to improve the effectiveness of defined contributions models and considering ways to regain fund member support and reconnect members to a viable and sustainable defined contributions model.

In Australia defined contributions fund members are suffering from continued volatile investment performance. They see their balances not increasing or at best they see a small positive return over the medium term. They read of fraud in the system and they belatedly find out that terms such as ‘balanced’ may not mean what they thought.

Yet despite this, the Australian private pensions industry is still highly regarded globally. I know that there has been a presentation at this conference regarding Australia’s international standing. The Melbourne Mercer Global Pension Index recently ranked Australia second overall in a list of 16 countries. We were ranked third in terms of the integrity of the system (a mix of regulation, governance, protection, communications and cost). Work by Allianz also rank Australia highly in terms of its retirement income system. And with funds under management of around A$1.4 trillion, equal to more than 100% of Australia’s GDP, the Australian industry is among the largest in the world.

However it is still important to recognise that in times of uncertainty, funds and regulators need to do more to maintain and rebuild confidence in the system. While this is especially true in countries where arrangements are purely voluntary, even systems such as Australia’s with both compulsory and voluntary elements, are not immune. In fact, it might be possible to argue that in a system of mandatory retirement savings where members have no choice not to be part of the system, the funds and regulators have an even greater obligation to ensure that confidence in the system is maintained.

Rebuilding confidence and connecting more effectively with members has become a major issue worldwide. Particular attention is being paid to both reducing risks to members of defined contributions schemes and more effectively communicating the nature of risks in the system, and building a more effective regulatory infrastructure that reflects the importance of the retirement savings industry.

Numerous countries worldwide have increased their communications with members over the past few years. Some of these have actually involved ‘public service’ advertising on TV emphasising the long term nature of pension savings (e.g. Chile, Turkey, Israel). In some countries, greater attention is being given to the ways to explain the nature of risk to fund members. Chile has recently re-named its pensions fund options in an attempt to more accurately identify risk. In Australia the work of ASFA and the FSC to more effectively define risk has led to the Standard Risk Measure Guidance Paper for Trustees, a good start to developing consistent methodology for the disclose of investment risk.

At a global level, financial education has had renewed focus. The G20 Financial Inclusion Experts Group has emphasised the relevance of financial education as part of a wider attempt to mitigate future financial crises.

However the complexities of investing for retirement will not be solved by financial education alone. Recognition of this is leading to attempts to improve the design of DC systems and the regulatory structure surrounding them in an attempt to decrease the risks to individual fund members. One important way of improving member protection in DC schemes is through the careful design of default investments and payout mechanisms. The introduction of life cycle investing in default funds and a range of guarantee options are attracting considerable attention. Work is also being undertaken on better design of annuity products to overcome consumer resistance to such products in some countries.

There have also been moves in many countries to improve the governance and risk management of pension funds. There is no doubt that in some countries funds have been exposed to investments whose risk profiles they did not fully understand.

The Stronger Super reforms announced by the government earlier this year are consistent with the general global objective to improve the effectiveness of the private pensions system. From a regulatory perspective, one of the most significant developments has been the proposal to introduce prudential standards for Australia’s superannuation industry.

For many years APRA has set prudential standards for authorised deposit takers (since 2000), general insurers (since 2002) and life insurers (since 2006). Currently APRA has more powers to regulate a small regional credit union than we do to regulate a multi billion dollar superannuation fund. And I would also reinforce the point that superannuation saving is compulsory. Prudential standards will give the industry the same form of regulatory oversight as the other prudentially regulated industries.

Fortunately this long overdue reform is not in response to a crisis or failure in the superannuation industry. While in the past 12 months the unfortunate circumstances of the Trio fraud has played out, the proposed reforms are not a response to a major catastrophe as were the prudential standards making powers for general insurance after the collapse of HIH.

APRA plans to focus prudential standards on the key obligations of RSE licensees to act in the interests of beneficiaries and other stakeholders. The standards seek to enhance the present requirements and responsibilities for superannuation trustees.

