Portability poses problems for trustees

n the last weeks of June this year the Government rushed through changes to portability with effect from July 1, 2005.

The implications were wide reaching and the industry was left with little time to come to terms with the changes. Now a few months into the new rules we are starting to see some of the implications of the new portability requirements and the issues that they raise.

BACKGROUND

Portability is the requirement that superannuation funds transfer a member’s benefits from the fund on the member’s request. This was introduced from July 1, 2004 and applied to accounts that had been inactive for at least 6 months. Prior to the introduction of portability, a superannuation fund had the right to refuse to transfer a member’s benefit. Since July 1, 2005, portability requirements have been extended to active accounts.

The trustees must transfer the requested amount within 90 days, but may refuse the transfer if:

1. an earlier request has been made in the previous 12 months; or

2. the transfer is a partial withdrawal and leaves less than $5,000 in the fund; or

3. the chosen fund refuses to accept the transferred amount.

The Australian Prudential Regulation Authority can suspend a super fund’s portability obligations if it will put the financial position of the fund under threat.

ISSUES

Portability gives members with accumulated superannuation benefits the flexibility to transfer those amounts to other funds. On the surface that appears to be a reasonable change consistent with the Government’s desire to give individuals more choice and control over their superannuation. Unfortunately the superannuation system has become very complicated. So even a relatively simple change can have a number of unwanted consequences. Below we discuss some of the benefit issues like insurance, interest rates and vesting that could lead to additional costs with portability.

Portability and Choice of Fund

The legislation for portability and choice of fund were developed independently. That means portability and choice of fund are not linked and are to some extent inconsistent.

It’s becoming recognised (including by the Government) that members can have portability without choice of fund.

Importantly, that means members without choice of fund can use portability to achieve a similar outcome by regularly transferring their balances to a fund of their choice.

For superannuation funds that don’t charge a benefit or transfer fee (or to some extent subsidise these fees) there is a risk of extra costs arising from regular transfers. This may be part of the reason why trustees have the power to refuse portability requests where another request has been made in the previous 12 months.

However, restricting members’ freedom to transfer their benefits can lead to frustration and dissatisfaction. Therefore, a fund may wish to allow members to make more than one transfer in a 12 month period, subject to a right to refuse excessive transfers.

Minimum balance requirements

The portability requirements include the provision for superannuation funds to refuse partial transfers where the remaining balance would fall below $5,000. The intention was to allow superannuation funds to avoid situations where the member protection provisions applied (the member protection provisions prevent the deduction of expenses in excess of investment returns from accounts of less than $1,000).

Unfortunately, the lack of coordination between portability and choice of fund legislation means that a member could request portability for all their accounts, even though those accounts are still active. In those cases the member will typically receive contributions shortly after exercising portability and will potentially be left with a balance of less than $1,000.

It is not clear whether a request for full portability could be interpreted as a request for partial portability (and hence potentially denied) if the fund were to delay processing the portability request until after a further contribution was received. That approach would certainly not be in keeping with the spirit of the legislation and would frustrate some members.

Insurance

Portability can significantly complicate some insurance arrangements. Where the death or disability formula does not clearly separate the insurance from the account balance (for example, the total death/disability benefit is a fixed multiple of salary or a fixed dollar amount) portability can effectively increase the insurance cover.

For example, if the death benefit in a fund is five times salary, a member with a salary of $100,000 and accounts of $200,000 has a death benefit of $500,000 and effective insurance of $300,000. By transferring their accounts the member can increase their insurance to $500,000 and their total death benefit to $700,000 (the $500,000 from the fund and the $200,000 from the second fund transferred to under portability).

These sorts of situations are not sustainable so many funds will need to review their insurance arrangements to ensure that they aren’t caught out.

Defined Benefits

Defined benefit components are not subject to portability. As the legislation talks about benefit components, rather than members, accumulation accounts for defined benefit members are not subject to portability if they make up part of a defined benefit, for example, through a ‘greater of’ formula.

But accounts such as rollover accounts and voluntary accounts are usually still subject to portability as they are purely accumulation accounts. For defined benefit funds this may mean that each account needs to be reviewed to determine whether it is covered by portability or not.

Communication and Documentation

Once a decision has been made on each of the above issues, the product disclosure statement (PDS) and the trust deed should be updated to cover these issues and explain the requirements for portability. Some of the comments that were typically part of PDSs, such as members can’t take their benefit while they remain employed by their employer, will need to be carefully reviewed.

Family Law Requirements

The family law legislation allowed benefits to be split or flagged. That places certain requirements on superannuation funds when a ‘splittable payment’, for the purposes of the family law legislation, becomes payable. A transfer to another fund under portability will probably be a splittable payment. So a request for the transfer of a superannuation benefit under portability will in some cases trigger family law requirements.

Interest Rate Smoothing

Some superannuation funds continue to use averaging or ‘smoothing’ of actual investment returns when setting fund credited interest rates. Where a smoothed interest rate is used on an account that is subject to portability the fund may be subject to potentially significant risks.

After a period of poor returns members may have received a smoothed interest rate that exceeded the fund’s investment returns. Those higher smoothed rates would have drawn down the investment reserve (or other assets in the case of a defined benefit fund). In the normal course of events the expectation would be that in future, investment returns would exceed the smoothed interest rates and restore the reserve.

However, with portability members can transfer their accumulation balances, having received the benefit of higher smoothed interest rates and avoided lower rates in the future, thereby exercising an option against the fund.

Members’ ability to transfer out of a smoothed interest rate at just the right time means that it will be very difficult, if not impossible, to maintain a smoothed interest rate for accounts that are subject to portability.

SUMMARY & CONCLUSION

The option to transfer superannuation under portability will be a benefit for some members and will allow choice of fund to operate in the way it was intended.

However, if employers and superannuation fund trustees are not careful to review the fine details of how it impacts on their funds they could find that it creates problems and additional costs.