SMSFs: taking control of retirement income

While the simplified superannuation changes have been the most significant development in superannuation in a generation, they have not diminished the main attraction of self-managed superannuation funds (SMSF), which is control.

SMSFs provide control over investments, pension features and service providers.

From this control, SMSFs can provide super that is handcrafted to suit the particular circumstances of a member as opposed to the uniform product of the large product manufacturers.

Control over investments

In respect of investments, SMSFs provide much greater control than public offer or industry funds.

The trustees of SMSFs are able to choose to invest in asset classes that, for prudential or administrative reasons, public offer or industry funds cannot.

In particular, SMSFs have access to the ‘real business property’ exception.

Another aspect of the investment control offered by SMSFs is the greater ability to tailor the investment strategy of the fund to the particular circumstances of the members.

Where there are at most four members (but often only one or two members), the investment strategy can be very readily tailored to the particular circumstances of the members, including the non-superannuation circumstances of the members.

Public offer funds and industry funds cannot readily match such individual tailoring given the membership size of such funds.

While both SMSFs and other super funds can invest in derivatives, the prudential regulation that applies to derivative investments made by non-SMSF funds is significantly more onerous than derivative investments made by SMSFs.

Further, trustees of funds other than SMSFs tend to impose a number of administrative hurdles in the way of clients who wish to invest in derivatives.

One aspect of investment control that is likely to feature more significantly in the future is the greater ability of members of SMSFs to manage the tax attributes of their investments.

Members of SMSFs are in a better position to refresh the capital gains tax (CGT) cost base by selling of assets and offsetting the gains against CGT losses.

Once the fund moves into pension phase, cost base management of the pension assets can be more readily achieved to minimise the CGT cost if and when the fund reverts to accumulation phase.

Pension features

Control over the features of the pensions payable from SMSFs is a particular advantage that SMSFs have over public offer and industry funds.

The issue here is not merely whether the fund will be able to pay (the new style) of allocated pension (which will be available from July 1, 2007), but the features of the new style allocated pension the fund will permit the pension to possess.

In particular, can the pension be partially rolled back to accumulation phase, that is, whether the pension can be ‘switched on/switched off’ as the circumstances of the member change?

Can the fund easily operate with a member in pension phase also running an accumulation account to which surplus pension amounts can be credited?

Can the pension drawdown amount be increased or reduced, and can lump sums be withdrawn from the pension account — whether as a partial commutation of the pension or simply as an additional pension payment?

Also, can the client direct the application of the pension account balance that remains on their death?

Can the client specify both the recipients as well as the form of the benefits?

Where part of the remaining account balance must be allocated at the discretion of the trustees, the deceased member can have greater control over the exercise of that discretion in SMSFs, as the executor of the deceased member can participate in the allocation decision (by reason of being the trustee standing in for the deceased member) and exercise the allocation discretion having regard to (but not necessarily bound by) any memorandum of wishes that the deceased member provided to the executor.

Control over service providers

SMSFs are not self-operating investment vehicles but require the skills and services of a number of service providers, in particular, accountants, auditors and investment advisers.

One key advantage of SMSFs is the control that the members (by reason of being the trustees or directors of the company as trustee) have over the service providers.

The members can select the service providers and can specify the service providers’ duties and engagement terms.

The members can also determine to change service providers to appoint replacement advisers or restrict or expand the duties of the service providers.

In public offer and industry funds, members have no control over the identity of or scope of the duties of the service providers.

In small Australian PrudentialRegulation Authority (APRA) funds (funds with less than five members that are regulated by APRA and the trustee of which must be an APRA licensed company), members have very little (if any) control over the service providers.

Understandably, the trustees of small APRA funds will, for cost, control and administrative ease, appoint the same suite of service providers to all the funds of which they are the trustee.

Pitfalls

SMSFs have been described using various industry names, such as DIY funds and private superannuation funds.

While the name SMSF is rather boring, it has the advantage not being misleading — consider the name DIY fund.

There is almost nothing DIY about SMSFs (unless the client has a very strong background in accounting, tax and superannuation). Consequently, most SMSF clients will have to engage various service providers — at the very least an accountant, auditor and investment adviser.

One of the most significant pitfalls for clients in relation to SMSFs is the belief that they can provide all the various services required to manage the fund themselves.

