Mitigating operational risk in superannuation funds

Enrique Gonzalez
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(Pictured: Enrique Gonzalez)

Comment by Enrique Gonzalez*

Superannuation funds in Australia have always outsourced a substantial part of their operations to asset managers, asset consultants, custodians, and fund administrators. The increasing size of both retail and industry funds has triggered a review into a number of important issues. For instance, whether some key functions may actually be better undertaken in-house for specific asset classes, and investment operations or member administration functions, and how best to oversee functions that are outsourced.

At the same time, there is increased attention on the impact of industry growth on operational risk. The focus here is specifically whether the checks and balances are in place and remain appropriate to outsourced functions, such as fund accounting.

There are a range of views on the right level of oversight. Ask ten superfund COOs for their definition of oversight and you’ll likely get a variety of answers based on their perception of risk and comfort with the status quo. Although there is currently no global standard, there is however, a well-established trend of what the market considers best practice.

Previously, it seemed adequate to select an outsourced partner and then simply trust the provider to undertake contracted activities, on the basis that it was their core area of expertise. It is now clear that even the best relationships are not without operational mishaps. The consequences of these slip-ups, particularly where it directly affects the fund valuation, can be serious and the more mature outsourcing models now recognise that it is in both parties’ interests to have an effective oversight protocol. Once this is in place, business critical results can be checked before errors have an impact. This is especially relevant in establishing effective oversight of outsourced unit pricing, where an undetected error may have a direct impact on members and their confidence in the fund.

Compromised fund valuations

Getting this wrong can come at a high price. Looking at the investment community globally, we can see high-profile cases of inaccurate fund valuations leading to reputational damage and significant remediation costs. In these examples, the service providers have taken on responsibility for delivering critical and complex functions. Suppliers are often expected to bear sole responsibility for quality, despite the fact that there may be an express or implied responsibility of the asset owner, manager or trustee to exercise due care in overseeing those functions. This suggests that there is a heavy reliance on trusting the outsourced function and too little emphasis on an additional layer of protection and control.

When fund valuations are compromised, it attracts the attention of clients, shareholders, internal pricing boards, regulators, and the media. And while regulators are focused on fund valuations, internal risk groups are increasingly focused on assurance and monitoring of service providers’ performance.

Inconsistent views and practices

Best practice dictates that clients of service providers participate directly in the control framework supporting an outsourced function. An effective oversight function then provides a second layer of protection to both parties as well as their respective stakeholders. All too often, existing practices have fallen short of this mark, lacking the correct level of transparency and timeliness of relevant checks. Oversight checks of unit prices are not necessarily undertaken in a timely manner, with post NAV release checks, or even less frequent weekly checks, still being a common practice.

Often oversight checks that were appropriate previously have become inadequate as a consequence of changing industry attitudes as to acceptable practice. Funds are also becoming larger and more complex in an increasingly challenging regulatory environment. At the other extreme, when applying oversight to pricing methodologies and calculations, some funds do take a more heavy-handed approach to avoid pricing errors not being resolved quickly.

Super funds must therefore strike a very careful balance. If they carry out too little oversight, reputational damage, funds outflows and regulatory risk can emerge. However, too much oversight may be inefficient or end up duplicating service provider activities, diluting the intended benefits of outsourcing.

In addition, super funds must often navigate a network of multiple service providers. With a number of outsourcing arrangements in place, there will be different data sets, practices, and operational procedures to oversee.

Effective oversight

Efficiency is key. It is revealing that a high percentage of super funds currently conduct their oversight activities manually, resulting in a relatively high-cost and high-risk environment. Increasingly, this approach is not considered fit for purpose. The process must be as automated as possible. Analysts should not be expending effort on collecting, normalising or manually reviewing data to deadlines; instead they should focus on analysing the results of the outsourced provider. The system needs to enhance accuracy, handling oversight of the entire process, and support data from end to end.

The system must offer transparency, allowing users to identify issues quickly and drill down to underlying data. This is essential in correcting errors as quickly as possible.

The process and system must provide a level of reviewing from the third party providing the service. Independence means different checks being performed to those undertaken by the service provider, rather than a duplication of controls and data sources used. Arguably, this is the most important feature.

Modern sophisticated fund processing systems are vital. Firms need to be able to independently verify the actual NAV and unit price values that the outsourced partner provides – and then compare them to an expected NAV or unit price. A benchmarking capability to allow for comparison against multiple indices, for accurate analysis of mixed portfolios and complex products, is also essential.

Critically, firms must be able to collect and combine data from multiple service providers and data streams. Super funds also need the ability to then recognise, validate, and present the relevant fund valuation data, while monitoring SLA performance and outlier exceptions.

Super funds need to treat oversight as a core business unit and deploy ‘built for purpose’ technology. This will allow for increased confidence that valuations are correct and that costly errors are being mitigated. All this means that Super Funds will be able to stay abreast of global best practice for protecting stakeholder interests where operating models continue to incorporate business critical functions that have been outsourced.

*Enrique Gonzalez is regional product manager APAC, Milestone Group

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