Prudential Practice Guide SPG 530 – Investment Governance November 2013 www.apra.gov.au Australian Prudential Regulation Authority Disclaimer and copyright This prudential practice guide is not legal advice and users are encouraged to obtain professional advice about the application of any legislation or prudential standard relevant to their particular circumstances and to exercise their own skill and care in relation to any material contained in this guide. APRA disclaims any liability for any loss or damage arising out of any use of this prudential practice guide. © Australian Prudential Regulation Authority (APRA) This work is licensed under the Creative Commons Attribution 3.0 Australia Licence (CCBY 3.0). This licence allows you to copy, distribute and adapt this work, provided you attribute the work and do not suggest that APRA endorses you or your work. To view a full copy of the terms of this licence, visit www.creativecommons.org/licenses/ by/3.0/au/. Australian Prudential Regulation Authority 2 About this guide Prudential practice guides (PPGs) provide guidance on APRA’s view of sound practice in particular areas. PPGs frequently discuss legal requirements from legislation, regulations or APRA’s prudential standards, but do not themselves create enforceable requirements. Prudential Standard SPS 530 Investment Governance (SPS 530) sets out APRA’s requirements in relation to investment governance for an RSE licensee’s business operations. This PPG aims to assist an RSE licensee in complying with those requirements in relation to the formulation and implementation of an investment strategy and, more generally, to outline prudent practices in relation to corresponding investment risk management arrangements. This PPG is intended to be read in conjunction with Prudential Practice Guide SPG 531 Valuation (SPG 531), which aims to assist an RSE licensee in complying with the requirements in SPS 530 relating to valuation of investments. SPG 531 also highlights the potential risks that may arise as a result of undertaking valuations of investments and provides guidance to assist an RSE licensee to implement governance arrangements regarding the valuation of investments. For the purposes of this guide, and consistent with the application of SPS 530, ‘RSE licensee’ and ‘registrable superannuation entity (RSE)’ have the meaning given in the Superannuation Industry (Supervision) Act 1993 (SIS Act). In addition, the SIS Act and the Superannuation Industry (Supervision) Regulations 1994 (SIS Regulations) set out various provisions that define the obligations of an RSE licensee when formulating an investment strategy. Subject to the requirements of SPS 530, an RSE licensee has the flexibility to structure its business operations in the way most suited to achieving its business objectives. Not all practices outlined in this PPG will be relevant for every RSE licensee and some aspects may vary depending upon the size, business mix and complexity of the RSE licensee’s business operations. Australian Prudential Regulation Authority 3 Contents Introduction 5 The investment strategy 5 Investment objectives 6 Portfolio construction 8 Implementing an investment strategy 12 Maintaining an investment strategy 14 Investment risk management 19 Stress testing 22 Liquidity management 24 Australian Prudential Regulation Authority 4 Introduction 6. SPS 530 requires an RSE licensee to take into consideration the whole of the RSE’s 1. SPS 530 requires an RSE licensee to have in place circumstances when formulating an investment a sound investment governance framework for strategy. Factors relevant to an RSE’s the selection, management and monitoring of circumstances include, but are not limited to: investments, including appropriate monitoring and management of investment risk, that is in the best (a) the benefit structure of the RSE (i.e. defined interests of beneficiaries. benefit, accumulation or hybrid); 2. The Board of an RSE licensee (the Board) is (b) whether the RSE is operating predominantly ultimately responsible for the prudent management in the accumulation phase, the withdrawal of the investments of each RSE and the RSE phase or a combination of the two; licensee’s investment governance framework. APRA (c) the membership profile (e.g. projected expects a prudent RSE licensee would have in place, membership growth/decline, members’ or have access to, appropriate skills, expertise and age, occupational profile and reasonable resources, commensurate with the complexity of expectations); the investments in which it is invested. (d) the size, stability and growth rate in terms of 3. For the purposes of this PPG, an ‘investment assets under management of the RSE, and any option’ is an investment that an RSE licensee other factors affecting its financial position; makes available for selection by a beneficiary. An investment option may comprise: (e) the tax position of the RSE; (a) a mix of investments managed by an RSE (f) the broader state of financial markets and licensee packaged as an investment option; or economies; and (b) an investment in a collective managed (g) any relevant findings regarding the investment (externally managed investment circumstances of the RSE in reports obtained option) that has been selected by an RSE from experts or advisers. licensee where, for practical reasons, some 7. In the case of a defined benefit fund or a defined activities may be delegated to the manager benefit sub-fund, APRA envisages that an RSE of the externally managed investment licensee would typically consider, in addition to the option; or circumstances of the RSE, factors including but not (c) a direct investment in one asset, such as an limited to: individual listed security, term deposit or (a) the benefit design, solvency position bond (direct investment). (including the shortfall limit), relationship with the employer sponsor, the probability of The investment strategy continued employer support via a restoration plan or a pre-arranged funding plan and the 4. The SIS Act requires an RSE licensee to formulate general economic climate; and implement an investment strategy for the whole of the RSE, and for each investment option (b) assumptions about contribution levels, salary offered by the RSE licensee.1 growth and investment earnings used in the actuarial projections; and 5. An investment strategy for the whole of the RSE can be broadly described as the RSE licensee’s (c) whether actuarial advice in regard to the plan for determining the collection of investment suitability of the investment strategy is options to offer to beneficiaries. needed outside the statutory triennial review. 1 Refer to s. 52(6)(a) of the SIS Act. Australian Prudential Regulation Authority 5 8. APRA expects the investment strategy for the 13. In APRA’s view, a prudent RSE licensee would whole of the RSE to include the criteria and ensure that it is able to clearly explain to selection process that the RSE licensee applies beneficiaries the basis on which it reasonably to determine whether an investment option is expects the investment strategy to satisfy the considered appropriate to be made available investment objectives. to beneficiaries. 14. APRA expects that an RSE licensee would 9. An RSE licensee would be expected to consider sufficiently understand and articulate the level and the amount of time, resources and expertise sources of expected returns that an investment required to make informed investment decisions strategy is aiming to achieve, and the level and in the best interests of beneficiaries. Where an sources of risk that it intends to accept in order to RSE licensee identifies any weaknesses in its achieve those returns. capabilities in this regard, APRA expects the 15. Where an RSE licensee offers an externally RSE licensee would strengthen its investment managed investment option, the RSE licensee may, governance framework appropriately in those following an appropriate due diligence process, areas. This may be achieved in part by the RSE adopt the existing investment objectives, where licensee obtaining external advice. An RSE licensee available, for that investment option. would be expected to articulate the circumstances for seeking external advice when formulating an 16. Where it is not practical for an RSE licensee investment strategy. Although an RSE licensee to articulate investment objectives for direct may seek external advice, the Board is ultimately investments, APRA expects an RSE licensee would responsible for having an investment governance nevertheless describe risk exposures and other framework as per SPS 530. characteristics of the investment option. 10. SPS 530 requires that all investment-related roles Return objective have documented responsibilities and reporting structures. This includes clearly identifying 17. A return objective assists current and prospective those roles involved in formulating investment beneficiaries of an RSE to understand the strategies and those roles with decision-making expected investment outcomes of an investment responsibility in that process. APRA considers it option. It also provides a point of reference against important that the reporting structures of these which to evaluate investment performance. roles are appropriately reflected in the investment 18. SPS 530 requires that an investment return governance framework. objective be specific and measurable. APRA expects a return objective would be expressed Investment objectives with a defined investment horizon and stated 11. When formulating an investment strategy, SPS as either a return relative to a quantifiable 530 requires an RSE licensee to determine benchmark return or an absolute percentage investment objectives that establish the desired return. For example: investment outcome for an investment option. (a) a return objective expressed as a rate 12. APRA expects investment objectives would be of return matching, or exceeding by x measurable, formally documented and clearly percentage points, a benchmark index over a communicated. A statement of investment period of y years; or objectives would ordinarily include a clear (b) a return objective to provide real long-term expression of a measurable target investment return growth, where measured, over at least y years. and a measurable target level of risk exposure. Australian Prudential Regulation Authority 6 19. In determining the investment horizon and 25. Where an RSE licensee has determined that it is benchmark (where relevant) for the return appropriate for an investment option to be invested objective, APRA expects an RSE licensee would in a single asset class, such as that of a single sector give due consideration to the expected range of investment option, APRA expects that an RSE investment returns and the risk objective(s) of the licensee would ensure an appropriate level of investment option. diversification within that particular asset class. 