Productivity Commission urges super overhaul

The Productivity Commission’s final report on Superannuation: Assessing Efficiency and Competitiveness was released publicly on 10 January 2019. Here Sally Linwood, Senior Policy Adviser from the AICD Advocacy team outlines the most significant recommendations, which include more rigorous management of conflicts of interest; and reducing impediments to fund mergers.

The report represents the culmination of an important inquiry into a vitally important sector for Australians and the Australian economy.

The scope of the inquiry required the Productivity Commission to assess the efficiency and competitiveness of Australia’s superannuation system, and to make recommendations to improve outcomes for members and system stability. The AICD made a submission to the Commission on its draft report (accessible here) which focused on the governance themes from the draft report (as opposed to broader questions around the overall structure of the superannuation sector).

The final report acknowledges that high quality governance is integral to a super system where members rely on others to make decisions on their behalf (especially in an environment of compulsory savings and muted competition).

So what does all this mean for directors? The key governance-focused recommendations (set out in detail below) are directed at strengthening the focus on director skills and experience; ensuring a clearer and shared understanding of ‘members’ best interests’; more rigorous management of conflicts of interest; and reducing impediments to fund mergers. Trustee directors should consider these recommendations and their application in the context of their particular funds.

While the Commission’s report is not binding – both sides of politics and APRA will consider the recommendations and formulate their own positions and policies – trustee boards do not need to (and should not) delay reviewing their own practices against the recommendations and considering where and how their current processes and policies can be strengthened.

In addition to the governance-focused recommendations, some of the most significant recommendations (which will have material impacts on the sector) are outlined at the end of this article.

Key governance observations and recommendations

In the report, the Productivity Commission observes that current governance practices in the sector lag contemporary best practice, and that some trustee boards are either not complying with all of their regulatory obligations, or are complying in a ‘tick and flick’ sense without striving to protect and promote members’ best interests.

It also addresses the evidence presented during the hearings of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services (Royal Commission). In particular, it acknowledges that the Royal Commission has revealed evidence of conflicts of interest resulting in member harm, including instances where trustees in vertically integrated retail groups have preferred the financial interests of related-party shareholders over those of their members.

While it asserts that vertical integration is not a problem per se, and indeed can deliver benefits when competition and regulators are both fully effective, it suggests that neither are in the current super system.

It also rightly emphasises that members’ outcomes – rather than process or intent – must be the key focus of governance arrangements and trustee endeavour.

Regulation of trustee board directors

The report directly addresses the regulation of trustee board directors, recommending that APRA should amend the relevant prudential standard to be prescriptive in:

• requiring trustees of all superannuation funds to have and use a process to effectively assess their board’s performance relative to its objectives and the performance of individual directors, and to disclose this process annually;
• requiring all trustee boards to maintain a skills matrix and annually publish a summary of it, along with the collective skills of directors;
• requiring trusts to have and disclose a process to seek external third-party evaluation of the performance of the board (including its committees and individual directors) and capability at least every three years. The evaluation should consider whether the matrix sufficiently captures the skills that the board needs (and will need in the future) to meet its objectives, and highlight any capability gaps;
• requiring all trustee board directors to have a professional understanding of the superannuation system and investment decision-making, gained either through industry experience or formal training; and
• defining what constitutes an ‘independent director’, based on the definition currently in the Superannuation Laws Amendments (Strengthening Trustee Arrangements) Bill 2017. The Government should ensure there is no legislative impediment to superannuation funds appointing independent directors to boards (with or without explicit approval from APRA).

In relation to the requirement to have and disclose a board skills matrix, the final report refers to AICD’s argument that it would be preferable to implement this measure through standards rather than legislation – standards have the force of law but are more readily amended; APRA processes for the review of standards enables greater industry participation; and consolidation of all governance-related requirements in the same place would avoid the fragmentation and potential confusion inherent in multiple instruments.

