Could superannuation cease to be prudentially regulated?

In brief

Written by Senior Regulatory Counsel Michael Mathieson

The Financial System Inquiry (FSI) has asked whether superannuation should cease to be prudentially regulated. Is this idea likely to go anywhere? Don't be so sure that it won't.

What may seem like the natural state of affairs today was, in fact, a very close-run thing in 1997. The Wallis Inquiry gave serious consideration to leaving superannuation outside the prudential regulation perimeter.

Wallis

The Wallis Inquiry's framework for assessing the ideal extent of prudential regulation turned on three risk characteristics of 'financial promises': the inherent difficulty of honouring promises, the difficulty in assessing the creditworthiness of promisors and the adversity caused by breaching promises.

Under this framework, prudential regulation is needed where promises are very difficult to honour and assess and produce highly adverse consequences if breached. This boiled down to the notion of the 'intensity of promise'.

Applying its framework, the Wallis Inquiry concluded that unit trusts and other managed funds should not be prudentially regulated. However, it concluded that superannuation should be treated differently – but it seems that that conclusion was reasonably line-ball.
In forming its view, the Wallis Inquiry pointed to the compulsory nature of superannuation, the lack of choice for a large proportion of members, the mandatory long-term nature of superannuation, the cost of the associated tax concessions and the centrality of superannuation to broader retirement incomes policy.

However, the Wallis Inquiry went on to say that the prudential regulation of superannuation 'is necessarily at the lower end of the scale'. Capital-backed investments and defined benefit funds aside, 'the risk in superannuation investments is largely retained by the investor'. The Inquiry believed that prudential regulation should not be allowed to diminish 'the risk spectrum of available superannuation investments'.

The Wallis Inquiry's ultimate conclusion was that:

• where superannuation involves a 'capital backed' product (retirement savings accounts and longevity-protected pensions backed by annuities spring to mind), it should be prudentially regulated on the same basis as similar products (ie deposits and annuities); and
• in all other cases (including, it seems, the case of defined benefit funds), the focus of regulation should, instead, be on risk management and operational matters.

From Wallis to Murray

The Wallis concept that superannuation should be prudentially regulated, but mostly in a different way to banks and insurers, has been eroded. The Australian Prudential Regulation Authority (APRA) has increasingly treated superannuation funds in the same way as the other prudentially regulated institutions.

Perhaps the most striking example of this lies in APRA's superannuation prudential standards, introduced in 2012-13. While there are some significant differences between the prudential standards applying to superannuation and the common prudential standards applying to banks and insurers, they are very much outweighed by the numerous similarities.

Today

The FSI interim report says that the unique characteristics of superannuation identified by the Wallis Inquiry have largely persisted. Nevertheless, it is asking whether 'there is a strong case for change' – that is, for prudential regulation of superannuation to cease.
Returning to the three risk characteristics of 'financial promises' under Wallis, it is difficult to see any difference between superannuation (on the one hand) and managed investments (on the other), except to the extent that the adversity caused by breaching promises is likely to be greater for retirees than for others.

Turning to the 'unique characteristics of superannuation', superannuation remains compulsory, long-term and central to retirement incomes policy. On the other hand, choice is available (although rarely exercised, unless it is to set up an SMSF) and, if the cost of the superannuation tax concessions was a determinative factor, the SMSF sector should be worried.

As for the Wallis idea that where superannuation involves a 'capital backed' product it should be prudentially regulated in an equivalent way, this seems questionable. If the product is an RSA issued by a bank, or an RSA-like product issued by a life insurer, it will already be regulated as a deposit or life insurance product respectively. If the product is, instead, a longevity-protected pension backed by an annuity, the annuity will already be prudentially regulated and it's not clear why this requires or justifies prudential regulation of the superannuation fund as well.

It may be that:

• the convergence of the regulation of deposits, insurance and superannuation has gone too far in practice for superannuation to be extracted from prudential regulation at this stage, with APRA's ongoing march along the path to conglomerate group prudential regulation illustrating the point; or
• the Inquiry's apparent predisposition towards longevity-protected retirement products would, if ultimately reflected in revised policy settings, weigh (rightly or wrongly) in favour of retaining prudential regulation of superannuation.

But the question asked by Murray is certainly worth asking.

Postscript

APRA's answer to Murray's question is both unsurprising and emphatic. In its second-round submission, APRA says that it 'firmly supports the status quo'.