26. APRA expects that an RSE licensee would consider Risk objective whether investment options that are inherently 20. SPS 530 requires an RSE licensee to consider and undiversified, such as direct investments, could articulate a measurable investment risk objective form the entirety of a beneficiary’s investment when setting an investment strategy for an portfolio, and whether implementing portfolio investment option. A risk objective aims composition parameters to minimise a beneficiary’s to assist current and prospective beneficiaries exposure to such investment options may assist of an RSE to understand the likelihood that the in ensuring that a beneficiary is able to achieve return objective/s of an investment option may adequate diversification. not be achieved. 27. Where an RSE licensee offers a MySuper product, 21. APRA expects the risk objectives would include APRA expects that explicit consideration would reference to the variability of returns over the be given to the diversification and liquidity needs defined investment horizon. For example: of the MySuper product given the product’s (a) to have no more than x negative investment membership profile, and also the absolute and returns over a period of y years; and/or relative size of the product to the RSE. (b) to maintain a tracking error below x Use of derivatives percentage points over a period of y years 28. APRA expects that an RSE licensee’s decision relative to the risk objective benchmark. to use derivatives as part of an investment 22. An RSE licensee may also consider including strategy would be consistent with the investment qualitative statements when developing a risk objectives for that strategy. An RSE licensee would objective to express the level and sources of risk to be expected to have a formal policy in place to which an investment option is likely to be exposed. govern the permitted range and uses of derivative instruments. Diversification 29. An RSE licensee may consider the use of 23. The SIS Act requires an RSE licensee, when derivatives to hedge investment risk in a number formulating an investment strategy, to give of circumstances in order to protect the value regard to the composition of investments within of the portfolio against any adverse changes that investment strategy. An RSE licensee is also (e.g. foreign currency exposures risk, counterparty required to ensure that the investment options risk, interest rate risk, liquidity risk and equity risk). offered to beneficiaries allow for adequate diversification.2 30. When formulating an investment strategy, APRA expects an RSE licensee would clearly 24. APRA expects that a well-diversified investment articulate the purpose for which derivatives will be strategy would be exposed to multiple sources used. An RSE licensee would typically demonstrate of risk and return. This is typically achieved by due consideration of the risks associated with investing across multiple assets and sub-asset the derivative instruments used, and develop classes, counterparties and geographic regions, and appropriate investment risk management taking into account other factors such as liquidity, arrangements to respond to these risks. credit or macroeconomic risks where relevant. 2 Refer to s. 52(6)(a)(ii) and s. 52(6)(c) of the SIS Act. Australian Prudential Regulation Authority 7 Costs and tax considerations and diversification.4 While ESG considerations may not be readily quantifiable in financial terms, 31. When formulating an investment strategy, the SIS APRA expects an RSE licensee would be able to Act requires an RSE licensee to consider the costs demonstrate appropriate analysis to support the and tax consequences that might be incurred by formulation of an investment strategy that has an the RSE and the investment option in relation to ESG focus. the proposed investments.3 36. In offering such investment options, a prudent 32. APRA expects that an RSE licensee would consider, RSE licensee would be mindful of exposing the when the strategy is being formulated: interests of beneficiaries to undue risk stemming (a) the general cost effectiveness and cost from matters such as a lack of diversification, efficiency of implementing an investment where investment in some industries are excluded strategy; and or a positive weighting is placed on certain non- (b) factors related to tax efficiency. financial factors as a result of ESG considerations. 33. Where an RSE licensee offers an externally Portfolio construction managed investment option, APRA expects that consideration of costs and tax consequences 37. Portfolio construction is a crucial step in the would form part of the RSE licensee’s due process of investment strategy formulation diligence process when selecting the underlying in order to achieve the stated investment collective managed investment. objectives. A well-constructed and maintained portfolio allows an RSE licensee to maximise its Environmental, social and governance issues return objective based on a given level of risk as determined by its risk objective. 34. The SIS Act requires an RSE licensee, when formulating an investment strategy, to give 38. Constructing a portfolio generally requires a regard to the risk and the likely return from the systematic approach to determine an appropriate investments, diversification, liquidity, valuation asset allocation across various asset classes. An and other relevant factors. An RSE licensee may RSE licensee may consider portfolio optimisation take additional factors into account where there methods to establish a portfolio that achieves its is no conflict with the requirements in the SIS investment objectives. Act, including the requirement to act in the best interests of the beneficiaries. This may result in Asset allocation an RSE licensee offering an ‘ethical’ investment 39. Where an RSE licensee formulates an investment option to beneficiaries to reflect this approach. strategy for an investment option that involves An ‘ethical’ investment option is typically more than one asset, SPS 530 requires that the characterised by an added focus on environmental, investment strategy determine asset allocation sustainability, social and governance (ESG) targets and ranges appropriate to achieving the considerations, or integrates such considerations investment objectives for the investment option. into the formulation of the investment strategy APRA expects that where an RSE licensee offers and supporting analysis. an externally managed investment option, the 35. APRA expects that an RSE licensee would RSE licensee’s due diligence process would assess have a reasoned basis for determining that the reasonableness of the asset allocation targets the investment strategy formulated for such and ranges of the underlying collective managed an investment option is in the best interests investment in achieving the stated investment of beneficiaries, and that it satisfies the objectives for the option. requirements of s. 52 of the SIS Act for liquidity 40. There are a number of different asset allocation techniques and approaches that may be adopted 3 Refer to s. 52(6)(vi) and (vii) of the SIS Act. 4 Refer to s. 52(6)(a)(iii) and s. 52(6)(c) of the SIS Act. Australian Prudential Regulation Authority 8 by an RSE licensee in formulating an investment 42. APRA considers it prudent for an RSE licensee, in strategy and an RSE licensee may use one or a determining a list of permissible investment types, combination of approaches. Asset allocation to consider: techniques and approaches include the following: (a) the nature and characteristics of the types of (a) strategic asset allocation: this is where the asset, including their consistency with the risk long-term asset allocation target and ranges and return objectives for the strategy; have been determined, within which the RSE (b) whether the range of assets facilitates the operates to achieve its investment objectives. construction of an investment strategy to The strategic asset allocation target and achieve the investment objectives; and ranges remain static; i.e. asset allocations are not expected to change frequently; (c) any potential changes in the circumstances of the RSE that may render certain types of (b) dynamic asset allocation: this is an assets inappropriate. investment approach that permits asset allocation targets to be changed during the 43. Where an RSE licensee adopts a strategic asset investment period. This would typically be allocation approach, APRA expects asset allocation in response to changes in specific market ranges would be set at levels that allow for factors and/or conditions that change the movements of the actual asset allocation due to RSE licensee’s investment views in the short normal market fluctuations; the ranges would and medium term; and not be set so wide or narrow that they render the strategy unconstrained or ineffective. APRA (c) tactical asset allocation: this is where the RSE considers that an RSE licensee would monitor the licensee has decided to deviate from the ranges to enable it to identify, and respond in a target asset allocation for short-term tactical timely manner, to any significant deviation from opportunities presented in the market. the investment strategy. 