Another pitfall is when the client realises they must outsource various functions in relation to the SMSF and then either fails to adequately oversee the outsourcing or simply disregards the outsourcing arrangement.

For example, making their own investment decisions and then subsequently advising the investment adviser of the investment, usually some considerable time later.

Perhaps the most significant pitfall is when the client simply fails to distinguish between the various roles they are playing in the SMSF.

Unless the client has previous experience in managing trust arrangements, they may simply treat the SMSF as their private pool of assets — which can be accessed at any time and invested in any manner they so wish.

With the simplified superannuation regime, this risk is likely to increase once the SMSF changes from accumulation phase to pension phase and the fund becomes tax exempt and the payments out of the fund become tax free.

A review of the key contraventions identified by the Australian Taxation Office in respect of SMSFs (based upon Auditor Contravention Reports lodged in the period July 1, 2004 to December 31, 2006) have as a common theme of members not appreciating the different roles they play in the management of the fund.

The most frequently reported contravention was “loans made to members or a relative”.

If a member does not appreciate their respective roles, then the member may inadvertently use SMSF monies to discharge personal debts by debiting the fund’s bank account when they should have debited the member’s own bank account (which seems to be the most common form of this breach, rather than a loan to a member or relative which is intended to be an investment of the fund).

Future directions

One of the most significant changes to superannuation over the previous 30 years has been the change from it being purely occupationally-based deferred income to, essentially, a tax-advantaged private investment fund.

The 2004 changes to superannuation (removal of the work test for contributions made before age 65 and the introduction of transition to retirement pensions and the simplified superannuation change removing of mandatory cashing requirements after age 65) means superannuation is no longer occupationally based.

Superannuation will now be a tax advantaged private investment vehicle. Consequently, super will become a wealth accumulation and holding vehicle and have a life beyond retirement.

Also, the removal under the simplified superannuation changes of taxes on benefits accessed, whether as a lump sum or as a pension, after age 60 means there will now be a very strong financial incentive to keep investments in the super system after age 60, as the assets that are supporting pensions will now be in a tax exempt environment. Because of this, superannuation will become the preferred vehicle in which to hold assets after age 60.

The price for holding assets after age 60 will be the requirement that the assets support a pension (otherwise the assets will remain in a taxed environment). For many, this may not be a significant price at all — given that pension income is tax-free after age 60.

The introduction of transition to retirement pensions, the removal of post-65 mandatory cashing requirement and the ability (if they are gainfully employed on at least a part time basis) to contribute to and claim (if they are unsupported) deductions for contributions to super in the 65-75 age bracket means the concept of retirement has been significantly diluted, if not made redundant.

If there is retirement (in the sense of the term that existed in the 60s or 70s), it is likely to occur closer to 75 than 65.

These changes mean that in the future:

~ clients will access their benefits as pensions rather than as lump sums;

~ clients will try to transfer non-super assets into super in order to gain advantage of the tax-free status of super assets that support pensions;

~ clients will be keenly interested in maintaining ‘part-time gainfully occupied’ status in the age bracket 65 to 75, so that super investments can be fed by the transfer of non-super assets into super and by the making of deductible contributions;

~ clients will want flexibility in relation to their pensions — not simply the drawdown amount — but flexibility to revert all or a portion of the pension back to accumulation status so pension drawdowns can be precisely tailored to their particular cash flow needs;

~ clients will increasingly need and value advisers who can effectively manage their retirement cash flow needs and the CGT liabilities of their pension assets — by regularly refreshing the cost base of pension assets to minimise the capital gain when the pension terminates;

~ clients will soon become aware of the need to finance their aged care accommodation — by retaining sufficient assets in their super to finance the accommodation bond by drawing down on their super; and

~ clients will also become increasingly aware of using super as a generation asset transfer by withdrawing (once they are 60 and able to access super lump sums tax free) capital from their super account and making a superannuation contribution for their minor grandchildren.

For these reasons, the number of SMSFs is likely to increase.

However, the increase is unlikely to be triggered merely because of July 1, 2007.

The driver for the establishment of a SMSF will be when a client undergoes a transition event such as change of employment, commencement of a second career, commencement of a transition to retirement pension or retiring.

Michael Hallinan is special counsel at Townsends Business and Corporate Lawyers.