Toolbox: Borrowing in super is still too complex for some clients

Borrowing in superannuation is not as simple as it sounds and a client’s needs and future circumstances still need to be considered carefully as the scope for borrowing is limited and subject to very restrictive circumstances.

To take advantage, superannuation funds must use an ‘instalment warrant’ structure, where the trustee has a right, but not an obligation, to acquire the legal title to an asset by making instalment payments.

The fund has beneficial interest in the asset, with the legal ownership attributed to the fund trustee following the final instalment payment.

As the asset is held in trust for the superannuation fund, where a commercial instalment warrant is not used effectively, a fixed or bare trust outside the superannuation fund will need to be formally established.

This appears to provide some increased flexibility, but we need to consider other legislative provisions and restrictions as well as the inherent investment risks and clients’ profile.

Existing provisions still apply

Superannuation trustees are still prohibited from giving a charge over, or in relation to, an asset of the fund.

This prohibits the transfer of title for existing assets from the superannuation fund to a security trustee in exchange for instalment warrants.

When formulating an investment strategy the trustee must also consider:

n fund circumstances (such as the core purpose);

n risk and return;

n diversification; and

n liquidity and the ability to meet the fund’s cash flow requirements.

Meeting these requirements to a prudent level in the superannuation environment makes borrowing more complex than the non-superannuation environment and may restrict investment opportunities.

Investments must also continue to be made at arm’s length and prohibitions against acquiring certain investments from related parties continue to apply.

New provisions add complexity

1. A trust arrangement is required

The trustee of the superannuation must retain the beneficial ownership of the asset.

This requires the formation of a fixed or bare trust, which has associated costs and administration requirements.

Poor structuring could result in unintended consequences such as stamp duty being incurred twice (varies between state jurisdictions) where a property is purchased by the trust and subsequently by the superannuation fund on payment of the final instalment.

Also, capital gains tax may apply if the fund cannot establish absolute entitlement of the asset.

2. Change in circumstances

If at some stage the superannuation fund cannot pay the warrant instalments and defaults on the loan, the fund will be unable to exercise its right to take ownership of the asset.

This risk can be partly mitigated with appropriate death, disability and salary continuance cover.

3. Lender recourse limited to underlying asset acquired

The rights of the lender in the case of default are limited to the underlying asset acquired with the borrowed money, with no recourse to other assets of the superannuation fund trustee.

The lender is therefore likely to impose a smaller loan to valuation ratio or higher charges, and this may restrict the attractiveness of an instalment warrant.

Other risks and concerns

Aside from the legislative restrictions, the other inherent risks and concerns associated with borrowing to invest need to be considered carefully.

Borrowing to invest exposes your client to both investment and interest rate risks, so your client must have tolerance for these risks and the risks should be considered within the instalment strategy of the fund.

In addition, your client will need to be sufficiently capable and prepared to be a trustee to administer and meet the legislative requirements for a more complex arrangement.

Age, health and financial knowledge and a possible change in circumstances may also be considerations.

It is not always clear what could happen with warrant structures should divorce or bankruptcy change your client’s circumstances.

Although these may be unlikely, they should still be considered.

The simpler borrowing alternative

Warrant structures may be suitable for some clients, but for others, alternatives may be more appropriate.

It is worthwhile considering the many internally geared managed investments as an alternative to the complex trust arrangements.

Retirement may be the longest life stage for many clients, so the superannuation nest egg must be invested appropriately.

As such, careful deliberation needs to be undertaken with regards to whether a person is a suitable candidate for instalment warrant arrangements for their superannuation fund.

Martin Breckon is the technical marketing manager at Aviva Australia.