41. Irrespective of which asset allocation technique 44. APRA expects that where an RSE licensee adopts is used, APRA expects that an RSE licensee would a dynamic asset allocation approach, the RSE adopt a formal approach to determining the asset licensee would establish a formal policy that allocation. In doing so, APRA expects an RSE governs the asset allocation process. The policy licensee would establish: would ordinarily include: (a) the investment horizon and investment (a) the permitted dynamic asset allocation objectives of an investment option; ranges and other investment exposure limits; (b) the initial target asset allocation for each (b) the factors and/or conditions that would asset class; lead to changes in either the target asset (c) asset allocation ranges for each asset class; allocation or the asset allocation ranges; (d) a list of permissible investment types; and (c) where dynamic asset allocation is used for a defined benefit sub-fund of the RSE, how this (e) any investment restrictions including approach meets the goals of that sub-fund; counterparty exposure limits and the use of derivatives. (d) the approval process for changes to the asset allocation target and ranges; and (e) the reporting of changes to asset allocation targets and ranges to the Board and relevant sub-committees. Australian Prudential Regulation Authority 9 45. Where an RSE licensee also employs tactical asset Risk budgeting allocation, APRA expects an RSE licensee would 50. An RSE licensee may choose to use a risk be able to demonstrate clearly the differences budgeting approach to determine the optimal between dynamic and short-term tactical asset asset allocation of an investment option. Risk allocation decisions where both are used. budgeting considers how different risks drive the returns of different asset classes, and derives the Modelling the asset allocation optimal asset allocation based on the expected 46. Where an RSE licensee utilises modelling to return per unit of risk of each of those asset determine its asset allocation, the RSE licensee classes. would be expected to possess sufficient expertise 51. In formulating an investment strategy, risk in evaluating any model-driven recommendations budgeting may assist an RSE licensee to better to enable assessment of the need for further understand and determine: analysis prior to investment decisions being made. (a) the nature and quantum of risks underlying 47. Model risk arises from the use of models the proposed asset class; in the formulation and management of investment strategies. In general, the validity and (b) the appropriate amount of risk to be taken; appropriateness of models used to determine (c) within which part of the investment strategy the asset allocation are strongly reliant on the (e.g. asset class, sub-asset class or sector) risk methodology and the underlying assumptions. should be allocated; and APRA considers it important that an RSE licensee understands the strengths and weaknesses of (d) the returns that can be expected for taking a any modelling approach and the underlying certain amount of risk. methodology employed. 52. APRA expects that an RSE licensee using a risk 48. Accordingly, APRA considers a prudent RSE budgeting approach would regularly review the licensee would have a formal policy to determine impact of market movements on its risk allocation and review the methodology and assumptions and the subsequent implications for the asset underlying such models, which considers the allocation of an investment option. potential variation in asset class characteristics over time, including expected returns, risk Lifecycle investment strategy exposures and interactions between asset classes. 53. A lifecycle investment strategy is one that varies This approach would also consider the risks of the asset allocation for a beneficiary according over-reliance on historical data when determining to factors such as their age and/or the time model assumptions. remaining to retirement. It typically consists of 49. APRA expects that an RSE licensee would be able to multiple strategic asset allocations, each one demonstrate through appropriate analysis that the assigned to a cohort of members of the same underlying methodology and assumptions are, and lifecycle group, e.g. age range, retirement time remain, suitable. APRA considers it important that horizon, account balance. APRA expects that an an RSE licensee gives particular consideration to RSE licensee would undertake appropriate analysis the modelling of unlisted or illiquid investments. An to demonstrate that adopting a lifecycle strategy is RSE licensee would typically take into consideration in the best interests of beneficiaries. the risks of downstream gearing and liquidity, any 54. To offer a lifecycle investment strategy as an factor risks (i.e. risks specific to that asset, such investment option, an RSE licensee would as credit risk or industry risks) and the reduced ordinarily have requisite expertise in employing transparency of other underlying risk exposures such a strategy or have access to relevant expert when assessing a model’s recommended allocation advice. At the formulation stage of a lifecycle to such investments. Australian Prudential Regulation Authority 10 investment strategy an RSE licensee would 57. An RSE licensee would ordinarily determine the typically assess its capabilities to implement such investment risk appetite appropriate at each a strategy. Where a lifecycle investment strategy stage in the lifecycle investment strategy and the is adopted, APRA expects an RSE licensee to be investment objectives to be achieved during each able to clearly outline the reasons for adopting of those stages. The investment objectives would such a strategy and how the strategy is in the best be consistent with, and contribute collectively to, interests of beneficiaries. achieving the ultimate retirement income goal for beneficiaries. 55. A lifecycle investment strategy is typically characterised by a compilation of separate and 58. The transition of the strategic asset allocation over distinct stages representative of a beneficiary’s the course of the lifecycle investment strategy own life stage. APRA expects that an RSE licensee within each stage is often called the ‘glide path’. would articulate and formally document its APRA expects an RSE licensee would determine a assumptions and considerations in determining strategic asset allocation target and an acceptable the respective stages within the lifecycle strategy. asset allocation range for each stage. When doing so, an RSE licensee may consider: 56. When determining the stages of a lifecycle strategy, APRA considers it prudent for an RSE (a) the trade-off between risk appetite and licensee to consider, amongst other things, the the investment horizon, which drives the following matters: proportion of growth assets in the final years before retirement. APRA considers (a) the demographic profile of its beneficiaries; the timing and market volatility just before (b) the age or other lifecycle factors that will and after a beneficiary’s retirement to be determine changes to the strategic asset particularly critical (i.e. sequencing risk); allocation for a beneficiary to achieve (b) factors other than the age of beneficiaries retirement income goals. Whilst smaller or number of years to retirement that increments between lifecycle stages may lead are critical to formulating the investment to smoother transitions, the benefits will strategy to achieve the investment objectives depend on the demographic composition (e.g. account balance); and may be outweighed by the associated complexity and cost of implementation. (c) inclusion and exclusion of particular In addition, the increment may change as asset classes; beneficiaries approach retirement age; (d) the expected frequency for rebalancing the (c) the relevant investment time horizon for the asset allocations and the factors that may entirety of the lifecycle strategy (i.e. whether be taken into account when rebalancing the end date for the final stage is assumed (e.g. the investment performance and to be the member’s retirement date or their economic/market conditions particularly for life expectancy); beneficiaries approaching retirement); and (d) the availability of post-retirement products (e) the liquidity of the investment strategy at offered by the RSE licensee; and each stage. (e) the structure of the drawdown phase (e.g. a periodic payment or lump sum withdrawals). Australian Prudential Regulation Authority 11 59. A glide path is typically set to maximise the 64. Where an RSE licensee has decided to outsource potential growth of the account balances of the investment management function to an beneficiaries in the initial years of investing, and investment manager, APRA expects the RSE to reduce the potential volatility of investment licensee would apply an equally robust due returns as retirement approaches. However, an diligence process when selecting and appointing RSE licensee would typically consider the risk that the potential manager. 5 small balances in the early years can be easily 65. Due diligence of a proposed investment eroded if the upside potential of investments or investment manager may be conducted is suppressed by mechanically switching to a either in-house or via external consultants. In conservative asset allocation. determining the most appropriate approach, an 60. When formulating a lifecycle investment strategy, RSE licensee would be expected to review the a prudent RSE licensee would also consider resources available within its business operations the risks associated with implementation, and consider the available skill, knowledge and such as changing the asset allocation with the understanding required to undertake an effective beneficiaries’ ages if this change were to coincide due diligence assessment. with a market downturn. Due diligence of investments Implementing an investment strategy 66. APRA expects due diligence for a proposed 61. SPS 530 requires an RSE licensee to establish a investment would include, but not be limited to, process and criteria for selecting each investment an assessment of: to give effect to the investment strategy (a) the industry in which the investment (investment selection process). The criteria must operates and current market environment; be reflected in the RSE licensee’s due diligence process to be undertaken prior to the selection of (b) the projected performance of the the investment. investment; 62. SPS 530 specifies that the investment selection (c) the identified risk factors to which the process must ensure an RSE licensee has a investment is potentially exposed, including, sufficient understanding and knowledge of each where applicable, derivative risk exposure; investment selected. In APRA’s view, a robust due (d) the valuation methodology of the diligence process would assist an RSE licensee in investment; and developing this understanding and determining (e) where the investment involves unlisted equity: whether each proposed investment is appropriate for the investment option. (i) the ownership structure, including information regarding Board membership Due diligence and senior management personnel; 63. SPS 530 requires an RSE licensee’s due diligence (ii) the business plan of the organisation; to be effective and commensurate with the nature (iii) financial analysis of any private market and characteristics of each proposed investment. for the investment; and APRA expects that an effective assessment would sufficiently address the complexity of that (iv) any future commitments required investment, with outcomes of the due diligence and any lock-up periods, including assessments documented. any restrictions on the ability to exit the investment. 