All superannuation funds strive to operate with operational excellence, yet this can be an elusive state with many barriers to achieving efficiency. Starting with this blog, Rice Warner will develop a specific Insight series where we will explore particular functions with a lens on member outcomes, giving greater transparency to the risks and issues that can be hidden within a fund’s operations.

The first area we explore is unit pricing (or crediting rates). Over the coming months, we’ll be looking to investigate reserving, custody and valuation of assets.

Are you operating with a unit pricing exposure?

Today, the approach to calculating and allocating investment earnings to members varies across funds. Some operate with unit pricing, either daily or some less frequent period (usually weekly), and others are continuing with crediting rate calculations.

Often there is an assumption that unit pricing is better than a crediting rate. The reality is that both can be used to produce equitable member outcomes.  It is also apparent that both methods can be subject to operational practices that leave an exposure for arbitrage. The same applies to the frequency, just because you have a daily unit price or crediting rate does not mean all potential problems are solved.

What do we mean by arbitrage?

Arbitrage is when members can take advantage of the time mismatch between unit pricing (or crediting rates) and underlying valuations by performing an investment switch or other transaction. Members with certain knowledge could potentially benefit and avoid a market fall or gain access to a market rise that has already occurred. When this happens, such transacting members can benefit at the expense of other members in the fund.

What are the challenges to be aware of and how can funds address these?

Funds can, with the application of due consideration, ensure that this opportunity is not created by ensuring that they fully understand the valuation process, knowing what is (and isn’t) part of a particular day’s valuation, and relating that to the timing rules for member switching.

Where funds have not focused on this interrelationship, there have been occasions where a few members have identified arbitrage opportunities, normally at the expense of other members in the fund. Such members have spent time and energy to understand the likely vulnerability and then exploited the weakness. Until the fund changes its practices and rules, the member is enabled to perform the transactions and will typically do so on a regular basis. These gains for specific members are not insignificant and Trustees should be eliminating such unfair opportunities.

More challenging to resolve are the under or over payments made to members on rollovers in and out. These can be further exacerbated by the timing constraints under the SuperStream rules. While there may well still be an issue in respect of the transaction, the member has less direct control over the specific timing and it is more challenging, although not impossible, to repeatedly undertake such activities.

The calculation of the provision for tax can also be an area fraught with difficulty as a result of tension between any method of estimation (and a number of different bases are used) and the true up of this with actual tax payments. How often should this be done and how should it be incorporated into the unit price are issues that need to be addressed in a fund’s unit pricing policy. The APRA guide to unit pricing identifies this as a relatively high risk area of unit pricing. Further issues may be introduced if the fund has an extensive investment choice menu with single asset class options, where detailed valuations are performed on an infrequent basis (real assets that are both directly and indirectly held typically fall into this category). This can give rise to fairly confident predictions of price movements that are not yet fully effective in the valuation (both positive and negative).

Key participants

Typically, custodians work with a range of member administration operations to support funds with a variety of unit pricing practices. In determining the specific unit pricing practices to adopt and how to apply these, funds will need to ensure they have a thorough understanding of the underlying activities undertaken by each service provider and the interaction between them. Individually, service providers will often be unaware of any issue as they are only focused on their obligations. The Trustee should understand how decisions in relation to unit pricing practices can impact a fund – and its members – and the roles and responsibilities of all stakeholders.  Members’ best interest obligations should dictate that any arbitrage opportunities are closed or at least minimised to the extent possible.

Funds may reduce the attractiveness of regular switching through the application of a buy/ sell spread on the unit price (also known as a transaction cost allowance), however care must be taken to ensure that where such a fee is imposed, it is fully supportable and not more than the cost incurred. Regulators only expect the application of a spread where there is a clear record of the costs being incurred as a direct result of the member activity and if the cost is not covered by the administration and/ or investment fee.

A scan of available data indicates that several funds appear to be operating with some vulnerability. Good practice would encourage all funds to undertake a detailed review to understand any significant or residual risks that may persist in their own unique operation. Even if the review endorses the Trustee’s existing robust processes, there is still value in this confirmation from a good governance perspective.