Direct borrowing by superannuation funds
Remove the exception to the general prohibition on direct borrowing for limited recourse borrowing arrangements by superannuation funds.
Government should restore the general prohibition on direct borrowing by superannuation funds by removing Section 67A of the Superannuation Industry (Supervision) Act 1993 (SIS Act) on a prospective basis.74 This section allows superannuation funds to borrow directly using limited recourse borrowing arrangements (LRBAs). The exception of temporary borrowing by superannuation funds for short-term liquidity management purposes (contained in Section 67 of the SIS Act) should remain.
Direct borrowing in this context refers to any arrangement that funds enter into where the borrowing is used to purchase assets directly for the fund.
- Prevent the unnecessary build-up of risk in the superannuation system and the financial system more broadly.
- Fulfil the objective for superannuation to be a savings vehicle for retirement income, rather than a broader wealth management vehicle (see Recommendation 9: Objectives of the superannuation system in Chapter 2: Superannuation and retirement incomes).
Problems the recommendation seeks to address
Further growth in superannuation funds’ direct borrowing would, over time, increase risk in the financial system. As discussed in the Interim Report, the Inquiry notes an emerging trend of superannuation funds using LRBAs to purchase assets.75 Over the past five years, the amount of funds borrowed using LRBAs increased almost 18 times, from $497 million in June 2009 to $8.7 billion in June 2014.76 The limited recourse nature of these arrangements is intended to alleviate the risk of losses from assets purchased using a loan resulting in claims over other fund assets.
Borrowing, even with LRBAs, magnifies the gains and losses from fluctuations in the prices of assets held in funds and increases the probability of large losses within a fund. Because of the higher risks associated with limited recourse lending, lenders can charge higher interest rates and frequently require personal guarantees from trustees.77,78 In a scenario where there has been a significant reduction in the valuation of an asset that was purchased using a loan, trustees are likely to sell other assets of the fund to repay a lender, particularly if a personal guarantee is involved. As a result, LRBAs are generally unlikely to be effective in limiting losses on one asset from flowing through to other assets, either inside or outside the fund. In addition, borrowing by superannuation funds implicitly transfers some of the downside risk to taxpayers, who underwrite adverse outcomes in the superannuation system through the provision of the Age Pension.
Superannuation funds use diversification to reduce risk. Selling the fund’s other assets will concentrate the asset mix of the fund — small funds that borrow are already more likely to have a concentrated asset mix.79 This reduces the benefits of diversification and further increases the amount of risk in the fund’s portfolio of assets.
The GFC highlighted the benefits of Australia’s largely unleveraged superannuation system. The absence of leverage in superannuation funds meant that rapid falls in asset prices and losses in funds were neither amplified nor forced to be realised. The absence of borrowing benefited superannuation fund members and enabled the superannuation system to have a stabilising influence on the broader financial system and the economy during the GFC. Although the level of borrowing is currently relatively small, if direct borrowing by funds continues to grow at high rates, it could, over time, pose a risk to the financial system. The RBA states that “The Bank endorses the observation that leverage by superannuation funds may increase vulnerabilities in the financial system and supports the consideration of limiting leverage”.80 In addition, such direct borrowing could also compromise the retirement incomes of individuals. APRA was of the view that “… the risks associated with direct leverage are incompatible with the objectives of superannuation and cannot adequately be managed within the superannuation prudential framework”.81
Borrowing by superannuation funds also allows members to circumvent contribution caps and accrue larger assets in the superannuation system in the long run (see the Taxation of superannuation discussion in Chapter 2: Superannuation and retirement incomes.
Direct borrowing by superannuation funds could pose risks to the financial system if it is allowed to grow at high rates. It is also inconsistent with the objectives of superannuation to be a savings vehicle for retirement income. Restoring the original prohibition on direct borrowing by superannuation funds would preserve the strengths and benefits the superannuation system has delivered to individuals, the financial system and the economy, and limit the risks to taxpayers.
Many submissions support this recommendation. Some propose alternatives to address the risks surrounding borrowing, including imposing a maximum cap on fund assets that can be invested in a single asset other than cash or bonds.82,83 These alternatives would limit the risk associated with borrowing by superannuation funds, and provide funds with more flexibility to pursue alternative investment strategies. However, these options would also impose additional regulation, complexity and compliance costs on the superannuation system.
In implementing this recommendation, funds with existing borrowings should be permitted to maintain those borrowings. Funds disposing of assets purchased via direct borrowing would be required to extinguish the associated debt at the same time.
74 The term ‘borrowing’ includes all loans as defined by subsection 10(1) of the SIS Act.
75 Commonwealth of Australia 2014, Financial System Inquiry Interim Report, Canberra, page 2-116.
76 Australian Taxation Office (ATO) 2014, Self-managed superannuation fund statistical report — June 2014 (Asset allocation tables), ATO, viewed 28 October 2014.
77 The lending institution can only make a claim on the asset against which a loan is made and does not have recourse to make claims on the other assets held in the fund.
78 Reserve Bank of Australia 2014, First round submission to the Financial System Inquiry, page 185.
79 Rice Warner 2014, Second round submission to the Financial System Inquiry, page 30.
80 Reserve Bank of Australia 2014, Second round submission to the Financial System Inquiry, page 20.
81 Australian Prudential Regulation Authority 2014, Second round submission to the Financial System Inquiry, page 32.
82 Barton Consultancy 2014, Second round submission to the Financial System Inquiry, page 3.
83 Rice Warner 2014, Second round submission to the Financial System Inquiry, page 30.