5 Outsourcing of an investment management function under a formal agreement or mandate (including implemented asset consulting) is considered a material business activity that would need to comply with the requirements of Prudential Standard SPS 231 Outsourcing. Australian Prudential Regulation Authority 12 Due diligence of investment managers 69. APRA envisages that an investment management agreement would set out the required investment 67. APRA expects that an RSE licensee would be able parameters or constraints determined by the to demonstrate appropriate analysis supporting RSE licensee as well as established performance its due diligence assessment of a prospective standards and benchmarks. investment manager prior to selection of the investment manager. At a minimum, an RSE 70. APRA expects that an RSE licensee would have a licensee would ordinarily consider: documented process for regularly monitoring and reviewing the investment manager’s performance (a) the investment strategy and approach to in meeting its obligations in written agreements. investment portfolio composition; Prudential Practice Guide SPG 231 Outsourcing (b) how investments are managed, including provides further guidance on monitoring the management of market and investment outsourcing arrangements. risk factors; (c) the approach, quality and extent of Conflicts of interest research, due diligence and investment 71. When implementing an investment strategy, an processes, including the expertise of key RSE licensee may face potential or actual conflicts investment staff; of interest. APRA expects that an RSE licensee (d) previous performance record and expected would manage conflicts of interest by having in future performance as determined by both place adequate arrangements to maintain the risk and return measures through various integrity of its investment selection process. market cycles; Prudential Standard SPS 521 Conflicts of Interest establishes requirements for the identification, (e) the investment risk management avoidance and management of conflicts. arrangements in place and the quality and timeliness of investment risk reporting; 72. APRA expects that, in conducting due diligence for each investment and the investment manager, (f) the approach, quality and timeliness of an RSE licensee would also give due consideration the investment valuation, monitoring and to any potential or actual conflicts of interest that reporting process, including downstream may be present or may arise. investments; 73. Where an RSE licensee utilises the services of (g) the methodology, frequency and approach an asset consultant, APRA considers it prudent for reviewing, analysing and reporting stress practice for the RSE licensee to ensure that testing results; engagements with related parties of the asset (h) the approach and quality of liquidity consultant, which may give rise to a conflict, are management arrangements; and appropriately documented. (i) the systems, policies and processes in place to monitor and manage operational risk exposures. 68. APRA considers the investment management agreement between the RSE licensee and investment manager would ordinarily specify the functions to be delegated to the manager. However, as required by SPS 530, an RSE licensee remains ultimately responsible for the sound and prudent management of the investments of each RSE. Australian Prudential Regulation Authority 13 74. APRA considers that an RSE licensee’s duty to 78. Given performance-based fees can vary depending act in the best interests of beneficiaries may be on the type of investment, when assessing the compromised if the RSE licensee accepts an asset reasonableness of these fees APRA expects an RSE consultant’s recommendation for the retention licensee would sufficiently understand: or engagement of an investment manager related (a) the fee structure attached to the investment; to the consultant without appropriate review and assessment of such recommendations by the (b) how the performance-based fees impact RSE licensee. APRA expects that an RSE licensee on the return objective of the investment would form its own view on whether a particular strategy; and investment manager would be retained or (c) how various market cycles may impact on engaged. In particular, an RSE licensee would be the performance-based fees. expected to satisfy itself that any conflicts do not unduly influence the proposed recommendation 79. The SIS Act requires that an RSE licensee consider by the asset consultant. a range of factors related to performance-based fees for each authorised MySuper product.6 APRA 75. APRA expects that an RSE licensee would develop expects that an RSE licensee would undertake a a process to conduct regular assessments and documented analysis to demonstrate that it has comparisons of the services provided by any given due regard to these requirements. associated entities to those of other unrelated parties of suitable quality, and consider the outcome of these assessments when negotiating Maintaining an investment strategy the terms and reviewing engagements with Asset allocation rebalancing associated entities. An RSE licensee would be expected to document the reasons for 80. SPS 530 requires that each investment strategy determining to continue, or terminate, the include a policy to monitor and maintain the asset services of the associated entity, demonstrating allocation within the determined ranges within why that decision would be in the best interests a reasonable timeframe. This applies equally to of beneficiaries. RSE licensees whether they adopt a strategic or dynamic asset allocation approach. 76. Where an RSE licensee conducts investment management or trading functions (including 81. Where an RSE licensee offers an internally derivatives trading) in-house, APRA expects that developed investment option, for managing the the RSE licensee would establish appropriate asset allocation using either a strategic or dynamic segregation of duties to ensure that trading, asset allocation approach, APRA considers a sound risk management and settlement functions are policy would include documentation of matters operationally independent. including, but not limited to, the: (a) basis on which changes would be made to Performance-based fees the asset allocation; 77. Performance-based fees can have an impact on (b) method of, and triggers for, rebalancing; the overall return of the investment strategy. APRA expects that an RSE licensee would analyse (c) permitted use of derivatives in order to the impact of performance-based fees on the rebalance; and implementation of an investment strategy. (d) reporting arrangements in place to approve and confirm any changes to asset allocation or rebalancing. 6 Refer to s. 29VD of the SIS Act. Australian Prudential Regulation Authority 14 82. An RSE licensee would be expected to be 86. APRA expects that a prudent RSE licensee would able to implement any required rebalancing be able to demonstrate an understanding of the without incurring significant costs to the risk that may arise as a result of implementing investment option, both under normal operating liquidity provider arrangements and would circumstances and under a range of stressed establish appropriate controls to manage these scenarios. potential risks. 83. Where a strategic asset allocation approach is Derivatives exposures used and there is a significant divergence from the stated asset allocation, a prudent RSE licensee 87. A prudent RSE licensee would be expected to would consider timely disclosure of the divergence have sufficient mechanisms to capture, monitor to beneficiaries. Such disclosure may include and manage the potential risks associated with information regarding how the RSE licensee the use of derivatives that are commensurate with intends to return the portfolio to its strategic asset the nature and complexity of derivative exposures allocation, including the reasonable timeframe within the investment strategy. Such risks would within which it intends to do so. ordinarily be included in an RSE licensee’s risk management framework.7 84. Where an RSE licensee offers an externally managed investment option, APRA expects an 88. In reviewing the potential risk exposures that RSE licensee would ordinarily review the asset derivatives may present, APRA expects an RSE allocation of that option to determine whether licensee would consider risks such as liquidity it has deviated substantially from the stated asset risk, basis risk, rollover risk and counterparty risk, allocation target. Where a deviation is identified, amongst others. a prudent RSE licensee would assess whether 89. APRA further expects that an RSE licensee would the deviation may have a significant effect on have formalised and documented limits to ensure achieving the investment objectives for that that risks arising from derivative exposures are investment option. If the deviation is determined managed within its established risk tolerances. to be significant, APRA expects an RSE licensee would consider options to address the deviation, 90. APRA also expects that an RSE licensee including the appropriateness of continuing to would receive regular and timely reporting offer the investment option to beneficiaries. on its derivative exposures, together with details regarding any mandate breaches when 85. In some circumstances, an RSE licensee may utilise appropriate. an investment option within the RSE as a ‘liquidity provider’ to the other investment options within 91. Where the derivative exposure arises from an the RSE. For the purposes of this PPG, a ‘liquidity externally managed investment option, APRA provider’ is an investment option that conducts expects that an RSE licensee would, when internal trades with other investment options in undertaking due diligence, consider the additional the RSE to rebalance these options back to their risks introduced by the derivative exposure, and strategic asset allocation. The liquidity provider whether the use of derivatives is consistent with investment option then conducts trades with the the RSE licensee’s investment strategy and risk external market to rebalance its asset allocation. appetite. The RSE licensee’s due diligence would APRA expects that an RSE licensee using a liquidity also be expected to review the internal control provider would document this arrangement within structure of the external investment manager to its policies. ensure that all derivative risk exposures are being appropriately monitored, mitigated and managed. 