PFS Consulting

Principles of value attribution for Unit pricing and Crediting rates – Business as Usual and Compensation

A framework to guide assessment and implementation

By Jules Gribble, Principal

Introduction

All investment products, superannuation and otherwise, require the attribution of value to investors.  Generally, the changes in value to be attributed at specific points in time (daily, weekly, monthly, …) reflect changes in value of underlying assets.

There are essentially two ways to attribute value.  A unit pricing approach, in which an investor purchases a specified number of units in a transaction and over time the value of these units changes.  Then the value attribution flows through the change in the unit prices.  A crediting rate approach, on the other hand, attributes value through the addition of units to the investors account with the classic example being interest earned on a bank account.  It is perhaps worth noting that while it is generally accepted that unit prices may move up or down depending on the aggregate movement of value of the underlying assets, it is less common to have negative rates of interest applied.  We note that if crediting rates cannot fall below 0.0% then this is a form of investment guarantee to investors.

Investment managers, super funds, trustees and all responsible for the attribution of value to investors in their products clearly have an important obligation to have their value attribution processes work as intended (and promised) and to be equitable and fair to all investors – entering, ongoing and exiting.  Managers need frameworks to assess their businesses and for value attribution to investors in their investment products, the set of principles below gives them such a framework.  For clarity, we note that if there are multiple investment options available in a given product, these principles apply at the investment option level, not at any higher aggregated level.

Management based on these principles must then also be set within an appropriate overarching corporate governance framework.  We do not pursue this overarching framework here but do emphasise its importance all the way up to the senior management and board levels.

The joint APRA/ASIC publication ‘Unit Pricing – Guide to Good Practice’ (the Guide), was initially published in 2005 and updated in 2008.  It is available from both the APRA and ASIC (RG094) websites.  That this document has not required any substantive review of update since then is testimony to its quality and durability).  The Guide is a very useful document and its basis for ‘good practice’ effectively gives the current minimum expected standards of practice for industry.  The Guide is also endorsed by the Financial Services Council of Australia in some of its Standards.

A couple of reality checks

We also suggest it is probably unrealistic to presume that value attribution errors do not occur (perhaps in some contrast to them being discovered).  There are a vast number of transactions done involving value attribution, in bank accounts, credit cards, investment options and superannuation funds every day.  There is real and ongoing challenge to generate assurance that these transactions are being done as properly intended and equitably.  When this is not the case, then the need for remediation and restoration of lost value to adversely impacted investors needs to be considered.

The gulf between setting expectations and their implementation and assessment can be wide.  We call this gulf between theory and implementation ‘Application Risk’: the risk of ‘knowing what to do’ (in theory) in contrast to ‘doing it properly’ (in practice).  To emphasise this distinction, most people can appreciate the theory of building a house, but few can actually execute it.  In the financial services, the investors validly expect a good house to have been built.  In our view, theory may be 5% of the game while implementation is the remaining 95% (think of ‘genius is 1% inspiration and 99% perspiration’).  Application Risk also explains the ongoing litany of major spreadsheet errors.

Generally applicable principles

We consider that the principles given here are consistent with the Guide and apply in both a ‘business as usual’ context, in error compensation exercises, and in situations of stress for unit pricing.

These principles are fully applicable in a crediting rate environment for the attribution of value to investors.

  • Principle 1: Proper Financial Position.  Investors receive the appropriate value for their investments at all times.

Considering unit pricing errors, the need is to return investors, having regard to the materiality of the error(s), to materially the same financial position as they would have been in had the error not occurred.  Practical constraints and considerations need to be recognised.  Investors include active and exited investors.

We highlight the focus on value as opposed to either number of units or unit prices separately.  This is obvious in the sense that value is the product of units and unit prices.

  • Principle 2:   The unit pricing methodology delivers equitable value attribution to all investors.

Considering unit pricing errors, applying equity considerations should take into account the nature of the errors, the data available and the practicalities of the situation.  Equity should also be maintained between active and exited investors.  In practice, equity can be difficult to assess and apply and appropriate materiality considerations need to be reflected.

  • Principle 3: Reflect Unit Pricing Basis.  The unit pricing basis, as disclosed in the relevant PDSs and any other relevant governance requirements, is adhered to.  All relevant constraints and governance requirements applicable by, or on behalf of, the product provider should be met at all times.

Considering unit pricing errors, the compensation outcomes must be consistent with the unit pricing and administrative bases the investor would have expected to have been employed at the time the error occurred. Put another way, the basis for compensation is ‘to redo the processes as they would have been done at the time with identified errors corrected’.   Historic processes, except for those processes or data items identified as being in error (and being corrected), remain accepted.  In the context of evolving practices and industry standards, it is important to ensure that judgements are made in the context of the environment at the time of the error, and not seek to impose current standards on historic situations.