Prudential standards will allow a more flexible regulatory framework that can evolve and be tailored whilst still being harmonised with other APRA-regulated industries. Principles-based prudential standards allow for appropriate flexibility, avoiding a ‘one-size-fits all’ approach to regulation. APRA’s emphasis is on sound prudential outcomes, without specifying or prescribing the exact manner in which those outcomes are to be achieved. APRA proposes to harmonise the requirements for superannuation as much as possible with consolidated standards. However, full harmonisation may not be possible in areas where the trust structure in superannuation creates a different relationship between the regulated entity and beneficiary than the insurer/policy-holder or ADI/depositor relationship other APRA-regulated industries. In addition to these harmonised prudential standards, there will be several technical standards will cover risks that are specific to the industry such as investment governance, defined benefit funding and solvency and conflicts of interest.

Let me now talk about a few specific issues.

1. Operational Risk Financial Requirement

The ORFR seeks to improve the safety and fairness of the superannuation system by introducing a risk-based financial requirement for operational risk. The ORFR would ensure that RSE licensees set aside resources to absorb losses that are incurred as a result of an operational risk being realised. The Government’s position is that spreading the remediation costs across generations of members will make the superannuation system fairer for all members. These financial resources would then enable the RSE licensee (and RSEs under its trusteeship) to continue to operate in a sound and viable manner while the problems are being addressed and resolved. The requirement is to apply to all RSE licensees.

APRA considers that a specific fund reserve, trustee capital or a combination of both would be appropriate to fulfil an operational risk financial requirement as each represents a readily accessible source of funds that an RSE licensee could call on to quickly make good an operational loss. APRA will not mandate the level of operational risk reserve, but will be issuing guidance that 25 basis points of funds under management is an appropriate level based on the operational risk capital requirements for funds management business in life insurers.

2. The Governance Standards

The governance standards (Governance, Investment Governance, Conflicts Management, Fit and Proper) will collectively focus on the processes and policies that RSE licensees should have in place as robust governance arrangements. Some of these include board renewal and performance assessment, Board committees, conflicts management, fitness and propriety of responsible persons, and investment monitoring.

Broadly - the mandatory character of superannuation demands a robust governance framework. To date, PPG guidance without the force of prudential standards, and other forms of guidance, have not provided the framework to do so. Although trustee law and s. 52 in the SIS Act clearly state that trustees must act in the best interest of beneficiaries, it has always been difficult to determine what this means in practice. The conflicts of interest prudential standard will introduce procedural requirements that trustees must meet to identify, manage and disclose conflicts. Also, heightened obligations will encourage transparency, ensure that duties are discharged effectively and focus greater attention on related areas of concern such as remuneration and investments.

3. Risk Management

APRA’s proposals for risk management shift the emphasis from documenting risk management strategies and plans to implementation of a holistic risk management framework. The framework will include comprehensive documents but would also require RSE licensees to articulate their risk appetite, align business planning with risk management and maintain a dedicated risk management function.

Effective risk management is a cornerstone of APRA’s prudential requirements across all APRA-regulated industries. Also, superannuation is a highly outsourced industry. The standards will assist RSE licensees in achieving better identification, management and monitoring of their risks.

The consultation period is open until Christmas but I can briefly comment on feedback received so far.

  • We have had some feedback that particular sectors of the industry may perceive that they will be more impacted than others by the reforms. This is not the intention of the prudential standards – APRA is not favouring one business model over another.
  • For example, on the issue of scale efficiencies. APRA does not have a magic number in mind for the optimal size of a superannuation fund. Trustees may achieve scale efficiencies by having a large fund, or may access scale efficiencies by investing in pooled investments and using large service providers with scale. The important requirement is that trustees assess for themselves whether their MySuper products have sufficient scale efficiencies to be in the best financial interests of beneficiaries.
  • Industry have raised concerns that it is difficult to know who are the default members in a fund.
    The government’s position, and APRA’s requirement in the Transition to MySuper prudential standard, will require default accumulated balances to be moved to a MySuper Account. A default member is one from whom the trustee has not received any direction in regards to investment option.
    Given the different administration systems in funds, some trustees may know whether each individual account is a default member balance or not, whereas some trustees may only know which investment options are default options, not whether the individual accounts within those options were member-directed. It will be a trustee decision based on their administrative capacity whether they can target individual accounts or must treat all accounts within an option as the same. The transition to MySuper prudential standard will require communication with members about the plan to move their accrued balances to MySuper – this will include an opt-out option for members. The Cooper recommendations, and the Stronger Super approach relies on engaged members actually making decisions – so engaged members, faced with a letter that gives them an opt-out, will hopefully exercise the correct choice for them.