7 Refer to Prudential Practice Guide SPG 220 Risk Management for guidance on the risk management framework. Australian Prudential Regulation Authority 15 Currency exposures 96. APRA expects that an RSE licensee would develop, 92. An RSE licensee would be expected to have document and approve a plan for managing mechanisms that adequately address the potential the transition of any investments prior to its risks arising from foreign currency exposures implementation. An RSE licensee may consider within its investment strategy and to ensure these seeking specialist advice and/or appointing a are appropriately documented and monitored. service provider to assist with its implementation where the RSE licensee does not possess sufficient 93. APRA expects that an RSE licensee would resources, skills or knowledge to undertake the establish regular reporting on the management of transition. foreign currency exposures. Such reporting would typically include: 97. APRA expects that an RSE licensee’s transition plan would clearly specify, amongst other things, (a) the current foreign currency exposures the objectives of the transition, the timeframes for within the investment strategy; various stages of the transition, the factors used to (b) the contribution of foreign currency measure the success of the transition and the roles exposures to investment returns over the and responsibilities of all relevant parties, including investment period; service providers. (c) hedge positions that are currently in place 98. APRA envisages that during a transition process, to guard against adverse foreign currency an RSE licensee would be provided with regular movements and the cost of maintaining and detailed information on the direct and those hedges; indirect costs associated with the transition of investments. A prudent RSE licensee would have (d) the performance of hedging strategies measures in place to assess the effectiveness of against their objectives, including the a transition process. For example, where there is effectiveness of hedges; and divergence from the transition plan, APRA expects (e) the counterparty exposures arising from the that an RSE licensee would investigate the root hedging strategy. causes for the divergence and, where necessary, arrangements to rectify the divergences. 94. APRA expects that an RSE licensee would also regularly monitor the liquidity impact of 99. APRA expects that an RSE licensee would conduct maintaining a hedging strategy for each investment a post-transition review against the objectives set option. It would be prudent for an RSE licensee for the transition and the transition’s measures to assess the impact that any sudden movements of success, to determine whether these were in the rates of foreign currency may have on the satisfactorily achieved. liquidity position of each investment option. Monitoring investments Managing transitions of investments 100. SPS 530 requires an RSE licensee to monitor 95. The need to transition investments may arise the performance of each investment in each where there are changes in the investment investment option on an ongoing basis. strategy and/or the asset allocation of the 101. APRA expects that an RSE licensee would have investment strategy, or where investment in place systems, structures and processes to managers are changed or appointed. An RSE measure and report the performance of each licensee may also need to transition investments investment within the investment portfolio of where an RSE merges with another RSE or when internally developed investment options. a successor fund transfer takes place. APRA expects that an RSE licensee would have robust processes in place for managing the transition of investments in these circumstances and that these processes are clearly documented. Australian Prudential Regulation Authority 16 102. An RSE licensee that offers an externally 108. An RSE licensee would also be expected to managed investment option would be expected monitor the performance of a lifecycle strategy to implement appropriate arrangements to on an ongoing basis. In this regard, an RSE monitor the performance of that option in line licensee would undertake performance analysis with its investment objectives. by separately monitoring the risk and return measures of each stage of the lifecycle strategy. 103. SPS 530 requires that the persons assessing the performance of each investment are operationally 109. Further, an RSE licensee, when undertaking independent from those carrying out investment its performance analysis of a lifecycle strategy, activities. This may be achieved through a would typically be expected to determine: separation of reporting lines. For example, where (a) the timeframe over which performance an RSE licensee undertakes in-house investment could be realistically measured given the activities, performance assessment would be investment objectives; expected to be conducted by a separate business unit or division, such as the finance unit, rather (b) whether the benchmark performance may than by persons involved in implementing and be measured against: managing the investment activities. (i) proprietary or custom benchmarks 104. APRA expects that an RSE licensee’s monitoring that compare the lifecycle strategy process would use appropriate pre-determined to the performance of underlying benchmarks and/or performance measurement indices weighted by allocation (even criteria to evaluate investments and investment though such a benchmark may not be managers. investible); and/or 105. In APRA’s view, effective performance (ii) products in the market that cater for monitoring arrangements are to be objective and targeted retirement dates, although an measurable and exhibit characteristics that are RSE licensee would need to consider consistent with those of the investment or the how well the peer group fits with its own style of the investment manager being measured, glide path in terms of philosophy, risk and would be formally documented. parameters and asset class exposures; and 106. When assessing the performance of an (c) the measure of performance for the glide investment option, APRA expects an RSE path of the lifecycle strategy, including the licensee’s reporting to include relevant performance attributed to implementing the information of appropriate detail to enable strategic asset allocation decisions and the the RSE licensee to sufficiently understand and use of underlying investment managers. adequately monitor the sources of risk and 110. Where an RSE licensee offers an externally return in order to assess the effectiveness of managed investment option, APRA expects the investment strategy. For example, the use a prudent RSE licensee would assess the of attribution analysis may assist an RSE licensee performance of that option against pre- to determine sources that contribute to the determined measures (e.g. an appropriate out-performance or under-performance of benchmark index) to determine the continuing investment strategies and specific investments. appropriateness of the investment options being 107. APRA considers that a prudent RSE licensee would offered to beneficiaries. measure the performance attributable to decisions to shift the asset allocation against relevant benchmarks and the investment objectives. Australian Prudential Regulation Authority 17 111. As part of its ongoing monitoring process, a 113. In order for an RSE licensee to satisfy itself that prudent RSE licensee would consider any actual an investment option continues to be in the best and/or proposed changes within the RSE, the interests of beneficiaries, APRA expects that RSE licensee’s business operations and in the a prudent RSE licensee would have in place a external environment to determine how such process for managing investment options which circumstances might impact on the investment have been identified as not performing in line options. Examples of such situations may include, with expected investment objectives. but are not limited to: 114. APRA expects that an RSE licensee would (a) a sudden unexpected growth or reduction determine measures for under-performance in membership, or changes in membership and the process to be undertaken if under- profile, due to corporate restructures or an performance occurs. This may include steps that unusual movement of members between will be taken to address under-performance, investment options; limit the exposure to these investment options (b) changes to the benefit design; or other actions that are in the best interests of beneficiaries. (c) changes to the liquidity status of underlying investments; 115. Where an externally managed investment option has been identified as under-performing, (d) unusual patterns in investment performance APRA expects an RSE licensee would have a given the nature of a particular investment process to manage the under-performing option and prevailing market conditions; in a timely manner. A prudent RSE licensee would (e) changes to the economic climate and the consider whether any actions, including the conditions of specific markets; following, are appropriate: (f) changes to, or within, relevant service (a) placing the investment option on a ‘watch providers, such as ownership, key personnel, list’; systems and legacy system issues; and (b) restricting the flow of funds into the (g) legislative amendments that may impact investment option; on the investment strategy of a particular (c) prohibiting (or closing) the investment investment option, such as changes option from receiving new funds; and to retirement income standards or tax arrangements. (d) where the investment option is considered no longer in the best interests of 112. SPS 530 requires the monitoring of investment beneficiaries, transitioning the benefits into a performance to be reported to the Board new investment option. and senior management. APRA expects the frequency and style of an RSE licensee’s 116. Where an RSE licensee has identified that an performance reporting to be dependent on the externally managed investment option is no longer type, complexity and amount of investment, and appropriate to meet the investment objectives, sufficient to satisfy the RSE licensee that it has APRA expects that an RSE licensee would adequate oversight of the investment. consider whether the option remains appropriate to be made available to beneficiaries and take appropriate steps to implement any decisions. Australian Prudential Regulation Authority 18 Reviewing an investment strategy Investment risk management 117. SPS 530 requires an RSE licensee to formally 121. Investment risk in superannuation is the risk of review each investment strategy on at least an an RSE licensee failing to meet its investment annual basis. APRA expects this review to include, objectives due to adverse or inadequate but not be limited to, a review of the key drivers investment performance. Investment risk can of the investment strategy to ensure that the arise from market-wide risk factors (e.g. equity strategy remains consistent with investment prices, interest rates, foreign exchange rates, objectives. A regular review process assists an commodity prices and credit spreads) or from RSE licensee to determine whether there are any idiosyncratic risks (i.e. asset-specific risks). evident gaps (or overlaps) in the governance Market-wide risk factors can affect other risks and decision-making process, thus allowing any for an RSE, such as liquidity risk, or its underlying weaknesses within the investment governance investment options. framework to be addressed. 