The final report notes that a focus on skills would likely lead to more independent directors as boards recruit from a wider ‘gene pool’, but acknowledges that the debate over independent directors in the superannuation context is polarising, and that arguing about the number of independent directors on a board loses sight of what matters: getting the right mix of knowledge, skills and experience, and managing conflicts of interest.

The AICD agrees with this point. We have previously supported independent directors on trustee boards but have emphasised (as quoted in the final report) that independence, on its own, is not sufficient to support good governance. Rather, the collective qualifications, education, experience and skill-set of a board play a critical role.

Accordingly, during the consultation process, the AICD supported the Commission’s suggestion that a stronger focus on board composition (particularly directors’ mix of skills, knowledge and experience), would support better governance. We have also, however, supported a governance model which enables the board to make a determination as to whether a director is independent, taking into account relevant factors included, for example, in a revised version of the relevant APRA prudential standard (similar to the approach in the ASX Corporate Governance Council’s Principles and Recommendations). We will continue to engage closely on this issue.

The ‘best interests’ duty

The Commission observes that it has become evident that funds do not always act in the best interests of their members, and that it would appear that this reflects not only trustee misconduct but a lack of clarity around what is expected of trustees under the ‘best interests’ duty in legislation.

Accordingly, it recommends that the Government pursue a clearer articulation of what it means for a trustee to act in members’ best interests, noting that the definition should reflect the twin principles that a trustee should act in a manner consistent with what an informed member might reasonably expect, and this must be manifest in member outcomes. In clarifying the definition, the Commission suggests that the Government should decide whether to pursue legislative change, greater regulatory guidance, and/or proactive testing of the law by regulators, and that it should be informed by the outcomes of the Royal Commission.

Further recommendations in relation to conflicts management

The Commission asserts that stronger disclosure is needed to “shine a light” on conflicts of interest.

To this end, it recommends that:

• APRA should require funds to conduct formal due diligence of their outsourcing arrangements at least every three years, with a copy of the assessment to be provided to APRA. Funds should also publicly disclose to current and prospective members the proportion of their costs paid to related-party service providers; and
• APRA should require trustees to include in all material service contracts a clause that obliges the service provider not to do or take any action that adversely affects members’ interests. The report comments that good trustees should already be doing this (along with monitoring contract performance).

Disclosure of merger activity

The Commission argues that evidence of unrealised economies of scale, persistent underperformance and a large number of small funds – all imposing costs on members – raises the question of why more funds have not merged. Self-interest of board members is cited as one impediment to mergers – and it is noted that the Royal Commission has revealed clear evidence that board composition decisions have scuppered some merger discussions.

Accordingly, the Commission recommends that trustees on both sides of a merger attempt should be required to disclose all attempts that reach the memorandum of understanding stage to APRA, as well as the reasons why a merger did not proceed and the assessment of members’ best interests that informed the decision.

During the consultation process, given the ongoing issues identified in relation to underperforming funds, the AICD did not oppose the introduction of such a requirement. We consider that it would be beneficial for such a requirement to be subject to an interim review – after at most two years – to ensure it is operating as intended.

Other key recommendations

Other significant recommendations (all of which would materially impact the sector) include:

• that a ‘best in show’ list of 10 super funds (to be decided by an independent expert panel) be presented to all members new to the workforce or who do not have a superannuation account from which they can choose a product. If implemented, this recommendation would, in effect, remove employer and union influence over default funds;

Next steps

In terms of political reaction, the Government has said it will await the Royal Commission report prior to responding, while the Opposition has welcomed the focus on member benefit and interests in the final report but responded negatively to some of the more contentious recommendations, including the ‘best in show’ concept.

Putting aside the political battles that will need to be fought, it is critical that governance in the sector improves. The AICD will continue to support measures which would strengthen requirements related to governance practices, and encourage trustee boards to proactively consider and address fund governance issues.

We will keep members updated.