SMSF investment strategy under the spotlight

When the Australian Taxation Office (ATO) sent letters to nearly 18,000 self-managed super fund (SMSF) trustees and their auditors in 2019, it raised concerns about the investment strategies behind those retirement savings – and whether member goals were being met.¹

The notice targeted SMSFs who had invested 90% or more in one asset or asset class, and who also had a limited recourse borrowing arrangement. In 99% of these funds, this was used to acquire property.² They were asked to check their investment strategy, to ensure it complied with the diversification and other requirements stipulated in paragraph 4.09(2) of the Superannuation Industry (Supervision) Regulations 1994 (SIS).

Many accountants are still working on responses to the tax office. As administrators and auditors for these SMSFs, they are re-wording investment strategies to ensure they meet requirements. However, unless they hold an AFSL, they are not able to give investment advice. 

So how can accountants best support their clients to ensure they are adequately managing investment risks – and meeting their legal obligations as trustees?

David Barrett, our Head of Technical Advice Services, says the ATO has access to many years of SMSF investment data and has picked up on “heavy concentration in particular assets classes – such as property. They would see that as a risk.”

Australian investors have traditionally been comfortable investing in bricks and mortar property, and Barrett says “SMSFs have provided a tax effective vehicle to do this. For example, if you own a business your SMSF can, in certain circumstances, invest in the premises.” 

However, recent market volatility has highlighted the risk of concentrating investments in any one asset class – whether that’s global equities or residential property. 

“These SMSFs are heavily exposed to property market value fluctuations,” explains Barrett. “And some trustees of SMSFs with property assets may now be struggling with unanticipated tensions. On one hand, they might need to meet mandatory requirements to make pension payments, but as landlords they are also expected to negotiate rent reductions with tenants experiencing hardship due to COVID-19 restrictions.”

The ATO’s warning does not mean SMSFs can no longer invest solely in property. But trustees do need to demonstrate they have considered the fund’s objectives, and diversification and liquidity risks, as part of their SMSF investment strategy. Otherwise, they could face an administrative penalty of $4,200.

Responsibilities for trustees

Under the SIS Regulation 4.09 referred to by the ATO, SMSF trustees must formulate, review regularly and give effect to an investment strategy that has regard to the whole of the circumstances of the entity including the following:

• the risk 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 cash flow requirements.

To ensure funds comply, trustees need to provide written evidence of how diversification, liquidity and risks have been considered. The ATO has specifically called out that “when formulating your investment strategy, it is not a valid approach to merely specify investment ranges of 0 to 100% for each class of investment.”

Barrett says the ATO’s position is “perfectly reasonable: you can’t just define your SMSF investment strategy to be the universe of possible investments, which is effectively what you’re doing when specifying investment ranges of 0 to 100% for each and every class of investment.”

But he says it’s possible to specify a broad range for a specific asset class when it makes sense to do so. For example, if the trustees are planning to sell the property in the forthcoming year, the range might be 0 to 90%, or even 100% – but the investment ranges for cash, bonds and equities may be more narrowly defined.

Barrett suggests focusing on three fundamental components to an SMSF strategy, and regularly reviewing this strategy in line with requirements – which means at least annually.

• Overall fund investment objectives: including return objectives and cash flow requirements. This may change as SMSF members move closer to retirement age, for example.
• Diversification requirements: a diversified portfolio helps spread the risk of investments. The ATO explains “While a trustee can choose to invest all their retirement savings in one asset or asset class, certain risks such as return, volatility and liquidity risks can be minimised if a trustee chooses to invest in a variety of assets.”³
• Liquidity requirements: a certain proportion of funds may be needed to satisfy pension payments, operating expenses, ASIC levies and/or death benefits. Property investments are not as liquid as cash holdings, for example.

Diversification concerns may have triggered the ATO letters, but it’s also important to consider liquidity requirements.

“There’s a real tension between what you should and shouldn’t do when in the retirement phase around your asset allocation,” explains Barrett. “Liquidity is much more important than during the accumulation phase, but cash can act as a drag on your overall returns. At the same time, market volatility is a bigger concern as retirees may not have as much time to recover from a market shock.”

More than one in three SMSFs use a Macquarie Cash Management Account (CMA) to manage their money.⁴ It’s an efficient and transparent platform for managing the liquidity component of an SMSF’s holdings, allowing funds to be easily moved into other assets as opportunities arise.

Macquarie’s recent whitepaper, Hidden risks in a safe haven, highlights the importance of active cash investment management in the current low interest environment, and explores the options for balancing liquidity, return and capital preservation. As this chart from the whitepaper shows, there is always a trade-off between risk and return.

And this is ultimately what SMSF trustees need to demonstrate they have considered in their investment strategy. As long as trustees document that they have taken the fund’s objectives and cash flow requirements into account when considering investment risk and return issues, including suitable diversification and liquidity, they should be able to satisfy the ATO’s concerns.

To learn more about the role of cash in an SMSF portfolio, download our Hidden risks in a safe haven whitepaper.