122. While investment risk is borne by beneficiaries 118. Where an RSE licensee has identified that the in a defined contribution fund or by employer- investment strategy of an internally developed sponsor(s) in a defined benefit fund, an RSE investment option is no longer appropriate to licensee is ultimately responsible for measuring meet the investment objectives, e.g. where the and managing investment risk that may arise due option has been identified as underperforming, to the investment strategy. APRA envisages that an RSE licensee would have 123. In APRA’s view, an investment governance a documented process in place to adjust the framework with robust investment risk investment strategy. management arrangements enables an RSE 119. In addition, APRA expects that an RSE licensee licensee to identify the likely manifestation of would establish triggers that may lead to interim investment risk in order to prudently manage reviews of the investment strategy. Matters such as risk exposures that arise from the complexities of a significant event in the economic environment, investment decision-making. a structural change in the membership profile or 124. Investment risk management arrangements a material outflow of beneficiary funds, are some would typically comprise a range of tools examples of circumstances that could render an for risk measurement and analysis that are investment strategy inappropriate and may trigger commensurate with the size, business mix and an interim review. complexity of the investments of the RSE and its 120. SPS 530 requires the results from each review investment options. to be reported to the Board and, where an 125. APRA expects appropriate segregation of investment strategy has been subsequently duties between those persons responsible amended, that the decision is sufficiently for implementing investment decisions and supported by appropriate justification and those persons responsible for the investment analysis. APRA expects that the reporting to the risk management arrangements, to ensure Board would provide necessary detail in order for investment risk objectives are monitored and the Board to satisfy itself that a comprehensive managed objectively. review has been undertaken and that any amendment to an investment strategy has been thoroughly considered and analysed. Australian Prudential Regulation Authority 19 Investment risk assessment (d) inflation risk – the risk that investment option returns are not sufficient to maintain 126. APRA expects that a prudent RSE licensee, when purchasing power; assessing either an investment or investment manager, would undertake a formal risk (e) tail risk – the likelihood of a low-probability, assessment that would typically include: high-impact risk event occurring; (a) identification of risk factors; (f) correlation risk – the risk of increasingly similar behaviour of investment returns (b) assessment and measurement of the amongst asset classes, reducing the benefit identified risk factors, including the potential of diversification; and impact on the sources of investment return; (g) liquidity risk – the inability to meet (c) the risk mitigation strategies in place; and obligations as and when they fall due without (d) how the identified risks would be monitored incurring unacceptable losses. and reported. 129. An RSE licensee would ordinarily have 127. APRA expects that an RSE licensee, when documented criteria for investment risk actively considering investment risk during the exposures as part of its investment risk formulation, implementation and performance management arrangements. This would typically monitoring of an investment strategy, would cover the extent to which an RSE licensee is ordinarily consider: prepared to expose an investment strategy to the (a) which sources of investment risk to accept investment risk factors and whether it would be and the extent of the risk exposure during in the best interests of beneficiaries to establish the formulation of a strategy; any appropriate investment restrictions. (b) mechanisms for ensuring that the risk Investment risk management approaches accepted is consistent with this decision 130. There are a number of investment risk during implementation; and management approaches for assessing and (c) the process for identifying, measuring and measuring the sources of risk that influence the assessing the actual exposure to investment returns attributable to an investment strategy. A risk via performance monitoring. prudent RSE licensee may use a combination of 128. When evaluating potential investment risks in the following approaches, including stress tests: an investment strategy, an RSE licensee would (a) factor risk analysis, which identifies and ordinarily consider the risks that may arise from allows an RSE licensee to measure the factors such as: underlying risk factors that may influence (a) volatility – the level of movement in value of the investment returns it achieves by an investment option, noting that negative implementing its investment strategy; movements in value are generally of greater (b) risk budgeting, which considers how different concern to beneficiaries; investment risks drive the expected returns (b) maximum drawdown – a measure of of various asset classes. It may assist an RSE the greatest decline in the value of the licensee in developing the optimal allocation investment option; to an asset class based on an expected return per unit of risk for that asset class; and (c) sequencing risk – the risk that the timing of investment returns of an investment option adversely affect beneficiaries during a critical period in their investment horizon; Australian Prudential Regulation Authority 20 (c) risk analysis, which takes into consideration 135. In times of heightened market volatility alpha and beta sources to assist the RSE or increased idiosyncratic risk (e.g. asset licensee to measure the sources of risk in an or investment manager-specific shocks), investment strategy that are generated by APRA expects that a prudent RSE licensee active or passive investment management would enhance reporting of its investment decisions. This may assist with analysing how exposures with greater frequency and intensity, risk aligns with the RSE licensee’s risk budget, commensurate with the complexity of the where appropriate. investment and appropriate to the severity of the particular circumstances. 131. Where an RSE licensee engages in hedging activity to mitigate identified investment risks, 136. Investment risk management reporting would APRA considers that a prudent RSE licensee ordinarily include, but not be limited to, matters when analysing the effectiveness of the hedging such as: program, would be cognisant that a hedging (a) market and economic developments that program itself may expose the RSE licensee to may result in altered risk exposures; risks such as counterparty risk and liquidity risk. As such, APRA expects that an RSE licensee (b) investment option risk profiles as measured by would assess the extent to which a hedging risk metrics (e.g. tracking error, Sharpe ratio, program has created additional risk exposures. standard deviation, maximum plausible loss); (c) asset class risk profiles as measured by Investment risk reporting key risk indicators (e.g. credit profile, yield 132. APRA expects that an RSE licensee would develop curves, credit spreads, in the case of fixed a set of relevant investment risk indicators interest portfolios); that enable it to monitor departures from (d) investment manager risk indicators (e.g. tolerances established for accepted investment changes to watch list, key staff changes); and risk exposures, along with formal escalation procedures for reporting of identified departures. (e) investment compliance and breach reporting. 133. APRA considers it prudent for an RSE licensee Review of investment risk management to establish regular investment risk reporting to arrangements appropriately inform relevant stakeholders of investment risk exposures. This puts the Board, 137. A prudent RSE licensee would ordinarily review senior management, Board committees and the appropriateness, effectiveness and adequacy other relevant stakeholders in a position to make of its investment risk management arrangements informed decisions in a timely manner. as part of the review of its investment governance framework. APRA expects that this 134. Investment risk reporting would typically review would assist an RSE licensee to determine include an appropriate level of detail and whether there are any evident gaps, thus allowing sufficient commentary to enable stakeholders to any weaknesses to be appropriately rectified and understand and adequately monitor the sources strengthened. of investment risk in order to make considered investment decisions. 138. An RSE licensee may choose to engage an external service provider to assist in some of its investment risk management arrangements; however, the RSE licensee remains ultimately responsible for managing the investment risk exposures within the RSE. Australian Prudential Regulation Authority 21 139. APRA expects an RSE licensee would also (i) circumstances that might lead to ad hoc conduct a review of the external service stress testing; and provider’s performance against the criteria (j) clarity in relation to the involvement and detailed in the written agreement.8 reliance placed on external service providers in assisting with stress testing. Stress testing 143. APRA expects that an RSE licensee’s stress 140. SPS 530 requires an RSE licensee to develop testing program would be appropriate to its a comprehensive stress testing program. investment options and underlying investments. APRA expects a prudent RSE licensee would An RSE licensee may determine that it is be able to demonstrate how the results from appropriate for different types of stress testing the RSE licensee’s stress testing are taken to be conducted at different levels within an into consideration when formulating and investment option (e.g. individual investments, implementing an investment strategy. sector, and/or asset class). 