SYDNEY - 19 February 2013: Market developments over the past decade have conspired to inspire the closure to new members of almost all defined benefit superannuation schemes (DB schemes).  As a result, it is natural to expect that most of the regulatory attention in the superannuation arena will in the future be directed towards accumulation schemes and (belatedly) self-managed superannuation funds.  That’s where the bulk of the assets and the members will be. 

This trend is problematic from a regulatory perspective for several reasons. 

First, DB schemes may be declining is size relative to other forms of scheme, but they still account for a very large collection of assets.  In its most recent annual statistical survey APRA reports that the assets dedicated to funding defined benefit schemes still amount to some $158bn, more than 60% of which are found in hybrid funds that contain both accumulation and defined benefit divisions.  That’s simply too big to ignore.

Second, the very nature of the defined benefit promise to members encourages a ‘set-and-forget mentality.’  Member engagement in a defined benefit scheme (except perhaps in the period immediately prior to retirement or where the employer enters insolvency) is in most cases very limited indeed.  That is one of the appeals of the defined benefit promise; that members need not worry about the investment planning implicitly required in the accumulation fund environment.  But the flipside is that regulators cannot rely to the same extent on the self-interested monitoring of members as they can in other arenas.

This is of course reinforced by the fact that defined benefit plans are complex, specialised beasts that give rise to quite distinct types of systemic and local risks.  The actuarial and legal skills required to understand them is hard-earned and increasingly rare.  A shrinking market for such specialist skills over the coming decades represents another major operational risk for the system if regulators hope to rely on the vigilance of expert gatekeepers. 

The challenge for regulators is to determine what to do in this situation?

The Wallis Committee, which provided the conceptual framework and policy impetus for the regulatory scheme applied to superannuation, noted that the most intense forms of regulation, and prudential regulation in particular, should be reserved for situations:

‘where promises are judged to be very difficult to honour and assess, and produce highly adverse consequences if breached.’

That description would seem to describe DB superannuation entitlements to a tee.  The basis-mismatch between the financial promise (usually a multiple of final average salary) and the financial and real property assets funding satisfaction of that promise is precisely the kind of promise that is ‘difficult to honour.’  The complexity of many schemes complicates risk assessment without even considering the long term financial viability of the employer-sponsor.  And finally, as the High Court recently observed in a slightly different context:

‘For some people, superannuation is their greatest asset apart from their houses; for others it is even more valuable.  ... Superannuation is not a matter of mere bounty, or potential enjoyment of another’s benefaction. It is something for which, in large measure, employees have exchanged value — their work and their contributions. It is “deferred pay.”’

It is perhaps not surprising then that one of APRA’s first bespoke Prudential Standards for superannuation is Superannuation Prudential Standard 160: Defined Benefit Matters.  SPS 160 is expected to apply from mid-year, when empowering legislation (Superannuation Legislation Amendment (Further Measures) Bill 2012) passes through Parliament.  SPS 160 requires superannuation fund trustees responsible for defined benefit schemes to set a shortfall limit, to ensure regular actuarial investigations of both the scheme and any self-insurance conducted within the scheme, and to formulate and give effect to a restoration plan if an actuarial investigation concludes that the scheme or self-insurance within that scheme is an unsatisfactory financial position.

Each of these very clearly is directed towards ensuring that trustees responsible for the administration of defined schemes are capable of meeting the financial promises they make.  Perhaps the only surprise is that APRA has not had the power to do this in the past.  It seems inherent in the very essence of prudential regulation.

It has recently emerged that APRA is not the only regulator interested in defined benefit funds.  For some reason ASIC, too, is keen to get in on the act.  It recently reviewed the disclosure practices of the approximately 470 DB plans and sub-plans still being administered in Australia.  ASIC Commissioner Greg Tanzer summarised ASIC’s conclusion in a release dated 21 January 2013:

‘Many investors in defined benefit funds may not be aware that their ultimate benefit is affected by the capacity of their fund to meet the defined benefit. ASIC therefore encourages trustees to be vigilant about the financial position of their fund and to actively consider making disclosures to help members better understand the financial position of the fund. Trustees are best placed to explain market risk and what happens in the event of a funding shortfall'

ASIC, the release went on to say, ‘was pleased to note that more than 70% of trustees of funds with a funding shortfall disclosed the shortfall to members in the trustee’s annual report.’  Setting aside the question of what a regulator tasked with overseeing disclosure should think about the 30% who did not disclose, the report raises a somewhat troubling conundrum.

The conundrum is this: what does ASIC expect that ‘investors’ (sic) in defined benefit schemes would do with the information?

In a typical investment context the recipient of publicly disclosed information can choose a course of action inspired by that information.  Put crudely, they can buy, sell, hold what they have, or, in some circumstances, vote; whatever they consider to be in their best interests (or the interests of those for whom they act). 

Those alternatives are not always available to members of a defined benefit scheme.  They cannot necessarily switch funds to another fund (at least not without potential prejudice from the vesting schedule).  They cannot usually buy more, nor can they typically vote on anything consequential. 

So disclosure may ‘disinfect’ (to employ Brandeis’ famous metaphor) in the sense that it might encourage greater diligence and attention to the needs of members on the part of the trustee.  But disclosure cannot empower the current members of a defined benefit scheme to provide the market discipline on which disclosure regimes in the financial and corporate sectors usually rely.  More direct, invasive regulation is required.

And therein lies the rub.  Defined benefit schemes are inherently different from accumulation schemes.  The financial risk lies in the first instance with the employer-sponsor and only secondarily, should the employer fail, on the employee-member.  The employee-member therefore has a form of credit risk quite different from the risk faced by the member of an accumulation scheme.  It is the employer, not the member, who should be most concerned about the funding state of the scheme.  To suggest otherwise risks a blurring of accountabilities.  It might suggest that members are expected to play some sort of monitoring role.  Such a role would be inconsistent with, and incompatible with, the legal infrastructure on which defined benefit schemes operate, but more importantly, it is inimical to the location of risk and responsibility inherent in defined benefit schemes in the first place.

Defined benefit schemes require a different type of regulation.  They require regulation that is sensitive to the distinctive location and nature of risk involved in their administration, and they require a regulator who understands the difference.  Enrolling members into the regulatory tapestry via disclosure is not the answer.