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Now, more than ever, as the superannuation landscape undergoes significant change, understanding the role of reserves is vital to the smooth operation of any fund. In this second part in a series on operational risks (the first was on unit pricing in case you missed it), we are now examining the creation, maintenance and reporting of reserves and their role in the efficient operation of a modern superannuation fund.
There are a variety of uses for fund reserves. They allow funds to meet regulatory obligation such as the Operational Risk Financial Reserve (ORFR), to maintain appropriate equity between member cohorts (e.g. insurance reserve), to invest in new services and improvements (the administration or general operational reserve), to meet unusual expenses (e.g. special regulatory levies) and to support merger activities without the need for additional one-off fee impositions.
A reserve is a pool of money or assets held in a superannuation fund and which is set aside for specific identified purposes, as permitted by the trust deed and best articulated in Board policies. The balance can be created by the reserving of some of the regular member fees or from other distributions such as a premium rebate under a group life policy.
Ensuring your fund has sufficient, and sufficient distinction between, reserves is of growing importance as the regulators place more scrutiny on reserves and demand more transparency in reporting to members.
Managing reserves is therefore an important operational aspect of superannuation fund management. Careful attention is required in relation to the trust deed provisions and Board policies:
As mentioned, reserves have a range of purposes and we should consider each as it applies to an individual fund. It is unlikely that any two funds will have identical approaches across all types of reserves.
This is occasionally still referred to as the operational risk reserve. APRA’s Prudential Practice Guide SPG 114 – Operational Risk Financial Requirement articulates that APRA expects a soundly run RSE licensee that has implemented an effective risk management framework to have an ORFR target amount that is equivalent to at least 0.25 per cent of funds under management (FUM). We note that this is a minimum expectation and as funds take on more and more operational risk, primarily as a result of insourcing functions including investment activities and administration, funds should on a periodic basis assess their own level of operational risk and perform their own assessment as to the required level of the ORFR which may be appropriate and which may be higher than 25 basis points.
Funds need to maintain strong records of actual and near misses in terms of operational losses to ensure they can support the level of reserve. An independent risk group can help ensure that internal incidents are properly identified and assessed. Funds should also pay regard to other funds’ experiences and factor this into the determination of adequacy.
Again, with the assistance of the APRA guidance, there is clarity on which type of incidents can make a call upon this reserve and what the process must be to replenish the reserve. APRA has provided a degree of flexibility around marginal fluctuations in the level of the reserve.
Typically, funds will invest this reserve aligned with the investment profile of the fund. This allows the reserve to fluctuate with the value of the fund and avoid requirements to place additional funds into the reserve simply as a result of market gains in the fund.
The requirements for these reserves are common to all funds. Importantly, funds need to create and maintain an ORFR policy that clearly articulates these matters.
This is the next most common type of reserve within funds. The balance within this reserve is most normally created as result of a surplus of collected member administration fees compared with expenditure. Balances accumulated in this reserve remain member funds but can be applied to support activity and investment designed to support members. This may be an appropriate way to accumulate sufficient resources to invest in new member services – for example, digital services.
These reserves can be used to support merger activity aligned to members best interests and avoid the fund having to impose one-time special fees to support strategic activities, such as a merger or major system investment.
Given the source of these reserves is member fees, care should be taken to accumulate only what is reasonable to support strategic activity and avoid intergenerational issues which can result from too low or too high a reserve. It should be noted that actual member fees charged impact the annual performance test so any margin embedded in these fees to build reserves is an important consideration.
Funds that find they are regularly using the administration reserve to meet business as usual expenditure should be reviewing their expenditure or considering a change to member fees.
For-profit funds do not typically maintain such reserves as they can use shareholder funds to support strategic activities.
Again, funds should have a clear policy covering their administration reserve which outlines what activity it can be used to fund and the process for such use as well as the target level and a notional maximum level.
This reserve has some very clear sources and restricted uses. As funds are no longer permitted to self-insure, this reserve now has a much more restricted function. Its source of funds is restricted to distributions from the insurance policy resulting from premium rebates (or profit shares). Given the source of the reserve there is a restriction on use of any accumulated balance and that must be member insurance related and not used for non-insurance related purposes. An example might be to support premium fluctuations in the future.
Funds without such a rebate arrangement would not be expected to maintain an insurance reserve.
On initial commencement, a number of superannuation funds operated on the basis of applying a year end crediting rate and would maintain an investment reserve with the express purpose of enabling the fund to smooth the annual crediting rate that was applied to the fund’s declared investment earnings. Market practice and regulation essentially have resulted in the elimination of investment reserves for this explicit purpose as it generates intergenerational inequities.
The reserve, if so held, today normally represents the undistributed income in relation to the last few days of market activity before year end and is reflective of the operational process of regular (usually daily) income distribution via unit price or crediting rate and the use of forward valuations.
A review of fund disclosure does reveal a small range of additional reserves; these tend to relate to unallocated member activity of funds and in that sense are not a true reserve but more simply the result of timing differences which will resolve in a relatively short time. Examples might include unprocessed contributions or unpaid insurance premiums.
The recent modification to this section of the Act, which becomes effective on 1 January 2022, results in some historic practices (which witnessed the use of the administration reserves of the fund to meet certain costs) no longer being permitted. The industry is considering a number of options which will permit these costs to be met without breaching the revised provisions of the Act.
In some cases, this requires amendment to the trust deed which has higher complexity due to the inherent self interest in making a change of this nature and is likely to require court approval. It may also require the creation of interposed entities. These actions may also cloud the “profit for member” status of the fund and will require clear and effective member communication. These matters can be further complicated within corporate fund or government fund structures.
We are assisting a number of funds across these challenges bringing our cross-industry experience to facilitate the right solution for them ensuring that member reporting obligations are met and full transparency achieved while still maintaining appropriate reserves to facilitate the strategic goals of the fund.
Steve is a partner in Deloitte’s Sydney office in the Actuarial Consulting practice. Steve has over 25 years’ experience in the financial services industry across all parts of the value chain, bringing a high level of market knowledge together with a deep technical knowledge of the superannuation, insurance and investment industries and participants. Steve’s areas of focus include: Member engagement, including tools and calculators to support our member research. Operations/ operational efficiency, including development of target operating models, support around regulatory developments, benchmarking and tenders of and for third-party service providers, and remediation activities. Product and proposition, including strategy development and M&A support, product development and validation, and market entry strategies.
Graeme Arnott is a Principal in Deloitte’s Sydney office in the Actuarial Consulting practice. Graeme has worked in a variety of roles within the financial services industry with over 25 years’ experience across superannuation, financial advice and custody. With prior C-Suite experience at a major superannuation fund, Graeme is ideally placed to advise on a variety of matters ranging from strategic imperatives, through product and pricing, down to detailed operational issues particularly in superannuation and group life insurance. Particular areas of focus include: investment operations remediation service provider reviews tenders and merger assistance. Graeme has personally overseen a remediation program involving the over and under deduction of insurance premiums which came to light during an administration platform transfer.