Trustees who use the same default investment strategy for post-retirement as for pre-retirement accumulation products could be sitting on a ticking time bomb.
The "sole purpose test" in the Superannuation Industry (Supervision) Act (SIS Act) requires superannuation trustees to maintain their fund solely to provide retirement and death benefits (and some ancillary benefits) to members.
However, while most trustees have good processes for investing members' benefits during the pre-retirement (accumulation) phase, they have paid less attention to the post-retirement phase.
One concern is that most trustees use the same default investment strategy for post-retirement as for accumulation products. Rice Warner has found that most trustees have not even considered designing an appropriate default fund for retirees.
This could be a ticking time bomb for trustees.
The importance of default options
Default options are very important for retirees:
- default options are overwhelmingly the most common investment strategy used, for many reasons including difficulties in engaging and educating members about superannuation and general decision-making inertia;
- members often see default options as a trustee "endorsement". This particularly affects older retirees when the quality of their decision-making decreases; and
- trustees are seen as best-placed to ensure optimal retirement outcomes because they understand the risk profile of the overall fund membership and of specific membership sub-groups. This was recognised by the Cooper Review.
Can't you simply use the same default option for pre- and post-retirement products?
Using the same default option for both pre- and post-retirement products may not be optimal for retirees. Retirees face issues that either those still working do not, or that impact more heavily on retirees. For example:
- Longevity risk — the risk that a person outlives their savings or must draw lower pension payments and become frugal;
- Inflation risk — inflation dilutes fixed incomes in real terms;
- Capital losses and volatile investments —many retirees are risk averse and want "peace of mind";
- Liquidity risk/uncertain expenses —it is virtually impossible to predict individual health expenses;
- Bequest motives — many retirees wish to leave money to their children or favourite charity;
- Mental faculties — retirees may not be able to manage money adequately in later life; and
- Legislative risk — superannuation, taxation and pension rules are constantly changing.
Further, individual retirees regard each risk differently. Those with retirement balances under $250,000 don't have sufficient assets to fund themselves to their life expectancy, let alone to an advanced age. They must necessarily focus on liquidity risk, not longevity risk. More complex considerations are required for those with balances above $250,000. Those with balances over $750,000 should be able to live off their investment earnings and draw down capital only later in life.
Accordingly, the use of a single default option not only insufficiently handles the particular issues facing retirees, but also implicitly combines highly individual investment needs and aspirations into an "average" strategy.
Trustee duties impacting on investment strategy
Currently, the SIS Act effectively requires a superannuation trustee to implement an investment strategy that considers the whole of the fund's circumstances, including certain prescribed circumstances (Investment Covenant).
The SIS Act and the general law also require a trustee to:
- exercise the same degree of care, skill and diligence as an ordinary prudent person would exercise in dealing with the property of another person for whom they felt morally bound to provide;
- exercise their powers in beneficiaries' best interests; and
- treat different classes of beneficiaries fairly.
Section 55(5) of the SIS Act provides a defence to an action for loss or damage in relation to an investment, if the trustee can show that the investment was made in accordance with an investment strategy formulated under the Investment Covenant.
Under the Stronger Super reforms, trustees will have to:
- exercise the same degree of care, skill and diligence as a prudent superannuation trustee would exercise (which is a higher standard than the ordinary prudent person test described above);
- review and give effect to an investment strategy for each investment option;
- exercise due diligence in developing, offering and reviewing each investment option; and
- ensure investment options are adequately diversified.
In addition, a trustee will have to establish they have complied with all relevant covenants and MySuper obligations (not just the Investment Covenant) to access the section 55(5) defence.
New duties on trustee directors
The Stronger Super reforms will also require trustee directors to:
- exercise the same degree of care, skill and diligence as a prudent superannuation entity director would exercise;
- perform and exercise the director's duties and powers in the best interests of the beneficiaries; and
- exercise a reasonable degree of care and diligence to ensure that the corporate trustee carries out its duties under the SIS Act.
These changes will hold trustee directors to a higher standard than currently.
A person who suffers loss or damage because a director contravened these obligations may bring an action against the director, or any other person involved in the contravention, within six years after the day the cause of action arose. However, under the proposed Stronger Super reforms, a person will need to seek the Court's leave to bring the action. The Court must take into account whether the person bringing the action is acting in good faith and whether there is a serious question to be tried.
The defence under section55(5) (as amended and as discussed above), applies to such an action.
Complying with trustee duties
It is possible that a retired member (or a group of retired members in a class action) could argue that the failure to have a separate post-retirement default strategy constitutes a failure to give effect to an investment strategy that has regard to the whole of the fund's circumstances.
This argument could be successful, given that retirees face different issues to accumulation members. If so, the trustee may not have the defence under section55(5) available to it, on the grounds that it did not consider one of the fund's relevant circumstances.
Once the Stronger Super reforms apply, a member, or group of members, could argue that the trustee had failed to meet its duty to:
- exercise the required degree of care, skill and diligence;
- exercise its powers in the best interests of beneficiaries; and
- treat different classes of members fairly.
If the trustee fails to meet just one of those duties, the defence under section55(5) falls away.
Also, importantly, the individual trustee directors will be subject to their new duties and will be directly and personally liable to fund members that suffered investment loss where the trustee directors breached those duties.
The Directors and the Trustee would need to consider whether a defence under section 323 of the SIS Act was available to them.
The Stronger Super reforms will hold trustees and corporate trustee directors to higher standards. Trustee directors must be on their toes in relation to the post-retirement space to ensure compliance with both current and future duties.
You might also be interested in...
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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this bulletin. Persons listed may not be admitted in all states and territories.