  • Principle 4:   Consistency with External Industry and Regulatory Guidance.  Unit price calculations should be carried out in accordance with relevant industry and regulatory standards and guidelines on unit pricing.

Considering unit pricing errors, assessments should be against guidance in effect at the time of the error.  As with principle 3, we note the importance of not applying current views in a historical context.  Unless applied on an industry wide basis, applying current views may imply different standards in compensation exercises than would have applied to other investors not subject to a compensation exercise.

  • Principle 5: Best Estimate at the Time.  This principle explicitly underlies much discussion in the Guide: ‘The calculation of each element of the unit price should be the “best estimate calculation at the time”’.

This principle is equally applicable in a compensation context.  When reviewing past methodology and its implementation, the issue is not one of whether a ‘best estimate’ was made but rather of whether the estimate historically made can be shown to be inappropriate, either by methodology or implementation, and so unable to be accepted as reasonable.   As with the above principles, breaching this one potentially results in attempting to apply ‘wisdom of hindsight’ to the compensation process.   This raises the spectre of implying that all ongoing business unit pricing processes which cannot meet a ‘wisdom of hindsight’ level of accuracy test sometime in the future will potentially become transformed into errors.

  • Principle 6: Simplicity and Robustness.  The unit pricing process needs to be robust and capable of withstanding stressful conditions, such as market movements of 20% or 30% in a day.

Considering unit pricing errors, the compensation methodology should be as simple as possible while retaining the necessary degree of accuracy and thoroughness to ensure equity.   The methodology should address all the relevant issues, without getting bogged down with immaterial issues.  In practice it is also essential that a compensation methodology can be implemented and be demonstrated to have been implemented.

  • Principle 7: Group – Long Term Interest of Fund.  Investors elect to join a group by joining the fund.  They expect advantages from the group membership, such as better performance and access to more investment options.  However, a consequence of group membership may be, in some particular cases, specific individuals will not be treated identically when compared to their being independent and individual investors.  This ‘group’ principle is fundamental to the existence of collective investment products. 

Considering unit pricing errors, the long term and ongoing interests of the Fund need be considered.  It is inequitable to seek to impose a compensation process which in the longer run leads to current or future investors of the fund being disadvantaged.

  • Principle 8: Independence of Investor Intentions. The assumed behaviour of investors needs to reflect their independence from other members in the group of investors. 

Offsetting and averaging arguments reflect summaries of aggregate behaviour from the perspective of the fund and do not necessarily reflect the perspective of the individual members of the group.  The fundamental conceptual flaw of historic unit pricing illustrates the need for this principle.

  • Principle 9: Independent Reviews.  Product providers need demonstrable evidence as to the appropriateness and validity of the inputs and outputs of unit pricing processes (together with all the steps in between) to be able to provide assurance to stakeholders of the appropriateness of the value changes attributed to investors. 

The Guide specifically endorses this principle.  Considering unit pricing errors, the importance of independent expert review is heightened.

  • Principle 10: Primacy of Investor Interests.  There are typically various stakeholders involved in providing a unitised product and they may have differing perspectives on issues.  This principle reinforces the equity principle by clarifying that the investor is the primary stakeholder.

Considering unit pricing errors, differing parties, such as administrators, trustees and others, may have differing interests that need be recognised, managed and balanced but the primacy of the interests of the investor always remains.

Additional principles for compensation exercises

Some additional principles apply for compensation exercises.  We leave aside the sometimes contentious question of what constitutes a compensatable error.

  • Principle 11: Inclusion of All Identified Issues.  To restore an investor’s financial position, all errors identified during an investigation should be addressed in the compensation, whether or not individually they may be judged to be compensatable.

Errors may arise from methodology, parameters, data or implementation issues.  A compensation exercise may therefore need to reflect the correction of multiple errors that have been identified during the data review process.

  • Principle 12: Compensation at Transaction Level.  The basic building block for determining compensation is to determine the impact of the compensatable error (or errors) for each transaction.

A transaction is the lowest level of data on which the compensation calculations can be based.  So, once adequate data integrity is established, the corrected reprocessing of transactions provides an accurate and focussed approach.  It minimises the risk of generating compensation where it may not be due.

  • Principle 13: Dollar Value of Historic Transactions.  The dollar values of investor transactions are generally established historical facts that should be preserved (barring specifically identified errors).

This is important in assuring adequacy and integrity of data for the purposes of compensation.  It is also important as adjusting transactions requires assumptions that are inherently judgemental and so can be subject to dispute.

Conclusion

The Guide raises many issues, perhaps not surprisingly as it is over 100 pages long and goes into considerable detail.  However, we believe the ‘technical’ aspects of unit pricing can be addressed by applying the principles set out above.

Further information and contact details 

For further information on these principles and their application, please contact Jules Gribble, Principal

Jules can be contacted on:

Email:               julesgribble@pfsconsulting.com.au

Mobile:             +61 (0) 456 801 401