4. MySuper authorisation process

Over the next few years there will be a very busy time for trustees to deal with all of the changes. Early and frequent discussion with your APRA supervisor will be crucial to a smooth transition to the new requirements.

APRA is developing a process for MySuper authorisation and expects to issue a draft application form in the middle of 2012. Our estimate is that most trustees will be applying for MySuper authorisation for most funds – this suggests there may be between 300 and 400 ‘generic’ MySuper authorisation applications. In addition, the large employer exemption which allows a tailored MySuper product for employer sub-plans with more than 500 employees will result in many more applications. Our internal estimate is that this will be around 1000 additional MySuper products, but I know that Pauline has suggested that there could ba as many as 25,000. We hope not!

APRA expects the authorisation process to be in place to accept applications at the beginning of 2013.

APRA expects MySuper authorisation to be a time consuming process for both APRA and industry and we are endeavouring to develop a process that works well from both perspectives. We have many lessons learned from RSE licensing in 2006, in particular that draft applications can help to smooth the process considerably as the quality of the application received for formal assessment is much higher. We would encourage trustees to talk to their APRA supervisor about a draft MySuper application as soon as possible.

APRA expects that draft prudential standards will be released for consultation in early 2012. Subject to the passage of legislative amendments proposed by the Government, final prudential standards are expected to be released later in 2012 prior to the commencement of MySuper authorisation.

In addition to developing prudential standards and the associated guidance, APRA will also be implementing other elements of the Stronger Super reforms. In particular, APRA is developing a revised data collection for the superannuation industry to update our current collection and expand the collection to include items coming out of Stronger Super, such as data on MySuper products. APRA expects to release draft reporting standards for consultation in mid 2012.

This is an important set of reforms for the industry, and will improve confidence and integrity in the superannuation industry. We have a lot to do over the next few years, but the benefits to beneficiaries are important to achieve.

Finally, I would also like to talk about the relationship between APRA and the industry going forward. Prudential regulation works best in a cooperative environment. Industry needs to trust the regulator and the regulator needs to trust the industry. Generally the relationship between APRA and the supervised industries is a good one.

Earlier this year APRA commissioned a study of its stakeholders (essentially regulated entities and knowledgeable observers). Some of you here today may have taken part in the survey. The results indicated that regulated entities generally agreed with the approach taken by APRA to supervision.

APRA is aware that its regulatory processes do impose costs on industry. This awareness will likely be particularly important next year when extensive consultation will occur regarding APRA’s new statistical collection for the superannuation industry. As many of you would recall, APRA began this process in early 2009, only to put the consultation on hold so as not to interfere with the review into governance, efficiency, structure and operations of Australia’s superannuation system (Cooper Review). However, now that the government has announced its Stronger Super package, APRA will re-commence discussion with industry in 2012 regarding an enhanced statistical collection for superannuation. This collection will likely include more detailed information on investment returns and costs and charges. While there may be some additional costs for some funds I would expect that most APRA regulated entities would already collect the information APRA will be seeking, although perhaps there may be issues regarding the format of such statistical collections. There may also be expectations from other interested parties in APRA collecting a range of superannuation statistics that go beyond those required for prudential purposes.

Finally, I think we will find that over the next few years there will be increased interaction between the regulator and the industry. As the quantum of retirement savings continues to grow and its importance to Australia’s wealth increases, a sound and effective regulatory environment will enhance public confidence in the superannuation industry. I hope that the industry and APRA will continue to work cooperatively to achieve a sound regulatory environment which will enhance safety and security and consequent public confidence in the industry.

The Australian Prudential Regulation Authority (APRA) is the prudential regulator of the financial services industry. It oversees banks, credit unions, building societies, general insurance and reinsurance companies, life insurance, private health insurers, friendly societies, and most members of the superannuation industry. APRA currently supervises institutions holding $6 trillion in assets for Australian depositors, policyholders and superannuation fund members.