141. APRA considers stress testing to be an effective 144. In conducting stress testing for investment investment risk management tool that may options with multiple asset classes, APRA assist an RSE licensee to identify and assess expects an RSE licensee’s stress testing program potential risk exposures that may threaten the would evaluate, amongst other things, how the likelihood of achieving investment objectives. investment option may: APRA is of the view that the objective of a stress testing program is to perform a forward-looking (a) perform under certain circumstances assessment of risk factors. (e.g. ability to stay true to label, timeliness of rebalancing, changes to liquidity profile); 142. APRA expects that the elements of an RSE licensee’s stress testing program would (b) meet its investment objectives; ordinarily include: (c) be impacted in its ability to redeem assets (a) the roles and responsibilities of persons during extreme market volatility; and involved in stress testing; (d) be vulnerable to certain risk factors. (b) the stress testing methodology employed; 145. Where an RSE licensee offers an externally (c) the approach to setting and reviewing stress managed investment option, the RSE licensee testing assumptions; may consider it appropriate to use the stress testing undertaken by an external product (d) the frequency of stress testing; provider (i.e. an external investment manager) (e) procedures for reviewing and analysing the as part of the RSE licensee’s overall investment results of the stress testing; stress testing program. In such circumstances, APRA expects that an RSE licensee would (f) procedures for reporting stress testing satisfy itself as to the extent and quality of the results to the Board, senior management, stress testing undertaken by not only assessing a relevant Board committee and, where the processes and procedures in place, but necessary, to APRA; the stress testing methodology used by the (g) triggers for the escalation of stress external provider. APRA expects that an RSE testing outcomes; licensee would be familiar with, and assess the appropriateness of, the assumptions used in (h) processes for the review of the stress stress testing. testing methodology; 8 Refer to SPG 231 where the external service provider conducts a material business activity. Australian Prudential Regulation Authority 22 146. Where an RSE licensee offers a lifecycle Risk factors investment strategy as an investment option, 150. The risk factors in a stress testing program may it would ordinarily perform stress testing to be determined by either historical or hypothetical determine the impact of various stress scenarios events. Historical stress tests replicate conditions at each stage and on the outcome at retirement, from previous events. An RSE licensee may and would consider the results of such stress consider historical events to be useful if some testing when formulating the lifecycle aspects of the event could reasonably be expected investment strategy. to recur and the parameters of the scenario are relevant to the investment or investment option Methodology under consideration. Stress scenarios 151. Hypothetical events are typically tailored 147. Depending on the nature of the investment constructions of low probability plausible future option, an RSE licensee may determine that events. An RSE licensee has the flexibility to stress testing in the form of ‘sensitivity analysis’ formulate a potential event that may comprise is appropriate. Sensitivity analysis measures the movements and interactions between various impact of a single risk factor, e.g. the impact of a risk factors. An RSE licensee may consider, for 200 basis point shift in interest rates on a fixed example, a hypothetical scenario that involves a interest investment. APRA considers sensitivity shock from a previous historical event combined analysis to be appropriate where the investment with other simultaneous developments that are option value depends primarily on a single source plausible but have not occurred in the past. (or multiple uncorrelated sources) of market or 152. Furthermore, an RSE licensee may also undertake investment risk. ‘reverse stress testing’. Reverse stress testing 148. In other circumstances, an RSE licensee may begins with an adverse outcome, which then determine that stress testing by undertaking requires an RSE licensee to consider which ‘scenario analysis’ is more appropriate. Scenario scenarios and risk factors may cause the outcome analysis typically involves analysing the impacts to occur. Reverse stress testing is used to identify of adverse scenarios that are relevant to the the extent of movement of risk factors that may, investment option and/or the underlying for example, lead to losses exceeding a given investments. Adverse scenarios would generally level and/or an investment option experiencing simulate the potential impact on an investment a liquidity event. option over a defined time horizon, or measure the aggregate impact at a particular point in time. Assumptions 149. Adverse scenarios would typically comprise a 153. A prudent RSE licensee would have in place a range of risk factors that are simultaneously robust process to determine and document the varied. This type of analysis reflects the assumptions used in its stress testing program. inherent correlation between risk factors given 154. The use of assumptions in stress testing often the circumstances of a particular investment requires an RSE licensee to establish parameters option and/or economic or investment market within which the assumptions will operate. In this conditions, e.g. the correlated movement of regard, a prudent RSE licensee would carefully market variables during the global financial crisis. consider the appropriateness of the parameters established. APRA expects a prudent RSE licensee to consider, for example, the movement of a specific risk factor when conducting sensitivity testing, or the movement or co-movement of a combination of risk factors when conducting scenario analysis. Australian Prudential Regulation Authority 23 155. APRA considers it prudent for an RSE licensee (d) potential actions to be taken as a result to review and validate stress testing assumptions of stress testing results, including possible on a regular basis to ensure that the assumptions changes to investment risk management remain relevant and appropriate. arrangements; and Frequency (e) analysis of stress testing results against historical results or comparison data to 156. APRA expects that the frequency with which identify emerging trends. regular stress testing is undertaken by an RSE licensee would be commensurate with the Review nature and risk of the investment option and 159. SPS 530 requires that an RSE licensee ensure its underlying investments. In any event, APRA that the results of the stress test are reviewed considers it prudent practice for stress testing to periodically by senior management and be conducted on at least an annual basis. reflected in the RSE licensee’s investment 157. APRA expects that an RSE licensee would governance framework. determine the circumstances where ad hoc 160. APRA expects that an RSE licensee would stress testing would be conducted outside of translate potential material issues identified by the regular timeframe. An RSE licensee may stress testing into appropriate actions in a timely consider developing triggers to indicate when manner. Such actions may include, but are not ad hoc stress testing would be undertaken. Such limited to, a formal review of the investment indicators may include factors such as market strategy, an asset class or particular investments, volatility, proposed changes to an investment or of the hedging strategies in place. strategy and/or asset allocation, changes to the risk profile of underlying investments, member 161. In addition, APRA considers it prudent movements and/or changes in the industry in for an RSE licensee to regularly review the which the underlying investments are allocated. appropriateness of stress tests performed in order to take into account changes in Reporting market conditions, investment strategy, the 158. APRA expects that a robust stress testing liability profile of investment options, and/ program would be supported by appropriately or circumstances that may affect the liquidity detailed reporting to the Board, senior requirements of specific investment options or management and relevant Board committees. the RSE as a whole. A prudent RSE licensee’s stress test reporting would typically include matters such as: Liquidity management (a) the various stress scenarios and risk 162. The SIS Act requires an RSE licensee to consider factors tested, including the coverage of the the liquidity of investments when formulating stress testing; and implementing an investment strategy, while also considering the expected cash flow (b) the assumptions used when conducting the requirements of the RSE.9 stress testing; 163. Liquidity primarily refers to the ability of an RSE (c) the results of the stress testing on the RSE licensee to meet benefit payments, rollover or and/or investment options, including transfer requests and intra-fund investment whether any tolerance limits were breached; switching requests from beneficiaries in accordance with the requirements of the SIS Regulations and the governing rules of the RSE. 9 Refer to s.52(6)(a)(iii) of the SIS Act. Australian Prudential Regulation Authority 24 164. The assessment of liquidity risk, in the context (c) contractual obligations related to of the member demographics of a particular investments, such as: RSE or an investment option, typically involves (i) the cash-flow needs for managing a the consideration of the quantum and nature hedging program; and of illiquid assets within the investment strategy. APRA expects that an RSE licensee would seek to (ii) the potential for a cash call by the understand the sensitivity of the asset allocation investment manager of certain of an investment option to any changes in investments. market or member sentiment, which may trigger 166. Where an RSE licensee offers an externally beneficiaries to exercise their right to change managed investment option or direct investment