Keeping an SMSF investment strategy on track
Self-managed super fund (SMSF) trustees are ultimately required to take on many responsibilities. From being the decision point for all fund actions, to managing the fund prudently for the benefit of all fund members – all while being aware that they, as members, will not have access to any special compensation schemes or access to the Australian Financial Complaints Authority (AFCA) if something goes wrong. It’s a lot to take on, and a financial adviser can help trustees understand how both superannuation and tax law may apply in their circumstances.
A key responsibility for any trustee is ensuring the fund has an investment strategy, which is appropriate, regularly reviewed and managed for the benefit of all fund members. An investment strategy is all about having a plan in place to manage the fund’s assets in a way that the trustees expect will meet the members’ retirement objectives.
Superannuation law specifically requires all SMSF trustees to ‘formulate, review regularly and give effect to an investment strategy’ that not only has regard to the whole circumstances of the fund, but includes the specific considerations discussed below.
With this in mind, an investment strategy should not just be a document simply repeating the requirements of legislation, but a live document tailored to the relevant circumstances of the fund. As circumstances change, so should the plan, to ensure things remain on track.
SPECIFIC LEGISLATIVE REQUIREMENTS
While there is no prescribed format for an investment strategy, nor does it technically have to be in writing, a fund’s trustee(s) may have trouble demonstrating they have met their various legislative requirements without having documented evidence of this having occurred.
An investment strategy is required to consider the following specific factors:
- The risks involved in making, holding and realising, and the likely return from, the entity's investments, having regard to its objectives and expected cash flow requirements;
- The composition of the entity's investments as a whole, including the extent to which they are diverse or involve exposure of the entity to risks from inadequate diversification;
- The liquidity of the entity's investments, having regard to its expected cashflow requirements;
- The ability of the entity to discharge its existing and prospective liabilities; and
- Whether the trustees of the fund should hold a contract of insurance that provides insurance cover for one or more members of the fund.
GUIDANCE FROM THE REGULATOR
While these specific requirements provide direction to fund trustee(s), further guidance over time has been provided by the Australian Taxation Office (ATO) to help trustee(s) understand their responsibilities.
One of the first points which challenges trustees is the requirement to ‘give effect to an investment strategy that has regard to the whole of the circumstances of the entity’.
Giving effect simply means the trustee(s) have ensured the fund’s investments are held in accordance with the investment strategy and the investments and strategy remain on track to provide for the members’ retirement goals and objectives.
ATO guidance suggests an investment strategy should be reviewed at least annually, with the trustees ensuring they document this review, including any decisions arising from it, to demonstrate they have met the requirement to ‘review regularly’ the fund’s strategy.
The fund’s auditor will also want to check each year that the SMSF has an investment strategy, the investments were held in accordance with that strategy, and the strategy has been reviewed.
Significant events may require the strategy to be reviewed more regularly than on an annual basis. For example, where new members join or existing members depart the fund, the investment strategy may need to change.
Where a member commences a pension, or a lump sum benefit is requested, the fund’s investments may need to be restructured to manage the payment of a lump sum or to provide the ongoing liquidity needed to meet the regular pension payments.
Having regard to the composition of the fund’s investments, including diversification, is probably the next area trustees need to understand when it comes to formulating and managing the fund’s investment strategy. This requirement tends to raise such questions as ‘do my fund’s investments need to be diversified?’ or ‘is it appropriate if all my fund’s investable assets are invested in one single asset such as a property, or in a single asset class such as direct Australian shares?’
In late 2019 the issue of diversification was raised when the ATO issued correspondence to nearly 18,000 SMSF trustees who may have held 90% or more of their fund’s investment in one asset, or a single class of assets.
Ultimately the ATO’s correspondence was a reminder to trustees that they are responsible for ensuring the fund’s investment strategy meets the requirements under superannuation law. It also prompted trustees who had a high concentration in a single asset or asset class, to provide additional details in their investment strategy, or in notes accompanying the strategy, around why they consider their investments to be appropriate, in light of the legislative requirement to consider diversification as part of the investment strategy.
Alongside considering how the fund may discharge its existing and prospective liabilities, expected cashflow requirements is mentioned twice.
One of the more obvious situations where this consideration would become a reality is where the fund starts paying a benefit to its members, in the form of either an income stream payment or member benefit lump sum. The timing of such payments may be expected, such as when a member attains their preservation age or retirement, or at other times unexpected, such as a premature death benefit or disability income stream payment.
An SMSF also has an ongoing liability to manage annual tax payments, plus the associated operating expenses of the fund such as accounting, auditing and sometimes advice services fees.
Where an SMSF invests in direct property, the fund may have repairs, maintenance, and other ongoing operating expenses which need to be considered.
When the fund has borrowed to purchase an asset, such as a direct property, under a limited recourse borrowing arrangement (LRBA), meeting ongoing loan repayments need to be considered.
The requirement to take into account the liquidity of the fund’s investments sits alongside considering cash flow requirements. Where the fund holds an investment which may not be immediately liquid, can the fund’s ongoing liabilities be met by the investment returns, such as rent or distributions; or are the regular contributions being made my members predictable and reliable enough to assist in providing the liquidity the fund needs?
The requirement for fund trustee(s) to consider whether they hold insurance for a fund member was enacted back in August 2012. Similar to the requirements to consider cashflow and diversification, there is no compulsion for a fund to hold insurance cover for a fund member; the trustee(s) simply need to consider whether it is appropriate or not to do so.
APPROACHING AN INVESTMENT STRATEGY
While not specified how, trustees still need to demonstrate they have implemented their fund’s investment strategy. A common way to do this would be to include target allocations, generally percentages, to various assets or asset classes.
Alternatively, if asset allocation ranges aren’t chosen, a trustee could list the material assets of the fund in the investment strategy. Including a statement as to why investing in the nominated asset or assets will achieve the retirement goals of all fund members would be helpful to support such a strategy.
As the range of investments options continues to grow, the best way to look at where and SMSF trustee could invest is to look at it from the perspective of what is not allowed. A trustee is free to choose from virtually any type of investment, provided that the investment is firstly permitted, or not otherwise prohibited by the fund’s trust deed, is not prohibited under super law, and meets the sole purpose test.
Common considerations for SMSFs in this area often include the acquisition of assets from related party rules, in-house asset considerations, and non-arm’s length income and expenditure rules for income tax purposes.
Finally, what happens when an SMSF’s investment strategy is not compliant?
The ATO can take compliance action against trustee(s) when fund’s investments breach super laws, or when investment strategies don’t meet the requirements. The ATO has a range of measures to deal with non-compliance more broadly from education or rectification directions through to administrative penalties or disqualification of a trustee.
When it comes to a fund’s investment strategy, a breach that has not been rectified can result in a penalty of $4,440 for each individual trustee or the corporate trustee.
While the role of an SMSF trustee carries with it a number of responsibilities, the ongoing implementation and review of the fund’s investment strategy is essentially important from both a legislative and member outcome basis.
Tim Howard is a technical specialist at BT.
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