Regulators raise alarm on super fund liquidity management and unlisted asset valuations

The liquidity management strategies adopted by superannuation trustees have increasingly shifted toward investments in assets with low or no liquidity. This trend has drawn scrutiny from global and domestic financial regulators, including the IMF and APRA, due to concerns about funds' ability to meet regulatory requirements and appropriately manage members' risk exposure. As some of Australia’s largest superannuation funds continue expanding their allocations to illiquid assets, regulators are emphasising the need for stricter oversight on portfolio diversification and asset valuation to ensure trustees act in the best financial interests of their members.

IMF's warning on Illiquid assets

The International Monetary Fund (IMF) in its latest "Global Financial Stability Report" has flagged the Australian superannuation sector as a significant risk to the financial system. As the sector currently manages $4.1 trillion in assets (as at September 2024), superannuation trustees' current liquidity practices have drawn particular scrutiny.

The IMF has expressed concerns over the flexibility afforded to superannuation fund members, allowing them to switch between investment options, including highly illiquid asset classes such as private equity, private credit, infrastructure, and even forestry and farmland investments. Under Australian law, superannuation funds must generally process these switches within three business days. This requirement persists despite the fact that, on average, superannuation funds hold illiquid exposures exceeding 20% of their total assets. In contrast, other vehicles, such as registered managed investment schemes holding 20% or more in illiquid or unlisted assets, are classified as illiquid schemes and are restricted from providing frequent liquidity (such as accepting applications and redemptions) under the Corporations Act. No such limit exists for super funds.

According to the IMF, a scenario in which members decide to shift en masse between super funds or investment strategies could trigger significant liquidity demands, leading to rapid and synchronised asset sell-offs. Ageing membership demographics, competition and changes in underlying employment sectors may also put pressure on a fund's liquidity. However, critics argue that it is challenging to envision a scenario where mass switching would escalate to the point of causing systemic financial instability – particularly given the stable cashflows unpinned by the guaranteed nature of superannuation, long-term nature of superannuation and preservation rules that prevent access to superannuation savings.

Proponents who remain committed to increasing its exposure to illiquid asset classes point to the strong historical performance of private equity, as well as other benefits of this asset class including long-dated investments, diversification and suppressed volatility.

Regardless, recent events have underscored the importance of effective liquidity management. In late 2024, AustralianSuper, Australia's largest superannuation fund, wrote off over $1.1 billion in equity and private loans tied to the American online education start-up Pluralsight. This came after Pluralsight underwent a restructuring due to a steep decline in its performance amid rising interest rates and increasing market competition. Despite this significant write-down, AustralianSuper’s diversified portfolio allowed it to absorb the loss without major repercussions.

Similary, HESTA was required to compensate 120,000 members after their retirement savings were left tied up in unlisted assets that declined in value during the early days of the COVID-19 pandemic. APRA stated that the fund's inadequate procedures for revaluing assets resulted in financial harm to members. The regulator has also warned that some funds are not reassessing their large unlisted asset portfolios frequently enough, leading to potential distortions in members' retirement savings balances.

APRA flags governance and risk management gaps in trustee review

In December 2024, APRA released the results of its review, which examined the practices of 23 RSE licensees, representing approximately 80% of the total assets managed by APRA-regulated superannuation entities.

The review found that 12 of the 23 RSE licensees required material improvements in their valuation governance, liquidity risk management frameworks, or both, to comply with the requirements of Prudential Standard SPS 530 Investment Governance.

Liquidity risk management

Regarding liquidity risk management, the review identified weaknesses in liquidity stress trigger frameworks, the management of unlisted asset liquidity risks, and the effectiveness of liquidity action plans. For example, APRA noted that many RSE licensees rely heavily on a single liquidity trigger (the percentage of illiquid asset exposure in the investment portfolio) to detect emerging liquidity risks. While APRA agrees this is a valuable metric, relying solely on one trigger may be overly simplistic and could result in an RSE licensee overlooking broader risks, such as trends in member outflows or switching behaviour.

Unlisted asset valuation governance

In relation to unlisted asset valuation governance, some of the key items noted by APRA in respect to board oversight and conflicts of interest management was that:

• There were instances of investment staff being involved in the valuation process (including individuals whose remuneration may be dependent on the outcome of the valuation process) and a lack of demonstrated challenge to valuations. APRA also observed inconsistent practices in the separation of operational staff from staff conducting valuation processes.
• Valuation governance for externally managed assets was shown to be less robust than for internally managed assets. For externally managed assets, there was often high reliance placed on the investment manager’s valuation policies and processes (especially for platform RSE licensees).

Arising from the above, APRA noted that there was a greater need for the inclusion of independent committee members with specialist knowledge concerning individual unlisted asset classes.

In respect to revaluation frequency and triggers, APRA found that RSE licensees generally adopted a quarterly valuation cycle. However, better practice has been observed across the board, especially in larger RSE licensees where they are carrying out more frequent independent valuations of asset classes with a higher valuation risk or reducing asset values more immediately when there is a market downturn.

APRA observed that the qualitative revaluation triggers used by RSE licensees were more focused on retrospective issues, such as the departure of a major tenant, rather than contemporary issues that could also impact valuations (eg., media discussion on office vacancies from the impact of remote working).

Overall, APRA noted a general lack of proactivity among RSE licensees in conducting out-of-cycle valuations and commissioning independent valuations for externally managed investments. This raises concerns that RSE licensees may be overly dependent on external managers for asset valuations, increasing the risk of conflicts of interest and potentially leading to inaccurate valuations that could impact member outcomes.