investment option or move to another RSE and option, the RSE licensee remains responsible hence lead to increased need for liquidity. for identifying and managing liquidity risk. 165. Liquidity-related factors that an RSE licensee may APRA expects that an RSE licensee would consider in the formulation of an investment formally consider the potential liquidity risks strategy include, but are not limited to: and corresponding mitigation strategies when undertaking investment selection. (a) member demographics and activities, such as: 167. SPS 530 requires an RSE licensee to determine (i) the age profile of members; procedures to measure and manage liquidity on (ii) forecast inward contributions from an ongoing basis. APRA considers that a forward- members and/or employer-sponsors; looking approach to liquidity management may assist an RSE licensee in identifying emerging (iii) forecast outward benefit payments, liquidity pressures, thereby assisting in the taking into account the retention rate preparation for potential liquidity events. and benefit structure (e.g. lump sum or pension payments); 168. APRA expects a prudent RSE licensee to have a substantial understanding of the liquidity (iv) forecast member switching activities; and of its investment options. In particular, APRA (v) events likely to trigger a significant considers that a prudent RSE licensee would number of members switching to have an awareness of the potential for an another RSE as allowed under the investment option to become illiquid in adverse SIS Act portability rules, or switching circumstances, how this might affect the value between investment options; of the investment option and the RSE licensee’s (b) the nature and characteristics of different ability to meet portability and benefit payments investments, such as: obligations in such circumstances. This would cover liquidity monitoring arrangements that (i) the relative ease of saleability of assess the impact of market conditions or events assets; and on relevant liquidity positions. (ii) possible market events that may result in previously liquid investments becoming illiquid, and/or a proportionate increase in the holding of illiquid assets as the values of liquid assets fall; Australian Prudential Regulation Authority 25 Liquidity management plan (c) investment/asset-specific events (e.g. capital 169. SPS 530 requires that an RSE licensee develop drawdowns arising from specific investments a liquidity management plan (LMP) for each or rollover of currency hedges); RSE that covers each investment option within (d) investment manager-driven events (e.g. an the RSE. The LMP establishes the procedures investment option is closed to redemptions); for monitoring and managing liquidity on an and/or ongoing basis. APRA considers the LMP to be a (e) a combination of these events. key element in an RSE licensee’s investment risk management arrangements. Management of liquidity risk 170. APRA expects that an RSE licensee would 174. A prudent RSE licensee would have a sound articulate the roles and responsibilities of persons understanding of the RSE’s cash flow profile and involved in the management of liquidity risk undertake cash flow analysis on a regular basis. under both normal and stressed operating This analysis would generally be conducted under conditions. An RSE licensee may consider it both normal and stressed operating conditions appropriate to include the involvement of at the investment option level over various time relevant Board committees. periods in order to identify any trends or variability 171. In developing an LMP, APRA expects an in the cash flow arising from assets and liabilities. RSE licensee to articulate the liquidity risk 175. APRA expects that each investment option tolerances it is willing to accept. An RSE licensee would be able to meet its cash flow requirements would typically take into consideration the on a stand-alone basis. That is, the interests of characteristics of the RSE and its investment beneficiaries invested in an investment option options when determining an appropriate would not be compromised by the need to meet tolerance level. This might include, amongst cash flow requirements of another investment other things, the benefit design of the RSE, option within the same RSE. the demographics of the beneficiaries, the range of investment options, or the amount of 176. APRA considers it prudent for an RSE licensee to transactional activity (e.g. the level of investment use cash flow projections in conjunction with the option switching and number of redemption RSE’s cash flow profile to identify possible short- requests from beneficiaries). term to medium-term liquidity needs for the RSE on a forward-looking basis. 172. SPS 530 also requires that an RSE licensee identify the circumstances it considers to be 177. APRA expects an RSE licensee to regularly review a significant adverse liquidity outcome that the outcomes of cash flow projections against requires action (liquidity event). In APRA’s view, actual results and review the appropriateness of the results from an RSE licensee’s liquidity stress the assumptions used. testing may assist the RSE licensee to identify 178. An RSE licensee may also determine an possible future liquidity events. appropriate buffer of liquid assets within 173. Liquidity events may be categorised as: each investment option that could be used to manage liquidity risk. The liquid assets may be (a) beneficiary-generated events (e.g. investment drawn upon in times of heightened liquidity option switching or redemption requests); requirements, including during the occurrence of (b) market-driven events (e.g. significant a liquidity event. downturn in equity markets); Australian Prudential Regulation Authority 26 179. To further strengthen the liquidity management (d) how investment-related flows such as arrangements, an RSE licensee may consider contractual arrangements relating to developing a set of early warning indicators to capital calls for investments and margining identify the emergence of increased liquidity requirements for derivative holdings would risk or the onset of a potential liquidity event. be met; Early warning indicators may, for example, be (e) developing processes for meeting set with reference to the level of beneficiary beneficiary-related flows such as managing transactional activity or the proportion of large redemptions; investments that are considered liquid and can be redeemed on short notice. (f) determining responsibilities for communication with relevant stakeholders, 180. Where a forecasting exercise identifies potential including APRA; and liquidity difficulties, SPS 530 requires an RSE licensee to outline what action will be taken when (g) where an RSE licensee is part of a corporate a liquidity event occurs. APRA expects that an RSE group, the appropriateness of group-level licensee would develop and document a range of policies or procedures, including the priority actions it may implement depending on the scope and hierarchy of actions. and severity of the liquidity constraint. APRA considers it prudent practice for an RSE licensee Liquidity management reporting to also test the appropriateness of potential 182. A prudent RSE licensee would ordinarily actions to ensure that they adequately achieve the document in the LMP the processes for liquidity intended outcome in managing and/or restoring management reporting including, but not limited liquidity within an investment option. to, matters such as: 181. In determining an appropriate plan of action, an (a) the different types of liquidity or cash flow RSE licensee may consider, amongst other things: monitoring reports to be received by a (a) assigning responsibilities to personnel for relevant Board committee and/or the Board; the identification and management of (b) the frequency with which various liquidity or liquidity events; cash flow reports are produced; (b) establishing liquidity limits and/or triggers (c) triggers for escalating liquidity matters and for deteriorating cash flow positions, breaches to the Board; and escalation procedures detailing when and how each of the actions would be taken and (d) procedures for informing staff, beneficiaries, nominating timeframes for rectification; regulators and other stakeholders when a liquidity event occurs. (c) identifying key sources of liquidity, their expected reliability and the priority in which assets may be realised to meet liquidity requirements, including an assessment of the impact that selling down assets may have on the intrinsic value of the RSE and the relevant investment options; Australian Prudential Regulation Authority 27 Liquidity stress testing 183. SPS 530 requires an RSE licensee to consider how the liquidity of investment options can be managed in a range of stress scenarios. APRA expects that an RSE licensee would develop liquidity stress scenarios as part of a comprehensive stress testing program. 184. APRA expects that liquidity stress test scenarios may be based on the likely behaviour of future cash flows of the RSE’s assets and liabilities and other contractual commitments under different operating environments. An RSE licensee may also consider, for example, RSE-specific events such as large-scale redundancies within an employer-sponsor, successor fund transfers or market-driven events such as illiquidity of underlying investments as observed during the global financial crisis. 185. With respect to the investments of an RSE, APRA expects that when developing liquidity stress test scenarios, an RSE licensee would generally consider the marketability of investments within each investment option and the likely value that may be generated from a distressed sale. This consideration would include the potential for an investment manager of an externally managed investment option to suspend withdrawals, and the circumstances under which such a suspension might be activated. 186. With respect to an RSE’s liabilities and contractual commitments, APRA expects an RSE licensee’s liquidity stress testing scenarios would take into consideration factors such as the potential transactional behaviour of beneficiaries under a volatile market scenario. Examples of this behaviour may be the level of switches to more liquid investment options, or cash flow requirements that may arise from commitments such as capital calls and margining requirements for derivative positions. Australian Prudential Regulation Authority 28 Telephone 1300 55 88 49 Email info@apra.gov.au APPG_SPG530_G_102013_ex Website www.apra.gov.au Mail GPO Box 9836 in all capital cities (except Hobart and Darwin)